Top 8 mistakes in commodity buying and risk management

1) Limited understanding of commodity risk

Many companies are failing to quantify their risk exposure to commodity prices. They often rely on ambiguous assumptions about price volatility and how and when movements in commodity prices impact on their bottom line.

2) Monitoring and preparing for ‘black swan’ events

Only a small proportion of firms actively look to monitor emerging commodity price pressures and and put in place plans to address high impact low probability risks.

3) Inadequate commodity procurement performance measure

Most companies measure their own commodity price performance against their own budget, leaving them unaware of how they compare with their competitors. With tight margins and weak pricing power commodity price volatility offers an opportunity to gain a competitive advantage over your competitors.

4) Renegotiation’s driven by expiry date of contracts

Most companies leave commodity price renegotiation until their contracts are about to expire leaving them exposed to whatever commodity markets are doing at the time. Companies that carry some flexibility in their overall procurement spend may be able to utilise commodity market insights to gain a better deal and a competitive advantage.

5) Static hedging strategies

Many companies adopt the same approach to contracts and hedging risk whatever the conditions in the commodity markets they are operating in. A flexible approach may be able to better capture additional value taking account of market conditions and the balance of risks in terms of price direction.

6) Incomplete or biased information on commodity markets

Many firms do not try to get an overview of what is happening to commodity prices key to their business. Just as worrying a significant number of companies list their raw material supplier as their main source of opinion on how commodity prices may develop.

Related article: Commodity market insights give companies a competitive advantage

7) Buyers not taking account of full material cost breakdown

There can be considerable information asymmetry between buyers and sellers. Suppliers will have a full cost breakdown of the raw materials they supply, information which is difficult for the buyer to obtain especially when there is a degree of value add to the underlying commodity being supplied.

Related article: 6 ways manufacturing companies can manage commodity price risk

8) Not considering Cash at Risk (CaR) as well as Value at Risk (VaR)

The VaR is associated with the underlying value of the commodity that the buyer is seeking to manage in some way and is therefore a very short term indicator. By its very nature the VaR is very difficult to monitor and predict. However, since a commodity buyer will generally want to take delivery of the commodity at some point the business needs to consider the impact that its risk management strategy will have on cash flow. By considering CaR businesses should bear in mind both the value of the commodity that they are purchasing and the sales price of the product that the commodity will be manufactured into over the lifetime of the hedging period. By doing so they should be able to more effectively manage their cash flow and be able to adapt more easily to unforeseen events.

Commodity market insights give companies a competitive advantage

High and volatile commodity prices has resulted in tight margins and unpredictable earnings. Firms are failing to monitor commodity price pressures and identify emerging risks as responsibility is split across companies. Companies that improve their insight into commodity markets could gain a competitive advantage over their competitors by being in a position to negotiate a better deal with suppliers while also identifying and managing price and supply risks to their raw materials.

A study by PwC of FTSE 350 companies found that around one-third of company profit warnings can be directly attributed to developments in commodity prices. High and volatile commodity prices, coupled with an inability to pass any increase on to consumers has resulted in tight margins and unpredictable earnings.

Yet despite its importance only a small proportion (5%) of firms actively look to monitor emerging commodity price pressures and and put in place plans to address high impact low profitability risks.

A survey of businesses by the Danish Purchasing and Logistics Forum found that a third of firms do not try to get an overview of raw material price fluctuations affecting their business. Of the remaining two-thirds almost a half list asking the opinion of their supplier of raw materials for an opinion on how prices may develop as their prime source of market information.

Despite commodity prices having such a big impact on businesses margins why are firms so reluctant to give it much attention? Part of the problem may be assigning whose responsibility it is within an organisation. Usually the finance department is responsible for many decisions involving managing a firms risk, including managing exposure to exchange and interest rates as well as setting the boundaries for sourcing raw materials, satisfying the need for regular predictable financial results but far removed from market activity and data.

Why should firms bother to monitor emerging commodity price pressures more closely? Companies that improve their insight into commodity markets could gain a competitive advantage over their competitors by being in a position to negotiate a better deal with suppliers while also identifying and managing price and supply risks to their raw materials.

6 ways manufacturing companies can manage commodity price risk

1. Do nothing:

Depending on the nature of the key commodity that a company is exposed to it may be best to do nothing. If a commodity is a relatively small proportion of overall costs and/or it exhibits very mild volatility then it may not be worth the company, especially if its a relatively small business from diverting attention to managing this commodity price risk more effectively.

2. Pass on price volatility to customers:

Companies that can pass on their commodity price risk to their customers without having an adverse effect on sales volume will have no exposure to commodity risk. In practice, price elasticity depending on factors like competition  and the availability of substitute products means this policy does not effectively cover all commodity price risk and risks losing market share to other companies.

3. Manage risk through procurement contracts:

Typically commodity price risk can be managed by entering into fixed price contracts with suppliers. Although this is relatively simple to arrange, the disadvantage might be higher costs and reduced flexibility.

4. Use derivative hedging strategies:

Derivative instruments can be used to hedge underlying commodity price risk. These instruments can either be arranged bilaterally or traded between physical and financial traders in commodity markets. However, given a manufacturing company’s specific requirements in terms of specification, timing, delivery (not to mention that not all commodities have functioning derivative instruments or futures markets) limit their effectiveness.

Options 2, 3 and 4 have the common theme of transferring risk to a third party; the customer, supplier or a financial institution.

5. Product reformulation or substitution:

One of the most obvious ways to reduce the exposure of a manufacturing company to commodity price risk is to use less of the commodity. This could be achieved through reformulating the product to use less of the material or introducing other materials in its place. By its nature though this takes significant investment and by the time a new product is ready to be introduced relative commodity prices may have changed, altering the commercial imperative. However, over the long-term this is a viable strategy. Furthermore, optimising process and distribution networks may allow commodity inventories to be reduced, lessening the commodity price risk exposure of the manufacturing company.

6. Vertical integration:

Ensuring access to resources higher up the supply chain help to ensure physical supplies while also providing some control over the cost of a firms inputs. A recent example of this is Delta Airlines which bought a refinery to reduce the risk of jet fuel price volatility. The advantage of vertical integration is that it reduces commodity price risk over the long-term. The disadvantage is that a manufacturer may not be as efficient in running a business further up the supply chain, introducing higher costs.