McKinsey warns firms on supply-driven price hikes
Businesses that pass on inflationary pressures to customers risk damaging their brand, a McKinsey report says, with companies instead advised to negotiate with suppliers and deploy risk management strategies.
Inflation in developed economies has been on the rise for 18 months, fueled by strong demand, disrupted supply chains and constrained manufacturing. Prices for energy, food, housing, and goods have risen sharply, while shipping costs have hit unprecedented levels.
Most punishingly, the rate for a single shipping container has increased seven-fold on some routes, with the cost of air freight also rising steeply.
Historically, inflation has rarely been a concern for most procurement, supply-chain, and operations leaders, McKinsey points out, saying that although certain commodities would see sharp price increases, these would fall away before triggering inflationary pressure on the wider economy.
Supply chain negotiation the way ahead on inflation
But, it says, current intense and ongoing inflationary pressures mean price negotiation has never been more important for supply chain leaders.
McKinsey says that with so many suppliers raising prices, buyers need to focus on honing their ability to determine whether a particular price increase is warranted, and that they must learn to deal with the long-term consequences of inflationary markets.
When faced with multiple supply chain price increases, businesses need to determine if suppliers are passing on an increase that’s in line with its costs. To do this, it says, it first needs to identify the costs to the supplier that have increased most - whether this is goods, labour, transportation or a mix of all three.
Next, it should calculate the percentage of the total cost of a product or service that these increases represent, so that it can determine an appropriate starting point from which to calculate the change in cost inputs.
“This is an important decision that requires alignment with the supplier, to find a point at which the agreed price properly incorporates the supplier’s materials, labour, and freight costs,” McKinsey says.
Study supply data to determine if price rise is justified
It continues: “The two sides can then review the past three-to-five years of economic data to see how prices fluctuated for commodities and other inputs, and how equitably the resulting benefits and costs were allocated between the buyer and the supplier. Whether an input-cost increase is reasonable depends on a detailed review of its price history.
“Of course, the supplier would repeat this process with its own suppliers, down through each tier of the supply chain.”
When crafting a response to a supplier who is seeking to raise prices, businesses must also have a clear understanding of the terms of its contract with that supplier, says McKinsey.
“This way businesses can prioritise contracts whose prices aren’t indexed for inflation, and request clawbacks on unindexed contracts that cover periods when commodity prices fell,” it says.”
Risk management needed to navigate inflation headwinds
Businesses also need to use risk management strategies to navigate through inflationary headwinds. It says it can take the following steps to help ensure such strategies bear fruit:
- Use digital and analytics solutions to determine the extent to which inflationary pressure affects supplier prices.
- Encourage supplier collaboration to improve resilience, particularly with regard to joint efficiencies and ways to cut consumption.
- Ramp up collaboration between pricing and procurement teams, to weigh the effect of inflation on the prices the company charges its customers.
McKinsey adds that another way to respond to inflation is by “value engineering” and adjusting batch sizes or order frequency. “Reducing stock-keeping units or high-cost features and attributes by modifying specifications is a potential medium-term technical lever that can help improve resilience,” it says.
Depending on the sector, it says options to address volatility in the short-to-medium term include optimizing supplier footprints for better control over logistics, cost, tariffs, and inventory.
Longer-term strategies might include:
- Inventory stockpiling
- Heavier reliance on vendor-managed inventory
- Expanding cross-industry collaboration to share commodity exposures
- Partnering through the end-to-end supply chain to cut risk on certain supply nodes
Passing supply costs to customers can harm market-share
McKinsey concludes by warning that passing on price increases to customers can create “unintended consequences”, such as negative customer perception and market-share loss.
“In the long run, such outcomes can lead to erosion of an entire category,” McKinsey says, adding that honest dialogue with suppliers can help minimize this type of risk.
“These conversations can be the starting point for building stronger strategic-supplier partnerships that enhance cost resiliency. A targeted playbook can help strengthen negotiation strategies.”
It advises businesses to “leverage ongoing partnerships” and says that in long-standing relationships “carefully designed joint incentives can help increase sales”.
It adds: “If a price increase appears unavoidable in the prevailing market, and is backed up by reasonable, supplier-provided facts, alternatives may nevertheless be available to minimize the cost increase’s effect on the category. For example, a vendor might be asked to help fund promotions to partly offset price increases for customers - an immediate action that can also help build a strategic-supplier relationship.”