How to Fix Index Based Pricing

by Joe Payne, Vice President of Professional Services

When developing a contract for materials that experience significant price shifts due to market volatility, many buyers will tie the cost per unit to an industry recognized index. The idea behind indexing is to take the volatility factor out of the price, which allows the supplier, now hedging less risk, to provide a lower margin. Tying to an index also makes it easier to compare proposals from competing suppliers by setting the index price for quoting purposes. For example, on an RFQ for steel drums, you might set the steel price at $400/ton. Then all suppliers are quoting the same material cost, and the difference in price will only be due to margin, overhead, and the tare weight of their drum.

Tying to an index takes risk out of a supplier’s quote, and does have a positive impact on bottom line cost. However, many companies find that having a fixed, predictable price is just as important, or even more important, than having the lowest possible price. A fixed price allows companies to easily cost out end product, and gives sales people greater flexibility when quoting business. In addition, in many cases, companies will hold off raising their price in spite of increasing raw material prices, so fluctuations in the index end up eating into your company’s margin.

So how can a buyer optimize the two seemingly competing concerns of getting the lowest possible price and a price that is fixed?

The focus should be on getting the best price possible up front, then ensuring that market swings have a marginal effect on the final price. Below I examine three factors that should be considered when developing an index based price structure. Considering these factors will help offset dramatic index shifts and at the same time maintain the basic principles behind indexing raw material costs.

Choose the Right Index
In many markets, there is more than one industry recognized index that prices can be tied to. Examine several indices, and determine which has been the least volatile over the last 5 to 10 years, depending on the commodity, then tie pricing that that index. In markets where different indices vary dramatically, I recommend index averaging, which will offset major swings in either index. This works especially well when a standard index is averaged together with a scrap index. A note of warning though – if your end product doesn’t use scrap, your index shouldn’t either!

Add a Cap
Though they hate to admit it, most suppliers are sitting on significant raw material inventories. Tying to an index typically throws the notion of sitting inventory out the door, as the price will move with the market regardless of how much inventory the supplier has at the old price. One way to include these inventory advantages into your contract is by adding a cap on the upward shift in price.

For example, let’s say we set a starting price at $10, with a 30% cap. If markets go up, the price will go with it, but it should never exceed $13. The idea is that once the price hits $13, the supplier will be required to buy enough inventory to last until the market calms down. Typically, the supplier already has this much inventory, and it isn’t a problem.

Many times, suppliers will ask for the same consideration for decreases in the market price, but the logic does not hold true. When prices take a downward turn, suppliers have the flexibility to buy raw materials at the lower cost, and they will take full advantage of it. There is no reason why they shouldn’t extend that opportunity to you, the end customer.

If a supplier gives significant pushback on upward caps, a buyer can always provide assurances that any inventory held on their behalf will be used up, even if the contract expires. This allows the supplier to justify the buy and calms any fears that the supplier will be left “holding the bag”.

Timing is Everything
Pick the right timing for adjustments in price, the longer the better. Remember, you negotiated the best possible price at the beginning of the agreement; the goal now should be to keep the price as stable as possible. Many suppliers look for quarterly adjustments, which are reasonable. If the material being purchased is critical in your supply chain and a major factor of the finished price, then semi-annual adjustments should be considered. When negotiating a six month price change, keep in mind that you are essentially asking suppliers to sit on six months of inventory at a time. Providing shorter payment terms as a bargaining chip could go a long way.

Index based pricing helps both buyers and suppliers, but keep in mind setting the starting price is not the end of negotiations. Once you pick your supplier, you should partner with them closely to develop a price change mechanism that keeps as much volatility out of the price as possible.

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