Toolkit Review: Get the Cost Savings You Deserve

The Impact of Commodity Prices on Your Procurement Practices

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After years of reaching peak after peak, commodity prices have suffered through their sharpest decline since the global economic recession and are now back to their 2005 levels. Now companies must set about the task of clawing back the cost increases that have plagued procurement departments, nimbly balancing between maintaining supplier relationships and their own bottom line. As price declines filter through supply chains, many organizations are struggling to answer the question: “Are we aiming high enough for cost savings in 2015?”

In December 2014,The Institute of Supply Management (ISM) in the United States asked purchasing managers how much they expect prices to change in 2015. A startling 59 percent of respondents believed that prices would increase this year. Just 18 percent of respondents foresaw prices falling, and of those, the expected decline was just 4.6 percent. As we have already seen, many categories have fallen to greater depths, and, as declines whip through supply chains, the savings will be felt across a broad set of categories. This suggests that many purchasing managers are ill-equipped to capture appropriate cost savings in today’s commodity markets.

Achieving and Extending Cost Savings Goals

Most organizations started the year with cost savings targets below 5 percent, content to allow multi-year lows for material prices to pass by without extracting the full value. Best in class organizations, on the other hand, can lean on econometric models to trace cost declines through supply chains to achieve optimal timing and cost savings. Models that fail to track the movement of cost savings through supply chains are tarnished in low-price environments. Knowing when to expect savings and quantifying price impacts in the categories you buy can mean the difference between 5 percent savings and 20 percent-plus savings. An organization that pushes for a 10 percent price cut rather than accepting a 5 percent decline will save an extra $50,000 on every $1 million of spend.

The Past is Prologue

The aforementioned cuts to commodity prices have already pushed prices lower in many key categories, setting a floor for cost savings at the next negotiation. But for many categories, this is just the beginning; IHS is forecasting significant price cuts still to come for a number of key material and equipment categories. Each industry and position in the supply chain has reason for hope, due to the broad-based nature of the declines. But the timing and magnitude varies based on the key materials in the industry and their location in the supply chain. Figure 1 highlights the breadth and depth of declines and the range of savings opportunities that are already available.

The cost declines have not just impacted commodity prices. Intermediate goods such as metal stampings (-26.6 percent), steel pipe (-19.2 percent), and industrial valves (-3.6 percent) have already shown steep declines in their direct materials bill and finished goods such as mining machinery (-6.6 percent) and aircraft engines (-1.0 percent) are not far behind.
What does it mean for you?

The key to leveraging commodity price declines in your negotiations is being able to quantify the impact of material price declines on the equipment you buy. Cost models that measure the contributions of key inputs to your suppliers’ production costs can help you to achieve real cost savings.

Example 1: Specialist Alloys or Materials
To best prepare for purchases of specialist alloys or materials, it is beneficial to understand the composition of the material. With this information, you can benchmark surcharges and costs against the market prices for the individual component materials.
Armed with a forecast of where prices and surcharges are headed in the near future, you can determine the most favorable contract position, whether it be to lock in a contract price, or float on spot. You can also navigate the complex waters of surcharge implements, with full awareness of the impact on your purchases today, and in the future.

Example 2: Industrial Valves
To prepare for the negotiation of various types of equipment, it is best practice to understand the contributions of material costs to overall production costs. Armed with the knowledge that your supplier costs have declined significantly, you can use fact-based negotiation tactics to achieve cost savings. For industrial valves, it is beneficial to know that over 20 percent of production costs are related to steel and steel-based parts. On average prices for those categories have declined by nearly 10 percent. These models give you the means to estimate the impact of commodity prices on your suppliers’ costs, enabling you to benchmark price concessions and gain leverage in negotiations. Approaching supplier negotiations with full tran sparency can improve collaboration and ensures mutually beneficial results. ■