Hitting on the right price

June 26, 2009: Purchasers are always on the look out to buy at prices lower than their previous purchases, provided market conditions are conducive for doing so. Obviously, this does not apply fully for project procurement which is generally a one-time buy, but would definitely apply for all commodity type items which he buys regularly.

The economic downturn has given rise to a peculiar problem in this regard. Buying commodity items has become tricky, as prices have slumped, and are inevitably lower than the last purchase price. In this situation, the extent of negotiations for lowering prices has become a debatable issue.

Purchasers normally depend a lot on cost break-up before negotiating for an item. The break-up goes as far as the cost of production of the supplier and manufacturing process of the commodity. However, the estimated price based on cost break-up is slowly proving to be inaccurate as suppliers generally innovate a lot to bring down the cost of production.

This becomes evident while negotiating with a large number of suppliers online. Prices often drop far below the estimated cost in such reverse auctions and the primary reason for this is the falling demand caused by the economic downturn. The suppliers obviously want to keep their production facilities running as shutting down an establishment may not be the ideal solution in the current crisis situation.

At the same time, buyers cannot depend on such low prices to continue, and thus depend on this to ensure a steady supply of their critical items. So he needs to make a long-term contract for buying critical items which are required in large volumes. Long term contracts for buying of iron ore and coking coal by steel companies who do not have captive mines are perfect examples of this kind of buying.

Tackling commodity price volatility

Purchase price is crucial for any company as a reduced buying price directly affects the bottomline of the company in a positive way. But the purchasers unfortunately have to pay in line with the prevailing market price, on which he has very little control. Thus in the current scenario, cost reduction efforts which are not limited to price reduction only, have become a necessity when the selling price of the company's finished product drops in the face of severe competition.

When market price for an input material soars, the purchaser will obviously buy at a price which is more than the last procured price. He may bring down on the usage of the particular commodity in his plant by innovative concepts to ensure cost reduction. One such concept is the supply-apply technique where the buyer pays on consumption basis provided the supplied material lives the committed life span. Total refractory management operates on a similar concept while buying refractory items. Steel plants like JSPL, have, in fact, managed to procure refractory items at the same price for the last two to three years under such schemes, plant officials said.

When the market price of an input material falls and if that critical item is an exchange traded item, it is fairly easy to negotiate with the vendor, going by how much the price at the exchange has dropped. So for panel builders or cable manufacturers buying copper and aluminium flat or wires, London Metal Exchange provides an ideal reference point.

But the real challenge comes while negotiating a non-exchange traded item which is critical in nature in a falling market. Purchasers need to set up their own control mechanisms or are soon controlled by the suppliers who ensure that purchasers pay the price they dictate. Tata Steel has come up with such a control mechanism for buying nitrovan from its monopoly supplier in South Africa. The "floor and cap" mechanism ensured buying at a controlled price even when the market price was fluctuating heavily. Cement manufacturers could also control their input prices while importing clinker to meet their expected selling price.

But on the other hand, sulphuric acid manufacturers could not control their buying price of sulphur through innovative processes and this completely eroded their profit margin.

Dependence on information technology has been attributed as a success factor to companies who successfully implemented suitable control mechanisms to buy critical items.

Information technology

Information technology like enterprise resource planning (ERP) centralising all data helped to reduce the duplicate work which the procurement team would have otherwise done. Thus in the time saved, the procurement team could innovate successful control mechanisms to control non-exchange traded commodity items.

Leading companies have even outsourced their low critical and low volume buy to service providers who buy on their behalf. This further saved time to the existing purchase team.

For the low critical and high volume purchase, the e-commerce mechanism was applied to negotiate with large number of suppliers online. Price was discovered in such mechanism on a real time basis defying geographical and time zone barriers. Suppliers all over the world can participate in a specific time and submit their bids in a competitive market to bring value to the purchaser. A purchaser, here, is not much involved in the buying process as the service provider offers the required service on behalf of the purchaser.

In large multinational companies who have multi-locational presence, buying visibility is offered by spend analysis programme on an IT platform which looks into each of the items bought by its every plant. Aggregation of low volume buy leads to a high volume purchase and a buyer gets suitable discount without much effort.

But the dynamics becomes totally different for project procurement as project buyers in a volatile market are going through a bigger dilemma of which price to buy.

Vagaries of project buying

A project buyer recently negotiated a package at half the price of what he got before the downturn. It was only later that the project supplier revealed that the negotiation could not affect his sales margin as it only wiped out his purchase margin!! It was thus clear that the project price could have gone down further.

Looking at these developments, a steel plant decided to negotiate the price of a package excluding the steel price. Steel was declared as a free supply item to the contractor. As steel constituted a major part of the total input price of the package, most of the purchase margin of the project supplier was now under control.

Some companies have also started to exclude price of cement from the project purchase as cement also forms a good part of the input cost. It was easy for the large companies to get a better discount for buying cement rather than the small competitors.

But in a downturn, not all project companies are looking to reduce their buying cost, as that may affect timely delivery of critical projects.

For this reason, a project company imported its prefabricated parts directly from China. Prefabricated parts for the aluminium smelter project consisted of over dimensional parts whose logistics cost was high. With bitter previous experience with domestic fabricators, the company decided to buy from China paying a higher cost. This was in order to ensure timely completion of the project.

In the current conditions, the buying price is thus directly related to the control mechanisms which the purchaser can implement. A logical and well thought out mechanism can help to keep the buyers well ahead of its competitors.

Source: Sourcing Insights