Beyond the Hedge: Making Inflation Your Friend

Spend Matters would like to welcome a guest post from Pierre Mitchell, Director, Procurement Research and Advisory for The Hackett Group.

As I wrap up our inflation study closing this Monday, April 4 (it's a quick study; 10-15 minutes, confidential; custom readout; etc.), I've been looking at the interim results and there are definitely some interesting insights, of which I'll share a few.

The study focused on quantifying current and future input cost inflation impact (including labor -- not just material commodities), and how well various hedging tactics were working. It also looked at how good the enterprise inflationary response has been. Interestingly, the top tactic wasn't even technically a hedge, but rather using strategic sourcing to further aggregate and/or hit less-impacted spend categories, etc. (i.e., "the best defense is a good offense").

What was even more interesting was the weaknesses in the systemic "inflationary response" capability between procurement, finance, and the spend owners. This triumvirate must be aligned not only in working capital vs. profit trade-offs, but also in broader commercial strategies. Do you want to "beat the market"? At what hedging cost? Smooth the market? Smooth profits (i.e., align buy-side and sell-side strategies)? While the majority of finance organizations say "Oh yes, we employ hedging for our commodities," it is usually focused on certain techniques for a narrow set of pure material commodities, even though buyers are making hedging decisions every time they sign a contract (e.g., 1 year vs. 3 year fixed; price adjusters; etc.), including services (e.g., offshore BPO).

Procurement's performance measurement system is also a sticking point. If procurement is measured on "book value" cost saves to baseline (of which a shockingly high percentage only take credit for savings and don't net out the price increases), it runs the risk of stakeholder ire of celebrating 3% savings on spend when true input costs have risen 10%.

So, just as the recession was a perfect opportunity for procurement to elevate its value and capabilities, the inflationary environment offers even more opportunity ("value beyond cost") and to use inflation and price risk as the perfect entrée into a high-impact upstream business involvement. For example, HP's price risk management methodology allows procurement to work with the business to understand demand variation (not just a point forecast!), to translate to supply variation, and make trade-offs to arrive at a consensus commercial strategy. Thus, no surprises or finger pointing.

It's hard to do pro-forma profit forecasts when input cost forecasts are not even really factored in. It also ties procurement systematically into the business planning process so supply uncertainty is managed and you don't have a situation like PepsiCo CEO saying "Had we not had ... this extraordinary commodity inflation, we're a solid double-digit [earnings growth] player...We have no idea what the commodity markets are going to look like in 2012 and beyond." This is not a proverbial happy place to be.

What's the bottom line? Change your tack to use market headwinds as tailwinds to power your Procurement transformation (just made that up -- schmaltzy but true). Oh yeah, and participate in our inflation study by Monday (for practitioners, registration required). Thanks!

-- Pierre Mitchell, Director, Procurement Research and Advisory, The Hackett Group

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