March 27, 2012
This is the fourth entry in a six-part series focused on exploring five of the key areas of opportunity for better pricing in the chemical industry
The chemicals industry is a notoriously cyclical business, and in recent years, raw materials cost volatility has become the new normal. As the price of key raw materials rises and falls daily – sometimes significantly – it makes it difficult for sellers and their buyers to agree on what the “market price” really is.
Here are some thoughts on ways to manage for profit, despite the volatility and unpredictability of your raw materials.
Agility in Pricing Updates
Make sure you can execute mass price changes well and with as little time as possible wasted on administrative tasks. By utilizing your product hierarchies, product groups, or attributes (like raw materials content flags), Vendavo can automatically select any applicable customer price record that you may want to change. For instance, some Vendavo customers will use select product attributes like “contains XYZ” material as way to grab every record out there for products where the raw materials costs have been impacted significantly.
Once you’ve identified the right subset of your business where the price change will occur, choose which type of price move this will be – a product price change (most likely), a new or changed surcharge, etc. Next, designate the actual amount of the price change(s) and model the potential impact this will have given your new costs as well – a predicted price waterfall is an excellent tool for that as well.
Formula & Index-Based Pricing
Consider where you can benefit from using formula-based or index-based pricing. Many chemicals companies do this today in various forms, and it can be an effective way to mitigate the risk of volatile feedstock costs. In this situation, the buyer and seller agree to a formula which takes 3rd party published price or cost data from a reliable source like IHS, and then adds (or removes) some component to capture factors to account for the supplier’s processing costs, any market advantages, etc. Typically the formula is negotiated annually, and the actual prices charged are updated monthly, but could be updated more or less frequently.
While formula-based prices can significantly help mitigate the risk of cost volatility, there are some challenges or considerations that go along with them:
- These formulas can be cumbersome to manage. We often see these being maintained in Excel spreadsheets with VLOOKUPs etc. Once the latest index data is available, the formulas need to be recalculated, and finally… uploaded into your ERP system.
- Due to the human intervention, there are opportunities to make mistakes in formulas and calculations. that can result in significant invoice errors, creating more work as you need to identify where the errors were made and who owes who how much money.
- And finally, this can reduce the pricing conversation to a primarily cost-plus conversation – not an ideal position in many cases.
The key is to think about how you can use these as a competitive advantage. Here are some best practices we’ve seen in utilizing formula-based pricing in chemicals:
Don’t try to use formula pricing in all cases. They may make sense on products which are more commodity-like and you have little pricing power. But where you have a specialty product that is unique or enjoys competitive advantages, then formula pricing may leave money on the table. In other cases, your service costs could be more of a problem than your raw materials costs, so be careful to include that into your pricing model as well.
- Leverage with large or sophisticated customers. Most customers with a large spend in your products will require you to price tied to a formula. When this is the case, think about the value, over and above the underlying index, that you are delivering to that customer, so that the initial price that is set is the right price. Remember, you may have to live with this price for years.
- If your product is really a blend or bill of materials, consider building a weighted formula that incorporates an approximation of the blend itself.
- Consider non-material indices as well. For instance, if you’re working with a base material that requires a lot of energy to convert, refine, etc. you may need to consider an index that would act as a proxy for your power costs, like natural gas.
- Lastly, strive to manage formulas centrally, but still give sales the ability to negotiate. By using the waterfall, you can account for both the adjustment made by the formula itself, AND any additional adjustment made by the sales team. This helps keep track of leakage and precisely where it came from. Some Vendavo customers have leveraged the concept of a “formula price library” where approved formulas are created by central roles like product management, and then they are used by sales. This reduces the risk of “formula proliferation”.
In summary, while volatile raw materials costs will likely continue to be the new normal for the chemicals industry, by employing best practices and the tools to enable them, you can effectively manage profit for your organization.
– Dan Bormolini