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“Locking in prices”: Indexed vs Fixed

January 7th, 2009 · by Ed Bockman · 3 Comments · best practices, contract management, sourcing, supplier management, supply management, supply market dynamics, supply risk

As commodity prices have continued to fall, the questions my colleagues and I are most frequently asked is, “should we lock in prices while they are low?” And “if so, when will we hit rock bottom?”

Obviously, I have no qualms with buyers wanting to get the best prices for their direct materials and indirect services, but trying to time the market and lock in prices based on the bottom of the market can actually be short sighted, and not necessarily the lowest total cost option in the mid-to-long term (and much like stock market timing, can burn you in the long run). Indexed pricing, on the other hand, can be much more predictable and fair (in terms of buyer/supplier risk), and therefore more conducive to long term strategic vendor relationships AND cost savings.

As an example of this situation, let’s look at some work we recently did with an organization sourcing hot roll steel stampings. In December 2007, they “locked in” a fixed price with their supplier that was 15% over the current market price ($0.31/lb). Given that steel prices had risen 6.9% in the previous year, a 15% markup seemed reasonable. But in the spring, faced with skyrocketing costs, the supplier refused to honor the contract and proposed a massive price increase. The buyer balked and quickly sought out a new vendor - but was forced to put this contract in place at the then spot market price (they also experienced a service disruption). Ironically, the market price that had risen 102% during the first 6 months of the agreement, plummeted 81% over the next 6 months. The graph below tells the story:

Even ignoring the interruption, which cost the buyer time and money, the average cost of the indexed price ($0.40/lb) would have been 12% lower than the fixed price ($0.46/lb) for the life of this contract.

Obviously, there are a lot of moving parts in calculating total cost for any direct materials. But at a time when contracts are no longer sacred and many suppliers are hanging on by a thread (in terms of their financial health due to the recession or credit crunch), even if you “win” by locking in a low fixed price, you may actually lose in the end when the supplier raises prices, refuses to honor the contract, or shutters their operations. A far safer and ultimately cheaper option is often to agree to an indexed pricing model. You will take advantage of the low price troughs and share the burden of higher prices with your strategic suppliers.

Ed Bockman is a Director in Ariba’s Spend Management Services Group. Ed leads the practice focused on providing spend management solutions to the diversified manufacturing sector.

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3 responses so far ↓

  • 1 Lisa Reisman // Jan 8, 2009 at 6:56 pm

    Great post! Another compelling reason to use an index (vs. trying to time the market at the lowest point) relates to the whole demand equation. Demand is slipping for most manufacturers. Locking in or buying forward typically requires a volume commitment. And with demand dropping and the need to keep inventories low, buying via an index may be a far more prudent strategy.

  • 2 Nick Kent // Jan 9, 2009 at 10:58 am

    I found the artilce to pack a great deal of information in a compact message. I am troubled, howver, I have concerns the use of an index for pricing as they can be affected by the very agreements tied to them, are reliant on acurate and honest information and may not have any benchmark against which to test the accuracy of the index numbers. I am curious how these concerns are met in industries where index based pricing is common.

  • 3 Charles Wink, CIRM, C.P.M. // Jan 9, 2009 at 12:45 pm

    I certainly agree with the use of indexed pricing. Creating a “win/win” situation for both sides is the hallmark of true professionalism and recognition that suppliers and the supply chains they participate in have greater effect on the business model than internal processes. Strong management education and support as well and wide use of the particular index in question (Nymex) plays a strong hand in the viability, lengh and strengh of any relationship.

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