The Commodity Management Mindset
With crisis and calamity stalking the corridors of the financial markets, the major success story for investors and stock-pickers has been the margins to be made on the commodities markets. From rice to wheat, and oil to aluminium, there are profits to be made from wise investments.
But what if these commodity goods are a major input into your business? Then the story is not quite so rosy. Rising input prices means rising output prices and tighter squeezes on profit margins. The trouble is that most manufacturers and producers of consumer goods still acquire their commodities in exactly the same way as they purchase their paperclips. It’s a function that resides in the procurement department.
But rising prices are also accompanied by unprecedented levels of volatility in commodity values. Purchasing a bulk order of steel at just the wrong time can send corporate earnings into a tailspin. At that point it becomes a shareholder issue, and moves firmly into the purview of the finance team. The fact is that it is no longer prudent to see commodity purchasing as anything other than a financial function. Passively procuring commodities as just another link in the supply chain has become a high-risk activity. What is needed now is active management to make the most of the commodity markets and protect earnings.
According to microeconomic theory, a commodity market is one of perfect competition: the price is ‘given’or ‘dictated’by the market, where prices can change from minute to minute. These real-time price fluctuations mean that a commodity may frequently be purchased at an index price that will be issued at some point in the future.
This is done to protect both the seller and the buyer from price movements. Commodities are often bought for delivery in the future; baked goods manufacturers will buy agricultural crop today for delivery in October, for example. But, of course, the price may change in the interim – if it goes up, then the buyer benefits, and the seller is out of money. If it goes down, however, then the buyer loses out. To reduce this problem, and ensure both sides of the transaction get the going price, the commodity can be valued against an index that will be published close to the date of delivery.
But this raises questions for the buyer. When do you buy at an index price rather than a fixed price, for example? There are advantages to both, provided the market moves your way. What is your risk in each case? And should you buy more than is required for the current manufacturing cycle and store the surplus? Or should you buy just-in-time?
This is why commodity acquisition needs to move out of the procurement department. These are exactly the questions that procurement teams cannot answer – they are not set up to do so. Conventional procurement wisdom dictates that the organisation receives a projection of the raw materials required plus details of when and where they will be needed which is based on demand forecasts for the finished product. The procurement team then buys enough of the commodity to meet the projection, but in a way that limits the cost of carriage and storage. In other words, the just-in-time model.
This approach works perfectly well when commodity prices are stable. But problems arise when volatility makes an appearance in the markets. A soft drinks manufacturer, for example, requires both sugar and aluminium as raw materials. If the company is stuck in the traditional procurement mindset it places just-in-time orders for both its key commodities based on final-demand projections at a price that is based on an index at the time of delivery.
If prices remain stable, then the cost of a can of drink will be approximately the same at the time the order for the commodity was placed and the time that the drink is produced. The result? Consistent and predictable margins.
However, if the prices of sugar and aluminium fluctuate then the organisation has a problem. Let’s say that the price of sugar increases by 30% between order and delivery. As a result, the manufacturing organisation’s cost for producing the drink goes up by 10%. To preserve margins, the price of the final product needs to go up.
But, as everyone knows, rising prices have a severe affect on demand. First of all, consumers may decide to drink less in general – particularly if they are tightening their wallets in a time of creeping inflation. Secondly, competitors who have a more market-orientated approach to buying commodities can keep their costs lower and their prices stable – and thus more competitive.
This becomes something of a vicious circle because, of course, the orders for sugar and aluminium were placed based on the demand that, in turn, is derived from the selling price of the final product. And at a time of profit uncertainty and margin squeezing, this is exactly the situation to avoid.
So what does it take to move your organisation away from a procurement mindset and towards a market mindset? The key is to change the way that procurement performance is measured, and to structure the organisation to make that measurement possible. That means establishing a separate commodity management function outside traditional procurement, and more closely aligned to the treasury, and using the right tools to make trading and performance measurement possible.
The goal is a situation in which commodity material requirements appear to the commodity management function as a short position that can be sold either at a time-of-delivery index value or as a current-market fixed price – or as some combination of the two.
This position can then be marked to market each day to show whether money is being made or lost. The job of the commodity management function is still to deliver the material when manufacturing needs it, but now it is given the flexibility over when to buy, whether to store, and whether to use financial derivatives to hedge the position. The measure of success includes both the mark-to-market profit and loss (P&L) and the ability to deliver on time.
Companies who wish to move in this direction should be challenging their ERP vendors to provide the tools to enable such a shift. SAP, for example, has already recognised their customers’need to change the way they manage commodity procurement and has introduced tools to make this transformation possible. Particularly important is the tools’ability to facilitate the interconnection between physical dealing and paper dealing, which is crucial for the overall commodity management process.
However this new marketing mindset must be accompanied by thorough oversight and audit to ensure that the inherent risks are being managed effectively. That in turn requires a separate risk management function that incorporates tools to measure risk metrics, such as value at risk (VaR), as well as the means to analyse the effects on P&L of movements in the market under both normal and stress conditions.
If all this sounds familiar, then that’s because the approach is not that dissimilar to the new approach to procuring energy. Like energy, the position of commodities in the input budget is changing and becoming far less predictable – not least because the two markets are increasingly interlinked. With the right approach, tools and risk management set up, organisations can exercise far greater financial control over the commodity supply chain. But without them? Well then that’s when the commodity supply chain controls you.