Daily Archives: September 6, 2007

The 2nd Sourcing Innovation Series: Trading on the Spot Market

Last summer, as part of the Sourcing Innovation sponsored cross-blog series on The Future of Sourcing, Jason Busch theorized over on Spend Matters that securitizing direct materials and capacity was in sourcing’s future and that suppliers would benefit from the model as well as buyers.

Under the securitized capacity model, suppliers would be able to forward sell capacity and realize cash flow to fund investments in equipment and labor. They would also benefit through an improved understanding of market price for capacity. Buyers would benefit through an ability to balance reserved capacity and spot-buy capacity to handle demand spikes and to do so at true market prices. They could also take a more active role in acquiring the underlying commodities that go into finished parts from suppliers, reduce risk and variability of supply markets pricing, and avoiding escalation / de-escalation clauses entirely. In addition, if they were not happy with the current market price for capacity, they could try a direct negotiation technique, or they might hedge their bets by buying a “call” on future capacity rather than the underlying contract itself. And if they know the supply market well, perhaps they might even become a trading party, buying and selling capacity for profit based on their analysis of the market.

And now we have some proof that Jason might be right. According to a recent study by Haim Mendelson and Tunay Tunca at Stanford’s Graduate School of Business, strategically using both fixed-price contracts and open market trading, supply chain participants can create greater efficiencies. Furthermore, both consumers and supply chains as a whole will benefit from these efficiencies.

Given that availability, costs of raw materials, and consumer tastes fluctuate, shorter-term spot trading is appropriate to handle these fluctuations. Furthermore, just as the stock market summarizes many pieces of information about the performance of a company, business-to-business spot markets can provide up-to-date information about the availability of raw materials, the cost of production, and consumer demand for the end product. Because all of this happens much closer to the time that the end product ships to the consumer, supply chain participants can update their plans to take into account real-time information.

However, it’s important not to overuse the open market, as that can have its drawbacks. Haim and Tunay found that the more you trade, the more you drive the price against yourself. For example, a manufacturer may want to buy 10,000 computer chips at $1 per chip, but trying to buy twice that amount may force the manufacturer to pay twice that amount as cheaper suppliers become exhausted. Thus, buying only in the on-the-spot market raises the risk that you’re going to spend more than you would have in a fixed-price contract made six months ago. On the other hand, you have a better idea of actual need, and may end up spending less by not overbuying. Suppliers face similar risks and benefits, and so may also benefit from both early contracts and spot-market trading. Thus, the best balance between long-term contracting and the spot market depends on the liquidity of the spot-market in the industry a company is buying in.

A good spot market creates efficiencies not only in the spot market itself, but also reaching back to the long-term contract stage. Furthermore, suppliers will anticipate when a well-functioning spot market is rising – where information about supply and demand is current – and price will become competitive early on. This makes the supply chain more efficient and increases the total profit potential while also benefiting consumers, as a more efficient supply chain translates into lower retail prices.