How Procurement Organizations Can Protect Against Inflation

In March, Institute for Supply Management^®’s (ISM^®) Report on Business^® continued a trend of increasing composite-index readings since mid-2020. The Services PMI^® hit a record high of 63.7 percent, and the Manufacturing PMI^® reached 64.7 percent, its highest since 1983. Both reports have included sky-high Prices Index numbers, as well as long lists of commodity price increases.

Commodity prices are increasing across categories and industries. There are inflationary signals across the economy, and the list of potential drivers is long. Several factors are creating inflationary pressure, and have the potential to increase with compounding effects in the future:

• Accelerating growth and economic activity
• A release of pent-up consumer demand as coronavirus (COVID-19) pandemic-related restrictions are lifted
• Continued low interest rates and relaxed monetary policy
• Massive fiscal stimulus in the form of the American Rescue Act and additional planned infrastructure spending
• Supply market disruptions like shipping bottlenecks and production shortages (for example, of semiconductors), with companies pre-buying in anticipation of shortages
• Labor shortages, which are already appearing in several industries.

It’s difficult to predict the impact these factors will have on inflation. It’s unknown whether inflation will manifest in a broad-based way over time or in a more acute way for a short period of time. There is much debate on both sides.

Nevertheless, it is prudent to plan for potential inflation and identify ways to mitigate its impact. For the prepared procurement organization, however, inflation can be an opportunity to create competitive advantage for the company and elevate the role of the procurement function.

Assess Risk and Prioritize

Creating transparency to risk and prioritization is key to an effective inflation protection program. Procurement organizations should take this first step to understand potential vulnerabilities. They should focus actions on categories that drive the most inflation risk for the company, categories with significant spend in which:

• Prices are tied to commodity indexes
• Products have high commodity value and/or are likely to face supplier requests for price increases in the near term, like personal-protective equipment (PPE)
• Price increases cannot be easily passed through to customers.

Once priority categories have been identified, procurement organizations can make informed and targeted decisions on what strategies to deploy in focus categories.

Strategies to protect against inflation fall into three areas: (1) contract management, (2) sourcing strategy and supplier collaboration and (3) financial hedging. Which to apply depends on the specific context of the business and the supplier relationship. Some also come at a cost and so should be considered carefully.

1) Contract Management

Procurement organizations must be aware of the risks in their agreements and make plans to mitigate those risks. Thus, while transparency to contracts is key to building a robust plan, the approach to contracting is also a method of mitigation in itself.

Contract design can be adapted to mitigate the impact of inflation. All contractual levers should be assessed, including duration/term, indexing, periodic limits to price escalations and frequency of price adjustments. Risk potential during inflationary times should be evaluated and contract terms adjusted.

It is important to also work closely with the finance, sales and marketing functions to ensure that, where possible, indexes in supplier contracts are symmetrical with those used in commercial contracts. This allows cost inflation to be passed on effectively.

Contract negotiations will be needed to enact changes and should be managed carefully. Prioritize negotiation targets by supplier as well as by commodity. For each negotiation, define a customized strategy, objectives and level of aggressiveness. Consider the unique context and leverage position for each negotiation — if there are no alternative suppliers with lower rates, it will impact the approach.

Set clear rules, roles and responsibilities for the team ahead of negotiations and ensure compliance. As a part of the overall strategy, also consider adjustments to the target mix of long-term versus short-term contracts to manage volatility and cost trade-offs.

2) Sourcing Strategy and Supplier Collaboration

Sourcing and supplier strategies can provide a variety of benefits. These strategies should be part of any robust supply management approach but can be deployed in specific ways to mitigate inflation risk.

Sourcing strategy can be used to both mitigate inflation’s effects and set up for longer-term cost benefits. For example, inflation can provide the impetus to shift sourcing to regions with longer-term strategic cost advantage. Product formulations and specifications can be adjusted to account for expected differences in input prices. Comparison of the underlying economics between substitutable products can also identify arbitrage opportunities to exploit.

Partnerships and collaboration with suppliers are another source of potential benefits. Cost-plus agreements should be considered in products with high expected volatility. Collaboration with suppliers can reveal opportunities to mutually reduce costs and offset increases. Long-term partnerships, especially in products with limited supply, or modest investments in suppliers can generate low-cost supply agreements. Establishing agreements to base-load suppliers can also achieve strategic supply benefits.

In-sourcing and vertical integration in specific areas may also be warranted. This is worth considering in strategically important products (meaning sources of differentiation or competitive advantage) with limited network capacity to ensure supply. Make-versus-buy analysis can be used to inform attractiveness, that is, alignment with internal capabilities and expected costs versus expected evolution of marginal costs.

3) Financial Hedging

Several types of hedging can be considered. Which is appropriate and the method of implementation will depend on unique business context.

Direct hedging by entering into a number of supplier contracts with varying term lengths, fixed and variable costs, and staggered purchases can even out total costs and manage volatility. Buying contracts that fix or cap the price of a commodity, if there are liquid markets (futures, forwards, options), can also be effective. This strategy should be used where other forms of hedging are not possible given the associated cost.

Physical hedging, buying and holding inventory, is an effective protection against future price increases. Logistical implications and impacts to working capital will need to be considered with physical hedges.

Indirect (proxy hedging) by hedging against a similar or substitute which moves in parallel with the original product (for instance, nickel as similar for stainless steel) is another means of mitigation. Derivatives that protect from adverse conditions — such as hedging produce harvests with derivatives on weather — can also be purchased.

Before launching a hedging program, assess these factors: call margins/counterparty risk, tax-rate impact, hedge accounting, and execution, such as using an internal trading desk or outsourcing.

Mobilizing the Organization

Mobilizing the procurement organization, coordinating the effort jointly with the finance, sales and marketing functions, as well as gaining buy-in from leadership are essential to rolling out a successful inflation-protection program. Communicating the strategic nature of the effort will motivate the procurement team, as well as help team members understand the need for new ways of operating.

Engaging finance and sales/marketing makes them partners in the effort. When approaching leadership, procurement should quantify the potential impacts, lay out a clear plan to address the issues and gain buy-in for needed cross-functional efforts.

Changes to procurement’s operating model will likely be required. Protecting against inflation typically requires a change in mindset regarding using new analytics, adopting a cross-functional approach, and coordinating with marketing to manage rapid price changes, among other steps.

Implementing the right metrics and tracking enables close management of the program and the ability to get ahead of issues and show value delivered. Essential elements to monitor include transparency to contracts (contract duration and market exposure), market volatility and price levels, contract levels versus budgets, and target economics. The most effective programs employ centralized project management, detailed roadmaps and thoughtful negotiation plans. Visibility to enable rapid response and rigorous planning to maximize effectiveness are crucial.

While this process involves a significant effort, there are many organizational benefits. A well-run inflation management program can demonstrate impact on a strategic issue and help elevate the profile of the procurement organization.

Inflation risk is increasing; there are signs in the market. By taking practical steps to prepare — including creating transparency to risk, identifying strategies, tracking commodity pricing and regularly evaluating trends — procurement organizations can create strategic advantage for their companies.

The last time the U.S. had with “real” inflation was in the 1970s, making this a new experience for leaders and procurement professionals. By laying groundwork now, procurement leaders can be ready to mobilize their organizations when economic conditions warrant.