How PROCUREMENT can manage inflation
March 28, 2022, By Jonathan Dutton FCIPS, CEO at PASA
ways procurement can make a difference addressing rising inflation
Inflation is back. The great economic evil is knocking on the door again. But what, exactly, can procurement do to help manage the inflationary threat to your business, and how exactly? Jonathan Dutton examines the problem for Supply Clusters members:
Many people working in procurement today throughout Australia & New Zealand will have no experience of managing an inflationary market of fast rising prices. Those that do, may struggle to remember exactly how they
What is INFLATION?
Inflation describes a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. Wikipedia
Inflation is rising
As January 2022 ended, the US reported a full 7.5% inflation rate, which many believe will still rise further. In the UK, inflation in January was reported at 5.4% - also set to rise further, many think.
How susceptible the Australian economy is from these direct influences can be debated. But history suggests it is likely to be more than we might want, even though a time-lag effect seems to exist.
Inflation in Australia is reported at 3.5% today, with expectations of closer to 5% in the relatively short term. With the inflationary effects of a general election yet to be factored in (rival parties promising spending binges to win votes).
And classic economic theory suggests that continued long-term Quantitative Easing (QE), the introduction of new money into the money supply by a central bank, in some countries might also work counter to control of inflation. QE formally stopped 31st January 2022 in Australia, but ….
So far, the data reported is clear. Prices are rising. And, inflation will rise too on the back of this, from an average significantly below 3% for the last ten years or so, back to more ‘textbook’ explained norms of the past – yet, hopefully, nothing like the 1980s when inflation looked more like 10% than 2% or less.
The insidious effect of inflation
An inflation rate around 7% (as in the USA) does not instinctively sound dramatically bad to ordinary folk. Yet in financial circles, 7% is something of a magic-number. Mathematically, a consistent growth rate of 7% doubles your money in ten years. Saving $10,000 today @ 7% for ten years compounded builds to $20,000 – which is great. Except this formula also works in reverse; for example:
Things that cost $100 today will cost $200 in ten years time at a set inflation rate of 7%.
A coffee costing $4.50 today, becomes $9 in future.
Dining out might cost you $200 today, say, but $400 in future – still want to go out?
And a new car costing $40,000 today, over $80,000 in future.
Beyond a very low level, inflation is ultimately always bad, most economists agree.
WHY inflation is BAD:
Erodes Purchasing Power
Diminishes currency strength
Builds uncertainty
Dissuades investment
Discourages saving
Higher inflation is certainly not part of the Government’s nor RBA’s plan for fiscal repair post-Covid. Nobody, least of all the RBA, wants to predict rising inflation rates, and contribute to expectations, but they will rise, many agree. To some degree openly discussing it raises expectations – which can be a contributory factor to more rising inflation. In fact, as 2022 started there was an open public debate (including both RBA and government contributors) discussing not IF but WHEN and HOW MUCH inflation (and subsequently interest rates) will rise?
A key factor holding down inflation in recent times has been the very stable wage growth over the last decade (ie; almost none - most haven’t had a pay rise in ages) as well as reportedly low business confidence and political uncertainty which stunts business investment and, in theory, economic growth. The goal of ‘growth without inflation’ has led to such low range inflation expectations over recent history (around 2% or so):
Source: statista.com
Why prices will rise
Post-Covid it seems that prices will rise – for a combination of primary reasons on both sides of business:
1. On the consumer side, there will be less choice. That is, less vendors available to supply. A number of firms will simply not recover from this crisis, for obvious reasons. And they will not be easily replaced by new entrants, who will struggle to raise capital during austere lending periods. Less vendors means less supply, meaning higher prices if demand sustains.
Part of the reason for fewer vendors in the market will be the amount of competitive business models that need high levels of demand to bring even a modest margin. This is a feature of buoyant and competitive markets in the past. And will affect businesses large and small – like airlines, Qantas maybe (filling ‘planes with the middle-seat free reduces load factors by 30% or so) and like CBD cafes (who needs eight sandwich shops per skyscraper now? Or that 10 socially distanced patrons per sitting in a café offers revenues way below break-even point).
More firms than we can think of will fall into this trap of operating quite unprofitability below necessary high-volume demand (hotels often target > 70% occupancy). This will be exacerbated when shareholders compare returns from businesses struggling around break-even point. Moreover, RoI targets from business owners will rise with inflation benchmarks.
Public sector departments and bodies will feel pressure to manage on less after immediate reflationary strategies give way to the reality of the pain of public debt and the goal of driving the federal budget back into the black to start paying down that massive debt we have all just incurred.
2. On the supply side, the winding back of globalisation now, due to obvious global risk factors, will increase cost for all – organisations will be increasingly re-shoring, dual-sourcing and buffer-stocking to de-risk supply chains. All these things can add cost.
In theory, wage rises are still unlikely, as unemployment should be high post-Covid and firms very sensitive to rising costs in low-confidence markets. Yet staff-shortages (no international students, no immigration for two years, people moving out of cities, people surviving on less cash/less work, the great resignation, sickness rates & absenteeism) have shown that in fact we are approaching full-employment rates in Australian now. The federal Treasurer openly talking of an unemployment rate well below the current 4.2% in Australia. This suggests scarce staff will succeed in demanding pay rises in the near time as firms compete to hire – spurring inflation more
Certainly, in the main, supply side costs will inevitably rise as lower supply meets gradually rising demand post-pandemic - and current subsidies and allowances disappear entirely as the recovery continues.
Indeed, supply chain shortages, bottlenecks and rising costs can exacerbate the rise of inflation in our market at the tip of the global supply chain. Although reportedly easing now, container shipping rates rose six-fold during the height of the pandemic. The lasting effects of container bottlenecks are still to iron out.
Also, some commodities have risen dramatically in price of late (oil, copper, wheat) and yet others have softened in price like energy in Australia (but not Europe). Generally many commodities are predicted to peak in 2022 and then reduce – but who knows?
Closer to home, suppliers will likely face rising costs themselves from their own supply chains; perhaps due to original equipment suppliers (OEMs) exposed to economic pressures within their home markets, perhaps due to international trade pressures like us. They could lose economies of scale if not operating to optimum scale and, most importantly, working to lower demand levels whilst simultaneously striving desperately to recover crippling losses and pay off debts incurred during the lockdown. This means price rises.
And, finally, whilst a higher Aussie dollar might make imports cheaper (and benefit consumers and demand here) these can be offset by other international factors not least rising prices for our exports, trade tariffs (including China issues), commodity volatility or shortages & bottlenecks in other markets – all these things affect risk profiles and prices.
Risk is the early priority
Yet, Initially, as we return to work in the office, the focus for most supply side managers will fall on RISK – how do we de-risk the supply side and ensure that we can always deliver vital goods in future? Will our business continuity plans (BCP) hold up next time? They didn’t for many during the Covid-19 shock.
A Grosvenor Performance Group (GPG) survey during the pandemic found that pre-crisis, just 6% of procurement managers saw supply RISK as their primary goal. Immediately post-crisis, supply RISK became the key issue for 40% respondents, with cost reduced to top-priority for just 15% of respondents, down from 29% and the usual ‘top spot’ pre-crisis: Thus, re-balancing COST advantages -V- supply assurance RISK is an important procurement priority as we climb out of the pandemic and look to sure up future business continuity plans.
Grosvenor procurement priorities research in ANZ 2019-21
Cost pressures will not subside quickly
So, after risk plans have been re-set, COST will rise back up the agenda for procurement managers, as the Grosvenor research suggests, because it must.
That is, firms will feel the pressure to return towards pre-crisis margins – however difficult that journey will be; despite lower volume in many markets.
Cutting costs will be relatively easier than driving up revenues for suppliers in these depressed and cautious consumer markets – certainly after remaining government wage subsidies and widespread rent and mortgage relief subside as this year gets going. And staff-shortages will drive some to look for easier ways to serve demanding customers (lower service, less range, shorter hours), all building scarcity.
Restart costs will also bite for suppliers, especially smaller ones. The cash demands of restarting businesses (new stock, unpaid bills, hiring new staff, advertising, re-opening set-ups) never mind the accounting costs (stock write-offs, rent arrears, outstanding tax liabilities) can be overwhelming for any SME sized supplier.
Add on the impulse to claw-back lost profits from the last two years of the pandemic and you might find real resistance to suppliers discounting, prices holding much firmer, even increasing, and charges for additional costs being added.
Yet professional buyers can do much to help SME suppliers; such as greater volume commitments, extending agreements, paying early or up-front, buying other product lines too. These are small things for a big buyer, but big help for a small supplier.
Given that the sum of all these ‘causes and effects’ of inflationary pressure post-pandemic seem more “supply-side” in nature, the potential for procurement to help our organisation’s specifically is higher:
10 ‘old’ ways to reduce inflationary impact on your cost base
So – the big question, HOW will procurement be able to address cost in such an inflationary environment post-crisis? Haggling down the price? Not so easy now. Tendering goods and services some more? Unlikely to help in a small marketplace like ANZ, where all producers feel inflationary effects.
As I have mentioned before, many times, the success of procurement in recent years had led many to experience the trend of savings tending towards zero over time. Especially in INDIRECT categories, which all organisations necessarily purchase. In other words, there is only so many times you can use competitive tools like tendering to drive cost reductions. And, the market is less likely to respond to these moving forward as suppliers will hold the line on price – because they have to, in a post-pandemic recovery.
More likely, is that as the recovery develops we will be digging out the old textbooks on how we used to negotiate down cost in stressed markets and applying them to our ‘new normal’ environment:
1. Knowing what the price should be – Procurement professionals will need to dig much deeper into the price. What are the various cost components that make up the price, how have these costs been trending? Are all cost components experiencing inflationary pressures e.g. margin does not necessarily need to grow at the rate of inflation?
Working with your suppliers to better understand the trends in these costs, and then also seeking 3rd party views to either support the suppliers view or not. Many will jump onto the bandwagon and talk up inflation, everybody accepts it, however, it is up to the procurement professional to really confirm whether this is an accurate statement for their spend category. Is it perhaps an accurate statement for today, but not for tomorrow? So be careful not to lock in inflation for the next 3-5 year contract.
2. Negotiation works best – and could become the default procurement strategy setting; so best polish up your skills fast. Negotiating-not-tendering (a tool best used for competitive markets) is more effective in stressed markets. Negotiating the outcome nearer to the one you want is also more efficient use of time versus go-to-market processes taking months – as users may well point out before long.
Negotiating is also a way of leveraging the strong SRM built up during the testing times of the lockdown perhaps? Try leveraging other prizes for the supplier such as longer-term contracts or buying more (non-critical) volume from them as a strategy in return for lower costs. Attacking the ‘common enemy of waste’ with buyers and sellers working together more as a team, is a helpful mindset. There is still too much waste in the supply side process.
PASA is running two training courses during 2022 to help – see the PASA website for details:
. Negotiation for procurement professionals
. Buying during Inflationary Times
3. Annual price increases – reframing cost negotiation as an annual price increase. That is, limiting price rises to 12 month cycles in times of growing inflation. Best arranged in step with your budget cycle, though, not their seasonality and their standard industry price rise times.
Traditionally buyers might think this tactic is dumb. Agreeing to an annual round of price increases? Giving permission for cost to rise annually! Yet, during high inflation periods it is not uncommon for prices to rise two or three times per annum. Or seasonally, each quarter even. And rare commodities more often still. Agreeing ONE increase contractually, can be a risk mitigation strategy to protect margins and even your business model.
4. Agreeing PVF driven contracts – that is ‘price variation formula’ (PVF) agreed and set into longer term contracts to vary price “officially” according to relatively predictable ratios and commodity prices. Preventing suppliers from leveraging up price quoting nebulous component data and a bit more added margin in times of inflation.
5. Challenging the scope of the requirement – Is it necessary to buy the platinum service in this inflationary environment, perhaps the business case for the gold or silver service is looking much more attractive to business leadership. Work with your vendors to find ways of reducing total cost, whether that be de-scoping or taking on greater obligations to help support the vender e.g. providing quarterly demand forecasts.
6. Preserving cash and keeping working capital – that is, managing payment terms largely. Not to make modest interest on unspent money so much, certainly with interest rates at such record lows, but really just slowing cash out of the business in advance of revenue returns downstream from customers. In other words, maximising working capital to invest cash into new business models as they develop, effectively meeting structural change.
Encouraging suppliers (especially SMEs) to use factoring or reverse-factoring (supply chain finance facilities provided by the buyer’s partners) to choose their preferential payment terms may become the norm to ease cash-flows for everyone in future at a relatively marginal cost. Supply chain finance is not dead with the arrival in Australia of the new Payment Times Reporting Act 2021. Far from it, but more about that another day.
7. Rebate deals – additional discounts in the form of quarterly rebates (synced to seasonality – or sales targets) aligned to volume spend targets might be a better way to taking advantage of upturns than downturns. But this can be a useful tool for returning REAL savings (cash) compared to booked savings (cost avoidance or budget savings then spent on other things by loose users). Specific quantity price breaks [QPBs] are tables of prices against pre-set volume levels that enable this negotiation. Rolling back this pre-agreed rebates based on real spend is sometimes a good way of pre-agreeing hard benefits in times of inflation.
A short-cut is to use off-the-shelf group buying contracts through aggregators like Supply Clusters, or others, as they offer such arrangements mostly in this format to their members. And have the added benefit of using others’ volume to drive up discounts, pre-negotiated to specific but fair industry terms.
8. Clawbacks and credits – both these tactics were used effectively by many buyers during the lockdown. Reports of 67% office cleaning savings, 25% reductions in rent, 15% insurance rebates were common. Some organisations were even collecting airline credits to cash-in as a bulk deal, as they anticipate far less travel downstream.
Buyers addressing low-volume usage worked well in the pandemic - if not contractually but morally, as well as from their suppliers’ longer-term relationship perspective. Certainly, from those suppliers which see structural change coming and want to delay any effects of that trend – for example, successful homeworking proving we need less office space and facilities in future.
Today, starting a negotiation from previously unused volume in the recent past at least puts your supplier on the back-foot in requesting price increases. Target your marginal volume categories for obvious savings, before goods/services delivered using higher fixed-cost overheads.
Other opportunities also present themselves as ‘spot-buys’ – for instance, when oil prices were at an all-time low (even negative for a minute, during the pandemic) as well as three-year lows for energy prices in Australia during the crisis. Staying awake at commodity dashboards will be a new requirement for busy buyers in volatile markets. Many might now wish they had done so with petrol tipping almost $2 per litre now, and energy prices on the rise worldwide if not yet in Australia.
9. Stock management – building larger buffer stocks of goods likely to be required in future, particularly DIRECT goods or raw materials, and purchased at today’s prices is a useful hedge against inflationary prices diminishing real margins in future.
Better still, negotiating to persuade suppliers to keep higher stock levels at their cost and their risk is a very valid strategy to address rising prices. Of course, building buffer-stocks was a go-to strategy for many firms whose vital supply lines were threatened during the pandemic.
Better still, again, is to minimise your requirements through stronger demand management strategies.
10. Offshoring – sourcing goods and services in countries without rising inflation makes perfect sense. And is perhaps opposite what many buyers have been considering lately in re-balancing COST advantages from overseas suppliers with the real RISK to assurance of supply in a volatile world growing ever more complex.
That said, much can be done to make vital supply lines more reliable. And, if so, offshoring to lower cost markets without high inflation (however temporarily) makes sense during times of high inflation here perhaps. Examining original sources of component cost, commodities and raw materials will also benefit smart analysis of the ability of your lower-cost overseas sources to sustain low inflation effects. It is also a consideration of whether your company exports a high percentage of product – which might benefit stronger network optimisation (sourcing closer to where you sell your goods) during times of inflation.
Currently, the major sourcing destination for many, China, reports around 2.2% inflation expectations for 2022. This is relatively high for China compared to recent years. That said, whilst many doubt the veracity of ‘official’ inflation figures from China, both the IMF and Bloomberg note inflation expectations in line with this and largely ‘under control’ as at January 2022. India, however, reports 5.6% inflation rates in the fourth quarter of 2021 – both countries impact the region’s cost base significantly. Yet the Bloomberg “emerging” country index (which includes China) suggests inflation falling to an average of 3.37% in Q4 2021. It is worth solid research before building an offshoring strategy to combat domestic inflation.
I think the word “negotiation" is too strong a word, it’s combative and should be done in the context of strong supporting data. It is necessary; I just think that it will be less effective in an inflationary environment if your focus is to maintain prices. I’d suggest using 'collaborating’, which in my mind is more inquisitive, explain to me why prices are increasing, let’s talk about what options are available to us to mitigate these cost pressures, what other sources of value are possible?
I believe the opposite. More price adjustments de-risk the suppliers need to build “fat” into their bid price. I recently conduct a tender process for exploration drilling (hugely inflationary environment as per the current narrative). Client wanted to fix the price for the annual drilling program and that reflected in the new rates – all bidders built that risk into their price. We ended up allowing some highly inflationary cost components for be adjusted prior to the commencement of the contract to remove some risk from the supplier.
This could be linked with no.1 – so that you can maintain 8 tactics.
Double check 6 is not in contradiction to 9?
Food for thought: Increasing stock levels in a low interest rate, highly inflationary environment might protect the business against 1 or 2 price increase cycles? I remember applying this strategy in South Africa when we were operating in +15% inflation – business had cash and so didn’t have barrow to fund the purchase.
The importance of forecasting
Imagine the impact on your business of a cost base rising steadily at 7% - particularly if your income is not rising commensurately at the same, or at an even better rate. How exposed might your CFO feel in such circumstances?
So, keeping tabs on the cost base trend INTERNALLY is important so the CFO can forecast impact and consequences BEFORE they eventuate – or, preferably, in good time to take corrective action (like raising your own prices to your customers).
During high inflation periods it is common for the Finance team to demand monthly re-forecasts of prices and their effect on your cost base from the Procurement team. Buyers are often asked to complete detailed forecasts by category of both actual rising prices (this is what went up this month, and its annual impact) and expected rising prices (this is what we think might happen next). This can lead to tricky conversations with suppliers – simply asking ‘how much will your prices go up in future do you think?’ is rather tempting fate, or at least influencing economic ‘expectations’ which can themselves play a role in influencing actual outcomes.
In effect, this reforecasting process is running an internal PMI process. Yet one directly relevant to your purchase categories and relevant to your business model – far less abstract than the mor generic public PMI indices available in some countries.
A brief outline of the PMI
The PURCHASING MANAGERS INDEX (PMI) – is an indication of change in input prices traditionally estimated by a monthly survey of procurement managers; particularly in the US, the UK, and now Australia, as well as some other countries.
A large group of procurement managers in (usually manufacturing companies) are asked by monthly survey whether they expect prices to rise, and sometimes by how much. The exact composition of different country’s PMIs varies.
Increasingly, this PMI data has become accepted by the market as a valued economic barometer in some countries and treated seriously as such.
The Australian PMI is calculated and published by the Australian Industry Group (AIG): https://tradingeconomics.com/australia/manufacturing-pmi
The old evil returns
The return of the old economic evil – inflation – can come in various forms: Cost-Plus, Demand-pull and Built-in inflation:
The most critical message to help shape your strategy to combat inflation is to fit your approach to your exact needs. Your supply-side profile, actual components & commodities impacted by inflation, and the nature of your business model are all relative factors. So is the relative impact on your demand-side too (your customers) and how the two can be re-balanced better?
We have experienced structural change in our market driven by the Covid pandemic and old norms will not apply so readily in future. Starting with the likely return of that old evil – inflation.
But, if this wave of inflation is more ‘supply-side’ led, as some observe, then perhaps procurement has the potential to do much to help out organisations to cope with it better than in the distant past?
Indeed, if we can help tame the effects of inflation on our organisation, it will be a great follow-up act to the success many procurement stakeholders reported during the pandemic (procurement fully aligned to business needs, proactively guiding stakeholders through red-tape & process, demonstrating a sense of urgency).
If not, perhaps our successes during the pandemic will be consigned as a one-off? In this sense it is a genuine challenge for procurement to frame the rise of inflation in the post-pandemic period as a make or break opportunity.
About the author:
Jonathan Dutton FCIPS holds a non-executive role at Supply Clusters and writes a monthly column for the Supply Clusters members’ newsletter.
He is also the CEO of PASA, who run a wide range of activities to support procurement professionals throughout Australian and New Zealand including conferences, industry roundtables and training workshops.
JD is also the former founding CEO of CIPSA - the procurement peak body in the ANZ region, works as a private consultant on a limited basis and is also a non-exec at Axis Group International based in Perth. https://www.jdconsultancy.com.au/
