How to set up a benchmark price index
Here is a detailed explanation of how to set up the benchmark price index
Summary of key points
What products to create a benchmark index for
Agree a price index as benchmark with your customer. Reduce friction and improve communication and keep the relationship in balance
what price index model to choose
Agree a full price mechanism with your customer. It will allow you to focus on the areas where you can add value to your customer.
how to approach the benchmark model
Track keep feedstock trends of your key raw materials, to be able to plan your purchasing and inventory management accordingly.
how to find feedstock price trend data
Set up a key feedstock price index for your key raw materials, and strengthen your negotiating position.
finetune the results
Index your category against key feedstocks developments, and keep an eye on opportunities and prcurement performance
how to analyse the outcome and drive action
Index your full purchases against a key basket of feedstocks and market indicators to understand performance and outlook.
Table of contents
Overview of the process
Step 1: Choose the baseline index
How to select your product or category
The first time you run the process
In general, the first time you run the process, it is best to pick a single product for which you have a good benchmark price index, either a direct market index or a solid indirect market index such as a key feedstock. It will be key for learning to start with an easy sample.
Guidance on how to select good candidates
Benchmark price indexes have most value for products and categories for which:
- There is no clear market benchmark pricing available
- It is not possible to switch between 3-4 competing suppliers on a regular basis to ensure prices are kept competitive.
In addition, you want to keep an eye out for other products/suppliers where:
- Where prices fluctuate regularly, and suppliers use feedstocks to explain price movements
- There are clear and measurable feedstock data available
- Trust in the supplier on pricing is gone and a new baseline needs to be established
- Supply to your business is dominated by 1 or 2 suppliers who are located close together
- Volumes are smaller, and competition level is insufficient
- Feedstock risks are significant, and prices fluctuate regularly
What purpose do you have?
The second topic to consider what purpose does the benchmark price index have:
Select a category as baseline price index if you wish to:
- To evaluate procurement performance
- To understand better feedstock correlation
- To develop a forecasting model
Select a single product as baseline price index if you wish to:
- To hold a supplier accountable for their explanation
- To develop a price mechanism with a supplier
- To estimate the full cost structure of a product
How to create a baseline price index?
Any baseline price index is a series of price values per month
For a product baseline price index
This is just the price per month
- It does not need to be the actual price, it can also be indexed to 1.0 at a certain point.The maths works similarly in both cases, unless you are trying to calculate the full-cost price index and you may be more comfortable not to type in actual prices
- For any month in which you do not make any purchase, i suggest you keep the price as the previous actual value.
For a category baseline price index
A category baseline price index requires additional work. The price index of a category is a weighted-average of a series of price developments of a series of products.
The products have to be weighted on a standard volume, which is usually the volume over a given year, either last calendar year or the last 12 months. In some cases where products replace each other 1-for-1, then this should be taken into account in the category price index accordingly.
However, this may not give representative answers and it may also be an option to select the most stable products representing 90% of the value of the category over 3-4 years.
In my experience it is best not to overthink this, and to establish a standard process for calculating a category price index without trying to make too many exceptions.
If you have questions about calculating a category price index, contact us direct and we shall send out a more detailed working file or give support as needed.
Step 2 Choose the benchmark index
The benchmark index is the index which you will use as a benchmark against your baseline index. There are 2 main types of benchmark index – either based on direct market index pricing for similar products, or an indirect price index based on critical cost drivers.
If you can get direct benchmark price index…
The key first question is whether there is a direct benchmark index available. If so, and it is affordable, then that is the best benchmark.
Buying accurate price data can be quite expensive, so i recommend doing a free trial first.Sometimes you can get a trial-account for a few weeks or get some older data, which will be sufficient to test the correlation between your price trend and the trend of the market price index.
If there is no direct benchmark price index
If there is no direct market index, then it is important to identify key cost drivers that are ey to the cost of the product or category that you are buying.
Identifying the critical feedstocks
There are many different ways to find the right cost drivers:
- You probably already know
- Ask an expert in your company or in the industry
- Look it up on the internet
- Ask the supplier directly
Consider other critical cost drivers, beyond feedstocks
Raw material feedstocks may not be only critical drivers. It is important to consider:
- Utilities like electricity, water, or gas
- Waste water cost
- High labour costs
- Transport cost (depends on INCO term)
- Taxes and surcharges
- Also consider exposures to currencies…
It only really make sense to index those other cost drivers if they fluctuate significantly. If they are relatively constant, they are only a factor if you want to estimate the full cost of a product or category. This is because we are working generally with a price index here to estimate one price relative to changes in other factors.
Consider cost influences which may be more obscure, such as an exposure to a certain currency. On the currency, it is a more difficult topic to understand. But if your suppliers purchase key feedstocks in a foreign currency, you might need to include that exposure in your model.
Calculate the value or volume % of the different cost-drivers
For each cost driver it is critical to the model to estimate the % of value of your product that drives the cost.
For example, the price of Oil will drive approx 50% of the cost of retail gasoline. (The other elements are tax at 23%, refining cost and profit 17% and distribution about 12%. Interestingly enough, it is the refining cost and profit expectations which is the biggest impact on the changes of price at the pump as the other costs are more constant).
To estimate the % of value that is driven by a cost-drivers, it is important to do the research. The numbers are rarely straight-forward, but looking into it is part of the valuable learning process.
Estimate the time-lag before the cost-driver would reach your inventory
Once you have determined the critical cost-drivers and their % of the value, it is also important to consider the time-lag between the price index of the feedstock and the price of your products. For example, the time-lag for the price of a barrel of oil to be seen at the gas pump is typically a few weeks. In some cases, this may be as long as 9-12 months, if we are speaking about a harvest. For example, dates are only harvested once per year and the quality of the harvest will determine prices 9 months in advance of the product being bought on a super-market shelf.
It is complicated to get this time-lag accurate, but the further you go upstream in the feedstock chain, the longer the time-lag will be. 3-4 months is not unusual when you are building a model. The model in the system allows you to experiment with different time-lags per feedstock to see what gives the best correlation, which may be one way to fine-tune the model.
How to find the right Feedstock Price index data?
Big question… here are your options…
a) Buy the data
There are extremely good companies who specialise in working with industry to supply industry price data. Here are a few of them:
There are many others which are more specialised if you search for price data.
These companies are not cheap, but their data is reliable and often country or subregion specific.
If you are basing a strategy on the data or you are developing an index to share with industry partners, then I strongly suggest you work with a professional provide of the data.
b) Use our database
We include in the ProcureAnalytiq some of the common commodities anc currencies as well as other economics indicators for which data is publicly available.
We do not give any guarantees on the data, but we use reputable sources and keep the data up to date.
We can also research additional price index trends based on select sources. This data is largely anecdotal, but it is still likely to 90% correct and we are willing to make it available to you for a small fee without any guarantee other than the guarantee that it is sourced from genuine industry sources.
c) Source your own data
Chances are that you have good connections to your industry. You may have access to data that is reliable as a source.
d) Find a good proxy
If you cannot find a reliable feedstock price indx, you may be able to find closely related alternatives, or go upstream in the feedstock chain.
In general, the further upstream you go in the feedstock chain, the more likely you will find price index data without losing too much of the correlation.
The additional benefit of going further upstream is that you will gain a longer forward look on likely price developments.
e) In Conclusion
This is not an easy topic, but our experience is that it is generally possible to source relevant benchmark price index data. It might require some effort, cost or out-of-the-box thinking
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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.
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