How to Manage Cost Pressure with Index-Based Pricing

Many businesses prefer long-term contracts with suppliers as these ensure continuity of supply and help manage price escalations and costs. But when the market crashes, these contracts become difficult to manage as the business has to again engage in fresh negotiations or terminate the agreement.

This puts pressure on procurement and supply chain teams to get pricing concessions and increase bottom-line savings.

To overcome these situations and build a shield against market volatility, businesses are increasingly adopting a flexible, cost-based contracting approach.

What is Index-based Pricing?

Index-based pricing is a thoughtfully designed contracting strategy with built-in price adjustment mechanisms. This helps a business determine the prices of goods and services based on changes in specific economic indicators or indexes.

Such a pricing strategy enables flexible and dynamic price adjustments in tune with market fluctuations and changes in underlying cost factors. Instead of negotiating a fixed price for a period, the contract is tied to an index such as a commodity price index, inflation index or any other relevant economic indicator. This helps adjust the contract price according to changes in index value over time.

Benefits of Index-based Pricing

Index-based pricing provides cover against price changes and market fluctuations. It helps a business hold down costs in a rising market. It also allows stakeholders to capture additional savings in a declining market.

Additionally, with agreed-upon pricing adjustment mechanisms in place, index-based pricing eliminates the need for repeated negotiations and helps build healthy and long-term relationships with suppliers. Negotiations are simplified with a clear and objective mechanism for price adjustments.

The strategy is beneficial for suppliers too since it allows them to protect their margins in a volatile market. As the contract is tied to a publicly available index, it enhances transparency in the pricing mechanism and diminishes the possibility of a conflict between buyers and sellers.

While index-based pricing may not be suitable for all contracts and categories, it can be especially useful for spend areas that are highly volatile and exposed to the market.

How to Leverage Index-based Pricing

Here is a brief description of the steps involved in establishing index-based pricing.

1. Establish a base price:

The first step is to determine a fair base or starting price. This can be done by conducting a competitive bid or running a strategic RFP to get price quotes from different suppliers.

2. Determine cost drivers:

Identify the key cost drivers for the product or service. Look at granular price quotes, historical contracts and line items in price sheets and invoices. Assign weightages to different cost drivers to arrive at a price escalation formula.

3. Shortlist favorable indices:

When you have determined cost drivers that will influence the pricing formula, the next step is to define specific market indices in the contract for each cost component. The objective here is to align the pricing formula with market movements.

4. Determine parameters for pricing refresh:

Decide on the frequency of pricing refreshes, depending on market conditions. In other words, determine how frequently should index-based prices be reviewed. A market downturn will require frequent reviews to capitalize on costs and capture higher savings.

5. Review contract pricing performance:

Track pricing movements over time to make suitable adjustments to pricing mechanism in the contract. Review pricing refreshes to ensure these are in tune with market conditions.

Challenges of Index-based Pricing

Index-based pricing can be heavily dependent on a single, primary commodity if the final product price is tied to a single raw material. Alternatively, it can comprise multiple volatile components if the final product price depends on the cost of different components.

To arrive at a formula to calculate index pricing, it is important to determine raw materials and additives that make up a significant portion of the final product. Also consider freight and other service costs as part of the overall offering to the customer.

Arriving at an index pricing formula can be complex. It can go wrong if procurement teams do not consider specific material indices or even a service component. Such exclusions can lead to mismatches between formula calculations and actual cost increases.

Additionally, companies may be using several variations of the pricing formula, thereby enhancing the possibility of manual error. They may also fail to track the latest index movements and end up using outdated, incorrect formulas. This can impact profit margins over time.

Finally, businesses must have central planning and approval mechanisms to arrive at consistent formulas and execution throughout the organization.

Know how GEP can help your business keep rising costs in check through its data and analytics platform.