What chess can teach buyers about managing inflation

posted by Tom Eveleigh
10 December 2021

If the Covid-induced supply chain shocks of 2020 took a while to translate into rising prices, as of December 2021 those rising prices have clearly arrived.

And according to the US Federal Reserve, they are here to stay.

As Supply Management has pointed out recently, this current inflation has a variety of causes, from elevated energy and commodity costs, to challenges around labour shortages and transportation bottlenecks, as well as weak importer exchange rates (particularly in the UK and Europe). With limited ability to pass inflated commodity costs to consumers, construction, business capital goods and consumer durables are likely to be particularly affected.

For procurement and supply management professionals, the natural question is: how do we manage inflation, or persistent rising input costs? Traditional answers to this question revolve around three main themes:

1.     Financial hedges: as well as holding physical inventory, firms can hedge directly (either by entering into multiple staggered contracts to help manage pricing volatility, or by purchasing derivatives such as commodity futures) or indirectly (using derivatives with pricing inversely correlated with the target commodity).

2.     Contract management: specifically, incorporating cost-plus agreements and inflation or commodity-linked indexes may help dampen the impact of rising prices.

3.     Sourcing & supplier relationship development: price volatility can be factored into sourcing strategies. For example, in-sourcing may help to mitigate exchange rate impacts, while sourcing globally from multiple regions may help stabilise input costs, and purchasing via consortia may provide opportunities to increase leverage and reduce inbound logistics costs.

A two-stage approach for tricky categories

For categories with material profit impact, it is especially critical to understand how firms can maneuver within a period of persistent high inflation, and perhaps to work with partners across the organisation to examine the entire value chain in order to determine how to gain long-term competitive advantage.

1.     Use the Krajlic matrix to determine which categories require attention.

An in-depth approach is resource-intensive, and so only makes sense for those categories which have the greatest impact on profitability and the broader organisational strategy. Start by using the Kraljic matrix to determine which categories fall into the right-hand side of the matrix, either by virtue of natural scarcity (as in energy or commodities) or by oligopoly or monopoly power, especially where geographical bottlenecks exist upstream in the supply chain. The list can be refined further by prioritising in terms either of absolute spend, or by examining the value chain and identifying categories with an outsized contribution to gross profit.

2.     Incorporate the Purchasing Chessboard and identify the ‘chess moves’ which make sense.

While Kraljic’s seminal 1983 HBR article did include a 3x3 grid covering the balance of buyer and supplier power, Schuh et al (1999) provide more detail for inflation-management options in their book ‘The Purchasing Chessboard’.

With 64 methods or ‘moves’, the Chessboard can broadly be divided into four squares representing four basic strategies, from ‘Managing Spend’ in the bottom right, through ‘Change Nature of Demand’ in the top-left, ‘Seek Joint Advantage with Supplier’ in the top right, and ‘Leverage Competition Among Suppliers’ in the bottom-right quadrant.

The Purchasing Chessboard (Schuh et al, 2009)

For those categories shortlisted in step one, the goal is to move the category from the top-right of the matrix, where buyer power is relatively low, to the bottom-and-right sections of the matrix, where buyer power is relatively high. An example of how this may work is as follows.

Using cells C7 and C8, the buying organisation (a cross-functional working group), can ‘tear down’ a product or service and identify the input components using the results of the value chain analysis from step one as a starting point. Classifying the function of each of the components can provide critical insight into the purpose of each and help the working group to identify potential substitutes.

This then provides the team with the opportunity to pivot using cell B7. Armed with critical information on (a) which supply categories are particularly vulnerable to price volatility, as well as (b) the role that they perform within the finished product, the group may be able to select opportunities to modify its sourcing approaches and gain greater leverage, effectively making a ‘move’ towards the right-side of the Chessboard.

Ultimately, inflation management is complex, multivariate and can involve a range of different approaches, but hopefully using a framework and systematic analysis and categorisation can provide opportunities for supply management to provide great value in a crucial cost management environment.

☛ Tom Eveleigh is a sourcing and category manager in the facilities management sector.

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