McKinsey: Digital Twins Can Revolutionise Procurement
Volatile commodity markets have defined recent years; between late 2021 and throughout 2022, sharp price increases affected everything from energy to metals, polymers and wood.
Now, prices for commodities like steel, polymers and energy have begun to fall. Purchasing teams, whom were used to contending with skyrocketing supplier prices, are now adjusting their focus to bring commodity costs back to a fair level that reflects today’s actual raw material and energy costs.
For purchasing organisations, ensuring fair prices - whether markets are rising or falling - relies on having a strong understanding of how changes in cost drivers impact overall prices.
In its new report, McKinsey & Co. found a new key tool to address this: the spend digital twin.
According to McKinsey, the powerful tool lets businesses dive deep into their overall spend, allowing them to see how market trends affect individual categories and use this insight to determine a fair price for supplier negotiations.
Upgrading analytics with a spend digital twin
A spend digital twin models the company's purchasing spend from the ground up, taking into account input cost factors like energy and labour.
The report found that it helps organisations track fair price development over time. Depending on how it's set up, the digital twin can cover entire categories or focus on specific items like the top ten parts in a commodity group.
Take aluminium die-cast parts, for example. The cost doesn’t just depend on the price of aluminium, but also includes factors like the mix of mined and recycled aluminium, the energy used in production (be it coal, gas, or electric) and the region where the supplier operates.
Labour costs, amortisation charges and a mark-up are also included in the fair cost calculation. The same principles apply to parts made from injection-moulded plastic, where the costs of polypropylene, energy, labour and other factors are considered.
Once the fair market price index is established, it can be used to compare supplier prices at various levels - whether by part, supplier, or commodity - and pinpoint where prices deviate from the fair market cost.
This analysis helps purchasing teams negotiate effectively and assess their own performance over time.
Negotiating with data: How spend digital twins help
In inflationary periods, supplier prices tend to rise- but when the market shifts and prices fall, it’s often harder for purchasing teams to secure the same downward adjustments.
This is partly due to the information gap between buyer and supplier. Suppliers closely track cost developments and are quick to raise prices when necessary. However, buyers may not be as quick to monitor market changes and suppliers certainly have no incentive to point out when prices should drop.
This is where the spend digital twin becomes invaluable. By highlighting cost trends, it gives buyers the insight they need to request reductions when market prices drop.
- Spotting negotiation opportunities: A spend digital twin allows buyers to compare current prices with fair market values. If there's a significant gap between the two, this becomes a key starting point for negotiation.
- Preparing for supplier discussions: Once discrepancies are identified, the digital twin helps purchasing teams calculate potential clawbacks (the difference between fair market prices and supplier prices). It also helps with fair price adjustments in the current market.
- Indexation contracts: Spend digital twins also help set up indexed contracts, ensuring that if suppliers pass on cost increases quickly but delay reductions, purchasing teams can take proactive measures.
- Setting goals and evaluating performance: Performance tracking is crucial for any purchasing department. A spend digital twin provides transparency by separating market shifts from actual negotiation performance, giving a clear picture of how well a team is doing.
- Engaging stakeholders across the company: The digital twin provides insights that can be shared across teams, such as updating sales departments on cost trends. This helps sales reps make more informed decisions when negotiating with customers.
- Scenario modelling: A spend digital twin can simulate different market conditions and project their impact on company spend. For example, companies can run financial hedging scenarios to see how they might protect against sudden market shifts.
Building a spend digital twin: What you need to know
Setting up a spend digital twin can take several weeks or months, depending on the complexity of the model. However, even a basic setup can yield useful insights. Three essential elements are needed to build a successful spend digital twin:
Software
Specialised software is necessary to track spend over time, though existing dashboard tools can also be adapted for the task.Fair market index modelling
This is the heart of the digital twin. Some companies may already have cost models they can adapt, while others may rely on supplier data or product lifecycle management information.Market index expertise
Selecting the right index—be it material type, region, or contract type—is crucial to accurately reflecting fair cost development.
A competitive edge in volatile markets
In today’s fluctuating market environment, purchasing teams need to be nimble to remain competitive.
A spend digital twin is a smart, forward-thinking tool that helps teams manage spend effectively, giving them a solid foundation for negotiations and decision-making.
By using this tool, businesses can refine their procurement strategies, optimise costs and position themselves for long-term success.
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