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A Material World

July 10, 2008
The growth of the global economy continues to change the landscape of the raw materials market. Realizing that the old rules no longer apply, manufacturers are looking inward for opportunities to drive costs back down without making their customers foot t

How many times in the past year were you certain that what you were paying for raw materials couldn't possibly go any higher? It's probably more than you would care to admit. Having been proven wrong on that point on countless occasions, manufacturers have reached a level of acceptance with the instability of the commodities markets. They have stopped waiting for prices to peak, realizing that their production cycles will in all likelihood continue to grow more expensive every quarter, if not a little bit every week.

While that sounds like the bad news, it's really not -- at least not completely. It means the novelty of those frequent and often vicious price spikes has finally started to wear off, and manufacturers can shift their attention to the question at hand: What do we do about it? But to fully understand where this issue is going it's important to know how we got here. According to experts and manufacturers alike, there have been two key developments in the last year or two that share responsibility for the substantial hikes in raw material costs. The first one should be easy.

Driving Factors

You guessed it... oil. According to OPEC, the price tag on a barrel of oil was still around $70 as recently as a year ago, but has now skyrocketed over $140 a barrel as of late June. And that price affects everything. Not only does oil play a vital role in the production and transport of every product manufactured in the world today, but it's also a main ingredient in literally thousands of plastics, resins and other synthetic materials used in automotive, electronics, apparel and most industries in between. And what's more, the oil companies themselves are in the same boat as everyone else, spending nearly twice as much on energy and transportation as they did last year.

In addition to natural rubber, Goodyear Tire & Rubber Co. depends heavily on a steady supply of oil-based products used in synthetic rubbers and a pigment material called carbon black. Above, a newly manufactured tire is inspected at the company's factory in Lawton, Okla.Rising oil prices have always been bad news for manufacturing, but adding recent trends in globalization to the mix has really launched prices into high gear. Demand for raw materials has grown enormously as markets in China, India and other Southeast Asian countries continue to expand. According to Patrick Furey, senior category manager for spend management solutions provider Ariba Inc., until an unlikely scenario takes place in which those markets stop growing and stop demanding energy and raw materials, those prices are going to remain extremely volatile.

"Most manufacturers have learned that this isn't the same market anymore," Furey says. "The growth in China and India is slowing, but it's not going to slow to the point to where all of a sudden these markets drop off the face of the earth. They're still growing and their demand for raw materials -- oil, energy, steel, copper -- is going to continue to put stress on those markets. This issue is not going away any time soon."

Thus far most manufacturers have been forced to push their rising material costs through to their customers. Dow Chemical Co., for example, announced in May a historic price increase of 20%, followed by another 25% in June, in response to the rising costs of oil, natural gas and hydrocarbon derivatives. Much like other manufacturers, Dow's chairman and CEO Andrew Liveris called the steps "extremely unwelcome but entirely unavoidable." Yet, these sorts of announcements seem to be made ever more frequently, with the increases growing more significant each time.

Synthetic rubber bales staged for packaging on a Goodyear production line.Obviously, passing on the costs to the customer isn't really a solution. So to prevent this practice from escalating out of control, manufacturers are looking furiously for more innovative ways to cut costs throughout their operations. Not only are they getting lean in more aspects of production and working to strengthen relationships with key material suppliers, they are also conducting intensive R&D efforts to explore cheaper alternative materials that can maintain the highest levels of quality while taking the pressure off themselves, their suppliers and ultimately their customers.

Constructive Relationships

Steel is of course a key material in manufacturing, and one that has been particularly vulnerable to the market's volatility. In fact, since the beginning of the year steel prices have doubled -- a combined effort of consistent demand and rising operating costs being absorbed by the steel mills, fabricators and even from the mines themselves.

Volatile steel prices are nothing new for construction equipment manufacturer Terex Corp., which purchases somewhere in the vicinity of 600,000 tons per year. But according to Tim Fiore, Terex's senior vice president of strategic sourcing, what makes this time different from previous run ups in the steel market is the recent consolidation that has taken place among the mills and their suppliers.

"We're working closely with [key suppliers] to make sure they don't become economically unstable -- and in the near-term, that they are able to acquire the steel we need to prevent major component shortages."

-- Tim Fiore, senior vice president of strategic sourcing for Terex Corp.

"There are fewer players and very little growth in capacity. Since there's such a consolidation of players now, the interest to cut prices as inventories start to grow is not going to be as great," Fiore says. "Coupled with that, the steel mills are having their own battles with the mining companies, who tend to command the market. And that has significantly driven up the price of coking coal and iron ore."

For Terex, some of most important battles are being fought by second- and third-tier suppliers who consume two-thirds of the steel they buy. Traditionally, each of the company's 25 to 30 manufacturing plants around the world independently had purchased steel components such as castings, forgings and bearings from key fabricators. Two years ago a concerted effort was made to transition to a more consolidated approach to supply management.

When steel prices began shooting through the roof those efforts were thrust into high gear. In the space of a year, Fiore says the focus of the program evolved from simply achieving significant cost reductions to working to ensure that supplier performance and on-time delivery of those critical components could be maintained.

"Several key suppliers have had significant capacity constraints and struggled to keep up with demand. Generally those are the smaller, vertically integrated companies, and many of their components have fairly long lead times," explains Fiore. "So we're working closely with them to make sure they don't become economically unstable -- and in the near-term, that they are able to acquire the steel we need to prevent major component shortages. Because as you get deeper into the supply chain, the degree of flexibility you have gets to be a lot less."

Terex purchases around 600,000 tons of steel per year. Two-thirds of that is consumed by its supply base to make castings, forgings, bearings and other components used to build products like the Genie scissor lift being assembled above. One area manufacturers are exploring to create even more flexibility is substituting some of their more expensive materials for cheaper alternatives. In an ongoing effort to reduce the overall material content of their vehicles, Terex started swapping out the sheet metal covering on certain pieces of equipment with plastic or fiberglass replacements. These developments are collaborative efforts between the company's engineering, quality and supply-management segments, and in many cases have included marketing and sales because they are the ones who will have to sell their customers on whatever material changes are ultimately made.

"For example, if we change from a metal enclosure to a plastic enclosure, what's the reception and market going to be? Are they going to see that as a less-expensive, lower-quality approach, or a smart move to reduce weight? It really takes a number of different functions to make these changes," Fiore says.

Burning Rubber

Steel only makes up 10% of the raw materials purchased by Goodyear Tire & Rubber Co., but that doesn't make the current market situation any easier. In addition to natural rubber, Goodyear depends heavily on a steady supply of oil-based chemicals used to produce synthetic rubber and a material called carbon black, which is used as both a pigment and reinforcing agent. According to the Rubber Manufacturers Association, oil-based products account for about 60% of the cost to manufacture a tire, which amounts to approximately 7 gallons per tire. And these days, those costs add up quickly.

In fact, JPMorgan estimates that raw material prices for tire manufacturers have gone up 23.4% in 2008, adding to the 22.6% boost the market had already experienced in 2007. The cost of natural rubber, an agricultural commodity sourced from plantations in a variety of equatorial climates around the world, has also increased more than 20% since last year.

Before costs really started to take off, Goodyear embarked on an "Advantaged Supply Chain" program, which closely evaluates how the company focuses its efforts in purchasing, logistics and global sourcing. The process quickly helped Goodyear evaluate how much could be done to offset the rapid price increases, says Mark Purtilar, vice president of purchasing and CPO at Goodyear.

"Manufacturers can't control these prices, and they often aren't able to offset all of them, so they have to focus internally," Purtilar suggests. "This program was the best preparation we could have done to face these costs. But we definitely put a turbo charger on the process when they started to rise at such a dramatic rate. We put more effort and resources behind the program, broke everything down, and implemented systems capabilities to automate wherever possible. It made us push down on the accelerator."

Even with the increased flexibility, high raw material costs still forced Goodyear to announce price increases this year of 7% to 9%. But further efforts are being made to reduce material costs through the exploration of other chemical-based alternatives. The company has technology in the works to increase its capability to substitute between synthetic rubber and natural rubber depending upon the cost of each material.

Since each type of rubber has different performance attributes, some can be substituted while others can't. Airplane tires, for example, have a predominance of natural rubber because of its inherent heat-dissipating capability. Consumer tires tend to have more flexibility. Goodyear is now capable of achieving a 20% substitution rate versus the industry average of about 7%, without impacting tire performance.

A large component of this success is that in addition to extensive R&D to determine suitable substitutions, Goodyear's procurement department often works in collaboration with product designers to help determine what possible alternative materials can be utilized.

"That is important because procurement is the eyes and ears to the outside world, continually scouring the supply base," explains Purtilar. "We discuss alternatives that R&D might be exploring to see if they mesh with alternatives we're exploring. Then we get our groups together to share best practices, innovation techniques and ideas to be able to develop those alternative materials."

Calculated Defense

In addition to being faced with the price of aluminum rising more than 20% this year, Lockheed Martin Aeronautics Co. has also been challenged by the availability of some key raw materials during production of its F-35 Joint Strike Fighter (JSF) aircraft. Recently the company started incorporating larger quantities of composite materials into its designs, which are strong, stable and can be integrated with sophisticated stealth technology and radar-absorbent materials.

However, the addition of these composites required a shift to titanium that has further challenged its supply chain, according to Mike Jones, Lockheed Martin's enterprise supply chain integrator of information systems technology.

"Titanium is expensive, it's rare and it's hard to work with," Jones explains. "There's a lot of it in Russia, but we work with the U.S. Department of Defense and we don't get to buy Russian titanium."

With foundries around the world running at capacity, Lockheed Martin was left struggling with short supplies. To support production of the F-35 the company developed a tool to assist in gathering data from various systems to generate a comprehensive, time-phased raw material forecast, dubbed the Forecasted Raw Materials application, or FoRM.

"We needed to come up with a raw material forecasting tool able to support both metallic and composite part manufacturing," says Jones. "And we needed to aggregate the totals by material type. Just saying titanium wasn't enough, because it comes in different forms, grades and classes. There are a tremendous number of different types of materials and each one has different properties, so we needed to know how much we used each and every time."

The technology was designed to be able to adjust variables throughout production to drive forecast recalculation and maximize availability of titanium and various composites. Accurate forecasting was especially important for composites, which are time and temperature sensitive and have limited shelf lives. "You have to keep [composites] in freezers until you use them," Jones explains. "Otherwise you end up generating rolls and rolls of scrap."

Material forecasting also helps Lockheed Martin reduce scrap by preventing miscalculations in respect to part sizes and thicknesses, which is particularly important for titanium orders. If a part made of the high-strength metal comes in slightly larger than designed, machining off the extra titanium will waste a great deal of valuable time and can result in unwanted part wear.

And while the initial purpose of this endeavor was to ensure availability of materials and prevent parts shortages, additional benefits soon became clear as well. Now that purchasing agents have access to accurate material forecasts, price negotiations tend to go a little differently, according to Jones.

"They never had this kind of detailed information before," he says. "Now buyers can negotiate pricing not based on past performance, but on what's actually going to happen on the JSF program this time. In fact, on the composite side we negotiated a 28% reduction in composite raw materials -- a little over $30 million in savings -- immediately out of the box."

Seeing All Sides

While a manufacturer's ability to predict its own material needs can certainly help control its costs and improve production, its ability to do the same for commodities prices probably won't improve any time soon. But there are enough ways to improve internally to sufficiently offset rising prices by looking at all other aspects of the operation that can contain costs.

In the meantime, manufacturers will need to realize that they are not the only ones feeling the heat generated by the market's volatility. Ariba's Furey points out that many suppliers are now more reluctant to enter into long-term deals without some sort of adjustment clauses for raw materials. That means buyers might have to change the structure of their supply contracts to include these types of clauses -- even in markets where they never had to before.

"Manufacturers need to remember that everyone is being faced with the same pressures on raw materials. A supplier in China isn't getting steel any cheaper than a supplier in the U.S. right now. If anything, it's probably more expensive," Furey says. "The companies who are going to come out on top are those who ultimately have gotten lean in their entire operation, can control costs and thereby remain the most competitive in the market."

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