There is no exact rule on whether or not to use a price formula, and although the time spent during the initial negotiation is lengthy, the benefits of having a formula outweigh it. Generally, a price formula is used when a large part of the material’s production cost is linked to a commodity.
Attention! We will not discuss the sales pricing method here (Such as contribution margin, markup, competitive price research or price based on profit). These are tools used by Marketing and Sales, which in addition to the cost of the products, include other aspects such as brand positioning and the company’s strategy. We will discuss cost, not price or value!
I will use an example of direct material to make it easier: Let’s say you buy a piece of metal that is used in the manufacture of an airplane. The basic raw material to produce this piece is Zinc, a metal (commodity) whose price is traded on the London Stock Exchange (LME – London Metals Exchange).
The application of a price formula is directly linked to the need of understanding the material’s cost composition, which consists of the processes and materials needed to transform a Zinc bar into the piece you buy.
The greatest advantage of applying a formula is undoubtedly the transparency in the relationship with the supplier, in addition to the visibility of prices — you are a connected buyer and you are looking to learn about the market in which you operate, you will know that your prices will increase if the quote of Zinc is increasing in the LME stock exchange before the supplier even requests an adjustment, and as you well know, information is a valuable currency in purchasing and the knowledge that the prices will increase can trigger strategic actions that will put your company in advantage. If you evaluate Zinc quotes in two different periods and for whatever reason, there is a 20% difference between the two quotes, it does not mean that the cost of the purchased piece will increase by 20% — believe me, this is one of the biggest mistakes buyers can make when dealing with commodities for the first time, and this is why I mentioned the need to know the cost composition of your material for the application of a price formula. If the raw material, in this case Zinc, is responsible for 5% of the cost of the final product you should apply a 20% adjustment only on top of the 5% referring to the raw material in your composition cost — which will mean a 1% increase in your final product’s cost.
Similarly, when there is a price formula applied and the buyer knows that the prices on the exchange have dropped dramatically, it is part of the category management that the buyer reaches out to the supplier and requests the cost reduction. The application of the formula price also provides greater security for the buyer by preventing the supplier from increasing “Invisible Costs’ — for example, it is common for suppliers to apply an undefined premium to price formulas, a value that covers the costs of processing the material. If there is no defined price formula, the supplier can say that the cost of the metal has decreased but the processing cost has increased, and therefore the adjustment will not be passed on to the buyer’s company.
Prices vary daily on the stock exchanges — normally in accordance with the Law of Supply and Demand, and it is common for the buyer and seller to negotiate the periodicity of the price adjustment. For example, you can negotiate a quarterly adjustment, which considers the average closing price of the raw material in the 3 months preceding the price readjustment. One can also consider a monthly adjustment, which considers the closing of the quotation of the day before the adjustment, and so many other options.. You may have already noticed that negotiating and applying a price formula is a painstaking task that requires a great deal of time. It is a tool that should be applied only to the items and categories that make sense — especially since the adjustment of pricing is a very operational task that will demand your attention according to the periodicity negotiated. A good general rule of thumb is to use the ABC curve and understand which items A have raw materials traded on the stock exchange.
To avoid periodic adjustments, some buyers and suppliers negotiate triggers. Triggers are previously agreed values in which both companies are committed to absorb market variations. Let’s say a company negotiates a 2% trigger, this means that if the commodity’s value in a given period falls within the 2% margin (2% drop or 2% increase), prices remain unchanged. If the price of the commodity increases and the price is not adjusted, the burden remains with the selling company. If the price of the commodity decreases and the price is not adjusted, the burden goes to the buyer, who will not be benefiting from a price reduction in the market.
It is important that the buyer knows how to choose and negotiate the correct trigger. A 1% trigger for example may not be suitable for a commodity that varies widely (the variation will always be greater or less than 1% and it will be as if the trigger did not exist). The opposite is also valid and if you choose a 10% trigger, perhaps you will lose saving possibilities depending on the volume and price of the commodity. A way to determine the correct choice of triggers is to evaluate the historical variation of prices — the more data you have, the better!
For example, you can evaluate the last 24 months (the good thing about using a formula on the price of commodities is that the price history is public information and widely available on the internet). You should evaluate this data and look for a trend, such as if the behavior of prices is cyclical (“falls-and-rises, falls-and-rises” month by month) a good suggestion is to request the quarterly adjustment, so that you can enjoy the falling months (“falls and falls”). If you request a bimonthly adjustment, you will have a month in which prices are falling and another month in which prices have risen, which will widen your variation and reach your trigger. You can always ask the supplier what adjustment periodicity they use with other customers, but be aware that the supplier can manipulate this information and use it as they want. It is the old saying that you must “trust but verify.” After defining the frequency of the adjustments, it’s time to get your hands dirty and define the trigger. And then my friend, it is a matter of scenario planning. In possession of your annual volume, you must calculate your current spend (total volume purchased multiplied by the amount currently paid) and your spend in the event of price changes (take, for example, the highest and lowest price of the commodity in your historical series). Then calculate the trigger possibilities (for example, 3%, 5% and 7%) and see the differences between the spends. For instance, say you choose a 7% trigger, if the variation is 6%, at the very least your price will remain unchanged and you can stop reporting important savings, but you can also benefit from a price increase that doesn’t happen because it falls within the trigger.
What is more worthwhile for your company? As previously indicated, the volume of purchases, the spend, the size of your team, the operational work and especially the relationship with the supplier will be decisive in choosing and negotiating the best price formula. Common sense and technical knowledge are extremely important and when added to soft skills (especially the ability to build a good relationship), we have a successful buyer!