By Elizabeth B. Baatz and Victor Maliar
Supply and demand chain executives tap into forecasts from many sources to figure out where prices might be headed. A necessary and important tool for planning and strategy, price forecasts invariably require human judgment with even the expensive econometric ones using fudge factors, or what econometricians call "add factors."
Naturally, price forecasts, like all forecasts, can miss the mark. That, after all, is the intrinsic nature of forecasting. For supply chain executives, however, perhaps forecast accuracy should not be their No. 1 concern. Why? Because even if a forecast ends up dead-on accurate, in the supply management trenches where buyers and sellers meet, relying too much on a price forecast has the potential to be damaging. The problem occurs when using a forecast stops the players from examining and exploiting the underlying negotiation terrain. Handed down from on high by planners in corporate headquarters, a price forecast can become a target for buyers. Armed with their target forecast, supply managers sometimes focus simply on winning price contracts with escalation rates that are better than the average forecast.
The price forecast, however, embodies a lot of critical market intelligence details such as costs, margins and demand. If the price forecast arrives without explicit insights into those details, then the buyer's better-than-average contract may overlook opportunities for additional savings. Alternatively, supply and demand chain managers who bypass a deeper exploration of the underlying forecast dynamics may not clearly see the risks inherent in a potentially untenable contract.
To the extent that the costs underlying a price forecast are considered, the analysis path taken often stops short. One might peg an escalation contract to a primary cost driver like aluminum or steel, for example, and paying attention to key materials costs certainly will be a worthwhile exercise, but costs are only one feature in the price negotiation landscape. Issues like margin pressures and earnings expectations, though more difficult to pin down, might be even more relevant to the outcome of a price contract.
So, with a price forecast in hand, we must ask: What's driving current and future price trends? For answers, the details behind the price forecast — details often obscured in the forecaster's black box — have to be exposed.
To explore the black box of price forecasting and see how understanding forecast details can empower buyer/seller decisions, the remainder of this article will take you on an imaginary negotiation journey with a supply manager who buys precision-turned products. Relying on data and analysis from Thinking Cap Solutions' Leveraged Metric Intelligence (LMIQ) cost model, first we will examine the price forecast in relation to underlying cost trends. Going a bit deeper, our second step will be to analyze industry margins. The third and final step will be to glance at demand trends and earnings expectations.
Last year, average product prices in the U.S. precision-turned manufacturing industry jumped 13 percent. After such a budget-busting price hike, companies that spend big on precision-machined products doubtless have finance keeping an eagle-eye on industry price forecasts, especially now as inflation heats up across the board for all kinds of costs.
Let's assume that the chief financial officer in our story has been monitoring the forecasts, and he charges the supply management team to hold all price increases in precision-turned components to under 2 percent in the coming year.
Right off the bat, the supply manager who is in charge of the biggest precision-machined products contract thinks she may be in big trouble. Why? Because her supplier has already indicated he needs a meeting to reach an agreement on a 10 percent price hike.