Best Practices and Capabilities Required for Index-based Pricing

The chemicals market is notoriously cyclical.  The pricing volatility associated with this cyclicality makes it difficult for buyers and sellers to agree on the ‘market’ price.  As a result, index or formula based pricing is broadly employed across the chemicals sector as a means of helping buyers and sellers agree on that ‘market’ price without having a tense, zero-sum negotiation each and every month.  Formula or index pricing can be complex, however, and is not always the right strategy, even in a volatile pricing environment.   

Understanding Index Based Pricing: The Basics

The idea behind indexing is to agree on a formula that works, even as the market goes up and down.  Index or formula based pricing, by definition, involves selecting an index value and formula for price calculation, and the periodic re-pricing of all contracts tied to each index. ‘Negotiate annually, update monthly’ is a common practice. 

There are two primary types of index based pricing:

1) Pricing tied to a market index on the finished product.

2) Pricing tied to raw material or component indices.

Most companies incorrectly consider indexing solely a pricing mechanism. But, price indexing does not address all of a business unit’s exposure to soaring energy costs.  What about delivery expense volatility?  Freight costs soar just as raw materials soar, and failure to index freight can still leave a supplier with significant exposure.  Chemical companies must always analyze index based pricing with an understanding of additional costs such as fuel and freight.

Index based pricing: Good idea or bad?

Index pricing is a good idea, especially in industries with significant price or cost volatility.  The question is: how much of your capacity should be indexed?  The answer, of course, depends.  Are you vertically integrated?  How volatile are your prices?  How volatile are your raw materials?  Are you on the specialty or commodity end of the spectrum?  Is your customer mix made up of price buyers or value buyers?  Do you have a few big customers, or lots of small customers? 

The degree to which indexing is ideal can only be answered after you segment your business unit, your appetite for volume risk, your customers and your products.  You can use the framework below to begin to identify the degree to which your BU is suited to index based pricing, and the percent of your volume that you should consider indexing.

By answering the following questions, and calculating your score, you’ll get a general idea of how much of your BU volume you should consider for index based pricing.

Give yourself a True = 1, False = 0 score for each question line, and then add them up. 

Based on your score of 14, you should consider indexing about 50% of volume.  Today you already have 30% of volume pricing with formula pricing.  Is it the right 30%?  Which additional 20% should be evaluated for fit with index pricing?

In the questionnaire above, where did you have the most 1’s, product or customer questions?  Start there, and pick the products/customers for whom those statements are most true.  The table below gives additional guidance about which customer and product combinations are best suited for index or formula driven pricing. 

Attention to Details

Blindly employing index pricing across product lines and segments is not the right answer.  Instead, examine each product line in detail, evaluate current and desired customer portfolios and pick a desired range of exposures to index based pricing.  Use index based pricing where you are unlikely to be able to realize strong margins over the cycle, and then vigilantly measure margins on indexed vs. freely negotiated volumes.  Do not use indexing where you have a specialty value proposition or relationship, or have high service costs.

Assess Risks 

Certainly index pricing does not address every risk in your supply relationships.  In times of high volatility and escalating costs, your customers will often prefer index prices as a consistent way of managing price.  But those are the periods, when capacity is constrained, when you could probably charge more.  In addition, in a weak market, indexing can’t keep your customers from switching suppliers or not buying.  Indexing is, however, certainly a good way to manage some risks on the portion of your portfolio least likely to generate superior margins over the cycle.

In addition, there is an execution risk associated with index based pricing.  If you don’t have the right organizational structure, processes or the right supporting tools, index pricing can be difficult to manage, resulting in significant administrative burdens and invoicing errors.  Consider your capabilities before significantly increasing your exposure to indexing.  

In Conclusion

Done correctly, indexing can limit your downside on contribution customers without limiting your ability to realize premium margins on specific customer product opportunities.  Only you can determine the ideal exposure to formula pricing, but we hope the framework above will help.  Used correctly, index pricing mechanisms can free up resources to focus on the most profitable pockets of demand without signing away your ability to practice intelligent price discrimination at specific opportunities. 

Colin Carroll is the Vice President of Business Consulting at Vendavo and a subject matter expert in pricing. Vendavo is a provider of price management and optimization software for business-to-business companies worldwide www.vendavo.com