Buyers are balancing cost and risk
Purchasing chiefs say that risk management in 2008 is more about reducing today's inflated costs of energy and materials than finding ways to minimize future costs.
By Tom Stundza -- Purchasing, 7/17/2008 2:00:00 AM
Inflation has been battering manufacturing commodities, transportation expenses and construction materials this year. Manufacturing and construction are having a lackluster year, yet energy and raw materials are setting high-cost records—with no sign of ebbing prices in the second half. At the same time, pressure from top management to reduce costs has put tremendous stress on chief procurement officers and that has jolted purchasing and supply chain organizations into numerous price risk-management exercises.
“This has been the most annoying, frustrating and aggravating year,” says David Price, corporate director of supply chain management at Clarcor of Franklin, Tenn., which makes numerous filtration and consumer packaging products. “We are being hammered by unexpected increases in materials and energy costs.”
In fact, “this has been the most challenging year I've seen in two decades of purchasing,” he says in an interview.
So, with cost increases evident at his firm for such raw materials as steel and paper, freight and utilities, Price has joined the ranks of purchasing professionals who are consolidating purchases, hedging future buys, initiating value-analysis programs, identifying alternative materials, contracting with new global sources and initiating other risk management programs.
Chief purchasing officers answering risk-management surveys say they also are intensifying the analysis of performance by suppliers, ranking their attentiveness to critical buying-company needs and reevaluating existing strategic partnerships. The goal is to ensure that suppliers don't get into the habit of suddenly charging unexpected extra fees for materials' transportation, packaging or service.
Based on conversations and e-mail interchange with top procurement officials, it's apparent that many of their risk-management efforts this year are directed at energy expenditures. That's because purchasing managers are bedeviled by spending way above expectations for fleet fuel, freight surcharges being assessed by suppliers, and spending on travel. Atop that, natural gas, coal and electricity costs have inflated operating costs.
Diesel fuel prices have increased almost 70% in a year while regular gasoline is 35% higher. The national average of $4.70/gallon for on-highway diesel in mid-June has erupted from $2.80 a year earlier—and has jumped 40% from the start of the year, when it cost $3.35. Trucks haul about three-fourths of all freight and the American Trucking Association in Washington says the industry spent $112 billion on fuel in 2007 and is on a pace to spend $154 billion this year.
Meanwhile, the national average price of a gallon of regular gasoline in mid-June was $4.02, according to AAA and the Oil Price Information Service. The average at-the-pump price is 32% higher than it was in January, when it cost $3.04 for a gallon. A year earlier, regular gasoline cost an average $2.98.
In the face of this gasoline/diesel inflation and the fact that oil analysts see pump prices increasing further in coming weeks, Price at Clarcor has initiated a total cost analysis on freight costs when delivering materials from corporate distribution centers to numerous plants of the company's 17 operating subsidiaries. The study includes a top-to-bottom review of internal shipping costs, optional methods of quoting alternate carriers and third-party logistics (3PL) providers, as well as exploring what he calls “freight optimization opportunities.”
He explains that plants all too often requested commodities or components with not enough notice—“sometimes virtually no leadtimes''—for third-party suppliers or internal materials managers, triggering numerous delivery stops. “Now, we are requiring three weeks' notice so we or our 3PLs can ship truckloads and consume less fuel,” says Price.
Other energy costs—specifically jet fuel—have disrupted operations at numerous airlines, resulting in air-service cutbacks by several carriers, including American Airlines. Jet fuel prices at $4/gallon nowadays costs 85% more than a year ago, “an inflationary fuel environment that has triggered a full court press to manage this commodity critical to our American Airlines' business,” says John MacLean, vice president of purchasing at parent company AMR Corp. in Dallas.
“American Airlines is the largest buyer of jet fuel in the world other than the U.S. military,” he says, adding he buys about three billion gallons annually from all over the world. “Jet fuel in the 1990s constituted about 15% of our total cost, but at today's prices, it now accounts for over 40% of our cost,” he says. “At the same time, ticket prices today are still below 2000 levels. This means that we must do everything we can to manage the total cost of jet fuel. Our company's efforts to manage this cost, therefore, have come in two forms, self-help and government policy.”
The most visible self-help policies to the public are shrinking capacity and exiting unprofitable markets, grounding fuel-inefficient airplanes and buying new lighter-weight aircraft that are more fuel efficient. Internally, American Airlines has had a hedging program in effect for a decade “to dampen the impact of volatility of jet fuel prices,” says MacLean, who notes that hedges saved the carrier $239 million in 2007 in purchases below the market price for the fuel.
Also, the airline's three-year-old Fuel Smart program is using employee tips to consume less fuel, and has saved American Airlines more than $300 million annually. “The company's fuel department continues to find creative ways to buy jet fuel by identifying imbalances in the regional market prices and by working with oil companies to jointly improve the logistics to the supply chain,” MacLean says.
The steep drop in the dollar this year has pushed up prices for precious and nonferrous metals as well as energy commodities as investors have sought assets that provide a hedge against the falling U.S. currency. This has resulted in numerous risk-management reviews of traded commodities by manufacturing firms. But, numerous buyers are being buffeted by costs of a single key untraded commodity, carbon steel.
Hot-rolled sheet, the benchmark product, has increased by 55% at midyear in a price spike unexpected either by market analysts or insiders when 2008 began. (In fact, one top purchasing executive e-mails the magazine that “I cannot envision any force available to stop the runaway price train of carbon steel.”)
According to Paul Miller, vice president of global purchasing at the Dana Corp., a major challenge this year has been the “unprecedented levels of steel costs” for the Toledo, Ohio-based automotive parts company. The firm annually purchases approximately 1.5 million tons of steel and castings, forgings and bearings products with significant steel content.
In a recent filing with the Securities and Exchange Commission, Miller explains that Dana's steel-buying team uses annual purchase agreements to eliminate or mitigate exposure to steel cost increases while the company's marketing executives attempt to pass all or a portion of the higher costs onto end-product customers. Sometimes, resale arrangements are used in which Dana purchases the steel at the cost negotiated by its customers and includes that cost in the pricing of our products. In other arrangements, Dana has material price-escalation provisions in customer contracts that allow unit prices to be adjusted up or down based on commodity cost increases or decreases during agreed-upon quarterly, semi-annual or annual intervals.
While this is happening on the buying side, John Devine, executive chairman, tells the SEC that Dana is trying to recover 40% to 60% of higher steel-related costs by obtaining price increases or surcharges from certain customers.
An extensive analysis of the unprecedented volatility in commodity markets that doesn't appear to be ending soon was led by Art Waldowski, vice president of worldwide purchasing for Arvin Meritor's Commercial Vehicle Systems business. This has been followed by new cost-recovery commodity surcharges from the Troy, Mich., auto parts supplier on its products. In fact, CEO Chip McClure says in a press release that a monthly review and adjustment process on market prices for all Arvin Meritor products now is being conducted. “We have a portfolio of complex products that require varying levels of commodities that are being impacted by the sudden and extraordinary surges in the price of steel, energy and other commodities.”
Other steel commodity buyers tell Purchasing that they have intensified efforts this year by consolidating purchases, contracting with new global steel sources, identifying alternative materials and redesigning products to be less dependent on higher-cost steel grades.
“Everyone is taking price increases on steel,” says Price at Clarcor, “but our goal is to pay no more for similar products than our competitors.” To accomplish this, his purchasing and supply management team has begun adding favored nations clauses to purchase agreements, seeking out alternate sources of supply, building supplier partnerships, leveraging the parent company's 17-subsidiary aggregate spend, using electronic sourcing when possible and exploring opportunities through consortium buying.
Len Berenfield, chairman of Berenfield Container in Mason, Ohio, tells Purchasing that the manufacturer of industrial steel drums is “actively working with our customer base to encourage the possibility of moving to thinner steel thicknesses for the packaging they buy from us.” He admits that this isn't a universal answer. Due to many end-product considerations, “several customers have already changed their specs, while others are actively looking into that possibility,” he says. He reports that the firm also is installing a process change in its stamping operations that will allow the use of wider steel sheet coils to reduce processing costs. The new system also will allow Berenfield to reduce the required steel weight, per piece produced, by 7%.
Roger Schulz, purchasing manager in the snow and ice equipment division of Monroe Truck Equipment in Monroe, Wis., says the recent run up of nickel prices in the surcharge component of certain stainless steel alloys “prompted us to switch from Type 304 to Type 201 as the main alloy in our stainless snow and ice removal products.” By using a forecasting matrix that was developed internally, Monroe Truck was able to accurately estimate the cost of Type 304 throughout 2007 and “pre-buy” for our larger quantity demands.
The aerospace industry as a whole has seen significant cost increases in raw materials due to supply demand shifts as well as energy costs. “In the face of these significant challenges,” reports Don Beverlin, vice president at Cessna Aircraft, “Cessna supply management has implemented materials cost-reduction strategies that have helped mitigate these cost pressures.” One specific strategy is a “raw material aggregation process,” which combines volume and other details about the raw material used by its internal manufacturing operations and the company's supply base. This, in turn, helps develop more cost-effective supply contracts.
Beverlin says Cessna Aircraft also is contracting directly with key producer mills and key global distributors to provide raw material for the supply chain—including its tiered parts suppliers. This has resulted in reducing and mitigating costs of such raw materials as titanium. Also, Beverlin says the Wichita, Kan.-based supply management team “is driving” corporate value analysis/value engineering, global sourcing, discount payment terms, Supplier Center of Excellence, Textron corporate agreements, and lean-implementation strategies.
Another approach being used by transportation products purchasing organizations is to put the onus on its supply base to cut costs. This effort has had limited success over the years among its chief proponents, the automakers in Detroit, but Chrysler again is asking suppliers to cut component costs by 25% over three years.
At a meeting this spring of the Original Equipment Suppliers Association, Chrysler executive vice president and chief procurement officer John Campi said corporate purchasing will try to help parts and components suppliers reduce costs. These efforts will include such changes in its manufacturing and purchasing operations to help suppliers by sharing more parts among nameplates, reduce late engineering and procurement changes and eliminate required purchases of raw materials for stockpile.
When he assumed this job in January, Campi told the media that “purchasing plays a critical role in cost management and building high-quality vehicles” so his goal “is to take a disciplined approach to purchasing and apply best practices learned from both within and outside of the automotive industry.” Campi said Chrysler hasn't been buying enough parts from low-cost countries, noting that the vast majority of the $40 billion in parts that Chrysler buys annually comes from North America. In recent months, however, Campi has expanded Chrysler's overseas procurement activities in India and Mexico and now is pressuring suppliers to source more overseas.
| 2006 | 2007 | 2008 | ||
| 1H | 2H | |||
| ENERGY | ||||
| Crude oil * ($/barrel) | 66 | 72 | 109 | 125 |
| Natural gas ($/mmBTU) | 8.35 | 7.87 | 8.54 | 12.88 |
| STEEL $/ton | ||||
| Hot-rolled sheet | 580 | 527 | 817 | 998 |
| Steel plate | 778 | 797 | 961 | 1080 |
| Merchant bars | 560 | 729 | 837 | 1061 |
| Wire rods | 527 | 568 | 800 | 939 |
| NONFERROUS METALS ¢/lb | ||||
| Aluminum | 116 | 121 | 132 | 174 |
| Copper | 306 | 325 | 366 | 399 |
| Zinc | 144 | 151 | 116 | 102 |
| Lead | 60 | 117 | 123 | 130 |
| Nickel | 1064 | 1688 | 1258 | 1240 |
| Tin | 389 | 659 | 898 | 878 |
| PRECIOUS METALS $/oz | ||||
| Gold | 603 | 695 | 916 | 884 |
| Silver | 11.55 | 13.38 | 17.60 | 17.10 |
| Platinum | 1142 | 1303 | 1425 | 2035 |
| Palladium | 320 | 355 | 443 | 433 |
| PLASTIC RESINS ¢/lb | ||||
| High-density polyethylene | 71 | 73 | 77 | 87 |
| Polypropylene | 68 | 71 | 79 | 89 |
| Polystyrene | 81 | 85 | 95 | 105 |
| * West Texas Intermediate | ||||
| Source: www.purchasingdata.com | ||||
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