Fear surrounding rising inflation is all everyone can talk about, and they have a point: If inflation continues to place upward pressure on wages, how does our organization strategically navigate this environment of increasing costs?
Wage costs are increasing as a share of revenue (due to a multitude of reasons discussed below), thus hurting profit margins and driving product and service prices higher. Furthermore, wage increases are sticky, meaning wages can easily increase, but wage decreases are less likely; this is having a direct impact on employee expectations because employees assume bigger raises are right around the corner. Buyers and investors alike are focused on whether rising wages and other costs are squeezing profitability, thereby suggesting a build-up of inflation in the economy. However, the impact is uneven and depends on the labor market, the size of an organization and the type of relationship with a supplier.
Here is what organizations should be thinking about when navigating potential wage increases and rising supplier costs:
The buyer should determine what is driving their supplier’s wage increases
Strong demand for new hires: Demand for service workers is recovering faster than supply, and employers are having to pay more to lure workers. For instance, non-managerial wages grew 1.5% in February and March of 2021, respectively—the single-largest jump in wages for leisure and hospitality workers since 1981. In addition, the Institute of Supply Management’s index of national factory activity reached a 37-year high in March of 2021. Because employers are all hiring at once and some of the labor market has been displaced during the pandemic, strong demand for labor is driving an uptick in wages.
Minimum wage increases: About 20 states raised their minimum wage as of January 2021, thus increasing the stickiness of wages as policy changes reaffirm employee expectations of future wage increases. These minimum wage increases are also spilling over into higher product and service prices. For instance, economists have found that a minimum wage increase of 10.0% between 2016 and 2020 at McDonald’s franchise locations resulted in an approximate 1.4% increase in the price of a Big Mac. Renewed focus on a nationwide $15 minimum wage and looming changes to state wages will continue to increase the stickiness of wages as employees come to expect additional wage increases in the near future.
Private sector wage bumps: In 2020 during the COVID-19 (coronavirus) pandemic, about 40 of the nation’s top employers across almost every industry raised employee wages or offered cash bonuses, including Kroger, CVS Health, Walmart, Bank of America, Comcast, Target, JP Morgan, Yum! Brands, Campbell Soup Company, Facebook and Amazon. These wage bumps are noteworthy because salary increases at one large employment facility directly impacts the wages of other workers in that area. For Instance, researchers at University of California Berkley determined that a 20% increase in Amazon wages resulted in a 4.7% spike in average hourly wages for other local employers due to strong competition for talent. Therefore, wage increases during the pandemic may accelerate momentum around additional price hikes as the economy heats up, vaccines are rolled out and demand for labor rises.
Tight supply of labor: Pent-up hiring during the pandemic and labor shortages in key industries will lead to significant wage inflation for skilled labor and workers with niche skills. Although unemployment remains high compared to 2019, the labor market is relatively constrained because some employees lack the right skills for new positions, while others do not want to change occupations. Additionally, some may not be looking for work because of child care responsibilities and are discouraged about their job prospects or prefer collecting unemployment insurance over earning wages. Industries most impacted by labor shortages that are already showing signs of wage inflation include agriculture, forestry, healthcare, mining, professional business services, manufacturing, computer systems design, construction, electrical engineering, software publishing, industrial equipment repair and maintenance, education and office administrative services.
Interest rates: There is an indirect link between changes in interest rates and wages because interest rates impact the pace of economic growth and corporate profit. Higher interest rates increase the cost of borrowing, which spurs businesses to decrease spending in favor of saving and spending in the future when interest payments are lower. Consumers also cut back on spending as credit card payments rise, further slowing economic activity. Elevated interest expenses and weak economic activity also result in lower corporate profitability. Therefore, organizations are generally less willing to raise nominal wages (i.e., pay rates adjusted for inflation) in low-profit environments.
Trade risks and expanding commodity prices: Pandemic-related logistics disruptions (i.e., higher shipping rates) and strong demand for commodities (i.e., higher raw material costs) are also driving up supplier costs and contributing to inflation in 2021. For instance, imported petroleum prices rose 6.7% in March of 2021 after jumping 11.7% in February, while the cost of imported food shot up 2.0%. Rising raw material prices are hurting supplier profit margins, which is further pressuring organizations to raise prices.
There is no single dominant factor driving inflation. Inflation is running well above the Federal Reserve’s target rate of 2.0% due to confluence of a strong snapback in demand for labor, soaring commodity prices, a red-hot stock market, economic stimulus and changes to the tax code.
Buyers should ask themselves: What kind of relationship do I have with this supplier?
Buyers must utilize their best judgment when selecting the classification for the supplier relationship because there may be an overlap between the quadrants (shown below). A buyer should make this decision based on the value of the product or service being procured. A buyer must then determine their relative risk when purchasing the product or service. Overall, if a factor (e.g., market share concentration, supply chain risk, vendor financial risk, regulation and other key risk factors) reduces buyer leverage, then the risk level increases.
Defining the type of buyer-supplier relationship is an important starting point to creating a successful negotiation strategy because each relationship type requires buyers to utilize a different style of communication and approach in supplier relationship management. For instance, applying hardball tactics in collaborative buyer-supplier relationships typically undermines the supplier’s trust and complicates negotiations.
Buyer should examine price-specific leverage points. Price elasticity matters!
When dealing with rising supplier costs, it is important to look at the product or service’s price elasticity:
Elastic products are easily substitutable (e.g., low-value, low-risk products or services). The buyer and the supplier aim to execute the sale at the lowest cost and with minimal time commitment. Buyers’ typical response to price increases of elastic products is to say no and to leverage a cheaper alternative to bring down prices. Suppliers typically do not have the pricing power to raise prices due to the large number of substitutes; suppliers usually absorb the price increase or risk losing business. Examples of elastic products and services include consumer durables or packaging, paper bags, carpet installation, window cleaning services and janitorial services.
Buyers should prioritize cost savings and leverage substitutes to negotiate lower prices when negotiating elastic products.
Inelastic products are difficult to substitute (e.g., high-value, high-risk products or services). Buyers are challenged by high-value products and services due to the limited availability of substitutes, moderate level of specialization, high market share concentration and a limited number of suppliers. In this instance, suppliers typically pass the price increase on to buyers at the risk of suffering a lower volume of sales. Buyers’ typical response to price increases of inelastic products is to pay higher prices as there are no alternatives. Example of inelastic products and services include drilling fluids, engineering services, construction, maintenance and repair operations and demolition services.
Buyers must prioritize negotiating better contract terms over cost reduction because they have fewer substitutes to leverage for lower prices. Buyers should negotiate additional key performance indicators (KPIs) and service level agreements (SLAs) directly into the contracts (e.g., customer service agreements, price escalations, quality metrics, additional service add-ons, future system upgrades, warranties, renegotiation breakpoints, payment terms, etc.). Buyers may consider pooling internal spend categories or forming a purchasing consortium to gain negotiation leverage in collaborative relationships.
Buyers must decide whether to take a supplier-centric approach, play hardball or deploy a little bit of both.
Whatever strategy the buyer deploys is likely to have lasting effects on the buyer-supplier relationship. Therefore, buyers should outline their ideal negotiation points and potential concessions in order to establish a clear strategy and tone of the negotiation. It is important that buyers do not switch between tactics without an underlying strategy. Buyers should determine their procurement strategy by assessing the type of relationship with the supplier, the negotiation power relative to price elasticity, the size of spend and other market-specific trends impacting negations.
Taking a supplier-centric approach: Strategies to foster innovative thinking with suppliers
Buyers typically want to take a supplier-centric approach to negotiations in negotiated and collaborative supplier relationships, when the product or service is inelastic (i.e., difficult to substitute) and the size of internal spend is high. In addition, buyers and suppliers must work hand in hand to ensure a mutually beneficial relationship. Buyers should be willing to compromise on cost to minimize supply disruptions for the product or service and gain contract concessions elsewhere. Any deviation from a buyer’s standard contract or negotiation process should be thoroughly explained to the supplier in writing, over the phone or in-person. Otherwise, a supplier will likely lose trust and is unlikely to understand strategic objectives when buyer processes unexpectedly change, which further complicates negotiations and can inhibit buyer leverage.
- Propose new value to your supplier: Buyers should identify new market opportunities for that supplier in order to gain price concessions (i.e., find emerging markets and offer to help that supplier get a foot hold in a new market.) A buyer might leverage the introduction of the supplier’s products or services into a new market in exchange for a price reduction.
- Consolidate or bundle purchase orders: Buyers should consider consolidating internal spend categories to leverage the total amount of spend and negotiate price cuts, service level agreements or other contract terms. Buyers may also consider consolidating purchases with a single supplier to increase negotiation leverage.
- Offer to reduce supplier risks: Engage in a constructive conversation with the supplier about supplier risk (i.e., volatile commodity prices, regulatory compliance and financial risk). Buyers should collaborate with the supplier to mitigate risk and create more predictable revenue streams via locking in rates through a long-term contract or agreeing to contract price escalations. Often, suppliers are willing to give a discount today to lock in revenue down the line.
- Increase purchase visibility and trust with suppliers: A company should break down what inputs are core to their business and also have a high-risk exposure to price hikes. In negotiations with a trusted supplier, buyers should increase transparency with the supplier to highlight the negative impact of blindly assuming a price increase in a key area of spend. Honest explanations and clear market rationales behind the impact of a price increase often open a new door for the supplier to split price increases or renegotiate other contract terms.
- Bargain in good faith: Buyers should avoid dominating negotiations and instead aim to reach mutually acceptable collective agreements. In addition, buyers should avoid unjustified delays, respect agreements and provide ample time to discuss and settle collective disputes. In instances where a dispute is unresolved, dispute settlement procedures are deployed, ranging from conciliation through mediation to arbitration.
- Increase competition via technology e-Auctions: A buyer may consider leveraging technology investments and access to online e-procurement (i.e., e-auction) marketplaces to pressure existing suppliers to compete with new suppliers on things like price, quality, environmental impact and plans for innovation and new products. Additional competition in the form of e-auctions may pressure existing suppliers to compete against smaller niche suppliers and offer additional concessions.
Engaging in a collaborative process and bargaining in good faith ensures that the outcomes of the negotiation are perceived as fair and are more equitable than those reached through individual bargaining or unilateral contracting. This has positive benefits for enterprises in terms of supplier engagement, worker commitment, stability and productivity.
Playing Hardball: Strategies to foster innovative thinking with suppliers
Buyers typically want to play hardball in transactional and leveraged supplier relationships, when the product or service is elastic (i.e., easy to substitute) and the size of spend is high. Buyers should aggressively leverage their power in the marketplace during negotiations with suppliers to secure the best deal possible. In addition, buyers should execute these purchases at the lowest cost and with the least time commitment or go to another provider.
- Reduce spend and purchase volume with the supplier: The threat of shifting spend volume away from a large supplier by switching to a lower-cost substitute can pressure suppliers to reduce prices.
- Create a new supplier: Buyers may consider creating an entirely new supply source and investing in a supplier in an adjacent industry to elevate market competition and avoid the dominant suppliers in the market. For instance, a large buyer may try to entice a European supplier to expand into the US market to avoid powerful domestic suppliers.
- Vertically integrate: Buyers may consider making themselves the new supplier by investing in new strategic partnerships and assets to bring the product or service in-house and eliminate the reliance on less predictable suppliers.
- Tighten deadlines and raise penalties: Consider using the “stick,” or punishing suppliers for not meeting the KPIs and SLAs established in the contracts, and pressure the supplier to improve quality, adopt technology and reduce costs.
- Cancel all existing and future orders: Buyers may consider contacting the supplier’s CEO to suspend all projects and eliminate access to the buyer’s payment system, leveraging the loss of existing and upcoming projects to cut costs.
- Threaten litigation with the supplier: Buyers negotiating against very powerful suppliers may consider teaming up with other buyers in the market and threaten to bring the matter to the national authorities responsible for regulating monopolies.
Companies that play “hardball” utilize every legitimate resource and strategy available to them to gain an advantage over their competitors and bring about fundamental change to an industry, put competitors into a reactive position, cause suppliers to make adjustments and deliver expanding value to customers. However, hardball tactics can fundamentally undermine trust in a supplier relationship, result in the loss or a partnership and establish a public reputation for cutthroat business tactics.
By: Riley Mallon
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