Introduction to price indexing

How to best benchmark procurement prices. An introduction to the concept and the tools

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Summary introduction to price index models

 

what is a price index model

A price index  tracks the development of prices over time. A price index tool tracks the development of baseline price over time against a benchmark price index to understand and predict price movements.

what is a benchmark price index

A benchmark price index is created as a reference point for a baseline price index. For example: The baseline price index of petrol can be tracked against a benchmark price index of Oil, as Oil and Petrol prices are considered to be correlated.

what do i use price indexing for

Tracking correlated benchmark price indexes will help you to understand and forecast price movements, as well as gain more insight on feedstock developments and procurement performance. It adds transparency.

what types of benchmark price index are there

There are many different types of benchmark price indexes: Direct benchmarks such as market pricing, Indirect benchmarks such as critical feedstocks, cost-drivers or full-cost. The suitability of each depends on the nature of baseline price index, the purpose and the available benchmark data

what types of baseline prices are there

There are 3 main types of baseline price index: a single product, a basket of products, and a full portfolio. The generation of a baseline price index, even without a benchmark price index, has significant business value to understand trends and outliers.

what is a price mechanism

A price mechanism is a process where the baseline price index and the benchmark price index are agreed with external business partners such as suppliers or customers, to add guidance on price changes over time.

Price index introduction

Price index use cases

Price index tools

Table of contents

Table of Contents
1 Introduction to price indexing

Detailed introduction to price index models

 

Introduction to price indexing

We all use price indexes

The most common price index we talk about is CPI, the consumer price index, also known as inflation. The CPI is a standard basket of household goods that consumer will typically buy. The CPI is one example of a price index.

But most of us use “baseline” and “benchmark” price indexing as well.

 

 

For example – if you hear on the news that the price of oil has increased sharply on the oil markets today, then you expect to see the price at the pump be adjusted up at the pump in a matter of days. You may even decide to go full the tank before it does. The price of a barrel of oil is a benchmark price index, a very reliable leading price indicator, for the baseline price index of gasoline at the pump. This is an example of price indexing in action. 

We can find a lot of evidence of this relationship. Here is an example based on data from EIA in the USA (link) and the general trend in oil prices. That relationship is seems obvious and well-established.

But if you index the retail gasoline line and the crude oil price, it is not quite as simple as it might seem. Here is the same data using a price index technique:

From this chart, where both prices are indexed to 1.00 at Jan 2009, you can see that the retail gasoline price does not match the increase of crude oil from Jan 2011 to Jan 2015, but then also does not match the decrease of crude oil there after. Why? Because there are more factors that determine the price of retail gasoline – the most important being the taxation and the profit expectation of the big oil companies. (Besides the cost of refining the oil, which is relatively constant, but still an absolute cost).

In this case, it is the profit expectation of the big oil companies which drives the correlation as well – we could model it also, but it would take more time.

 

Price indexing can be far more applied can be applied much more broadly, and can have many uses. Let us take a closer look and describe what a price index is, when applied to procured products. 

What is a price index?

A price index  tracks the development of prices over time. The price index can be a price chart or as an index chart which sets the price to be 1.00 for a defined date, and measures changes from the index point.

A price index tool tracks the development of baseline price over time against a benchmark price index to understand and predict price movements.

In the case of a single product, this is a relatively simple process. If price index tracks multiple products, such as a consumer price index, then there needs to be a standard weighting for each product in the price index basket to avoid changes in the price index to be a result of the mix of products. 

What are different types of price index?

In price indexing, we use an external benchmark price index to compare against a baseline price index. There are various types of baseline price indexes and benchmark price indexes as described below.

Definition & Types of Baseline price index

A baseline price index is the index for which you are trying to establish an external benchmark

There are generally 3 types of baseline price indexes:

1) Product baseline price index

  • The price index of a single product , showing the price development over time

2) Category baseline price index

  • The price index of a group of related products over time, showing the price development over time
  • Each of the products is weighted with a standard volume for the entire timeline to eliminate portfolio effects
  • The volume weighting can be on current or historical average basis

3) Portfolio baseline price index

  • The price index of a group of categories over time
  • Each of the categories is weighted with a standard volume for the entire timeline to eliminate portfolio effects
  • The volume weighting can be on current or historical average basis

Definition & Types of Benchmark price index

A benchmark price index is the index which is used a benchmark price index.

There are generally 2 main types of benchmark price indexes:

1) Direct benchmark price index

A direct benchmark price index reflects the price of identical or similar products in the market.

There are generally 2 types of direct benchmark price index

  • Market price index: The price index of a similar product or service
  • Category price index: The price index for a category of products, with a standard weighting

2) Indirect benchmark price index:

An indirect benchmark price index reflect price trend of cost drivers for a product.

There are generally 3 types of indirect benchmark price index

  • Feedstock price index: The price index of upstream feedstocks which impact the price of a product or service
  • Full-cost price index: A price index of the full cost of the baseline price index. This will include critical feedstocks as well as production cost and overhead/profit assumptions
  • Cost-driver price index: A price index which captures critical cost drivers of a baseline price in addition to feedstocks such as currency exposure, freight and duties, etc

Example of the use of a price index

Johnny runs a business buying and packaging dried fruit and selling it to local supermarkets. He is an expert on the purchase of dried fruit, but he also needs to pay for packaging of the fruit for which he spends US$200,000 each year.

Johnny has worked with 1 packer for many years, who supplies the packaging material as well as the packing service, and charges a cost per pack. The supplier gives great service on rush orders and gives a guarantee that there is no contamination with nuts inside their packing lines which are both important to Johnny.

Johnny investigates the cost of pricing of the packaging for the last 5 years against a market price index. He looks for direct market price indexes, as well as investigating the critical feedstocks and cost drivers of packaging materials and services. He finds 2 relevant feedstock benchmarks:

  • Development of plastic film prices
  • Development of ink prices for film

When he charts those price trends, he gets the following overview:

And when Johnny benchmarks the benchmark index of the feedstocks againt his prices he get the following overview:
When he compares the price development of his pricing, against the indirect benchmark price index, he sees the following trends:
  • Prices to him do not follow the feedstock market down, when the opportunities comes.
  • The supplier is not increasing prices to the full extent of the benchmark market prices
  • Currently, Johnny is probably overpaying for his packaging cost

Johnny will have a better discussion with his supplier, armed with more details. Of course it will not necessarily lead to price reductions, but here are some possible outcomes:

  • Gain a price reduction of 10% = US$20,000
  • Split the purchase of the packaging from the packing service
  • Agree clear market price benchmarks for the pricing with his supplier
  • Get more quotes from competition at least once per 2 years

The key benefit for Johnny is that he will have a much better understanding of the key cost drivers of his packaging and packing cost, and greater awareness of the price developments.

And over time that will lead to cost benefits…

Overview table to price index and business benefits

 
Use-case Baseline price index  Benchmark price index Lower prices Better cash management Clarity of Focus Support sales-price increases Reduce business risk Reduce conflict with supplier Better grip on procurement performance
Product vs. marketprice  Product Market pricing Yes Yes Yes Yes
Category vs. marketindex Category Mix of market pricing Yes Yes Yes
Product vs. feedstocks Product Critical feedstocks Yes Yes Yes Yes Yes
Category vs. feedstocks Category Mix of key feedstocks Yes Yes Yes Yes
Product  cost drivers Product Feedstock& costdrivers Yes Yes Yes Yes Yes
Category cost index Category Feedstock& costdrivers Yes Yes Yes Yes Yes
Product full cost Product All cost elements Yes Yes
Category  cost index Category All cost elements Yes Yes
Simple price mechanism Product Feedstock& costdrivers Yes Yes Yes Yes Yes
Complex price mechanism Product Feedstock& costdrivers Yes Yes Yes Yes Yes

 

 

What does price indexing show us?

The purpose of the RM price index is to benchmark price development against a relevant benchmark, either a direct comparison, or an indirect comparison of cost drivers. If done well, this helps companies as follows:

  • It raise awareness and transparency of the key trends in cost structures
  • It enables greater clarity on price and supply risk in future
  • It gives us additional information for price negotiations 

The business benefits of a price index

If benchmarking is done well, it can give rise to significant business benefits:

Lower prices for products and services

The analytical approach from tracking relevant prices indexes, and the additional insight gained from the process will lead to better information and stronger arguments in price negotiations.

This position of strength will build increasingly over time, as arguments used by suppliers will be tested, set up and tracked over time. But even in the first year of implementation there will be a positive profit impact.

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.

Better decisions on cost saving focus

The process of full-cost price indexing gives the ability to identify products where the gap between an approximate full-cost analysis and the actual prices are excessive.

For example: If the full-cost analysis of one category (or product) shows a gap of 70% between the full-cost estimate and the actual price, and for a second category (or product) there is a gap of 30%,  then it is more likely that the level of competition for former category is insufficient and needs to be looked as a priority.

Of course it can also be a costing error, and other analysis should be used to examine the cause of the discrepancy.

Under all circumstances, the rigorous analytical approach will help to focus on key categories in which price improvements may be gained by increasing competitiveness over time.

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.

Reduced risk of supply shortages

As leading indicator feedstocks are identified and tracked for certain categories, you will gain additional insights into sources and potential disruptions in the supply of critical feedstocks.

You may uncover that, despite having 3-4 competing suppliers, you may be dependent on single sources of critical feedstocks. Or the various feedstock suppliers are carefully coordinating prices and volumes in the market (yes I know it is illegal, but it happens in some markets quite openly)

You will also be alert earlier to feedstock disruptions and price increases. That will allow additional time to take action to protect your business

The additional understanding of feedstock trends and risks is one of the key benefits of setting up feedstock indexes. You will be better able to steer your business and avoid disaster.

Reduced risk of surprises

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 price increases, supply risk, and other shocks.

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 relationships with 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.

Better grip on procurement performance

How do you know if the procurement department is doing a good job?

  • If they get a total 3% saving?
  • If they report specific cost-saving projects to reach a target?
  • If each category is managed via a competitive tender on a regular basis?
  • If they can show that there are 5 competitors for each category?
  • If they say so?

Setting up a benchmark price index for each category or area will help you confirm your intuition. It will help to establish an external benchmark of the procurement performance.

  • Is it a perfect benchmark from day 1? Rarely….
  • Does it help from day 1? Most of the time
  • Does it get more accurate over time? For sure!
  • Will it deliver business benefit Absolutely!!

 

The fundamental challenges of using a price index

There is a fundamental challenge to finding a benchmark price index. No benchmark price index will show a perfect correlation with an actual price, and act as a perfect leading indicator.

I would describe the challenge of benchmark price indexing as follows:

Price is determined by supply and demand, not just supply

The price of any product is driven by supply AND demand pressure, as well as input Raw Material costs. A benchmark price index, no matter how useful or correlated, will never model all supply constraints or surges in demand, and does not model all drivers of the price of a raw material.

However, by making the supply-cost aspect more transparent, you can also start to identify the capacity/demand impact  more clearly.

The correlation between cost drivers and the final price is rarely very high

This is my experience:

– Statistics takes care of some of this issue. Once you know the correlation between two lines, you can use statistics to predict when the variance between them is likely to be “in control” and “out of control”. In other words, the correlation does not need to be perfect – the statistics takes care to translate the movements into clear messages for you.

– You get better at finding the right correlation over time. It is rarely accurate at the first try, but the more you look into a topic, the better the correlation will become. I guarantee that you will be surprised how close you will make a fit over time. And the process of thinking about it adds value also, as you will gain insight into the industry and help you to understand it like you never did before. That too helps to manage risk over time.

No benchmark price index will cover all the cost-drivers of a product.

Any benchmark price index will, at best, cover a few of the main cost drivers. It will not give a complete picture.

However, the process of understanding and tracking the few critical cost drivers is already valuable.

There is no feedstock price information available

It is not always easy, i agree. But i have not yet found a case where it is not possible to construct a benchmark price index with a reasonable correlation and usefulness.

We have a service that helps you to identify usable benchmark material price indexes and to help set them up.

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 finetuned until it adds value.

Don’t let perfect be the enemy of the good

But the challenges of finding an accurate benchmark price index are not killer flaws.

It is my experience that the process of setting up a benchmark price indexes has tangible benefits despite not being perfect:

  • The process of establishing a benchmark price index gives enormous insight into cost-drivers and risk.
  • The statistical correlation between a baseline price index and a benchmark price index established cost-drivers tends to be relatively.
  • The understanding of feedstock prices, and awareness of data availability improves over time. Similarly, a benchmark price index improves over time, as knowledge is gained.
  • A benchmark price index can be useful to track agreed and established cost-drivers so that both a customer and a supplier agree on a transparent index

My strong view is – the earlier you start tracking benchmark price indexes, the sooner they will add serious value to your business.

 

 

Which products/categories to set up a benchmark price index for?

 

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

  • There is no clear direct 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 fo other select 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

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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.

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