Short-term buy ideal in economic downturns

While fixing the purchase contract period of a strategic input item, there are usually two broad criteria that the procurement team keeps in mind. One is the price trend of the item and the other, the demand for their finished product. The demand for the finished product helps to determine the quantity of the input item to be bought at one go, and the quantity to be bought thereafter. Purchasers obviously prefer a shorter term contract if prices of the finished product is expected to drop by the time the next lot is bought.

Also, in case the demand for the finished product starts to fluctuate, production is also curtailed, and inventory of input items bought just for a month may turn out to be inventory for three months!

This is precisely what has happened in the last economic downturn of 2009, when most industries found demand of their finished product plummeting. In order to control inventory, therefore, most of them resorted to short term sourcing of their strategic inputs.

Short-term contracts

Purchasers opt for short-term contracts or spot buying primarily when the demand for their finished product is uncertain, and short contracts help in inventory control.

However, such contracts increase the administrative cost to a great extent. Purchase orders must be released more frequently and deliveries have to be ensured by pushing suppliers who are inevitably new each time.

On the flip side again, if the input item of the seller is volatile in nature, the seller can decide quickly the best price at which to sell. Sometimes the seller also sells at prices below his cost of production as future demand is uncertain and he urgently needs to clear inventory in order to ensure cash flow.

However, industry best practices indicate that long-term sourcing is ideal, as it creates a perceptible price advantage as well as creates dedicated suppliers.

Long-term sourcing

Industry trends indicate that if a finished product is in demand, it makes sense to opt for long-term contracts of strategic input items. For one, bulk buying inevitably means more discounts. The other major advantage is that it helps to build a long-term and valued relationship with the supplier. Since strategic inputs are mandatory for the production process, and are usually required in large volumes, they are usually also scarce and highly priced. Thus, a long-term relationship with the supplier of such a commodity is also valuable for a buyer.

However, it is also important that a purchaser must have sufficient negotiating power and the situation for the item is not monopolistic in nature. For instance, if the supplier supplying furnace oil is as big as Indian Oil and the purchaser’s buy is not even 5 percent of the total volume sold by the seller, the purchaser will have no choice but to comply with the terms set by the seller.

Thus it is only in a competitive market that long-term contracts can secure supplies from the sellers who agree to such contracts.

Apart from assured supplies and a long-term relationship with the vendor, the other consideration for a long-term contract is of course the price. However, if the price of the input item is volatile, the seller will put a higher purchase margin on the selling price for long term negotiations, making the buy expensive. The purchaser, in this case, can impose a price variation clause (PVC) on a benchmark input price.

In case the input material is an exchange traded item, the PVC clause works well. However, for non-exchange traded items, things may not work out always as desired.

A Steel Plant for instance, had floated a tender to buy 24,000 tons of silicon-manganese for the period September 2009 to August 2010. A price variation clause linked with Manganese Ore India Ltd (MOIL) price list, power cost and the fixed cost of the manufacturer had been indicated in the tender.

But in case cheaper imports of manganese ore start flowing in, the Steel Plant will pay a higher price to the vendor for a full quarter as MOIL revises its price list every quarter. In spite of this, advantages of long-term contracts far outweigh its disadvantages, according to industry users.

Dynamics of exchange traded items

Metals such as copper, aluminium, zinc, lead, nickel and crude oil are exchange traded items and deciding on a contract period is much easier in case the products are bought from a competitive market. Purchasers often buy products which contain major quantity of these exchange traded items. Here they can indicate to the seller that price settled in a long-term contract would follow the price trend of the exchange. Benchmarking a major part of the product thus leads to an effective long-term contract.

For example, dry cell battery manufacturers often buy zinc through long term contracts from international sellers, using the London Metal Exchange (LME) prices as benchmarks.

Driven by demand and supply of the exchange traded commodity, both physical and notional, declining price at the exchange is likely to be accompanied by heavy buying which will drive up the price. Similarly, rising price will be accompanied by selling of the commodity if the participants at the exchange feel the price has risen enough.

Determining the point at which market reversal will take place is difficult and this gives rise to widespread speculation among the market participants.

However, for a non-exchange traded item, such a benchmark is difficult to get and hence the benefits of a long-term contract are negated. It is natural for a SAIL buyer to benchmark steel products buy on the price they set, but other buyers may find imported price ruling much lower than SAIL price.

Non-exchange traded items

Items such as steel and polymer are not normally dealt through exchanges and hence decision making for long term contracts is difficult for buyers of such items.

Even steel makers buy steel through spot contracts and benefit immensely. For this, it was found that a Steel Plant, with a Growth Shop which produces ladles and torpedo cars for the steel plant, buys flat products in spot contract through the reverse auction route. This forms a part of their regular procurement for the company.

More and more converters manufacturing PP bags used for packing cement and fertilizers import their strategic item polymer granules, when domestic market price rises above the imported landed price.

At one point of time, it was found domestic caustic soda manufacturers were losing out to the international players as domestic buyers such as Hindustan Lever preferred to import than keeping long term relation with domestic seller for manufacturing soaps and other detergents.

To avail the emerging opportunity, several buyers were seen to outsource their non-strategic items to a third party vendor. Their internal procurement team was removed from the burden and was asked to focus only on strategic items which included procurement of steel and various metal in bulk quantities.

A Steel Plant based in central India, for example, had benefited by implementing outsourcing of non-strategic buy through third party vendors. In case another economic downturn is apprehended, market insiders are therefore of the opinion to allow experts to operate at least in the area of non-strategic items procurement to judge the best contracting method for the benefit of the procuring company.