While many economists agree that risks of price deflation currently exist, they view future threats as minimal. However, manufacturers would do well to focus on cooperation with suppliers to fare better should deflation turn out to be more than just a threat.

It’s a case of good news versus bad news. The good news is that economic indicators, such as Purchasing Magazine’s Industrial Supplies Price Index (ISPI) which has dropped 24% since peaking last December, are telling us that commodity prices are falling fast. The bad news is that the U.S. economy is risking a deflation. If the price of finished goods should begin decreasing, economists say the pressure to cut corporate costs would become severe, resulting in layoffs, pay cuts, and an overall consumer trend towards saving versus buying, at least until prices fall further. Such a trend could lead to a vicious downward cycle like the one currently afflicting the Japanese economy.

Putting things in perspective, the majority of economists are predicting a return to economic growth in the second half of 2002. They do acknowledge, however, that deflation remains a possibility, albeit a slim one. A sure warning that deflation is looming will be if prices for housing, healthcare and college begin to fall with prices for commodities and goods.

Economists worry that manufacturers’ supply managers may use the opportunity of evaporating revenues and retail pricing power to take advantage of suppliers. Potentially illustrating this trend are the results of a recent poll conducted by Purchasing Magazine in which 88% of buyers indicated they were setting higher cost-reduction targets for 2002. However the reality is that pressuring suppliers for too-deep discounts could be an unwise move, resulting in a host of long-term economic pitfalls. Such pitfalls, which will eventually hurt buyers as well, include damaged buyer-supplier relationships, tarnished corporate images, a smaller domestic manufacturing base as suppliers go bankrupt or close down, and a weaker supplier base as suppliers cut back on technology investments and productivity improvements. The current trend of reverse auctions doesn’t seem to be helping either since these intensify the current deflation dynamic in the manufacturing sector of the economy. As Drew Schram, vice president of supply management for Herman Miller, Inc., Zeeland, MI, puts it, “[With reverse auctions] you obtain better prices, but suppliers can no longer afford to invest in technology or people development. They become weaker and weaker over time.”

The key to weathering less than stellar economic times without putting suppliers out of business is for manufacturers to institute sourcing strategies that insulate them against the dangers of deflation while simultaneously helping to ensure that their suppliers stay healthy. One strategy a manufacturer can employ is to apportion its supply base in a way that allows for market-based opportunities without being exposed to risk. This strategy might entail breaking purchased commodities into strategy groups that take into account long-term supply relationships, supplier performance, pricing and the importance of preserving competition among suppliers.

Another strategy is to convince suppliers of the benefits of “open book” costs. In an economic downturn, this cooperative approach to assessing costs will give suppliers greater bargaining power when it comes to negotiating prices. While the ability to maintain a transparent view of costs will vary from supplier to supplier, since some suppliers do not themselves completely understand their cost structures, what is important is that an honest attempt is being made to keep the manufacturer abreast of changing costs. Some firms have gone so far as to state that suppliers who do not reveal their costs will fare worse in negotiations.

Training supply managers to become experts in their commodities and to use advanced cost-modeling techniques is another means of keeping the manufacturer-supplier relationship healthy. In cases where open-book costing isn’t an option, these experts can reverse-engineer the costs based on factual data by using this approach.

Should ending a supplier relationship become necessary, some manufacturers have adopted the strategy of developing fact-driven processes for explaining their decision, in other words, justifying the need for the move with irrefutable data. This gives suppliers information they could use to improve practices while protecting the manufacturer’s reputation as an ethical business.

Some savvy manufacturers have taken it upon themselves to keep an eye on their suppliers’ financial standing, assessing each according to the viability of their positions with the ultimate goal of the continued economic health of the supplier. If another buyer is significantly weakening the supplier, the manufacturer is not afraid to ask the supplier to reevaluate the disproportionate relationship. Another tactic is to designate qualified staff as a permanent cost-reduction team with the goal of continually analyzing and engineering the value of the manufacturer’s supplier relationships. These professionals can work with suppliers to reduce set up times or help them change over to one-piece-flow manufacturing systems that eliminate inventory.

It’s important for manufacturers to give their suppliers ample opportunities to reduce costs any way they can. In some cases this may mean encouraging suppliers to standardize parts which will ultimately allow them to manufacture and move the parts more efficiently. It may also mean giving suppliers real-time access to demand information via web portals and comparable technologies. The bottom line is that a purchasing strategy that scores price concessions at the expense of further weakening a beleaguered supplier is economically bad for everyone in the long run.

Source: Deflation: Taming the Risks
Anne Millen Porter
Purchasing, Jan. 17, 2002
http://www.manufacturing.net/pur/index.asp?layout=articleWebzine&stt=000&articleid=CA190143&pubdate=01/17/02