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Which Price Increases Are Fair?

22 May 2022

In these inflationary times, when you might be facing price increase pressures from your suppliers or thinking of increasing your products/ services prices to protect business margins, it becomes absolutely critical to be able to intelligently answer the question ‘Is this price increase fair?’

Please watch the video carefully to understand the Price Fairness approach. This would help you deal with the situation with confidence and logic rather than just taking a GUT (Gave Up Thinking) based decision because the margin of error in these times is very thin.

I am also sharing some additional information below with examples for you to deep dive into this matter.

From a procurement and cost management point of view, we must understand the procurement success factors.

Procurement success factors

  • Understand your standard costs (COS / COGS line in P&L) and how it impacts Gross Margins
  • Review cost drivers that have an influence on supplier cost movements
  • Track your costs on monthly basis and measure variance standard cost / budgeted costs vs actual costs
  • Focus on “what you can control” – Deploy all sourcing levers – 3Rs (Re-negotiate, Re-Source & Re-design)

You need to understand the cost of sales in your P&L and how it impacts the gross margins. Also, it’s important to understand the cost drivers. You need to track the cost and the movement of costs diligently. In a business where you’re bidding for new projects, and by the time you have the project, you might realise that the cost which you have considered is no longer valid. And you might be making losses. If you don’t re-open the discussion, that’s the hard part of today’s environment. We have little control over it. As a professional business, be in control rather than worry about what’s happening in the marketplace. But the reality is, if you have supply, you can fulfil the demand. And if there is no supply, you can’t ever fulfil the demand. Going back to managing the cost, fundamentally we’ll maintain a very transparent and close working relationship with the suppliers and customers. There is no point in holding back the information as there is really no trade secret in today’s business environment. So successful businesses, whether they are large or small, is not what they do, it’s how they do it.

Some Finance basics:

  • P&L
  • Sales Revenue – Cost of Sales = Gross Margin
  • Gross Margin – Overhead – Selling Expenses = Operating Profit

Cost of Sales can be on an average of 50-70% for manufacturing companies, and it can be as high as 80-85% for trading businesses if they’re simply not adding any value.

So, the key question is, do you know the cost structure of what you’re buying? Bring some focus to the factors which influence the cost. Any business will have an element of energy and labour involved. And there is a logistics rate when you move stuff from point A to point B throughout the supply chain. Now we’re seeing an unprecedented increase in the freight cost. The container price of a 20-foot container to move stuff out of China used to be around $1,500 and is now $10,000. So it’s a highly challenging situation. Freight used to be around 4-5% of the total project cost, and it’s now taking up 15-20%.

How to assess whether the cost increases are fair. What is the systematic way to understand that? How does the volume affect the pricing?

Here’s a very structured, simple and practical process for you to easily understand.

Step 1

Conduct a detailed review of all the cost factors, not just today but also apply this analysis to a medium-term period of 3 to 5 years

It is important to know if you are dealing with the supplier, or dealing with the customer. You have full understanding of where we are coming from, what is happening today and what has happened in the past, whether the supply pricing, whether to go with a customer pricing in raw materials, energy and exchange rates? Consider all variables we discussed earlier. The reality is, that most of these variables are cyclical. They go up and they come down. So you need to review with your suppliers or with your customers. Did you receive any reductions from your suppliers when they were at a low point? Did you get any discounts? Most commodity historic price data and forecasts are available publicly, so it’s important to understand the data.

An example of steel benchmark. Steel date: www.steelbenchmarker.com

Steel dictates whether an economy is booming, or if it’s going into a low point. Steel is the fundamental driver and a good predictor of what’s going to happen. In this graph, as we can see in various regions, Europe, Asia, China, and the US, the previous high points of steel, they marked a booming economy. When the steel prices came down in procurement, that is an easier problem for us, and we have the reduction. The reality is, during those points when the economy accelerated but there was not enough demand, suppliers were struggling at those times. Today, there is enough business for everyone, and the challenge is how to grow the business profitably.

 

Source: Gov.uk

If you are buying for your businesses, for example, timber, the Gov.uk website is a good source of information where it tracks prices every quarter and every year. This chart shows that prices fluctuate. But the point is to understand the cycle of it. So, we are systematically reviewing it from a business perspective.

 

 

As mentioned, most data is publicly available. The above graph shows energy prices which are highly relevant to us these days. We need to apply some time, focus and understand it.

 

 

Bank of England data – £ vs Euro & USD

If you are a business which are having an import content, whether it’s from US or Europe, exchange rates also play a part. If you are buying a fully finished product, it will apply to the entire cost of goods. If you are buying only 30% contribution of your materials outside the UK, it would apply to that 30% contribution what you’re buying outside. The main point is to look at the exchange rate as a fluctuating factor.

Step 2

Understand the cost structure and how commodity / inputs cost variances influence or impact the overall cost

This graph is to show a typical cost structure of steel, timber, electricity, gas and other energy or labour. Through your experience while taking multiple quotes with a proper breakdown of the cost, you can establish a cost structure of items. On the right side is a simple calculation that says steel is mobilising by 10%  (% movement), and it is still within the % content which is 19%, so that is 1.9% of the total overall cost.

Likewise, for timber and power, you can look at all these percentage movements for a particular period. When you discuss the pricing scenario with your supplier or customer, it’s important to track what was the earlier baseline and what are the changes during that period? So, this percentage movement is for a particular period, whether it is quarterly or monthly or yearly. By applying all this, you can work out there’s an overall price increase of 21%. With this information, you can have a sensible discussion with the supplier.

The second piece of the table, which most people may have missed, is the volume benefit. In 2019-20, the spending is $4 million, for example. In the last 18 months and forward projections, you can clearly see that we would be doubling its suppliers’ business to $8 million. If an average business has an overhead structure of minimum 10%, that will mean a 5% favourable gain because of the volume effect.

We will look at the cost breakdowns, the volume effect in the equation, and we’ll see if the currency is in play. Basically, we will look at the whole picture of a supplier.

Step 3

Review your business spend and variances history with suppliers over a period of 3-5 years

Look at how you have grown the business for the supplier, or with your customers, over the years. What is the year on year growth for the last 4 or 5 years, and when dealing with the supplier, review what was established with them, and what was a fair reduction. We’re looking at not only the economics of cost increases, but also from the business angle.

Step 4

Conduct the market benchmarking of pricing with similar situated suppliers and obtain 2-3 quotes

With the combination of steps 1-4, you will know where the fair pricing is today.

It’s a tough environment we’re in right now. The fundamental immediate strategy, for any company today, is simply to delay and minimise increases. Negotiating and re-negotiating for a better outcome. In order for a good negotiation outcome, you need a combination of hard facts, i.e. data, and soft skills, i.e. people skills and the relationship with the business partners. The first level of negotiation is preparation. If you don’t have data, when the supplier comes to you with a 10% increase, and you counter-offered 8%, and in fact, you could have got 5% if you’ve done some preparation and have understood the cost. If you don’t apply focus and due diligence, you might end up with serious erosion of your margins.

If you would like to discuss any of the points covered here, please feel free to request a free call below.

 

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