Product Price Adjustment Mechanism –  using price indexing

An introduction to the concept and the tools of product price mechanisms to adjust existing commercial prices with the help of price indexes

Summary on product price mechanisms

 

what is a price mechanism

A price mechanism is a tool that tracks certain cost drivers over time, and translates the impact of those cost driver movements into the impact on a sales price.

what are those cost drivers

The cost drivers that are tracked can be anything. Usually the cost drivers capture critical exposures by either the supplier or the customer, so that those impacts are made transparent and shared.

what do i use a price mechanism for?

Price mechanism are a way for a supplier and a customer to establish a transparent way to track key cost drivers and financial risks, as a basis of input into the quarterly price discussions

what types of price mechanisms are there?

There are many different price mechanisms. From a simple tracking of a key commodity feedstock, to a complex model including exposure to critical currencies or other cost elements, as well as rebate and volume movements etc. 

when do i consider using a price mechanism?

You would consider to establish a price mechanism when either the supplier or the customer have significant exposure to a certain cost or currency that they want to make transparent and agree a sharing mechanism to manage risk

does a price mechanism set the price

In my view, never. A price mechanism should only be used as guidance into a commercial price setting process. Both parties may decide to follow the price mechanism, but a price should always be a commercial agreement and not a system.

Introduction to price mechanisms

Use-cases of price mechanism tools

How to set up a price mechanism

Detailed introduction to product price adjustment mechanisms

 

Introduction to price mechanism

 

Search the internet on pricing, and you will find a lot of information on how to set the price for a product. Every textbook methodology from cost-plus to market skimming and everything in between. In reality, it is the adjustment of existing prices which takes far from energy in a business-to-business environment, and this can be partly addressed by establishing an agreed pricing mechanism which provides input into the quarterly price adjustment process. 

Price mechanisms help to manage risk for both the supplier and the customer. They make significant cost exposures transparent, and ask both parties of a commercial relationship to discuss the cost exposures and how to handle that risk. Thereafter, those cost exposures are shared in an agreed manner so that neither party to the commercial relationship suffers extremely and is forced to take drastic action.

Price mechanism so help to make economic factors transparent, and establish a sound partnership between 2 parties in a commercial relationship. At best, it allows that commercial partnership to focus more on the value-added elements of the service and development areas, rather than the conflicts that may arise from the quarterly price negotiation.

The concept of a price mechanism is best explained with an example:

  • A supplier sells plastic packaging to a customer for which they have agreed a price of X
  • The main cost driver of the price X for plastic packaging is the price of LDPE
  • For LDPE there is a price index available which tracks the cost in the market of similar products
  • The supplier and the customer agree to track the price of LDPE as 30% of the cost of the final price X
  • Therefore, if LDPE prices go up 10%, the price mechanism will recommend a 3% price increase to X
  • The parties may agree that any price X increase or decrease will be limited to 2% to protect both parties
  • If the price X gets adjusted up by 2%, then the price mechanism will show a 1% increase still proposed for next quarter

The most common type of price mechanism relates to an agreed feed stock to the supplier which is significant in terms of cost into the final product and and a commodity for which market pricing is available.

 

What cost drivers can be added to a price mechanism?

There are many different elements which can be built into a price mechanism. Here are just some example:

  • Key feed stock for which market pricing is available e.g. Cover LDPE price changes on 30% of the price
  • Key currency exposure either by the supplier or by the seller e.g. Cover EUR/USD exposure on 20% of the price
  • General inflation exposure e.g. CPI impact on 15% of the price
  • Other cost drivers such as freight, duty, tax e.g. Import duty changes applying to 30% of the price
  • A quarterly or annual target for productivity improvement e.g. a 3% annual cost decrease on 40% of the price
  • Volume commitments can also be built into the price mechanism process on a quarterly or annual basis
  • Any other agreed manual adjustment can be built into the price mechanism
  • Changes can be added and backdated to a certain date, or not backdated at all

No matter what commercial agreement is made, it can be captured and tracked in an overall price mechanism that captures the different impacts and consolidates it into a single price increase or decrease proposal.

Which products to agree a price mechanism for?

Price mechanisms have most use for products and categories for which:

  • There is clear feedstock which is a commodity and a significant driver of cost for the supplier.
  • If either supplier or customer as a significant exposure such as FX, which will lead to a break int he commercial viability of the deal

In addition, you want to keep an eye out for these situations: 

  • Where suppliers regularly use feedstock prices to justify to explain price movements
  • Where the customer is significantly more powerful than the supplier, it can help avoid constant price erosion
  • Trust is gone between the supplier and the customer and the quarterly price negotiation is a major conflict
  • Feedstock prices fluctuate rapidly and significantly 

Overview table to price mechanism and business benefits

 

Use-case Baseline price index  Benchmark price index Better cash management Support sales-price increases Reduce business risk Reduce conflict with supplier
Simple price mechanism Product Feedstock Yes Yes Yes Yes
Complex price mechanism Product Feedstock& costdrivers Yes Yes Yes Yes

 

 

The business benefits of a price mechanism

A price adjustment mechanism can give rise to both parties of the transaction if it is set up well. 

Reduced risk exposure

Price adjustment mechanisms will make explicit any major risks that your business faces. In the short term, those risks can be managed in a price mechanism by sharing the impact with a supplier or a customer. 

For example, if you have a significant FX exposure, part of that risk can be built into a price adjustment mechanism.

Reduced risk of surprises

A price mechanism will reduce exposure to financial risk and reduce surprises in pricing. The ability to identify relevant trends earlier, and to clearly understand the impact of those trends, will help to plan for those trends before they are visible to the wider market. Those trends can include potential price increases.

That ability to see issues coming earlier may only give you a a month or 2, but the first to take action usually gains a disproportionate benefit. In the cases of harvest shortfalls and the like, the advance warning and clarity of impact may be as much as 6-9 months ahead of the event

Better cash management

Once leading indicators are established for price developments, the ability to anticipate future price movements more accurately results in more informed inventory planning decisions in the short term.

If prices are likely to increase in the short term, planning orders should increase, and options and arguments considered to avoid the price increases. If there is a building business case for price decreases, then purchases can be slowed down, and options explored to bring forward price decreases.

Faster price increase process

Once leading indicators are established for price developments, the ability to anticipate future price movements results in the ability to signal earlier to customers the risk of price increases and to explain those price risks in clear terms.

The option to increase or decrease prices is always a commercial decision, but the early conditioning of customers (And the internal sales team!) and the early ramp up of the process is always an advantage.

Better relationships between customers and suppliers

Although price indexing can be used to develop arguments to reduce prices, increase focus and reduce risk, they can also be set up collaboratively with customers or suppliers to establish an indicative price mechanism.

A price mechanism is a tool where feedstocks and other critical cost-driver trends are agreed upon by a customer and a supplier, as well as certain rules to be followed for quarterly pricing in case of future movements.

Mostly price mechanisms are indicative only – prices should be discussed and set commercially but agreeing to track certain cost-driver indices will help to make key movements transparent. And it will allow both supplier and customer to establish a fair and transparent process that takes some of the potential for conflict out of the quarterly negotiation.

Of course, in many cases, a commercial price agreement will not be modelled on a price mechanism, but the assumptions underlying a price agreement can then be established and tracked in the price mechanism as well.

The fundamental challenges of using a price mechanism

I would describe the challenge of a price mechanism be as follows:

No model of cost drivers will replace a commercial negotiation of a price.

I completely agree. Ultimately the price of a raw material is settled through commercial negotiation. At best, a benchmark price index gives additional, useful, information. At worst, it is misleading, but if so it can be fine-tuned until it adds value.

The initial price setting becomes more important

If a price mechanism is to be agreed, the initial price setting becomes doubly important, as the ability for a supplier to slowly increase the margins through pricing is more limited than without a price mechanism. However, the opportunity is always there through service, R&D, finding general cost savings in raw materials etc.

Don’t let perfect be the enemy of the good

But the challenges of establishing a price mechanisms are not killer flaws.

It is my experience that the process of setting up a price mechanism establishes real and tangible benefits on the assumption that they are set up i for the right areas with the right benchmark price indexes.

  • The process of establishing a price mechanism makes cost and risk transparent
  • A good price mechanism will establish a partnership approach
  • A good price mechanism always cuts both ways in a fair and transparent manner
  • And in general, you will be exposed to lower risk and less surprises….

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