Capitalizing on lower-commodity prices
08 June 2015
Human Capital Alliance Senior Advisor Somsak Jaitrong analyzes how deep understanding of value-chains is aiding Asia’s manufacturers.
Although oil and cotton prices have plunged between 30 and 50 per cent in the past year, few Asian apparel and footwear companies have captured significant commodity-related savings.
A recent McKinsey article “Sewing up lower costs from falling commodity prices” by Patricio Ibanez and Eli Townsend said many companies don’t have structured processes in place to ask for supplier cost reductions when commodity prices fall and others don’t know what cost reductions to ask for.
“Of those that do ask, many receive small reductions of one to two percent from some suppliers, while others receive no savings at all.”
Huge potential cost reductions
According to the authors oil and cotton prices reductions should be good news for most apparel and footwear companies, since these are key raw materials used for producing clothing yarns and synthetic rubber in footwear.
To produce a typical, mid-priced knit garment, raw cotton represents around 50 to 60 percent of the total cost of cotton yarns. Yarns accounts for about 60 percent of fabric, and fabric for about 50 to 60 percent of the cost of a finished garment.
“Therefore, given the 30 percent drop in the price of raw cotton in the past year, a buyer might expect a 5 to 7 percent drop in apparel cost, depending on the complexity of the garment.
Commodity suppliers’ arguments
When commodity suppliers are pressed to offer commodity-related cost reductions, the authors said suppliers may argue that the effects of raw material prices on their own costs have been smaller than estimated, have been diluted by other players in the value chain, or have yet to trickle through to them.
“Without a deep understanding of the whole value chain and such facts at their fingertips, companies find it very hard to counter these points.”
Developing detailed picture of value-chains
To capture a larger share of potential savings from commodity prices decreases, companies need to develop a detailed picture of their products end-to-end value chains, and how input costs fluctuate and percolate through that chain.
This process is a complex business, requiring an understanding of the underlying chemistry of key raw materials, the structure of the industries that produce those materials, and the evolution of supply and demand over time.
Companies that have taken such fact-based and structured approaches to supplier negotiations in responding to commodity price changes, McKinsey said have been able to capture savings of 4 to 6 percent from their suppliers in a wide range of categories.
Developing rapid response system
A large apparel retailer built a “rapid response system” that was based on a detailed analysis of the effect of commodity price changes on the costs of different yarn and fabric types.
Any significant commodity price changes, the authors said triggered assertive communications with suppliers, asking for price adjustments within 30 days.
“The company was able to support subsequent negotiations with the data from its analyses.”
Long-term procurement effects
The rapid response system approach not only gave the manufacturers a better understanding of commodity price effects but also created a deeper value-chain understanding that provides long-term value.
This new understanding can help the industry meet some of its most enduring challenges, including fighting rising costs, driven by increasing labor, raw material and energy prices, as well as compliance costs in Asia.
In the past, the companies’ main weapon was to move production to lower cost countries and regions.
“But this strategy has many drawbacks: Supply chains must be reconfigured, and companies need to expend time and effort ensuring new suppliers meet the required standards of quality and environmental and social responsibility.”
By focusing too much on where products are manufactured, the companies don’t pay enough attention to how they are made—and to the opportunities to reduce costs, manage risk and improve efficiency in their existing value chains.