Using Price Indexes for Contracting and Negotiation (Part 2)
In the first post in this series, I discussed a range of available approaches for managing and mitigating commodity price risk and volatility, including the deployment of pricing indexes. You can also read a basic overview of the subject we wrote a couple of years back during the last commodity boom: Using Sourcing Intelligence to Combat Commodity Volatility -- The Price Index Advantage. Today, I'll share some lessons learned that Paladin Consulting recently posted over on Iasta's blog in an entry that looks at the pitfalls and mistakes in crafting indexed pricing.
In the post, Paladin Consulting's Rob Patton suggests five pitfalls to watch out for in using price indexes. These include "failing to synchronize index price with your purchase price" by using the wrong calculation to craft a raw material component calculation on a total cost basis. Another mistake companies make is failing to adjust prices frequently enough. Here, Rob recommends that, "in volatile markets, consider adjusting prices at least quarterly and perhaps monthly." By the same token, when it comes time to renegotiate or revisit a contract, it's also important to evaluate whether the underlying index a price component is pegged to is still appropriate. For example, if production is coming from a different facility in a different geographic market, it may make sense to shift an index to reflect the local country/geographic price.
Rob also suggests that we shouldn't get too lax in trusting suppliers to "automatically adjust pricing consistent with the agreed upon index." Here, we need to "Trust but verify," he suggests. Companies with more advanced electronic invoicing and payment systems and controls may wish to tie invoice matches and pricing to underlying contract terms/conditions including indexed pricing references within the contract and third party index data-feeds on a live basis (e.g., MetalMiner IndX). This can ensure that invoices above the amount they should be aren't approved based on the underlying contract and movement therein is related to the price of an underlying index.
Most companies that I talk to are still in the early stages of deploying price indexes in contracting, let alone using more advanced hedging and commodity risk management techniques. I hope through the types of suggestions that Rob shares as well as our continued coverage of the topic, we can start a broader conversation to enable more organizations to deploy price indexes and risk management strategies more effectively. If you have something to add to the topic, please chime in!
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In my experience, suppliers' sales teams in general don't really understand index-based price adjustments. And if you are incorporating multiple indices into a price adjustment formula (e.g., aluminum for a portion, labor for a portion), the chances of suppliers getting the price adjustment calculation right are very slim.
A basis for a supplier selection is the fact that all prospective suppliers will submit their pricing based on a uniform formula. So, when it comes price adjustment time, the winning bidder must absolutely adhere to that formula. Otherwise, your entire selection criteria become invalidated. This can get contentious, so that pre-bid meeting (or web meeting) is essential.
It took the customer a while to even realize that there was a discrepancy, as nobody was really monitoring that contract closely. Which brings me to a second important point: Category managers who want to apply index-based pricing need to be ready to put effort into monitoring pretty closely, especially if changes are applied monthly. They need to weigh the potential benefits against that effort, and also work closely with their Req-to-Pay folks to get invoices and payments right. I've seen several months worth of payments being put on hold, because "nobody" could tell easily if the invoices were correct.