Our fictional supply manager takes her first step into the cost data and is alarmed to find her supplier has plenty of data to bolster his case for higher prices. Indeed, recent monthly data from the LMIQ model estimate that average manufacturing costs in the industry that makes precision-turned products increased 10.6 percent from a year ago.
The impetus for the supplier to request such a large price increase obviously comes from this past year's inflationary surge in the cost of materials. The LMIQ model shows spending on raw materials for the average precision-turned machine shop increased 16.5 percent from a year ago. Looking at details within the materials budget, the supplier can point to a whopping 42 percent increase in the cost of basic steel shapes. Even after adjusting for the fact that steel shapes contribute to only a portion of the entire materials budget, the effective cost increase in steel shapes was still a distressing 10.1 percent.
On top of the blast from steel costs, the precision-machining industry also saw big year-ago cost hikes in steel wire (up 16.5 percent); spring and wire products (up 10.5 percent); and rolled, drawn and extruded copper (up 9.5 percent). The only consolation that our supply manager can find is that after adjusting for each commodity's relative share of the entire materials budget, the effective cost increases for these three key materials actually registered more modest increases of 3.3 percent for steel wire, 0.3 percent for spring and wire products, and 0.8 percent for copper inputs.
When the precision-turned products supplier makes his case for a 10 percent price hike, he notes that the most recent monthly data show his industry dropped its average product prices by 2.4 percent from price levels held a year ago. That means for every 1 percent increase in manufacturing costs over the past year, precision machining prices declined 0.23 percent.
This may flummox our pretend supply manager, because cost pass-through analysis doesn't normally yield such a dramatic story in favor of the supplier. More often, the supply manager has seen prices up a certain rate and underlying costs up a somewhat lower rate. By tracking and understanding how her suppliers are passing through a certain percentage of their inflation burden, she has been able to negotiate a reasonable reduction in the share that she, the buyer, has had to absorb.
Far from passing along any of its growing inflation burden, the precision-turned machining industry has absorbed all of the cost increases incurred and then some, completely shielding buyers from price hikes. To finally drive his point home, the supplier says that for every $100 worth of market-valued product the industry made, the average supplier is making $4.79 less in gross margins than was earned a year ago.
Step Two: Shifting with Margins
At last, the subject of margins has been introduced. This provides the opening that the supplier manager needs for changing the focus of negotiations from simple price/cost comparisons to long-run margin benchmarks. In the precision turned products industry, long-run margin data just happen to favor buyers. Price/cost pass-through analysis helps the parties understand how inflation burdens are being shared (or not) between buyer and seller. Shifting prices and costs also have implications for industry margins. After adjusting for inflation, productivity shifts and other economic factors, the LMIQ model can show the margin context in which the price forecasts are operating.
Profitability is the underlying factor that price forecasts cannot, but sometimes do, ignore. The margin or profitability picture of the supplying industry will be a critical feature of any negotiation landscape.
To navigate safely, the supply chain manager has to examine the implied impact of cost and price changes on supplier margins. When an industry enjoys fatter margins, suppliers have room to be more flexible about not passing through cost increases to buyers. Conversely, when margins are tight, then suppliers will be less willing to give ground.