If you see on the news that oil prices per barrel are increasing, you know that the price of gasoline will increase at the pump in a matter of weeks. That advance warning is because we all know oil is a critical cost-driver of gasoline. (For example the correlation between the price of oil and the price of gasoline looks like the image above)

Tracking cost-driver prices can be applied to many industrial products such as chemicals, pharma, food and other manufactured products. And, if done well, you will get advance warning of price changes as well.

But tracking price developments of critical cost drivers include many more benefits than just an advance warning of price changes for your business. Although those early warnings in themselves can be extremely valuable.

The correlation between critical feed-stocks and final product

Before I address those other benefits, let me manage expectations about the benefit of tracking cost drivers. Often the correlation between critical cost-drivers and the final product is not a perfect fit. A correlation of 65%-80% is the norm. This means that the movement in prices of the product you purchase can be explained by 65%-80% by changes in the prices of cost drivers.

Partly that is because the volatility of the prices of critical cost drivers tends to be higher than the volatility of the final product pricing because your suppliers will be hedged or have purchase agreements with fixed prices etc.

Other reasons for changes in prices of your inputs may be demand-related, production capacity related, related to duty and freight costs, changes in volume or specification, etc.

However, if there is an analysis that will give you 65%-80% insight into price changes, including a 1-2 month warning, it is something you must have clear visibility on.

After all, in the land of the blind, the one-eyed person is King.

For example, a standard comparison of product price (baseline) and a set of cost-driver prices (benchmark) will look something like this over time:

You can see that the correlation is not as close as Oil and Gasoline. Nevertheless the correlation is close enough to be valuable in decision-making.

You can also clearly see that the outlook for the input price in future is stable to down, which means you can delay purchasing or push the suppliers for a further price decrease.

 

The other benefits of tracking cost driver prices

But keeping one eye on the price developments of critical cost drivers has other major benefits which may not be so obvious but which are nevertheless very real.

Better negotiating position

Understanding cost drivers help to manage negotiations and pin down suppliers on their arguments
Having a clear view on cost drivers movements, and understanding the impact of those cost drivers is critical preparation for the monthly or quarterly price negotiation. In addition, if the suppliers use the cost-driver argument to increase prices it is important to start to track those cost-drivers prices to ensure you get a price decrease in future those cost drivers decrease in prices again.

Improved risk management

Understanding cost-drivers helps to manage risk. For key categories it is critical to understand any upstream vulnerability or dependency. Even if you have 3 suppliers are competing for your business, if they are dependent on a single source for the critical feedstocks, you neither have the price competition you need nor do you have security of supply. It is time to identify other sources of critical feedstocks and develop competing suppliers.

Basis for discussion with internal business partners

When prices of raw materials are increasing, the ability to explain to business partners the underlying conditions for price increases not only helps them to understand the general market environment, it also provides the business partners the basis for preconditioning and justifying price increases to their customers.

Building knowledge and insight

In my experience, the models of critical cost drivers which are created are relatively simple. But over time they are made more complicated and insightful. The understanding of a supply category is strongly developed over time.

 

ProcureAnalytiq brings additional benefits

ProcureAnalytiq was built to support tracking critical cost-driver price development against your pricing. It has additional benefits compared to the usual way that procurement teams do this tracking

Choosing the right data sources

Choosing the right data sources for the critical cost drivers and proving the correlation through a look at history. Many procurement managers already keep an eye on 1-2 critical cost drivers. But often they are searching for the right price trends and they may choosing the wrong source of cost-driver data leading them to reach the wrong conclusion.

Using the cost-driver price data in an inconsistent way

Or they may choose to interpret the feedstock data or multiple cost-driver prices incorrectly over time.

Incorrectly applying FX data

Many people struggle to understand how to apply FX translation over time. Often this results in a distortion in their analysis due to the misunderstanding of how to apply FX translation to data series to make them consistent.

Choosing the wrong or inconsistent data of FX sources, or incorrectly applying the results, may lead to incorrect conclusions.

Save time & effort in procurement

In addition, the search of data as well as model building in Excel takes times and effort by the procurement staff. This time is better spent on interpreting data and planning negotiations rather than fiddling around in Excel?

Sharing of results

ProcureAnalytiq helps users to share their analysis over time, so that only 1 junior person can maintain the data (based on reliable data sources) and the others can use the analysis for interpretation and communication. It also allows a team to share their input with the supervisor or with research or other business partners.

Interested to explore the topic futher?

If you are curious about the topic of price benchmarking, especially of critical cost-drivers, please feel free to reach out to me through the Explore ProcureAnalytiq page

 

Procure Analytiq

DELIVER DIRECT MATERIAL SAVINGS

ProcureAnalytiq is an online cloud-based software tool to track market developments and leading indicators related the direct material purchases for your business. 

ProcureAnalytiq enables user to faster reaction to market changes, better negotiations, automated forecasting of material pricing, better internal and external communication, and ultimately reduces direct Raw Material prices.

Interested to explore more?  

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