Taming the risks
PURCHASING's Industrial Supplies Price Index (ISPI) has plunged 24% since it peaked last December. And the trend will likely continue well into 2002.
By Anne Millen Porter -- Purchasing, 1/17/2002 2:00:00 AM
The good news (ostensibly) is that commodity prices are falling fast. PURCHASING's Industrial Supplies Price Index (ISPI) has plunged 24% since it peaked last December. And, according to PURCHASING's Major Market forecasts (starting on page 26 of this issue), the trend will continue well into 2002.
The bad news is that some economists are now saying the U.S. has moved dangerously close to a deflation—one that could rival the deflation of the Great Depression.
Should finished goods prices start to fall, they say the pressure to cut corporate costs would intensify dramatically. It would lead to more layoffs and/or wage cuts and could foster a consumer mentality that eschews "buy now, pay later—because the price is going to rise" for "save now, buy later—because the price is going to fall". Such a mindset, according to the deflation seers, could lead the U.S. into a "liquidity trap"—much like the one plaguing Japan—where consumers resist borrowing no matter how low interest rates go.
And so a vicious downward cycle would begin.
Mainstream economic forecasters, who are still predicting a return to growth after mid-2002, say a full-blown deflation in the U.S. remains a long shot at best. The time to worry, they say, will be when prices for homes and such services as healthcare, college, and cable TV start falling alongside prices for commodities and goods. (Note: Services comprise a far larger share of the U.S. economy than goods.)
But, whether or not an all-out deflation materializes in the overall U.S. economy, it's clear that deflation is posing some serious risks for supply managers in the manufacturing sector. With both revenues and retail pricing power evaporating, the fear is that profits-hungry manufacturing finance managers will be on the warpath for cost cuts from suppliers in 2002. Case-in-point: One recent report has auto industry experts predicting that, in order to return to profitability, Ford Motor Co. will need to cut $3-$5 billion from its annual spend. A poll conducted at www.purchasing.com finds 88% of buyers reporting that their management is setting higher cost-reduction targets for 2002.
But savvy supply ex-ecs know that to press suppliers for deep price cuts in the current economy risks—
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Irrevocable damage to supply relationships and corporate reputations. Note: A study published by Andersen L.L.P. finds supplier executives already ranking Ford, by a margin of more than 2-to-1, as the worst automaker with whom to negotiate costs.
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A smaller domestic manufacturing base as U.S. suppliers either fail or seek bankruptcy protection, close plants, or pursue mergers. Six integrated steel mills have filed for bankruptcy protection and one major merger has been announced since PURCHASING's published transaction price for hot-rolled steel sheet dropped to $240/ton or below. And, while most will agree the U.S. steel industry needs a dose of rationalization, no one has an interest in seeing it occur so rapidly that it dislocates supply chains or derails an already fragile manufacturing economy.
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A weaker, less competitive domestic supplier base as U.S. manufacturers curtail investments in technology, personnel development, efficient capacity, and productivity improvements. Drew Schramm, vice president of supply management for Herman Miller Inc., a maker of office furniture based in Zeeland, Mich., believes this may be a long-term outcome of reverse electronic auction technology, which is, no doubt, intensifying the current deflation dynamic in the manufacturing sector of the economy. "Auctions strip out margin," Schramm says. "You obtain better prices, but suppliers can no longer afford to invest in technology or people development. They become weaker and weaker over time," he adds.
Weathering the storm
Some companies are better positioned than others to cope with these risks in 2002. That's because they've spent the last three to five years putting into place sophisticated sourcing processes that, they believe, will insulate them from the darker perils of this year's deflationary climate in manufacturing.
For example, Garry Berryman, Harley-Davidson's vice president of materials and product cost says, "We find ourselves in a healthy condition relative to our suppliers and their ability to weather this economic storm."
Likewise, Dan Enneking, chief procurement officer for NCR, the Dayton, Ohio-based maker of store automation and payment solutions plus point-of-sale ATMs, suggests that no "efficient, capable suppliers" are going to lose competitive position or fail outright.
Schramm says Herman Miller is coping with downward pressure on finished goods pricing and new orders, but that the company's management is not really pressuring his organization for greater cost cuts from the supply base. The reason: "We were already placing a great deal of pressure on ourselves to take costs out permanently."
While big discount retailers keep constant pressure on companies like Black & Decker to reduce their product costs, Tony Milando, the company's vice president of global sourcing, says the Towson, Md.-based maker of power tools and small appliances works hard to meet these demands without backing its suppliers into nonviable positions. "We know we can't negotiate prices down forever. Our 'productivity initiative' focuses on keeping suppliers healthy."
PURCHASING'S index took one of its
steepest-ever plunges last year.
Some strategies these companies have in common include:
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Carefully segmenting their supply bases in ways that allow them to capture market-based opportunities for reducing costs without exposing them to unacceptable supply risks. For example, NCR's Enneking says the company has split its 23 major purchased commodities into four strategy groups: partner, leverage, shop, and manage risk. "Partner" covers long-term supply relationships that emphasize permanent cost reductions and supplier development. Both "leverage" and "shop" are price-focused, but "leverage" includes emphasis on supplier performance and development, while "shop" implies buying decisions are driven strictly by price. The fourth group, "manage risk", covers commodities where, for example, the supply base is narrow, making it important to preserve competition and capacity.
With such a strategy framework in place, Enneking believes that NCR is well positioned to reap the benefits of downward market price movements without creating undue risks for the company or its critical suppliers. "There are certainly some good opportunities to reduce costs at this time," he observes. "It's a great time for reverse auctions in our 'leverage' and 'shop' categories because suppliers are hungry for the business. But, we've also sharpened our focus on suppliers' financials to ensure we aren't creating new risks." -
Asking suppliers to maintain "open book" policies regarding costs. Favoring cooperative approaches and honest conversations with critical suppliers, Harley-Davidson's Berryman says the Milwaukee-based motorcycle manufacturer has achieved "full" cost disclosure with an estimated 75%-80% of its supply base, which leaves him feeling confident the company is seeing adequate pass-through on commodity cost declines from suppliers. Note: He qualifies the term "full disclosure" with a caveat that degree of disclosure varies among suppliers, and some suppliers claiming full disclosure may not understand their cost structures very well. Nonetheless, he says suppliers that make good-faith attempts to reveal their cost structures to Harley-Davidson always have opportunities to negotiate for relief when it's needed—as some foundries did when their fuel costs soared in 2000—while suppliers who keep costs "close to the vest" aren't given the same option. "Full disclosure allows for some very productive and mutually beneficial conversations with us," Berryman says.
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Training supply-management personnel to be experts in their commodities and to deploy sophisticated cost-modeling techniques. "Where we can't achieve open-book costing with suppliers, we've made sure our commodity experts are very good at reverse engineering the costs," remarks Black & Decker's Milando. "What we do in this vein is highly fact-based," he adds, "so we feel confident our suppliers are earning healthy—but not enormous—profits."
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Developing and formally articulating fact-based processes for making supplier rationalization decisions. Companies that avoid using heavy-handed pricing tactics with suppliers are still apt to see supplier casualties in 2002, simply because their business volumes have fallen too low to support sourcing strategies born in better times.
Herman Miller's Schramm explains it this way: "Let's say we have four metal stampings suppliers. Our company is big, and stampers are typically small, so we might represent 50% of each supplier's business. When our volume falls 20%-25% (as it has done), their volumes fall by closer to 40%, leaving all four suppliers in financially unstable positions. They can no longer invest in technology or training. They can no longer cover their overhead." At that point, Schramm says, "We're going to identify the best of these suppliers and rebuild its volume to the point where the overhead is leveraged positively."
But that means troubles for three stamping companies go from bad to worse. They may have to lay off people. They might even have to shut down.
"It's hard," Schramm says "to hurt companies that are already hurting. Very often," he adds, "our consolidation decisions affect people in our own community. We see them at church and at soccer games." So to protect the company's reputation for fair and ethical business dealings, Schramm says his group is careful to ensure its decisions are always defensible and rooted firmly in fact.
"We never consolidate capriciously," Schramm says. "When a supplier asks why they weren't chosen, I can refer them to their Supplier Quality Process (SQP) score. I can tell them the winning supplier was deemed more sustainable because it had invested in its infrastructure, technology, and people instead of maintaining the status quo. I can say: 'They do one-piece flow manufacturing while you're still building in batches. They build to order while you're still meeting our needs through inventory.'"
Schramm says the company is also careful to minimize its own risks and to telegraph its intentions loudly before making a big leverage move. "If it's a strategic commodity and suppliers are hostile, we might buy extra tools and build inventory before we notify. At the same time, we try to be as gracious as we can. If a nonhostile supplier asks us to stretch them through Christmas, we'll usually accommodate that. Our goal is to be as sensitive as we can while maintaining a fact-based business focus." -
Keeping a close eye on suppliers' financial positions and, also, paying attention to the moves that suppliers' other customers are making. Harley-Davidson's Berryman says the company uses "a very formal process" for tracking suppliers'financial positions and relationships with other companies. A group called Harley-Davidson Financial Services prepares "red-yellow-green" financial status reports on key suppliers, giving plenty of advance notice when a company is slipping into an nonviable position. "If anything moves away from green, which is rock solid, then we have conversations. We make sure our suppliers don't move into a red condition."
What's more, Berryman says the company is not shy about asking its suppliers to reevaluate their relationships with other key customers who employ purchasing tactics that could weaken them over time. "Aluminum foundries are a good example," Berryman says. "When the auto industry fell on hard times, aluminum foundries' margins grew so thin that they were turned upside down. Today, if we see another foundry customer pursuing purchasing tactics that create risk for us, we're not bashful about speaking up." -
Allocating highly qualified personnel to permanent cost reduction duties. Herman Miller, for one, has an team of purchasing professionals dedicated to ongoing value analysis/engineering duties. It also has an team of professionals working constantly with suppliers on such tasks as reducing setup times and transitioning to one-piece-flow manufacturing systems that eliminate inventories.
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Giving suppliers opportunities to reduce costs on all fronts. Milando says current business conditions have Black & Decker stepping up its work on parts standardization, which ultimately allows suppliers to manufacture and move parts more efficiently. The company is also extending its leverage for raw materials to Tier II and III suppliers.
Technology is another key. Schramm notes that Herman Miller's Web portal gives suppliers access to real-time demand info and features an automatic alert system when paperwork discrepancies threaten to delay suppliers' payments. "This improves their cash flows. Discrepancies are resolved quickly, without phone calls, so suppliers still get paid in their 45-day windows."
Driving down prices poses risks for steelmaking.
Common denominators here are: decision-making processes that focus on facts and purchasing strategies that emphasize price stability and ongoing cost elimination where it counts the most. Winning deep price concessions from desperate suppliers might make buyers look like heroes in the short term. But economists generally agree that deflation poses more of a risk to the country's economic wellbeing than inflation does. Price stability is the articulated goal for policymaking authorities in the U.S. It should be the goal for supply management executives as well.
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