Price Forecasting Reconsidered

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.

Price/cost Negotiations

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.

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.

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.

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