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
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.
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.
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.
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.
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