There are many cost models available in Procurement Industry. Let us start by naming a few
1. Total Cost of Ownership (TCO) Model
2. Should-Cost Model
3. Cost-Plus Pricing Model
4. Activity-Based Costing (ABC) Model
5. Benchmarking Cost Model
6. Volume/Portfolio based Cost Model
7. Index based Costing Model
Out of these, the most common costing model used in Commodity Purchasing in Index Based Cost Model. Â
In an Index-based pricing, the contract price for a commodity is tied directly to fluctuations in a third-party market index, rather than being a fixed negotiated price. The index can change according to different industries. Â
For example, for you are buying into steel, the index could be London Metal Exchange Steel Prices. If you are buying Crude Oil, it could change to US Platts index. Â You could also be buying derivatives of these commodities and hence, Index based pricing approach is adopted vastly across the manufacturing industry.
Key Components of an Index Based Costing Model
The key elements of an index based costing model are:
An independent market price index is selected as the pricing benchmark (e.g. Platts, Argus, CME indexes for various commodities).
A pricing formula is agreed that incorporates the market index value over the delivery/consumption period as the core pricing component.
This index price is usually modified by negotiated premiums/discounts to account for delivery logistics, grade differences, etc.
The final settlement price fluctuates based on changes in the underlying market index according to the pricing formula.
Let us provide you with two examples to understand this concept.
Example 01 : Natural Rubber Commodity Buying:
The pricing while buying Natural Rubber (commodity used in Tyre Manufacturing) Long Term Contract :
Selling Price for April'24 Natural Rubber = March’24 average of SICOM (Singapore's Commodity  Market Exchange) for Natural Rubber Grade (Typically a grade is pre-selected, TSR20 in this case) + Shipping + Insurance + Supplier Manufacturing Cost (Fixed per USD Metric Tonne)  + Supplier Profit Margin (Fixed per USD Metric Tonne)
Example 02 : Coal Commodity Buying:
U.S. steel manufacturer needs to purchase coking coal for their mills over the next year. They typically consume 500,000 tons per year. Instead of negotiating a fixed price for all their coal needs upfront, the manufacturer decides to implement an index-based pricing formula with their coal supplier.
Index: They agree to peg the contract pricing to the monthly valuations published in the CME Group Coal (CAPP) Fob Terminals index. This index tracks the spot pricing for high-vol coking coal loaded at terminals in the CAPP railroad region (Central Appalachia).
Pricing Formula: The pricing is calculated as the average of the monthly index valuations over the delivery/consumption period, plus a negotiated $10/ton premium to account for delivery costs to the mill.
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Example Pricing Period: For coal delivered in Q3 2024
-Â July 2024 index average: $175/ton
-Â August 2024 index average: $180/ton
-Â September 2024 index average: $165/ton
-Â The average index value across Q3 is: ($175 + $180 + $165) / 3 = $173.33/ton
-Â With the $10/ton premium, the final price paid by the steel mill for their Q3 coal deliveries would be: $173.33 + $10 = $183.33/ton
-Â Compare this to if they had negotiated a Q3 fixed contract price of $200/ton - they saved over $16/ton by using index-based pricing for this period.
This allows the contract price to automatically adjust higher/lower as market prices change, avoiding complicated renegotiations while maintaining pricing transparency. Of course, if coal indexes had risen, they would pay higher prices.
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Risks and Challenges with Implementing Index Based Pricing Model
One of the major risk is that in an index based pricing, you are committed to the deal, irrespective of the market movement. For Procurement managers, this model is beneficial in a falling commodity market but it doesn't work if the prices are climbing. In other words,
if the index prices move out of sync with the company's specific cost drivers, it could lead to pricing that either erodes profit margins or makes the products/services uncompetitive.
However, there are other notable risks to know of. These are:
1.) Complexity and Administrative Overhead
Monitoring of various indices, coordinating with suppliers and alignment on final price index can be a administratively intensive task, especially when you are dealing with a basket of different commodities,
2.) Counterparty Risks
It is likely suppliers (especially Small Enterprise suppliers) may not agree upon an unfavourable landed price (Derived from a index based pricing). This has often lead to delivery issues. So, index based pricing model works best for suppliers with stable cash flow and positive financial outlook.
3.) Dependence on External Data Sources
Index-based pricing relies on external data sources. So, the first important task is so align on a common External data source with your supplier.
Secondly point to note that Index might not always publish real time pricing update. Not all the indices publish their data points publicaly. So, you might have to subscribe to an external provider report. Example -US Platts.
4.) Challenging Renegotiations Switching from fixed pricing to index pricing can disrupt commercial relationships if not properly done. Suppliers will always try to add protections on their fixed premiums/profit margins in a index based pricing. Hence, always note that a renegotiations clause is added for premiums paid over index cost.
Lastly, Few tips to watch out for while building Index based Costing Model
1.) Ensure the index chosen is credible and widely accepted in the industry.
2.) Be specific : In your contract, do specify Index name, commodity specifications, calculation formulas, pricing periods.
3.) Most important, discuss and negotiate fallback mechanisms in case the index is discontinued. Define responsibilities for data errors clearly.
4.) Also discuss, if you would like to switch the index to a different one. Hence, do a benchmark of transition cost If migrating between different pricing indexes over time. Have a clearly defined process to manage that transition seamlessly.
5.) Index price performance, price calculation and communication oversight: Ensure a proper validation is achieved with suppliers on price calculation before releasing the purchase order. Ensure a database or a common dashboard is established to review the unit price evolution overtime. Especially, do project the performance of your index based pricing versus spot purchase pricing. This is required to calibrate your index based formula and the premiums your suppliers are charging you.
Way forward?
Question is how to make ensure pricing movement in index based costing model doesn't bite you as a procurement manager. Is it possible? The answer is yes.
Watch out for Part 2 of this post!