Prices are going up. We are paying more personally and professionally because the rate of inflation “the change in prices for goods and services over time” is going up. This is likely to continue over the short to medium term.
Magnitude and timing
If the Consumer Price Index (CPI) is your default price change mechanism then a 7% increase (forecast, as I’m writing this) on a total spend of £350m is £24.5m. Why total spend? Organisations use the start of the financial year as a default contract start date, which means it is also when most price changes will take effect. Suddenly you are paying an extra £24.5m, a total of £374.5m for more or less what you bought last year.
Levers to mitigate inflation
To mitigate the adverse effects of high inflation consider:
- Minimising risk premiums: don’t make suppliers price uncertainty, include inflation in price models
- Forward buying: underwrite supplier purchases and store (you or supplier) until future use
- Incentivising cost-to-supply reductions: maintain absolute £ profit despite lower cost to supply
- Needs, not wants: optimise to satisfy beneficiaries needs, not wants
- Not being a pain in the a**: help, rather than hinder, minimise adverse impact of buy side/demand
- Budgeting for inflation: visible savings against budget, rather than invisible cost avoidance
- Prioritising time/attention/resource: on high spend with higher rates of inflation
- Influencing supply chains: use relationships to influence your supplier’s suppliers
- Improving supply relationships: collaborate in more depth and communicate more often
Don’t make suppliers price an uncertain future
The single most effective mitigation action is to avoid making suppliers price an uncertain future. The four most common culprits are:
- Expectations: don’t be surprised if suppliers’ expectations about future changes in inflation are different to yours and, when you get there, reality. Suppliers are no more able, than you are, to forecast what inflation might be in the future. To combat this inherent uncertainty suppliers self-insure against inflation changing by more than they expect. They incorporate a ‘just-in-case’ risk premium into their pricing and if the risk doesn’t happen the premium simply boosts profits.
- Timing of price change calculation: price change mechanisms often have the price change being calculated several months before it is implemented; just like the state pension. For 2022/23 it will increase by 3.1% from April 2022, the increase in the CPI to September 2021. However, inflation is currently 5.4% (Jan 2022) and is forecast to increase beyond 7%. To combat this potentially hefty commercial risk suppliers self-insure by including risk premiums in their original tender price.
- Time it takes from tender price calculation to first price change: could be more than 18 months. The cost to supply at the first price change will not be the same as when the supplier calculated what price to tender. This is a big commercial risk. Supplier’s self-insure against, they forecast how much their costs are likely to change and then add a bit more just in case they get it wrong.
- Volatility: when prices have and could change by more than 5% in a month or two. I’ve used 5% but you could set your threshold higher or lower depending on what it is you are buying and current circumstances. If a price change reaches or breaches this threshold it triggers an automatic price change. Otherwise you and the supplier don’t stand a hope in h*** in agreeing an equitable price.
Now we’ve got that out of the way, I’ve two rhetorical questions. “How accurate are suppliers self-insurance risk premiums?” and “Why make suppliers price an uncertain future?”. You can avoid unnecessary and inaccurate risk premiums that self-insure against inflation, simply by having a separate line for inflation in your price model.
Test for intended and unintended consequences
When considering the above don’t forget to test for intended and unintended consequences. For example, when forward buying could deprive others of goods and services and consequently damage your reputation, especially when they could be your suppliers and/or residents.
Pick the right indices
The ONS calculate the CPI from the change in the prices of a basket of goods/services. However, when inflation is higher than expected and changes are more volatile, the changes in the CPI rarely mirror changes to a supplier’s cost to supply. This amplifies suppliers concerns and the size of the risk premiums they perceive necessary to self insure themselves.
To limit these concerns and mitigate or even eliminate inflationary risk premiums, you can use indices that track the change in prices of specific goods and services in your price change mechanism. Develop your price model to enable this, that is to the lowest practical and reasonable level of detail, and apply relevant indices to each element that makes up the total price. If it helps, I often use three or four indices.
Current inflationary hotspots include:
- Raw materials
The dramatic increase in the price of energy has had an adverse impact on the cost to supply pretty much everything we buy, although this will vary according to how much energy each good and/or service requires. Other influences that have had an adverse impact are the Covid 19 pandemic, Brexit, politics and disruptive world events. Taken together these influences have conspired to change demand (type and amounts) and cause a scarcity of some goods, particularly for construction and building services.
Shifts in demand, such as fewer cars being bought led manufacturers to cancel silicon chip purchases, manufactures of said chips then diverted production to satisfy greater demand for mobile hardware. The economy started to come back to life and demand for new cars started to increase, but there wasn’t and still isn’t sufficient capacity to manufacture enough chips for car production to reach anywhere near previous levels. An unexpected consequence is that prices of second hand cars have rocketed, some are up by more than 50%.
When inflationary pressures increase it’s important to understand why. This helps you decide what you can or can’t influence through your procurement decisions to mitigate the adverse impact of inflation.
And finally …
Develop a deep understanding of the impact of inflation on your ability to satisfy beneficiaries needs and consequent affordability; the total cost you will incur to do so. Then use it wisely, so you:
- Avoid making suppliers price uncertainty
- Don’t make inflation a supplier’s responsibility, it’ll come back to bite
- Make sure you aren’t part of the problem
- Offset inflation, by reducing the overall cost to supply
- Re-evaluate what will satisfy beneficiaries needs; avoid wants, theirs and yours.