6 Ways to Manage Price Volatility in Procurement
In early 2020, with the Covid-19 crisis unfolding, the price of Brent Crude Oil fell from $70 to $20 per barrel in a matter of months. By February 2022, due to global economic recovery and the Russian invasion of Ukraine, the Brent Crude Oil price had risen six-fold, to over $120 per barrel. Even within the month of March 2022, as sanctions hit Russia, the commodity price rose and fell by up to 20% multiple times within a period of weeks.
The World Bank has warned that in 2022 and beyond, the global economy will suffer ‘the largest commodity shock’ since the 1970s, with further rises in not only oil, but also natural gas, wheat, cotton... the list goes on. Experiencing the brunt of the market volatility in your company will be the procurement department. Suppliers will go out of business or call-in demanding price rises. Meanwhile, the sales department will want to hold commodity prices in order to maintain sales volumes in a disrupted market, and the board will be busy protecting against the complications caused by the underlying reasons for price volatility. Margin will suffer, or, worse, the deliverability of the goods and services themselves will be at risk.
‘The true investor welcomes volatility.’
Improperly managed, price volatility can quickly become an existential threat. But, as most stock market investors will tell you, volatility is not something to be feared. Indeed, it was Warren Buffet who said ‘The true investor welcomes volatility.’ To some extent, the same goes for the ‘true procurement department’ who, in their day-to-day operations and supplier agreements, are fully prepared for price fluctuations.
In this article, we first review the reasons for price volatility and the challenges it can cause for the procurement department. Then, we provide 6 procurement levers you can employ to handle price volatility in procurement.
What causes price volatility in procurement?
In short, anything and everything can cause market volatility. Pandemics, conflict, drought, recession: in the last few years we’ve seen it all. Perhaps when NASA spots a meteor on a collision path with Earth, we can claim to have completed the set. But in all seriousness, what exactly are the mechanics of market volatility? What is causing the volatile prices?
The price of a commodity is, as we all know, determined by supply and demand. Simply put, anything that affects either the supply or demand of a commodity will shift the equilibrium price. Depending on the elasticity of the supply and demand, the equilibrium price will change by a little or a lot.
In the last two years (2020-2022) we have witnessed shifts in both demand and supply, causing downward and upward pressures.
As the pandemic hit, demand for a number of commodities fell sharply: demand for travel was greatly reduced and so the price of oil fell; construction companies halted operations and so the demand and commodity prices of steel and timber declined. Downward pressures were felt by commodities across the board.
Then, as the global economy recovered, the commodity markets found themselves not only experiencing an increase in demand, but also a shortage of supply. During the downturn, the commodity producers had cut back production to reduce their fixed costs, and they could not upscale operations quickly enough. Add to this the supply chain disruptions caused by events such as the blocking of the Panama Canal and the war in Ukraine, and the supply challenges intensified. Commodity prices recovered and then rose above pre-pandemic levels.
As is often the case, price volatility originates from seemingly unique market conditions. Few could have predicted a novel corona virus and all of its subsequent variants sweeping the globe in 2020; and the invasion of Ukraine is, hopefully, an international aberration. But we can generalise such events into a number of categories that help us understand the impact of similar conditions.
- Weather & Climate: Depending on seasonal weather conditions and temperatures, the demand for fossil fuels to heat homes will change. For example, cold winters and high demand lead to high prices. Similarly, poor growing conditions due to extreme weather reduce the supply of food, leading to increased prices; excellent growing conditions can produce a bumper crop, reducing prices.
- Conflict: Disruption on the international stage will almost certainly impact supply, whether it be due to an inability to produce in conflict zones, or by the introduction of international sanctions on belligerent states, disrupting established supply channels.
- Economic downturn or recession: Reduced spending by consumers and reduced investment in e.g. infrastructure will typically lead to reduced demand and prices. The converse is true in times of economic recovery or boom.
- General supply chain disruption: From blocked trade routes to component shortages, when production or the movement of goods is disrupted, prices will generally increase.
Needless to say, each event affects the global economy in its own unique way, particularly when drilling down to the impact on individual commodities – wheat production from major food producer, Ukraine, for instance. The impact of each event should therefore be analysed on a case-by-case basis.
What are the key challenges caused by price volatility in procurement?
Typically, between 10-50% of the manufacturing cost of a product is attributable to the cost of the raw materials. Factor in how, for example, oil prices affect logistics costs and how inflation impacts workers’ wages, and it’s easy to see how market volatility impacts not only the prices procurement pay for commodities, but for any good or service.
Rising commodity prices are obviously an issue for an unprepared procurement department. Either margin will shrink or there is a decision to be made about increasing sales prices and risking customer loyalty. But equally difficult challenges are met when encountering falling prices.
For example, when commodity prices fall, but the procurement department is contractually beholden to prices agreed at a higher commodity price, the company has forgone an increase in margin or the opportunity to lower prices and gain market share. It gets worse if a competitor has agreed purchase prices that track commodity prices: the company might see its prices undercut. In such circumstances, market share ebbs away and the company can find itself in the midst of an existential crisis, the same way it might when experiencing a margin squeeze during rising commodity prices.
Furthermore, the challenges caused by market volatility are not limited to the prices paid. As explained, volatile prices and markets are often caused by supply issues, which can have the following knock-on effects:
- Missed delivery dates: Agreed delivery dates with customers are at risk when there are delays in the supply chain, causing contractual issues or missed business opportunities.
- Competition with more profitable industries: When commodities are in short supply, more profitable industries are able to afford increased commodity costs. Less profitable industries suffer disproportionately.
- The rise of low-cost competitors: When belts tighten in the face of rising commodity prices, the importance of price in the procurement decision-making process – and the retail customer’s decision-making process – increases. If a company offers a premium product or a service with benefits that are difficult to quantify financially, it may be elbowed out by the low-cost competition.
- Uncertainty in production planning: For production involving volatile commodities, planners must work in a degree of risk. Over-planning production leads to resource downtime and unnecessary cost, while under-planning leads to missed opportunities and costly inventory.
So, among great supply and price uncertainty, how does a company set itself up for success?
How to manage price volatility in procurement
Price volatility doesn’t have to be all doom and gloom for the procurement department. In fact, when handled effectively, it can create an advantage over unprepared competitors.
Here, we present 6 procurement levers that you can employ to manage market volatility in your procurement department:
Price Volatility in Procurement: Conclusions and Recommendations
As ancient Greek philosopher Heraclitus once proclaimed: ‘The only constant in life is change’. Volatile prices are inevitable.
For some categories and industries, price volatility poses significant risks but, with a proactive approach, the procurement department can mitigate the risks and even turn market volatility into a competitive advantage.
Data transparency is the foundation of all price volatility initiatives; it can inform fixed or variable pricing strategies, material substitution, and collaborative vs. competitive SRM.
Needless to say, dealing with market volatility is complex and multi-faceted, and the analysis is often data-intensive and dependent on supplier cooperation. Here at OCM, we have experience in addressing price volatility in procurement. If you would like to know more about our service offerings, and how we can help you specifically, please don’t hesitate to get in touch.
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