How to prepare for what may come next in the global trade war

The ongoing trade war has had a huge impact on global supply chains. The aftershocks have been felt by the unlikeliest of categories.

One of our global pharmaceutical clients wanted to assess the impact across its category families. Their procurement team had anticipated impact on capital and construction (e.g. building and packaging equipment), and supply chain materials and products (e.g. chemicals and electronic systems). However, when our procurement intelligence and risk monitoring work identified impacts for the R&D category (both directly – lab supplies and equipment and indirectly – clinical development), category leaders were surprised. Our assessment for the pharma company identified $30–$40 million-worth of impact on their supply chain by trade tariffs. 

The effects of the trade war are only likely to spread further. US tariffs are expected to increase from 10% to 25% starting 1 March 2019, on $200 billion of Chinese goods. Regardless of how the trade deal is negotiated between the Trump and Xi Jinping administrations, organisations need to be prepared for all potential outcomes. Here we recommend some risk mitigation strategies that procurement functions can undertake in the coming months:

1. Supply chain transparency

   The first step for procurement leaders navigating this volatile trade landscape is to increase visibility across their supply chain. It helps identify where costs have increased after the imposition of tariffs, gives clarity on what are the cost-driving areas (feedstock/products), and highlights potential risks with suppliers or sourcing locations.

   In our work with procurement teams across sectors, we have observed one common challenge, i.e. lack of visibility at all levels of the supply chain. Mostly, procurement teams have good visibility of Tier 1. For instance, a cosmetics company’s category leader may know that lipstick excipient (the base on which the formula of cosmetic product rests) is not being sourced from China. But if any of the excipient’s raw materials are coming from China – from Tier 2/3 suppliers – then the price is likely to be negatively affected. Knowing the source of the indirect as well as direct materials helps category leaders identify the high-risk commodities.

2. Total cost of ownership (TCO)

   To accurately estimate the impact of trade tariffs on the supply chain, a recommended strategy is to use a Total Cost of Ownership (TCO) model. There are various ways in which procurement teams can use this to mitigate their trade tariff risks; some of these include the following:

   • Alternate sourcing locations

     Since China is not a straight-forward cost-saving solution for sourcing teams, category leaders have started looking at other countries within Asia, and also parts of Eastern Europe and Mexico. However, deciding on an alternate sourcing destination requires the procurement team to answer several questions, including:

     • Is the cost of shifting sourcing destination less than the cost incurred due to higher tariffs? Have all the factors – such as transfer of knowledge to new suppliers, transportation costs, loss of current investments, and labour and utility charges – been factored in?
     • Is the alternative sourcing destination stable and expected to be feasible in the long-term?
     • Will the quality component change when shifting the destination?

     To answer all these questions to evaluate the ‘right’ option, the TCO model can be helpful. There could be a possibility that moving your supplier base from China to say, the Philippines, might not yield cumulative cost-savings; for example, the business could avoid a trade tariff, but the logistics cost could be higher. Even if the Philippines emerges as a cheaper supplier base than China in 2019, it might be worth comparing it to Mexico – where the business might save on transportation costs or incur lower tariffs.

   • Changing formulations

     Organisations can also leverage TCO models to calculate the changes in the cost of a product if its formulation changes. The sort of questions which can be answered include:

     • How would an alternate herb for a sauce sourced from a different country impact the product cost?
     • If the artificial ingredients sourced from China could be replaced with natural elements procured locally, what would be the cost differential?

      

A significant price increase for critical categories can prove to be detrimental for organisations, especially if there are only a few key suppliers in the market. Our procurement solutions team encountered this scenario in a recent market study, when a demand-supply imbalance was identified in silicones. China constitutes ~60% of the global silicon metal supply and 40–45% of the global silicone production capacity. An incremental increase in the raw material price in China resulted in a significant price hike (20-30%) of all silicone-based products globally. For a CPG company, this would mean that manufacturing personal care products could become more expensive. We found that a few CPG giants have filed patents for silicone-free formulations. In such a scenario, a TCO model can help CPG procurement teams determine the difference in cost between procuring now-expensive products versus switching to silicone-free formulations. 

3. Contract hedging

Companies may also look at contract hedging to reduce the impact of trade tariffs, and consider it as a cost avoidance strategy.

For categories such as logistics, which may face indirect impact due to trade war, contract hedging can prove to be beneficial. Since the price of products/services procured may depend upon a host of other costs (such as maintenance, labour cost and equipment costs), entering into fixed price contracts with preferred suppliers can result in business benefits.

For categories that are volatile in nature and likely to face a direct impact due to the trade war, companies may choose to enter into fixed price medium-term contracts with suppliers. This flattens the extremities and helps when the prices of these commodities inflate. However, finding the right contract price is very important, as the company may end up paying too much in case the market prices fall down below the contracted price. 

Additionally, if a product is expected to witness near-constant demand and a relatively stable supply market, we recommend fixing the prices. It can be beneficial in case of any adverse event, as the probability of getting volume-based discounts is low.

From our experience of working in different industries, we have found suppliers show reluctance in entering into a fixed price contracts in dynamic markets. In these circumstances, demand forecasting and assessment of market dynamics have been proven as helpful tools to assess the relevance of contract hedging.

What to expect in 2019?

Much of 2018 has been spent battling the uncertainty presented by the global trade war. Who is to say what will happen next in this unpredictable geopolitical climate? Could there be a favourable trade deal between the US and China before the higher tariffs deadline? Could the deadline be extended further? Could the tariffs increase, decrease, or be removed altogether?

These are just some of the many unpredictable and uncontrollable questions global procurement teams will have on their minds going into 2019. Faced with such volatility, organisations must scenario plan for every possible outcome. By leveraging regular market intelligence, commodity forecasts, and tools such as Total Cost of Ownership models and decision forecasting, procurement can be armed with the insights needed to make informed sourcing decisions and manage supply chain risks.

To find out how The Smart Cube can help businesses stay ahead, please read about our intelligence and analytics solutions or get in touch. We can help you understand and anticipate the forces and changes influencing your critical procurement categories today and beyond.

With additional inputs from Harsh Kumar, Senior Analyst, The Smart Cube