Spend Matters welcomes this guest post from GEP.
The process of sourcing commoditized raw materials is nuanced, with strategies that are not generally applied to other direct materials. While this article will dive deeper into the strategies deployed specifically with sourcing commodity chemicals, it is important to note that these principles can be applied to several other commoditized raw materials. In order to gain a better understanding of best practices with regard to sourcing, we will first define what this article considers a commoditized chemical:
- Widespread availability — Indicating multiple sources providing mostly interchangeable material.
- Low cost — Commoditized materials are generally priced lower than specialty counterparts. In the case of commodity chemicals, this would include materials under $1/lb.
- Fluctuating cost — This is largely driven by the supply-demand situation in the market. Given the easy availability of materials and low fixed costs involved with production, prices are largely driven by consumer specific demand and volume (to a lesser extent).
With the recent crash in crude oil prices and other feedstock materials, commodity chemicals have seen significant price fluctuations. These uncertain market conditions further strengthen the need for a rigid sourcing framework. Some important criteria that should be considered while developing a sourcing strategy are given below:
1. Understand Cost Structure and Drivers
- Commodity chemical prices are driven largely by price variations in the underlying base chemical. Tracking these price variations helps with predicting and understanding commodity chemical pricing trends.
- Given low unit costs of raw materials, the importance of understanding other cost components within the total cost is amplified.
- Freight and packaging costs can range anywhere between 8%–25% of total costs for commodity chemicals.
- While material costs often sees minimal variation among suppliers, value can often be driven by focusing primarily on logistics and packaging costs.
2. Identify the Supply Market, Distribution and Logistics Network
- Commodity chemicals typically have a widespread network of suppliers providing similar and fungible materials.
- Understanding the network used by each vendor to supply a facility is crucial in determining an optimal supply setup. Often, a low cost supplier may not have the tank facilities needed to store enough material to be delivered on a timely basis.
- A few points to consider while evaluating a supplier’s fit are listed below:
- Delivery lead time
- Delivery method (tank truck vs. rail cars vs. marine) and the ability of the supplier to use a particular delivery method throughout the year
- Availability of storage facilities and capacities
- Repacking capabilities
- It is also important to consider the use of distributors while developing an effective supply setup. Distributors make use of a pool of widespread manufacturers and are frequently able to supply material with a shorter lead time.
3. Develop a Pricing Mechanism
- Commodity chemical pricing often sees significant fluctuations based on feedstock pricing.
- Monitoring pricing on a monthly basis can be an arduous task and requires constant vigilance to ensure supplier pricing is in line with the market.
- Developing pricing mechanisms can be an effective tool in ensuring pricing remains competitive and also eliminates the need for manual intervention.
- Several pricing mechanisms are frequently employed and can be customized based on material and quantities. A few commonly used mechanisms are listed below:
- Index based pricing – Pricing follows a formula that is governed by price of feedstock material.
- Fixed Quarterly pricing – Pricing is negotiated on a quarterly basis. This mechanism is used less frequently and is generally employed with materials that are less influenced by global commodity prices.
- Monthly negotiated pricing – This method usually results in the most competitive price, but also requires considerable effort. Multiple suppliers provide quotes on a monthly basis followed by a negotiation. In cases with high volumes, this process can be automated by use of an e-auction.
4. Develop Alternate Sources and Establish a Competitive Situation
- A crucial element of sourcing commodity chemicals is the development of alternate sources.
- Developing multiple qualified sources not only ensures a competitive environment, but also guarantees security of supply in the case of catastrophes or force majeure situations.
- A commonly used best practice is to maintain a primary and secondary supplier for each material, thus ensuring suppliers remain price competitive.
Overall, the most vital aspect of sourcing commodities is to understand the difference between market related and supplier related price fluctuations. A better understanding of these two components allows an organization to take advantage of any fall in market prices while also ensuring a supplier is competitive. Making use of the points discussed in this article, one can develop this understanding and put in place a system that will allow maximum flexibility while maintaining competitive pricing.