Using Price Indexes for Contracting and Negotiation (Part 1)

In recent months, as commodity prices have picked back up, I have increasingly seen procurement organizations accelerate their research on how best to use price indexes for negotiating, contracting and total cost management. This is a subject that Spend Matters originally introduced in an early PDF download on the subject: Using Sourcing Intelligence to Combat Commodity Volatility -- The Price Index Advantage. Yet including a price index as part of a negotiation or contracting arrangement is not a panacea to maintaining margins in volatile markets. How and when you deploy a price index to your advantage is as important as understanding how to embed one as a component of escalation and de-escalation contract clauses.

For example, you might find that rather than pegging the raw material component of a contract to an underlying index that a better strategy might be to have your vendor assume pricing risk. For example, what premium, if it were even possible depending on the circumstance, would a supplier or distributor charge to lock in prices for a certain time period (e.g., 1 month, 3 months or 6 months)? That premium will raise other interesting questions, such as whether it is less than the implied volatility would suggest. Or, perhaps, rather than assume the commodity price risk yourself or having the supplier assume it, it might make sense to have a third party assume elements of pricing risk. Depending on commodity, there are many options (pun intended) in this case, including forwards/futures, exchange traded funds (ETFs) and, in certain cases physical-backed exchange traded funds.

Unlike hedging currency exposure, you can't trust your treasury group to take commodity pricing and volatility risk off your plate. Yet few procurement organizations outside of the CPG/food area that I know are up to speed on the options they have available to them, from basic approaches such as embedding pricing indexes as part of a contract structure to more advanced techniques like price discovery and hedging involving different commodity risk options. Stay tuned as we continue to investigate this topic. In the next post in this series, I'll call your attention to a recent blog post that gets to the heart of some of the challenges of using price indices specifically.

Jason Busch

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