Falling commodity prices give buyers using cost analysis upper hand in supplier negotiations

USA: The headlines often trumpet news about declining commodity prices. So why don’t these reductions ever seem to result in price reductions from suppliers?

Suppliers will never volunteer to lower their prices, of course. Because of that, the only way for purchasers to parlay falling raw-materials expenses into real cost savings is to arm themselves with critical knowledge that can give them an edge in price negotiations.

Speaking at a recent webcast event, entitled “Improve your Negotiating Position & Achieve Cost Savings with Supplier Cost Insight,” Paul Robinson, senior economist, IHS Pricing & Purchasing, demonstrated how a little knowledge about commodity and raw-material pricing can go a long way when haggling with suppliers.

“Tremendous commodity price volatility has generated additional need for reliable and timely pricing information,” Robinson observed. “By employing the right tools and knowledge, companies typically achieve 1-1.5 percent savings on their total material spend – a figure that can translate to big savings for most manufacturers.”

As an example, Robinson presented a case study of a major power generation company that was facing another 5 percent annual price increase on its industrial valve purchases. The company employed the IHS Pricing and Purchasing Service Purchasing Analyzer to break down the cost structure of the industrial valve. The Analyzer gave a complete itemization of the cost, including labor and all types of direct materials, as presented in the attached table.

“The analyzer allows purchasers to identify the key elements of price, and then pick some of the largest-cost segments as areas for price negotiation,” Robinson said.

One of the primary material cost elements of the industrial valves is the iron foundry work, which accounted for a major portion of the total expense, at 10.2 percent. A further analysis using a forecast from the IHS Pricing and Purchasing Service revealed that cost increases for iron foundries are expected to slow to a 2.7 percent compound annual growth rate from 2012 through 2015, down from 5.4 percent from 2005 through 2011.

“This reduction in cost increases represented a kink in the forecast—a kink that presented an opportunity for the buyer to negotiate a lower price,” Robinson said.

A more comprehensive analysis of the total industrial valve showed that the total cost increase for all components should amount to just 0.4 percent in 2013—the lowest rate of increase since the recessionary year of 2009.

“This slowdown in price increases reflects the fact that iron ore supply is growing faster than iron ore demand,” Robinson observed. “Labor costs also are stagnant in many developed economies where highly engineered castings are made. This means the supplier is seeing lower costs, which can be the key negotiating point for the buyer. By leveraging this information, a buyer saving 3 percent on this purchase, amounts to saving $30,000 for $1 million in spend.”

Robinson presented a second case study that required a purchaser to engage in an even more detailed and sophisticated cost study to gain the advantage in price negotiations.

A major aerospace and defense company was buying a rare alloy—called 17-7 PH—known for its strength, hardness, formability and corrosion resistance. To understand the supplier’s expenses for making the alloy, the buyer commissioned a custom cost forecast using the IHS Pricing and Purchasing Service Alloy Cost Calculator. The Alloy Cost Calculator can break down the chemistry of an alloy, and determine the respective costs of each metal used.

Once the mix of metals in 17-7 PH was known, the purchaser utilized the Alloy Cost Calculator to forecast their respective costs. The Calculator revealed that prices for the 17-7 PH alloy fell 33 percent from the first quarter of 2011 to the fourth quarter of 2012. It also indicated that pricing should remain flat in the future.

“This particular aerospace company went on to employ the alloy cost forecast as means to objectively justify a contract price negotiation based upon credible market supply and demand factors, ultimately realizing a significant reduction in overall costs,” Robinson said.