Managing raw material risks in procurement

In the highly competitive global automotive industry, every penny counts at every stage of the process. For suppliers, winning a contract at a price that allows a reasonable profit is an important first step, but managing costs all the way through development, production, and delivery of components is a long road with plenty of potential potholes.

The purchasing department faces one danger zone, procuring raw materials and items that generally add up to between 40% and 70% of the selling price. A challenge lies in the fact that raw material prices operate according to their own laws of supply and demand, and in recent years we have seen periods of not only gradual trends but of outright volatility.

Given that suppliers’ contracts are typically for the life of a vehicle program, a price swing in a key ingredient can change the equation for a component and turn a good job into a bad one within months.

Raw material price volatility came to our attention in 2008 when some clients were finding double-digit price increases each week for several types of steel. IRN was asked to gauge how widespread the impact was and how suppliers were coping.

In our survey, 96% of respondents said they had experienced significant enough increases to approach customers for relief. One-fourth of respondents felt without financial assistance from the customer, they might need to stop shipping parts.
 

The economic downturn in 2009 alleviated the problem, although not in a way that anyone would have considered an improvement. North American light vehicle production plummeted from 15.0 million units in 2007 to 8.6 million in 2009, decimating raw material demand as well.

Proactive suppliers have developed more systematic solutions to managing material price uncertainty. A popular option is to work with the customer to negotiate an agreement that adjusts component prices according to what is happening with raw material prices, using a commodity price index as an external data benchmark.

Other tools include negotiating with raw material suppliers for fixed price contracts, or hedging through the use of futures contracts, swaps, or options.

Since 2010, suppliers have increasingly worked to manage volatility at the front end of their contracts. The percentage of respondents to the annual IRN survey who are in the position of seeking cost recovery from at least one customer has fallen from 81% to 52% for steel users, and 71% to 53% for aluminum users.

Industry observers believe price volatility is here to stay for many raw materials used by automotive suppliers. Risk management in purchasing is likely to be a skill that continues to evolve and comes to serve as a competitive advantage for the most savvy and attentive suppliers.

IRN Inc.
www.think-irn.com

About the author: Vice president of automotive research group IRN Inc., Melissa Anderson has worked with automakers and suppliers since 1986. She can be reached at melissa@think-irn.com.