by Manish Govil and Bob Anson
As global price volatility and supply risks increase for many commodities, especially for scarce ones, effective strategies to compete for these resources become more important than ever. Emerging countries such as Brazil, Russia, India and China are absorbing much of the world's output of raw materials, and many companies are now finding competition for these resources, where previously supply was taken for granted. This is especially true with commodities used in manufacturing, such as base metals for aerospace, automotive, heavy equipment, and white goods (appliances), and precious metals used in the high-tech and medical fields.
One of the biggest challenges, then, is guaranteeing supply and containing costs through smart sourcing. For global enterprises with geographically distributed operations, this is a four-step process:
- Identifying and aggregating the material requirements on a global basis. The single most important advantage companies have to secure supply and pricing is demand volume. Often, different regions or even divisions within a company use different names to describe the same commodity. Thus, the first step in volume aggregation is capturing detailed technical attributes of materials and then establishing cross-references among different names.
- Aggregating the requirements for multiple tiers of the supply chain. This extends the concept in the previous step in two directions. First, cross-referencing includes the organization and the multiple tiers of the supply chain as well as the manufacturers and the suppliers of the material. Second, the original equipment manufacturer (OEM) should aggregate the total demand obtained from this cross-referencing from different suppliers in one contract. For example, an automotive OEM may buy tailpipes and front-grill assemblies from two different vendors that both independently purchase chrome as a key ingredient. Similarly, an electronics company may get laptops and flat-panel TVs from different contract manufacturers, although both utilize the same liquid crystal displays (LCDs) as a key ingredient.
- Securing supply for the entire supply chain using contracts that delineate innovative pricing. OEMs can aggregate volume purchases for a material as leverage for securing favorable pricing and supply terms. For example, a car manufacturer may have a direct need for 500,000 tons of steel, but the combined other tiers in the supply chain may have need for an additional 500,000 tons. Thus, the combined volume for the supply chain is now 1 million tons. For a large, global steel manufacturer with total capacity of 12 million tons, this represents more than 8 percent of its total output, which makes this OEM a strategic customer.
Strategic customers have many opportunities to enter into innovative contracts with suppliers that go beyond the normal unit-price-based negotiations, spot buys or auctions. Some of the innovative pricing methods used in these situations are:
- a. Tiered pricing: The base unit price is set for initial purchases. As cumulative buying volume increases, however, the unit price is discounted at certain preset volume levels.
- b. Index-based pricing:When there is high volatility in price, and there may be a lag between establishing the contract and the actual acquisition of the material against the contract, index-based pricing may be used. Index pricing is applicable for contracts involving commodities, such as gold and silver, where an established, international market price exists. Because these contracts with suppliers must reflect market-price fluctuations, pricing is based on an established external index, using a formula with a defined margin. An example would be: "104 percent of the trailing three-month average of the NYMEX Silver Index for 1/8 ton per quarter."
- c. Matrix pricing: Matrix pricing is used when considering multiple parameters for engineered materials. This process takes into account many variables. For instance, with steel it may include variations such as material type, specification, grade, thickness, width or weight, different treatments, etc. The matrix is usually based on a spreadsheet, with variations in price against two or more variables. These kinds of matrices are well known to purchasing departments, but here the variables are established at the time of the contract, rather than being subject to change.
- d. Total landed price: In traditional pricing, the transaction is based on a single price. It is accepted that this price actually incorporates a number of factors, such as base material cost, transportation cost, material handling cost, inventory handling cost, etc. In a strategic supplier relationship, the trading partners collaborate to bring the true cost down. Hence, they are willing to break down and share the different components of cost. The partner with the lowest cost for an operation may "own" that cost. For instance, if it is cheaper for the supplier to transport material to the buyer's warehouse, it will undertake this activity. Thus, based on the manufacturing location of the material and the buyer's location, the price for the same commodity may be different for different buyer locations, instead of being an "average price" for all locations. This results in a truer cost, as the supplier estimates and averages the volume it will be supplying to different locations to arrive at a single price.
- 4. Smart execution against contracts: Increasingly, we are seeing OEMs acting as buyers for their entire supply chain needs. This entails the OEM acting as a broker, reselling materials or allowing suppliers to purchase through the OEM contracts.
Strategic collaboration
OEMs are also collaborating closely with their suppliers for these strategic contracts, on both the demand and the supply side. The buyer may have manufacturing locations distributed globally, similar to the supplier, who in turn may have production facilities distributed globally. Instead of providing for the total demand, if the buyer provides for demand by location and time, the supplier can match supply to production, thereby reducing warehousing and transportation costs for both partners. In the case of supply-constrained environments, the OEM may be best positioned to make trade-offs to maximize the profitability of the entire supply chain.
A good example is that of an automotive OEM needing different specifications of steel of a particular type, where the basic production process of the different specifications is similar. Thus, the capacity for producing them is quite interchangeable. In the case of a supply constraint, the buyer may ask the supplier to provide the type of steel that is used for the more profitable product (the supplier may be agnostic to the supply of the different grades, since they may be very similar in price).
As these examples show, sourcing is no longer the domain of the supplier alone. Advanced software solutions are helping manufacturers understand and manage the complexities of supply-constrained and price-volatile commodities and to integrate complex pricing and contract structures.
For more information on i2's SRM solution, contact program manager Manish Govil or senior technical director Bob Anson (supply_chain_leader@i2.com). |
