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High prices expected? Shorten those contracts.

Category managementCost and Cash ManagementBlog

Procurement Leaders is about to publish its Category Planning Guide, which overviews all indirect categories in 2014. Interestingly, we find that the higher the expected price, the shorter the contracts.

 

This research surveyed hundreds of category managers and buyers to understand their expectations of price shifts in their categories. Generally speaking, we find that levels of inflation are lower than we forecast last year. Indeed, even those buying direct services are also predicting relatively low price changes.

 

For those categories which buyers believe will increase in cost over the course of the next year, and there are a few which are vulnerable, buyers are taking a rather counter-intuitive stance. Rather than increasing the amount of forward-contracting to decrease the impact of volatility on their planning, they are in fact shortening the length of their contracts.

 

Why is this? We often associate long-term contracts as a means to reduce exposure. The answer may lie in two factors. Firstly, a long contract is essentially a bet. If a supplier is willing to accept this bet, there is a possibility that prices will not rise as much and therefore the supplier gains. If there is universal acceptance that prices will rise, then few will accept this bet.

 

Second, and related to this point, much of the risk inherent in market trading is the uncertainty over how the future unfolds. This risk is multiplied over longer periods. Taking the spot price effectively nullifies the risk of volatility. This is especially relevant to indirect categories, which are often project-base and difficult to forecast demand.

 

Moreover, the use of forward contracts also defers the risk. By doing so, they also fail to send key messages conveyed by the price mechanism regarding the value of the goods and when it comes to planning by stakeholders. By deferring the (almost) inevitable price rises, there is a possibility that operational planners may have committed to activities which may be unsustainable in the long term.

 

Despite the pain that this may entail, it can be better to accept the consequences of high price raises in the short term over acting under false impressions in the short-term.

 

Download an executive summary of the Category Planning Guide 2014 here.

Jonathan Webb
Posted by Jonathan Webb