Getting real about mitigating price inflation

By guest authors Felix Kaiser is a consultant in McKinsey’s Munich office, where Marc Sommerer is a partner and Stefan Thimm is a consultant; and Jan Vandaele is an associate partner in the Brussels office.

Category managers can respond to inflation—and save their companies a lot of money in the months ahead.

Procurement managers have been scrambling to secure supply, making the tolerance for taking price increases higher than ever. Yet category managers need to be careful: there’s consensus among market analysts that price increases are no longer rooted in fundamentals but skewed by the impact of the COVID-19 pandemic and an acute winter event that idled between 30 and 70 percent of petrochemical capacity in North America. That sparked a cascade of force majeure situations through North America and Western Europe, driving some commodity prices to levels not witnessed before (exhibit).

Although buyers and sellers battled over price increases of 2 to 3 % in the past, the world could not be more different in 2021. But a critical question remains: What is an appropriate increase? Some market prices may be inflated by self-reported values or reliance on spot indexes, while other commodities may stay at peaks for longer periods or even temporarily increase. It’s a tough situation for category managers, but it presents an opportunity to generate massive value by doing the following five things right now:

  1. Gain a full understanding of supply–market dynamics and outlook. Price increases should be attributable to a limited number of clearly articulated causes, not to arguments such as “the market is just crazy” or vague and anecdotal supply-and-demand issues that happen far away. Category managers should understand and track the elements that trigger price increases and rescind these increases once those drivers are no longer applicable.
  2. Ensure suppliers can clearly articulate the impact of price increases in the market on suppliers’ prices. In times of upward price pressure, sellers often overstate the share of raw materials in input costs, taking the opportunity to inflate their margins. Using cleansheet methodology to identify and challenge these situations is key. For example, a consumer-goods company was faced with a 30 percent price increase for a specialty chemical. The company reduced the increase to less than 10 percent by demonstrating that the share of raw materials was substantially lower in the final cost price, and by showing that the market reference used by the supplier was incorrect.
  3. View unavoidable price increases as temporary surcharges, not the new future state. This mechanism, partly psychological in nature, is very effective in dealing with stickiness of price increases because it shifts the burden of proof to the supplier. One effective tactic is to review the size of price decreases when the market shows an opposite trend. For example, one specialty-chemical company found that while prices for some smaller materials had not decreased much during 2020 (when prices were generally down), suppliers asked for significant price increases for the same materials this year.
  4. Prioritize cross-functional initiatives. When prices are high, the impact of a yield improvement, waste reduction, or substitution is amplified. Now is the time to push through alternative specifications or supplier qualifications. The walls frustrating agile buyers can finally be toppled. Now is also the time to push through qualifications that, in the past, were untouchable: in an inflationary market, the argument of sharing benefits with customers can easily be countered by price stability and certainty. For example, one building-products manufacturer revised its packaging and reduced its packaging materials costs by 30 percent—completely offsetting higher wood and plastic prices.
  5. Work with sales to pass on price increases. Procurement needs to understand its broader role as not only a price negotiator but also an interface between the company and the external market. Category managers work closely with finance and commercial teams to shed light on pure market effects and their impact on the prices of goods sold, while ensuring the right arguments are advanced to pass market-price increases to customers. One chemical company, for example, has procurement and business teams meet multiple times a week to ensure alignment on the inflation pass-through strategy.

The marketplace won’t be for the faint of heart in coming months. While many analysts expect commodity price spikes to ease, other prices will remain volatile; one thing we know is unexpected events always create new upheaval. That’s why it’s critical that category managers know whether to play offence or defence, and that they make the right judgment calls underpinned by solid category strategies, market insight, and an understanding of cost drivers.

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