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Shipping containers at the Port of Oakland in California, US, on July 14. Worker disputes at major US ports are weighing on already-stressed supply chains. Photo: Bloomberg
Opinion
Macroscope
by Charlie Grahn
Macroscope
by Charlie Grahn

Solving inflation in 2022 means throwing out the 1980s playbook on supply chains

  • In decades past, supply chains were smooth, inflation levels were low and long-term supply contracts with annual price-adjustment clauses posed few risks
  • Cut to today’s inflation and supply chain crisis, and it’s clear that ‘vintage’ contracts with built-in cost inflators need to be brought up to date
Charlie Grahn
Charlie Grahn
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Last week’s US inflation data has many drawing comparisons to the early 1980s. We are assured that today’s central bankers have a plan. It’s plucked from a playbook last used in the same era: increase short-term interest rates, stall new home construction and demand for consumer durable goods, and create enough surplus labour to thwart excessive wage increases. Crude, yes, but effective.

Yet the world today is very different from the one that spawned the Pontiac Fiero and the first Sony Walkman. This is especially true for modern supply chains.

For the past three years, supply chains have endured hastily revised demand forecasts, pandemic-induced trade disruptions, port congestion and all-around chaos. It has been a challenge for a generation of professionals who have toiled for decades in a global marketplace characterised by Swiss-like stability.

However, as trying as these conditions were and continue to be, they were only stressed, not broken, and managing these circumstances is what supply chain personnel pride themselves on doing well. But add to this the complexity of spiralling costs?
Fruit for sale at a market in New York on July 16. Food prices have risen 10.4 per cent in the US from a year ago. Photo: Bloomberg

Inflation is a more formidable adversary, and one supply chain personnel are not prepared to manage nearly as well. The problem originates with the nascent Japanese production methods that were adopted, first by American companies and then elsewhere, beginning in the late 1970s.

These approaches involved integrating supplier personnel, involving them earlier in the design stages of product development, and pursuing stable supplier relationships and long-term supply contracts. Today it’s de rigueur. The last feature is the most important in today’s context.

Negotiating long-term supply contracts is like playing the game Jenga. The parties pull and yaw the pieces just enough to excise the ones deemed prejudicial or unnecessary, only relenting when calamity threatens.

In this context, one of the easiest things to agree to in a long-term contract is an annual adjustment in the price of the goods or services to be received. This is exactly what happened in the past decade and now it is coming down like so many Jenga blocks.

These automatic price inflators usually come in two forms. The first permits the supplier to increase prices annually by any amount up to a specified percentage, maybe up to 5 per cent. This is appropriate if you concurrently source the same thing (usually a service) from multiple suppliers, for example. For industrial and high-volume manufacturing, the adjustment happens by a price index measure published by a reliable government office.

Agreeing to a price inflator is easy. First, absent such a mechanism, suppliers would anticipate long-term cost increases by overpricing in the near term. Second, revenues also increase over time, which means that a purchaser’s margins should hold up. Finally, inflation has been low and stable for the entire careers of the most senior of today’s business leaders; it was easy to agree because it was usually of little consequence.

In the environment we’re in now, these price-adjusting terms are causing a sustained chain reaction, further intensifying inflation. So while central bankers try to throttle consumers, built-in cost inflators elsewhere continue to cascade down the supply chain towards the same target. Whatever the future holds, it promises to be interesting for some, unfortunate for others.

01:08

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Supply chain managers and others are being asked to fight increases, notwithstanding whatever a contract permits a supplier to do, but this is a tall order. Some are making slight headway by bargaining for unspecified future consideration. Most often the result is fruitless.

The next option will be to jettison long-established trading relationships and find alternative, less costly sources. Doing this also entails additional costs, and embracing unfamiliar suppliers also brings considerable risk. Plus, there’s a linear relationship between cost and quality and the trade-off isn’t always appreciated, meaning the cost avoidance as such could be illusory.

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Once we pack away our nostalgia for the 1980s, I expect that price inflators like those used in past contracts will be more carefully used in the future. More precisely, contracts will continue to be long-term but the annual price adjustment provisions will be replaced with less frequent options, maybe every other year.

It will be a kind of circuit breaker. Only by doing this will the amplification of cost pressures be curbed during inflationary periods.

In the meantime, there will be a lot of drama. Because to quote the American singer-songwriter Jerry Reed, “We’ve got a long way to go and a short time to get there”.

Charlie Grahn is a supply chain veteran. He teaches at the Melville School of Business and at Langara College, both in Vancouver, Canada

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