How Procurement Can Mitigate Risk With Inflation Tracking
One of the primary tasks that Procurement faces on a regular basis is spend management. Identifying savings targets and developing a strategy for meeting those goals can be significantly influenced by Procurement. Cutting costs is sometimes viewed as a great achievement, but what about inflation tracking? If costs are constantly on the rise, how can you reduce them?
With inflation reaching a new 40-year high in February of 2022, organizations are taking a longer look at how inflation is affecting their operations. A recent Deloitte study showed that inflation is a top concern for 75% of CFOs, with many looking at ways to mitigate risks involved with inflationary conditions. Procurement teams are uniquely positioned to leverage supplier relationships and strategically source opportunities to help combat the rise in prices.
With constant change creating new challenges and opportunities at every turn, corporate resilience has taken on renewed importance. Procurement and supply-chain functions are playing a critical role in enhancing resiliency by serving as orchestrators between a business and its suppliers.”
Procurement should continue to reduce volatility as much as possible by tracking inflation and factoring it into savings targets.
Factoring Inflation Into Savings Plans
First and foremost, you can’t mitigate what you don’t measure. Before you can begin developing a savings plan, you need to understand how inflation factors into your goals. To do that, you need to perform an initial inflation analysis. Identify the rate of inflation over a specified period and compare that to your costs.
The Impact of Creative Procurement Strategies on Inflation Plans
Often, when prices are on the rise, companies tend to immediately look to cutting costs. But Procurement can rely on some other strategies to help with inflation.
- First, check your category strategy and see if it includes a plan for dealing with inflation. If not, it’s time to rewrite your category strategies!
- Reduce complexity. Identify any areas where you can use cheaper or alternative supplies to continue with production. Perhaps you can eliminate the need for a supply or to purchase extra supplies to reduce costs later.
- Understand your major cost drivers. This may involve particular raw materials or processes. Analyze the impact that inflation is having on these drivers. Then, either negotiate proactively to secure the best position over your desired time scale (mid- to long-term) or look to redesign your product or service to minimize the impact of high inflation cost elements. Simultaneously, you should seek to understand how much of any particular cost increase can or cannot be passed on to customers, and if they are willing to pay to cover that cost.
- Implement a sourcing system to encourage competition. Instead of relying on one source for a supply, encourage RFPs and other systems to allow for competitive bidding, helping to drive down costs.
- Negotiate for better terms with both suppliers and customers. Are there ways to offset rising costs in one area by achieving reduced costs in another area? Or perhaps a supplier might offer consistent pricing in exchange for longer contract terms. It is critical that you understand your organization’s cash position. Can they afford to commit to higher inventories?
- Adopt a long-term approach. In a time of rising gas prices, some industries look to replace fleet vehicles with electric over gas-powered versions. While this might incur higher costs initially, the elimination of gas costs and contribution to sustainability efforts will easily make up for your investment.
Tracking Changes to Inflation Over Time
Inflation occurs as a result of market shifts and is related to current supply-and-demand conditions. This changes regularly with different global and economic conditions and is a constantly evolving condition over time. For example, a chip shortage has recently led to a reduction in new-car production, in effect causing a rise in vehicle prices.
Due to the persistent nature of inflation, you’ll want to make sure you have a steady strategy to track changes over time. Document historical purchasing prices and calculate the rate of increase. Continually update your forecasts to reflect inflation and engage in proactive planning. Make sure you have a central system for documenting these changes and providing transparency across your organization. It’s also a good idea to negotiate currency escalator clauses into your contracts to mitigate risk for unexpected market shifts.
Taking a Cross-Functional Approach to Inflation
It’s often enticing to look to Procurement with a sympathetic glance and feel glad that inflation isn’t your problem. But realistically, inflation impacts entire organizations—from procurement to delivery.
Case in point: McKinsey provides one example of a manufacturer who stockpiled steel when prices began to rise. However, the manufacturer didn’t communicate with their warehouses upon acquiring the additional stock and they quickly became overwhelmed. As a result, they began storing the stockpile outside. Within weeks, the steel became rusted and unusable, adding to further inflated costs and a significant loss. While this company was able to utilize a forward-thinking procurement strategy, the departments downstream were unable to take the steps needed to utilize their strategic purchase.
Every department, from finance to production to delivery was impacted by the scenario above. Therefore, if you truly want to mitigate the risk associated with inflation, you have to ensure that all teams are on board to enable effective negotiations and sourcing, ensure realistic usage of supplies, and maintain a long-term approach to inflation.
How to Create and Manage an Inflation Plan
To survive and thrive during inflation, you’ll need a plan. Follow these steps to create and manage your inflation plan.
- Determine your essential cost factors. What is absolutely necessary to deliver your product or service? Can you substitute, reduce, or replace any supplies? What is absolutely necessary to continue operations? Divide your costs into essential and desired buckets.
- Evaluate historic pricing and estimate valuations for supply costs and fluctuations going back 3-5 years. Document those prices in a visible system.
- Next, identify what is appropriate for a cost increase, based on your data. What is the rate of increase? If the rate of increase over five years is 5%, then a 15% increase isn’t acceptable.
- Determine where you can leverage existing relationships to keep costs down. Ask suppliers what they can add or modify to help keep costs low.
- Identify places where new suppliers might provide better quality for the same price or better contract terms.
- Based on your analysis, adjust your forecasts for the future to enable better financial planning.
- Understand your organization’s capacity for implementing changes in the short term. There have been several examples of companies who have struggled during the current chip shortage when buyers, with the best of intent, bought what was available and the company then had to make a significant investment in order to track which of its products contained which types of chips.
- Divide your plan into multiple phases, including strategies for now, the near term, and the long term. Define what you need to do to weather inflation today and what you can do for the future.
- Engage with suppliers and other departments to execute your inflation plan.
- Train your suppliers on techniques for negotiating price increase requests. This was a commonplace practice 30 years ago, but because we have had such a long period of low inflation, this is a skill or practice that has been lost by many buyers.
Inflation presents a significant level of risk and volatility but planning for rising costs can help you manage the situation most effectively.