When we look at how cost and price escalation trends over a five-year time period have influenced margins in the precision-turned products industry, the data shift quite nicely to support the supply manager's request to hold price increases down. The supply manager in this story wants to drive her own point home now: For every $100 worth of market-valued product the industry made this past month, the average supplier is making $3.84 more in margins than he earned on average over the past five years.
Why is the supply manager's five-year margin statement so drastically different than the one-year margin statement made earlier by the supplier? Comparing costs and margins to year-ago levels favored suppliers because last year the precision-machining industry was in a unique position. In April 2007, margins in the precision-machining industry actually had hit a record high. That explains why the industry so magnanimously could absorb those year-ago cost increases while dropping prices.
This sets the stage for our supply manager to argue successfully for something much, much less than the 10 percent price hike that the supplier wants. Indeed, the LMIQ model estimates that in order to return margins to average levels seen over the past five years, the typical supplier in the precision-turned product industry has room to cut prices by 7 percent.
In the Final Analysis
The supply chain manager has one more market intelligence detail to explore, which is the demand and earnings picture. Information for demand is a bit harder to track down. In the LMIQ model we see factories in the machine shop sector (which includes standard machine shops, precision machine shops and metal fastener factories) have been humming along at a very healthy pace. According to industrial production data from the Federal Reserve Board, unit production for the sector was up 9 percent in the 12 months ending April 2008. This kind of factory output growth implies that even as average prices fell from a year ago, increases in the number of units sold would have helped earnings significantly. In fact, the LMIQ model for the precision-turned products industry shows that in the most recent 12-month period, revenue potential increased 14.6 percent and total gross margins potential soared 18.6 percent. (These are rough estimates, which is why we qualify the terms with the word "potential," but the insights the estimates deliver are helpful, nonetheless.)
Suppose the economy does slide into recession over the next year. With consumer confidence down and unemployment rising, the outlook doesn't bode well for manufacturing earnings in general. So the recent rosy margin and revenue estimates for the precision-machining industry certainly cannot be expected to hold. Yet, the precision-turned products industry has managed to put itself in a fairly strong position as of mid-2008. Despite her initial worries, the supply manager in this negotiation story without a doubt should have no problem cutting her supplier's price hike request down to the 3 percent increase her CFO expects. Well, since it is a story, let's say she negotiates a 1.5 percent price increase. That certainly sounds reasonable (and it would have the added benefit of making our price forecast for NAICS 332721 come true).
When all is said and done, hopefully this story illustrates one key point: Supply and demand chain executives who ask their teams to delve inside the price forecast box can achieve more equitable and sustainable price agreements.
About the Authors: Elizabeth B. Baatz (ebaatz@ALERTdata.com), an economics writer and editor for the past 25 years, works for Thinking Cap Solutions, Inc., which produces the ICE-ALERT monthly report. The goal of ICE-Alert has been to deliver accessible and affordable cost analysis to the procurement function. The ICE-Alert is the work of Victor Maliar (vmaliar@ALERTdata.com), an economist and writer for the past 30 years, who founded Thinking Cap Solutions. Baatz and Maliar can be reached at 360-452-6159. More information at www.ALERTdata.com.