Don’t let volatility in raw material markets get you RAW
In the current market environment, almost every kind of raw material is volatile. From a manufacturer’s perspective, “volatile price in the market” means that prices for raw materials—for one reason or another—are trending upward, sometimes sharply and unpredictably.
If and when manufacturers believe that raw material costs will be trending downward, they generally are amenable to agreeing to fixed prices for long periods. After all, even if the finished-product price remains unchanged over an extended period of time, when raw material costs drop, manufacturers can expect higher profit margins as time moves forward. However, in recent years, buyers and sellers have been dealing with the reverse problem, and that is the focus of this article.
Three common contracting strategies
Generally, public agencies that purchase large quantities of chemicals, oil-based products, steel products and other products use one of three contracting strategies to address the raw material cost volatility that exists in the raw materials market. Briefly, those are:
1. Repetitive bid process— Conduct repetitive bids for the same product on a quarterly, semiannual or annual basis. This ensures that the seller always will get a price that the seller deems sufficiently profitable and that the buyer, whether the price is high or low, is reasonably assured of paying the best-available price given the current conditions.
2. CPI-based price adjustments—Put a clause in longer-term contracts that generally allows product purchase price to automatically adjust on an annual basis consistent with the Consumer Price Index (CPI).
3. Cost-based price adjustments—Acknowledge that raw material cost is the one cost element that a manufacturer is least able to control and allow the manufacturer to request annual price revisions based on proven raw material cost fluctuations. This tactic also can be used when other cost drivers such as labor or overhead have significant impacts on supplier costs.
Before we can proceed to a suggested alternative to these three concepts, it is important to briefly discuss the flaws that reside in each of these three contracting strategies.
Repetitive bid process
Clearly, this strategy is administratively expensive for the buyer and the seller. Many of the products in question here are products that are heavily relied upon by the various public agencies.
For example, many water, wastewater and city agencies are dependent on water-treatment chemicals. These products are purchased on a continuous basis, and not treating drinking water when chemical prices are high is not an option. As a result, this strategy causes a purchasing organization to revisit competition for the next purchase of such items almost as soon as the organization makes an award for the current purchase.
This may be the extreme. Most agencies at least attempt to create a one-year fixed-price contract when they make the effort to engage in a formal bidding process. In recent years, however, raw material cost fluctuations generally have impacted vendor profitability every three to six months.
When preparing a bid price in such a market, manufacturers tend to “estimate” (I like the word “guesstimate”) what their raw material costs might be during the next three, six or nine months from the date of the bid and then build today’s price on information not yet known. To make matters worse, manufacturers will tend to inflate that unknown number just to eliminate the probability that their profits might be compromised at some point during the next 12 months. As a result, the buyer likely is going to pay too much for the desired product during the initial months of the agreement and possibly not enough in the later periods of the agreement.
Paying too much is always a problem—and one that needs no further explanation. Not paying enough, however, is a problem that professional purchasers often overlook.
When purchasing water-treatment chemicals, for example, it is just as important to secure confidence that the buyer will receive an uninterrupted flow of product as it is to secure the best price. Most would argue that the guarantee to ensure a continuous and uninterrupted supply is even more important than price. When raw materials are scarce and manufacturers begin to put agencies on allocation, you can bet that the customers guaranteeing manufacturers the most profitability will be the customers first- and best-served.
Finally, this competitive process runs the risk of creating a “revolving door” for suppliers, which can become administratively expensive for the buyer and the seller. When new suppliers are introduced to the replenishment process—especially when chemical supplies must be routinely replenished—the “order-delivery-receipt” process continually must be re-established between buyer and seller every time a new supplier is introduced into the process. Maintaining one supplier over time helps to establish a routine for both the buyer and the seller and leads to a smoother and less costly continuous-replenishment process.
Routine CPI adjustments
This strategy is almost never fair for either the buyer or the seller. The raw materials market is one unto itself. Depending on the commodity, raw material costs fluctuate wildly both up and down. A given commodity can be up 25 percent one year and down 50 percent the next. The CPI index, however, represents a combined average of prices throughout the market, and when all the pluses and minuses are added together and then divided to establish an average, we normally see a change in the CPI of 1 percent to 5 percent.
Please note the percentage range just mentioned. When is the last time that we as professional purchasers saw the CPI go down? It goes up slowly, but it always seems to go up. If this strategy is used and the primary raw material used in the production of the finished product goes down 15 percent, the buyer will grant the seller a price-adjustment increase equal to the CPI when a re-bid probably would prove that the buyer could get a better price in the current market.
The reverse is true for the seller. There is a high probability that the seller’s raw material costs will go up by 15 percent, and an automatic 2 percent CPI increase likely would be insufficient.
As buyers, we say: “That’s why we have a contract. We need to protect our ratepayers/taxpayers, and by avoiding the price increase that was probably justified, this CPI strategy has positioned me to get the best deal for my agency. Tough cookies.”
Well, there’s just one flaw in that philosophy: We need manufacturers. What happens if our hard-line attitude drives them out of business?
This hard-line approach also may backfire when it comes time to renew our contracts through competition. Other suppliers will see how we deal with our existing vendors and either inflate their bid prices or choose not to bid at all. Not having access to needed supplies just isn’t a viable option, so it’s important to deal fairly with the suppliers that your agency depends on to meet its objectives.
In short, a long-term material-and-supply contract that relies on CPI price adjustments rarely is viewed by the buyer or the seller as fair. Often this simply is a default strategy when the buyer can’t figure out another alternative.
The most sensible approach, but …
In my view, the most sensible approach is to allow price adjustments based on changes that occur in raw material costs. But again, the administration of this process often leads us astray.
Normally, clauses that support this strategy say something like, “Prices will be adjusted annually, semiannually or quarterly based on the manufacturer’s ability to show that its material costs have actually changed since the last time prices were adjusted.” There are three problems with such clauses:
1. When is the last time that a supplier contacted you and said, “My material costs just went down, so I’m proposing that the price you pay be reduced for the next 12 months”? To be honest, this never happens. And if the supplier fails to pursue us for a price adjustment, we’re content to allow things to move smoothly along at the same price. However, injury is added to insult when raw material prices return to their old levels and the manufacturer comes forward and shows that its costs have gone up during the past year. Invariably, the manufacturer tries to use that as proof to raise its already inflated prices even higher. Buyers rarely get to ride prices down, but they almost always get to ride the elevator when it goes up.
2. Generally, the supplier provides marginal information to support its claim and, of course, buyers never can determine what percent of price is tied to raw material costs. Consequently, suppliers usually attempt to contend that since raw material costs have gone up by 10 percent, a 10 percent price adjustment/increase is appropriate. Too often, we see the “logic” of this argument and we grant a 10 percent price increase. This means that we’re also giving them a 10 percent adjustment to their labor costs, overhead costs and general sales and administrative costs and that we’ve improved their profit margin by 10 percent. Oops!
3. Public purchasers have a responsibility to maintain a level, fair and impartial competitive process—not only during the competitive process but also throughout the life of the agreement. Unless the price-adjustment calculation process can be defined before entering into an agreement, runner-up competitors may claim later that their costs did not rise as much as the winning supplier’s cost did and as a result they now can sell to the buyer at a lower price than the buyer will be paying the initial low bidder after the new price adjustment is allowed. Admittedly, the probability of actually receiving such a protest is low, but it reinforces the idea that price adjustments in this type of multiyear contract are essentially negotiated prices and not a product of legal competition.
Therefore, it is important to establish a proposal/contracting process that ensures that the exact price adjustment eventually granted to the initial winner will be the adjustment that any and all other competitors would have received had they been the initial low bidder.
In 1996, East Bay Municipal Utility District initiated a multiyear contracting strategy. Between 1996 and 2001, the district experimented with all of the aforementioned strategies. In 2001, the district adopted a modified “should-cost” approach as the price-adjustment strategy for multiyear contracts.
Should-cost is a price-modeling process described in the book “Zero Base Pricing” by David Burt, Warren Norquist and Jimmy Anklesaria. The process uses average statistical cost factors for various industries to calculate the approximate price for a manufactured product. By reversing this process, the district found that it could work from known prices established in competition to calculate the related cost-element values (labor, raw materials, overhead, general sales and administrative costs and profit) used to determine price.
By using statistical information provided in the index of the book, the district was able to work backward from known price information (“reverse should-cost”) to calculate the dollar values of each primary cost element. As a result, the district was able to determine the percent of total price that is impacted by raw material costs.
By holding suppliers accountable for managing their costs relative to labor, overhead, general sales and administrative and profit, the district was able to create a price-adjustment scenario that produces fair price adjustments based on fluctuating raw material costs only, over the life of each respective multiyear contract.
To complete the price-adjustment calculation, it was necessary to identify a third-party raw material index to serve as the indicator for price revision. Available on the Internet, these indices are unique for each contract (raw material type) and are confirmed by various potential competitors to be neutral sources of information that will work fairly for all competitors in the determination of future price adjustments.
The authors of “Zero Base Pricing” did not necessarily envision this to be an effective tool primarily for public agencies. In fact, it was designed to help large companies with significant resources to obtain the information that they needed (along with significant investigation) to look at the cost elements of a product and determine what any given product should cost. Given that detail, private-sector buyers were positioned to negotiate price from an informed position, which is much different than bargaining for price.
Public-sector buyers, however, now are learning that given price (which is established in competition), they can use the information in “Zero Base Pricing” to determine appropriate relationships between cost elements and product pricing. The advent of the Internet provides a source of information by which raw material costs in the marketplace can be tracked for almost any commodity, from chemicals to metals to paper products. For example, if a should-cost calculation enables the buyer to know that raw material costs are 30 percent of price, and the raw material index for the primary material used to manufacture the contracted product shows a 25 percent positive market adjustment, the buyer automatically understands that a 7.5 percent (25 percent of 30 percent) price adjustment is in order.
In a 3 percent CPI world, this price adjustment would have been 3 percent, and it would have harmed the supplier. In a “prove-it-and-you’ll-get-it world,” the vendor would have received between 0 percent and 25 percent. Knowing that the buyer lacks information, the seller opens negotiations at 25 percent and the buyer counters at 0 percent, hoping to buy time to figure out what the real price should be. The negotiation often ends somewhere in the middle (around 12.5 percent), with the buyer believing that he or she saved a lot of money and the seller returning to his or her office with a 5 percent (12.5 percent to 7.5 percent) windfall that goes directly to the seller’s bottom line.
A final benefit to this process is that it puts the buyer in a position to proactively manage price adjustments. There is no need to wait for the vendor to contact us and claim that a change is necessary. The dates for change are identified in the contract, and on those dates, the buyer looks at the appropriate raw material index and compares the current index to the index at the time of the last price adjustment. The buyer then calculates the price adjustment and sends a change-order notice to the supplier, informing the supplier that, “In accordance with Section X.XX of contract number XYZ, the price for the subject product will change from $A.AA to $B.BB.”
Now there is no fear that vendors won’t reduce prices as raw material costs go down, and there is no negotiation when raw material costs go up.
Should-cost is not infallible
At its best, should-cost only puts the buyer in the ballpark. From company to company, the various cost ratios never will be exactly the same. Even so, the industrywide average consistently proves itself to be relatively close.
The statistical data offered in Appendix E of “Zero Base Pricing” is old and, to my knowledge, has not been upgraded since the book was published in 1990. However, it does summarize a wealth of data, so the fact that some companies have introduced new technology and processes into their respective industries since 1990 may contribute to a slight statistical variance from the published data.
In my view, the resulting deviations in cost calculations are not significant. Suppliers in a wide range of industries (such as the chemical, steel and paper industries) rarely have challenged this agency’s cost-to-price ratio calculations. But then again, not being absolutely accurate may be a benefit.
When the cost-to-price ratio identified in the resulting proposal/bid is off by more than 5 percent, potential competitors should complain. When the complaint can be confirmed by asking other potential competitors, a more accurate cost-to-price ratio can be identified via an addendum to the proposal. When this happens, the buyer ends up with information that is relatively accurate for the commodities included in the bid. This leads to price adjustments that are equally appropriate and reflective of the actual costs incurred by the manufacturers.
If, before bids are due, a competitor complains that the material cost-to-price ratio is inaccurate, the buyer should contact other potential competitors and ask for their feedback on the issue. If there seems to be a consensus that the ratio identified in the proposal is inaccurate, it’s appropriate to issue an addendum that changes the ratio to be more consistent with the actual information provided by the various manufacturers. The long-term benefit is that the buyer now knows exactly what an appropriate ratio for the product in question should be and can depend on that ratio for a long period of time.
Results to date
Since implementing a multiyear contracting strategy, savings for the East Bay Municipal Utility District since 1996 have accrued in the areas of organizational operating costs and prices paid for materials and supplies.
With regard to operating costs, two changes in the way that the district purchases materials and supplies have been implemented, so it’s hard to distinguish how much of the total savings should be allocated to the respective changes. The first program change introduced use of a purchase card for high-volume, low-dollar value transactions. This action reduced the annual number of purchase requisitions received by the Purchasing Division by 67 percent.
The purchase card program positioned buyers to spend more time managing high-dollar-value contracts, and in doing so, they had the time to devise and implement the multiyear contracting strategy that is the subject of this article. This strategy (multiyear-contract price-adjustment process) actually reduced the number of high-dollar-value contracts that had to be rebid every year, so the program also helped reduce the division’s overall operating costs.
Ninety-six percent of the division’s operating budget is allocated to labor and the related costs (such as medical benefits and salary taxes). Salaries to district employees have risen 36.6 percent over 10 years, but the Purchasing Division’s operating costs have risen only 12.5 percent during that same period. This 24.1 percent difference represents an annual operating cost reduction of $73,200.
When looking at material price changes, the district tracks a market basket of items that it purchases in high volume every year. These products are tracked in four major commodity types: paper products, steel pipe products, water-service brass products and chemical products. These products are key to the operation of the district’s treatment and distribution of water and disposal of wastewater, so utilization is surprisingly consistent year over year.
During the first five years of the program, the district actually witnessed a purging of costs that served to inappropriately escalate product prices over the years. In 2001, the district actually paid 10.2 percent less for materials and supplies than it paid for those same products in 1996. During that period, the CPI rose 21.6 percent. The difference in the prices paid compared with what they could have been if allowed to drift with the CPI equaled $15.9 million in 2001 alone.
However, it was about that time that raw materials prices in the worldwide market began to rise at a rate that generally outpaced the CPI. China was well into its infrastructure upgrade program, and its demand for raw materials put a strain on commodity prices worldwide. Nevertheless, the district did not start paying higher prices for material and supplies compared with 1996 until 2004.
At that point, the district paid 2.1 percent more for materials and supplies than we paid for the same products in 1996. Currently, the district is paying 21.8 percent more for materials and supplies than was paid in 1996, but the CPI has risen more than 33 percent since that time. The difference still represents an almost $6 million annual cost avoidance compared to growth in the CPI.
A significant result of this program has been related to the consistency in which absolutely critical materials have flowed into the district from its various suppliers. Despite the volatility of prices in the chemicals and metals markets over the last decade, this contracting strategy has enabled the district to create vendor relationships that have served to ensure a continuous supply of critical materials to the East Bay Municipal Utility District.
Before closing, it is important to note that this process is not perfect. Among the reasons:
1. The cost relationships identified in “Zero Base Pricing” are for manufacturers. Many of the companies with which public agencies do direct business are distributors and/or retailers. As one moves down the “food chain,” the ratio of material cost to price increases. Going through the should-cost process described in the book and the reverse process described in this article should equip buyers with sufficient information to talk to people who represent the supplier community and gain information that better positions buyers to identify appropriate ratios for the supplier community that they are using.
2. If you purchase “Zero Base Pricing” in an effort to better-understand should-cost, know that the book does not teach the reverse calculation process (in which price is known and cost elements are unknown). It teaches how to calculate price if one or more of the cost elements are known. “Zero Base Pricing” also fails to calculate the various cost-element-to-price ratios (labor to price, material to price, overhead to price, general sales and administration to price and profit to price). These details were developed as a result of the concepts learned from the description of should-cost found in the book.
On the positive side, however, this process will cause buyers to review the basic cost elements that lead to price. Just knowing these basic concepts will help a buyer understand why a 10 percent rise in raw material costs is not justification for a 10 percent price adjustment.
This process also serves a buyer well in helping the buyer understand at least the general parameters of price development, and it positions the buyer to talk about these issues from an informed perspective with sellers. When the buyer is informed and the seller senses this, information soon evolves that enables the buyer to establish appropriate price-adjustment parameters and, therefore, create multiyear contracts that ultimately will position purchasing personnel to more effectively serve their client base.
A review of the basic concept of cost elements and how the various elements combine to identify price also will reveal other uses for this concept. For example, the idea can be used when the basic cost driver is labor or overhead and not raw material.
The concept also is useful in the administration of service contracts, such as security guard service contracts. If a guard is asked to work overtime, should the bill rate for the overtime hours be time and a half, the basic (straight-time) bill rate or some rate lower than the bill rate for straight-time hours? By recognizing and identifying cost elements, the buyer quickly learns that cost elements to cover things such as vacation pay, sick pay, other benefits and uniform allowance are recovered in the straight-time bill rate but do not expand just because a guard works a few extra hours in a day. As a result, when these hours are deducted from the bill rate calculation, a buyer generally will conclude that the bill rate for overtime should be less than the normal bill rate—despite the fact that the person doing the work (the guard) gets paid time and a half and the dollars associated with income taxes go up accordingly.
Finally, because nothing is perfect, it DOES make sense to rebid your material-and-supply contracts at least every five years. In the event that the adjustment process used during the life of the agreement begins to favor either the buyer or the seller, periodic competition will serve to reset the clock and correct any imbalance that may have accrued.
About the author
Paul Ghere has been the manager of purchasing for the East Bay Municipal Utility District in Northern California for more than 13 years. Before that, he spent 25 years in various purchasing and materials management positions at Fortune 100 private-sector companies. He periodically has volunteered his time to share his purchasing-related experience in training forums sponsored by the California Association of Public Purchasing Officers and the National Institute of Governmental Purchasing. Ghere is a graduate of California State Polytechnic University.