This risk is as old as Procurement itself. Demand drives prices. Always has, always will. But let’s start by expounding the pounding before we give you a few tips to deal with it.
Expounding the Pounding
Costs rise. Continually. The average rate of inflation in the United States over the past hundred years is approximately 3.2%. That means that something that cost $1 in 1914 would cost approximately $33 today. Costs go up. However, costs are not static. During pandemics, wars, natural disasters, and market crashes where there are huge drops in supply and surges in demand, or vice-versa, the average rate of inflation can quintuple or more (with a recorded rate of 23.7% in June 1920). The same happened to shipping costs during the pandemic. Three thousand dollar shipping contains shot up to thirty thousand, a factor of ten.
However, it’s not just inflation, and surges, that are the issue. It’s also consumer demand. If consumer demand shrinks as costs rise, and the company, and its suppliers, are unable to reach and maintain the optimal economy of scale, costs will rise even more. (Every company has its own optimal output level where it can operate at maximum efficiency and maximize outputs relative to inputs. If output is too low, and resources are not being used at capacity during regular operating intervals, the cost per unit of product is higher than it should be. Similarly, if that peak is surpassed, then overtime will need to be added, additional equipment and lines, which can’t be kept producing at optimal levels, will need to be added and so on.)
And, of course, it is available supply. If the product requires a renewable commodity or raw material where there are limited harvests or limited mining capacity, there just won’t be the supply to meet a rapid demand surge. This will cause prices to surge even more (as sellers sell only to the highest bidders as the balance of power shifts fully to them).
Due to the rapid rise in global market uncertainty around product and material availability and cost — due in part to an increase in natural disasters and extreme weather, wars, geopolitics and trade wars — managing this balance between consumer demand, market supply, cost, and inflation is a tough equation.
Reducing the Risk
There’s no easy or truly global solution here. Every category, and product, is different. Every supply and demand market is different. Every country has its own trade rules, economic plans, and sanctions. And all of this can change overnight. A mine collapse or factory fire. A rapid drop in demand due to recession. A new sanction or 145% tariff. And so on.
However, if we break it down, there are three main risks:
A) Unexpected Supply Unavailability
Due to a natural or man-made disaster, your (primary) source gets cut off.
B) Unexpected Drop in Consumer Demand
Due to a new external market condition (recession and/or massive layoffs, more popular competing product, brand backlash, etc.), consumer demand suddenly drops.
C) Unexpected rapid cost increase due to natural or man-made events.
A pandemic, droughts in Panama, or terrorists (in the Red Sea) slow down or cut off shipping routes and escalate costs. Or a mine collapse shoots up raw material costs.
For each of these risks, there is a primary solution:
A) Dual/Tri-Sourcing
It’s critical to always have an alternate source of supply in an alternate geography that can be scaled up rapidly if the primary source of supply becomes unavailable. Don’t do 80/20 or even 70/30 splits if the product, part, or material is critical. Do 60/40 and make sure both suppliers could handle at least 50% additional capacity before awarding. (That way you are still fine if the 40% supplier becomes unavailable as you should be able to scrape by long enough to find an emergency replacement supplier, even if the cost increases moderately. Most importantly, if the 40% supplier is willing to do some OT, you would still be fine for a short interval as long as you were willing to pay some OT related costs – and there’s no way that would be the case with a supplier getting less than 40% of the award.) Better yet, for (very) large categories, do 40/30/30 splits (possibly by giving majority per regions if your organization is global). In this situation, one supplier becoming unavailable wouldn’t be a serious problem as you’d be fine if the other suppliers could supply an extra 50% to 60%.
B) Flexible / Discount-Based Contracts
Never assuming continually increasing demand. Hope for it, but look at past averages, rises, and falls, and typical drops in demand from an unexpected, negative, market impact, and negotiate contracts for a range, with cost reductions (and not discounts) when thresholds are reached. In other words, once you know the expected worst case to expected best case range, ask for quotes for at least 3 tiers, the minimum, the expected, and the best case range and negotiate a contract with price breaks when certain demands are reached. (Suppliers will love to offer rebates when you hit a tier, but don’t fall for that because you’ll never realize them because the onus will be on you to prove that you’ve purchased the required quantity. Even if you have the best e-Procurement system on the planet and capture every order, as well as returns and show any refunds were accounted for, and can document it all, you still might not get the rebate. The supplier could claim hardship or, if the amount is significant enough, file for bankruptcy protection and restructuring. And even if they have the money, if you can’t assemble and provide the necessary documentation before the contract expires, forget about the rebate after the contract expires.) As long as you ensure every order, invoice, and goods receipt, flows through your e-Procurement system, you can ensure that as soon as the first discount tier is reached that you issue the PO for the lower amount. (And then your system will refuse to auto-approve it if the invoice doesn’t reduce the unit cost appropriately).
This way, you’re paying more than you’d like if you hit the worst case, but you’re not paying a huge penalty when you don’t hit the contracts and the suppliers come after you for damages.
C.i) Alternative Source Ramp-Up
If the price skyrocketed due to a supply issue with a specific region or supply base, you switch to the alternate supply in another region until the issue passes or you identify a new secondary (or tertiary) supplier for the product or component or material.
C.ii) Alternative Product/Component/Material
If the price skyrocketed due to a drop in supply, pushing all the power to the suppliers, then you switch to alternative products/components/materials. This is difficult because you need to have alternate designs ready to go for custom-made products and have previously identified alternatives for standard/off-the-shelf products which, while more costly or less desirable at the time, are now the most cost effective or most desirable products/components/materials due to the change in market dynamics by a material/component/product unavailability.
Unfortunately, while these solutions all sound simple, they are different for every category, product, material, organization, and geography. Risk management and supply assurance (as summarized the doctor‘s and Bob Ferrari’s Direct Sourcing MUST be Supply Chain Aware and Vice Versa series, summarized in Part 7) become as important as cost, and in some locales, carbon management when sourcing. The (expected) worst case has to be considered at all times and key events need to result in multiple, but balanced, awards.
And of course, when it comes to risk management, there will always be exceptions to the rule that you need to look out for.
