Facing the perfect storm of cost increases

The article was first published 2 February 2022 in the Contracting Excellence Journal.

The perfect storm is a consequence of the pandemic. We are all in it. My article surrounds how to combat and overcome our perfect storm of cost increases and explains why, to do so, procurement must establish a good relationship with suppliers and be properly informed about the suppliers' cost challenges. And we all need to work together to mitigate the effects of the perfect storm. True, we cannot remove our volatile cost challenges, but our effort to collaborate and smooth the bumpy road ahead might be more valuable than the money we are spending.

Here is what we know — the pandemic caused prices to surge across the board. Being hit hard, suppliers needed to pass the increased costs over to their customers. This caused a knock-on effect for procurement, facing a cascade of aggregated price increases — not to mention supply chain woes associated with trying to meet worldwide demand.

Late 2021 many countries were slowly re-emerging from the strict lockdowns of societies during the covid-19 pandemic, creating a strong global demand. However, the pandemic is still ongoing with ups and downs and with varied severity around the world. Thus, in today's globalized market we are still seeing reduced productivity and capacity to meet the growing demand.

Demand is picking up much faster than supply, and we are now experiencing many shortages of raw materials like oil and natural gas, metals, and plastics, of key components like computer chips, and of transportation. The new omicron variant has also resulted in new lockdowns, creating renewed uncertainty.

The perfect storm

Before the pandemic, fluctuations of raw material and transportation costs were usually quite predictable. They would go up and down with varied intervals and speed, but usually without the extreme surges and plunges we have seen during the pandemic. In long term relationships, procurement often faced regular and quite predictable requests for price increases.

However, this changed with the pandemic. In the early days of the pandemic, the lockdown of cities and entire countries, combined with the ceasing of strategic goods, created production and supply chain problems. Shipping containers were stranded. We saw a sharp increase in the demand for oxygen, face masks, and other pandemic-related goods.

Today, with the gradual reopening of societies, the situation is still volatile but in a different way. A rapidly increasing global demand has led to raw materials and commodities shortages. Decreased capacity of air, land, and sea transportation, and a shortage of shipping containers and manpower to handle loading and offloading, has led to a sharp rise in transportation costs globally and increased lead times.

In addition to the consequences of the declining pandemic, other factors increased the volatility. The 5G implementation (the 5th generation wireless, mobile network) and a general rise in demand has led to a global shortage of electronic chips.

Increased protectionism (reducing or blocking international trade) has led to stricter trade regulations and increased customs duties that are adding cost and affecting availability. Oil and gas and electric energy prices are rising. China even implemented strategic power cuts due to high prices on coal and cuts in coal production.

Faced with shortages, market players purchased extra to stock up materials and safeguard their supply. This creates an extra pull on demand, boosting availability issues and accelerating price increases. For example, in the beginning of the pandemic, the demand on toilet paper in the consumer market exploded in several countries, resulting in empty shelves.

It is important to consider that before the cost increases hits the end customer, the cost impact may be accumulated through a series of suppliers and subsuppliers, each facing increased cost of transportation and energy, adding up to an aggregated amount.

That is what happened during the pandemic, when in its early stages we were uncertain how long the high-cost situation would last, and many suppliers chose to temporarily take the hit without forwarding the increased costs to their customers. Many price increases were therefore postponed until it became clear that the cost increases were long-lasting and increasing. Thus, instead of a gradual price increase, several end customers experienced a sudden and substantial increase.

In total, procurement was hit by a perfect storm of cost increases. Across the board, procurement faced an avalanche of requests for cumulated price increases from their suppliers.

The cost increases of the pandemic are caused by volatility, and the volatile situation is expected to continue for quite some time. Volatility means increased fluctuations, which in turn means that while the ups are high, we can also expect the downs to be significant. Supply is likely to increase and better align with demand, leading to decreased costs for suppliers. During volatile times, it is easy to become a victim of the circumstances, with procurement accepting well-founded price increases when costs are record high — without ensuring price decreases when costs go down.

Facing the storm

What can procurement do to mitigate the negative effects of the perfect storm of cost increases and avoid being bound to prices that they accepted when a supplier's costs were record high?

One key focus should be on relationship. The pandemic showed how important it is for procurement to continuously develop good relationships with key suppliers. When there is a disbalance in the market, with demand greatly exceeding supply, well-established relationships are important competitive differentiators.

Face-to-face is the optimal way of communicating. But during the pandemic, lockdowns and physical distancing meant that we communicated via emails and video calls — making it more difficult to build relationships. Customers who already had invested in establishing close relationships with key suppliers and who managed to maintain these during the pandemic, could harvest from established trust and personal connections. This gave them a competitive advantage and stimulated prioritization, transparency, flexibility, and joint innovation between the parties.

Another key focus on this perfect storm should be on accessing key information. We are seeing an asymmetry of information between suppliers and buyers in the market. The supplier is closer to its own costs and best positioned to be well informed. So, it is important for procurement to mitigate the information gap by investing in information access.

In the volatile market of the pandemic, prices are subject to rapid fluctuations, increasing the need for proactivity when it comes to keeping a continuously updated overview over the suppliers' costs.

• Suppliers facing cost increases that are far beyond what could be reasonably predicted, will need to pass them on to their customers.
• Procurement may be faced with unexpected and well-founded requests for significant price increases that are difficult to reject without jeopardizing the relationship as well as future deliveries.

However, you can predict and mitigate such requests by being properly informed by requesting information from the supplier and comparing it with your own data.

One way for procurement to obtain information is to require supporting documentation when faced with arguments from the supplier. Supporting documentation will give procurement a better understanding, but it still places the supplier in the driving seat. The supplier can to a large degree choose what information to provide and focus on.

Another way is to identify the suppliers' key cost drivers. Without such an overview, you will be left with negotiating the price without having the key information you need to do so. This makes it difficult to verify the other side's argument. When a supplier requests a price increase, the amount of the increase anchors the negotiations. And breaking away from an anchor is difficult without information showing that the anchor is unfounded or unreasonable.

Most products have one or more key cost drivers. After identifying these cost drivers, procurement should look for a way to objectively monitor their development, which can often be done by using an index. Costs of raw materials, as well as for other products, may be monitored in indexes developed by independent actors, providing an objective overview over the development of such cost drivers. The supplier is best positioned to understand what index is relevant to their costs, and to achieve predictability, the parties should agree on a common index to use as benchmark.

Having identified both the key cost drivers and how to monitor them, procurement should establish processes to monitor the cost drivers regularly. Procurement may only be able to predict and proactively mitigate requests for price increases by closely monitoring the development of key cost drivers.

An additional benefit from monitoring the key cost drivers is that it will expose the suppliers' ongoing efforts to ensure that their costs are competitive in the market. A proper overview of the development of the suppliers' key cost drivers will also support procurement in assessing whether a supplier should be pushed to look for substitutes — and even whether it is time to find a new supplier.

The complexity of monitoring cost drivers varies from product to product. For some products there is one dominating cost driver. For others it is far more complex with several interlinked cost drivers, creating a need to consider the relationship between the cost drivers and how to weigh them against each other.

Suppliers may also purchase components from subsuppliers, who in turn may purchase components further down a chain of suppliers. Thus, some cost drivers may be outside the parties' control, making it difficult for both the customer and supplier to properly monitor the cost development.

Reversing price increases

Procurement should also ensure that accepted price increases may be reversed if the supplier's costs drop. The price increase may be based on a temporary spike in a key cost driver, and it is unfortunate to be bound long-term to prices based on a short-term extreme-cost situation for the supplier.

One of my clients' suppliers experienced a significant cost spike for a key cost driver, resulting in a price increase for my client. However, the spike turned out to be a short-lived peak in the index. When negotiating the price increase, an extraordinary price negotiation clause was also added to the contract. Using this clause, we could negotiate a price decrease some weeks later, bringing the prices back to where they had been before the increase.

The purpose of this extraordinary price negotiation clause was to ensure that both parties could mitigate unusual cost fluctuations. In normal times, the parties would regularly conduct price negotiations, and to avoid the extraordinary price negotiations to become the new normal, a trigger was implemented. The trigger was linked to the development of a key cost driver, using a mutually agreed index with a trigger point that exceeded normal fluctuations. And to enable my client to request a price decrease when prices fall, a process of monitoring the index was developed.

Another alternative we considered was to accept the price increase, but on the condition that the customer could demand a price decrease later if certain conditions were met. However, both parties wanted a lasting solution for addressing volatile cost situations, making the extraordinary price negotiation clause more suitable.

Summary — information and relationship are key

To mitigate the effects of the perfect storm of cost increases, key focuses for procurement should be on information and relationship. The asymmetry of information between customers and suppliers creates a need to mitigate the information gap. And a well-established relationship with key suppliers makes it easier to cooperate and find good solutions during volatile times. Several interlinked factors are at play, and being informed and having good supplier relationships will not remove the effects of a volatile cost situation. But it will make procurement better prepared for the bumpy road ahead.

If you would like more structured support with supplier risk, sourcing decisions and negotiation strategy, you can read more on the Procurement service page.