Contracting in Volatile Markets
Source: David Jacoby
In the heat of the moment, Serena Williams recently told a line judge to “shove the tennis ball” (where it didn’t belong). In the heat of the moment, Spain set its interest rates at such low levels that it the ensuing growth resulted in epochal unemployment and deflation. In the heat of the moment, George W. Bush faltered embarrassingly when asked was the greatest mistake of his administration. If only we had time to plan our strategies and responses. Supply chain is about more than transactions – it’s about win-win cost reductions in long-term commitments. Time is a critical dimension.
Over time, upstream players bear most of the cost. This occurs in four ways. The first (for suppliers) is the cost of lost orders near the peak – orders that could not be fulfilled due to inadequate capacity. Second (also for suppliers), suppliers over-invest at market peaks, resulting in excess capacity investments. Excess capacity is burdensome to maintain when markets turn down. Look at Dow’s recent acquisition of Rohm & Haas – it is still struggling to maintain its debt payments at lower commodity prices. Third is the unanticipated cost, for buyers, of escalating prices of equipment, which are upwardly but not downwardly flexible. Fourth is the cost of holding inventory including the cost of obsolescence and storage, which applies to all downstream partners. In some supply chains such as oil and gas supply chains, upstream partners (refiners) have little supply chain cost (since most risk is in the selling price) and component suppliers bear the most supply chain cost (most is in the raw material price risk).
The supply chain cost of volatility magnifies in later periods. In fact, there is no impact in the initial years, as the sine cycle begins. Later periods experience exponential increases in cost as a result of the bullwhip effect. So for anybody in capital-intensive industries, supply chain management is all about multi-year relationships.
What does this all mean for corporate executives? For those that set business strategy, supply chain management means positioning closer to the end-customer (downstream). In the case studied by Boston Strategies International, this means oil companies getting into refining and equipment suppliers getting into refining through performance-based contracts.
For procurement executives, contracts should be for at least six years (based on oil industry economics) and have renewal clauses of equal or greater lengths. Supply chain partners should engage in risk sharing based on unpredictable volumes. Contracts should be flexible and employ cost indexing. Component suppliers should give discounts for longer-term commitments, providing buyers an incentive to commit to long-term agreements that ride through the peaks and valleys of the market.
Boston Strategies International’s recently helped one of its clients structure ten-year agreements with three strategic suppliers. It involved nearly a year’s worth of preparation, which included benchmarking, cost and price analysis, strategy consulting, and contracting support. That foresight and strategic thinking helped support the suppliers through the recent financial crisis and maintained strong relationships during the most fractured and challenging economic times in 70 years, which is the ultimate testament to the strength of supply chain strategy well implemented.
David Jacoby is the President of Boston Strategies International Inc, a consulting firm that provides strategy consulting, international cost and price intelligence, and market data to help manufacturers achieve competitive advantage through supply chain management. To contact Mr. Jacoby or the firm, please call (1) (781) 250-8150 or e-mail firstname.lastname@example.org.