Responding to inflation and volatility: Time for procurement to lead

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Key inflation statistics as of mid-2021 include the following:

  • The US Consumer Price Index is up 5.4 percent for the 12 months ended June 2021—its highest level since August 2008. In Europe, inflation surged past the European Central Bank’s target of 2 percent in May 2021.
  • While lumber and steel prices have fallen from their 2021 peaks, they remain up substantially compared with mid-2020; by more than 75 percent for lumber and, at the time of publication, more than 200 percent for steel. Polyethylene prices have also reached historic highs in 2021, diverging from long-standing correlations to the prices of oil and ethylene.
  • In July 2021, the US Bureau of Labor Statistics reported that the US unemployment rate in May 2021 was down to 5.9 percent (from 13 percent a year earlier) and the share of unfilled job openings across nonfarm industries had risen to 6 percent—its highest figure in more than two decades.
  • Companies are facing yet another major macroeconomic disruption after the sudden COVID-19 crisis and deflationary environment in 2020 and trade tensions in 2018 and 2019.

As the old saying goes, “the only constant is change,” and this is as true today as ever. Companies are navigating an uncertain market—inflation, capacity constraints, and supply-chain disruptions are challenging traditional savings levers. None of these variables is new by itself. However, their combination and the velocity of change coming out of the COVID-19 crisis is generating new forms of financial and operational risk—steering many organizations into uncharted waters.

With constant change creating new challenges and opportunities at every turn, corporate resilience has taken on renewed importance. Procurement and supply-chain functions are playing a critical role in enhancing resiliency by serving as orchestrators between a business and its suppliers. To build on their success, they will want to take a broad set of actions across several time horizons:

  • Here and now, procurement ensures supply and price stability.
  • For the medium term, companies will deploy an advanced volatility toolbox, with a broad range of levers to minimize costs.
  • To be ready for the future, companies will institutionalize the cross-functional approach and volatility toolbox as part of their next-generation procurement approaches.

One of the most promising early-stage approaches within this broad set of actions is a procurement nerve center. The structure brings together specialists across the value chain—from supply chain, planning, finance, operations, and engineering—to triage supply-availability problems for raw materials, components, and related inputs. In a centralized, strategically informed way, a nerve-center team accelerates a company’s response to uncertainty. When facing inflationary pressures, a nerve center collaborates to capture cost savings, find and approve alternative commodities and their sources, and develop deeper partnerships with key suppliers to generate additional sources of value.

Companies that implement nerve centers effectively can structurally improve their cost base, protect and enhance margins, and drive organizational alignment. For example, a basic-materials company reduced a major supplier’s price increase by more than 20 percent, and a component manufacturer successfully navigated supply and price volatility in semiconductors and steel.

Trends are fueling uncertainty

A wide range of factors, including rising commodity prices, supply-chain disruptions, expansionary economic policies, tightening labor markets, and the sustainability imperative are driving the current market uncertainty and inflation.

Rapidly increasing commodity prices largely reflect the impact of the COVID-19 pandemic on the business environment. In response to abrupt shifts in consumer demand and rebounding economic activity, some raw-material prices have hit all-time highs. Lumber prices, for example, more than doubled in early 2021, while the price of steel (hot rolled coil) has risen by more than 150 percent in the same period as voracious raw-material demand compounded supply scarcity.

With input prices soaring, many companies reported higher costs in the first quarter of 2021 and fear that inflation may continue. Identifying and implementing approaches to minimize exposure and protect margins has vaulted to the top of many C-suite agendas.

Effective responses demand cross-functional collaboration

To respond to the urgent challenges in the current market, as well as any future uncertainty, procurement organizations can apply a much broader set of levers to create value. Many will rely on cross-functional collaboration. Breaking down silos and enhancing visibility among functions will be even more important.

Failing to coordinate across functions can have expensive consequences. One procurement organization stockpiled steel from various suppliers in anticipation of further price increases. However, because procurement did not coordinate with the supply-chain team, the warehouses were inundated with so much steel that it had to be kept outdoors. After a few weeks, the company was sitting on a pile of rusty steel—and a bleeding balance sheet.

Monthly business reviews or quarterly supplier workshops are not enough to handle fast-moving prices.

To avoid this sort of mistake, companies can build an infrastructure that enables rapid collaboration and execution on many initiatives at once. Monthly business reviews or quarterly supplier workshops are not enough to handle fast-moving prices. A company that relied on monthly meetings among its supply-chain, operations, and procurement teams needed more than 30 days to decide on its action plan to counter inflation and then another 30 days to execute. Within those two months, steel prices had increased by close to 50 percent.

These imperatives to plan for market uncertainty will likely remain relevant after the current inflationary concerns subside: our colleagues’ recent research on supply chains estimated that significant disruptions to production now occur every 3.7 years, on average. Uncertainty therefore appears set to persist in the business environment as markets and businesses regain their footing in the postpandemic world.

In this era of upheavals, procurement leaders have an opportunity to reinvent their function and broaden their mandates to promote greater resilience. To fulfill this broader mandate, procurement needs an end-to-end operating model that promotes the creation, preservation, and enablement of value (Exhibit 1).

Top procurement organizations have an end-to-end operating model focused on three sources of value.

The nerve-center approach in action

Enabling cross-functional collaboration here and now is the first phase of the chief procurement officer’s response road map, which also includes taking action to deploy advanced solutions and institutionalizing the new capabilities and tools (Exhibit 2).

The chief procurement officer’s road map helps a company fight inflation and volatility.

To address the immediate challenges, companies can benefit from launching inflation nerve centers that illuminate supply-chain risks, control spending, and accelerate collaboration—all in comprehensively addressing exposure in critical categories. The approach helps guide decision making so that rapid responses can focus more on strategic implementation and less on firefighting. Here’s how it works.

Launch the nerve center

The nerve center brings together a team of specialists from the supply chain, planning, finance, operations, and engineering. On day one, the team sets up the crucial working infrastructure, including the activity cadence and dashboards that track progress on initiatives. From that point, impact can take as little as five weeks.

Prioritize categories based on exposure

Within the first week, the nerve-center team prioritizes categories based on an exposure matrix considering inflation (or deflation) and the degree of exposure to the market forces (Exhibit 3).

Understanding which categories face inflation and their current contract terms helps in crafting responses

Inflation can be assessed using index trends and futures, triangulating indexes if required. The impact of the index change should be applied to the raw-material portion of the spend—making a “should cost” understanding of the category very valuable. Exposure is highest in index-based contracts (those that use indices for price adjustments), along with spot buys and contracts that are up for negotiation in the next three to six months. This approach yields a clearer view of which categories teams need to “defend” against inflation, and which offer opportunities.

Understand should costs and embedded costs

Negotiation practices offer further opportunities to counter inflation. Tactics such as bundling separate purchases to enable volume discounts and using should-cost models based on current prices to understand suppliers’ underlying cost exposures can create new saving opportunities. A more sophisticated approach creates an embedded-cost analysis for further illumination about what is driving prices, what is happening with those cost drivers, and how to use these insights in negotiations (see sidebar, “Questions an embedded-cost analysis can help answer”).

These sorts of tools helped a basic-materials company respond to a 40 percent price increase from a critical supplier. The company’s detailed analysis of the supplier’s embedded costs revealed that the supplier had significantly overstated raw materials’ share of overall price economics. Applying this insight in its negotiations, the company was able to mitigate the proposed price increases by almost one-quarter.

Identify an expansive set of mitigation levers

An expansive set of commercial and technical levers is available to support a defensive position against inflation. Some levers have immediate impact (to mitigate cost increases), while others are forward looking (to boost resilience). For each category, a nerve center helps identify potential commercial and technical levers and design their implementation:

  • Commercial. Immediate commercial opportunities to mitigate volatility typically include maximizing the spend on existing contracts that are not reflecting inflation, or demanding clawbacks on commodity dips over previous time periods in which prices remained flat. Digital and analytics solutions can deliver should-cost models quickly for large portions of spend, allowing the team to quantify the extent to which inflationary pressure on material will affect supplier prices. To improve future resilience, supplier collaboration can drive joint efficiencies and improve the total cost of ownership. Finally, companies can consider ramping up collaboration between pricing and procurement teams to weigh possible effects on the prices the company itself charges.
  • Technical. Immediate defensive technical levers include accelerating value engineering and adjusting batch sizes or order frequency. A longer-term technical lever to improve resilience can often be found through reducing SKUs or high-cost features and attributes by modifying specifications. To address volatility in the short term, opportunities include optimizing the supplier footprint for better control over logistics, cost, tariffs, and inventory. In the longer term, technical levers that challenge volatility may include strategic stockpiling of inventory, relying more on vendor-managed inventory, expanding cross-industry collaboration to share commodity exposures, and partnering through the end-to-end supply chain to derisk certain nodes.

Time is of the essence with both levers. An automotive supplier confronting steel and semiconductor inflation set up an inflation nerve center that applied commercial and technical strategies in tandem. After identifying the specific categories under the most pressure, the procurement team took action to broaden the supply base, using analytics to sharpen negotiation tactics and craft deals for volume discounts. Meanwhile, value-engineering efforts reduced internal demand for high-cost components and enabled substitutions. The combination produced double-digit savings that not only met immediate needs but also reduced costs at the structural level for better long-term resilience.

Now is the time for procurement to lead value capture

Now is the time for procurement to lead value capture

Learning from nerve centers

Several important lessons have emerged from the companies that have been early adopters of nerve centers:

  • Keep your friends close. Companies can identify which suppliers are their true strategic partners. The best incumbent suppliers will continue to collaborate.
  • Waste not, want not. Reducing waste helps companies get through short-term challenges. Moving inventory and consumption control to top of mind is critical and can help over the long term as well.
  • Share and share alike. Raw-material prices affect both buyers and suppliers. Each party is interested in incentives, creating real opportunities to create win–win outcomes.
  • Increase value by design. The time is right to revisit value engineering and design to value. Changes to material costs can change business cases and offer the largest savings.
  • Plan for the long term. Suppliers want to plan ahead. They value long-term commitments and are willing to give something in exchange.

In a world of growing uncertainty, procurement can deliver significant value to enterprises, but only if it is armed with the right capabilities for pursuing sophisticated approaches. The nerve-center approach makes this possible by enabling rapid assessments of the market situation and fast action for greater resilience.

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