Spanning the last ten years or so, highly fluctuating pricing in the raw material markets has put a heavy financial burden on manufacturers.  From 2003 – 2008, prices for many of the raw materials needed for producing consumer goods, such as paper, wheat and milk, saw double-digit increases and then fall spectacularly the next year.  While some manufacturers have recovered others have not.  The consensus is more volatility is certain to continue.

Many manufacturers lack the capability to respond to these market fluctuations due to the failure to integrate the following functions: product development, procurement, manufacturing, finance and marketing. 

The failure to fully integrate these functions may lead to costly nonalignment of efforts. The lack of coordination between supplier and customer sales contracts is one example.  Say procurement renegotiates a higher price for a specific raw material to ensure its availability when prices are increasing, but sales department has locked the company into non-negotiable customer contracts that increase cannot be passed along to the customer.   In effect, the company has taken the full brunt of the supply risk, as opposed to sharing the cost with the customer.

Companies without department collaboration grapple to develop production methods that can and will respond to price fluctuations.  Implementing new processes in the production process can allow a manufacturer to substitute raw materials depending on the volatility of the time.  At many companies sales, procurement, product development and manufacturing are not working in unison to take advantage of these opportunities.

Too often companies rely solely on hedging to manage the volatility of raw material pricing.  This is usually the financial areas’ domain and accomplished with limited visibility to sales and procurement during sales contract negotiating periods.  With the “wrong” bet, companies can be locked into these contracts while prices have fallen.  A little while ago when the natural gas prices fell from their peak, some chemical companies hedged with six month contracts and the company lost its price advantage as prices continued to fall.

A viable risk management strategy has companies looking up and down the value chain. Just think of the uncertainties from the supply chain point of view with transporting cheap raw materials from afar locations, storing large inventories and the capital or carrying costs expenditures of multi-plant locations. 

Once these risks are measured, there are four risk mitigation approaches to choose from: 

  1. Upstream risk transfer to suppliers: diversifying the supplier base for primary raw materials will give companies negotiation leverage and negates the power of some suppliers if and when prices spike.  Can share the risk with suppliers through fixed long term contracts.
  2. Downstream risk: when volumes are agreed upon for the long term, pricing can be updated recurrently as the market demands. Or companies can use indexing – trending prices to a market price for a specific class of raw materials.
  3. Risk transfer to outside entities: as stated previously about relying solely on hedging, these strategies can transfer risks to counterparties can work. However, a strong financial department must be in place to fully comprehend and understand the consequences of such strategy.  Companies that gain access to materials by negotiating a swap of raw materials with another company will allow both of them to reduce costs and gain flexibility.
  4. Internal risk mitigation: the solution is developing elasticity in product development and manufacturing. Companies can switch to cheaper materials when prices rise or move production to another geographical location for cost advantages. Stockpiling inventory is another option when prices are low.  There are carrying costs linked to having high inventory levels.  But they may be justified by cost benefits during times of volatility.

For any of these methods to succeed, companies as a whole must support the risk strategy.  First, strong leadership is required to synchronize the strategy throughout all the departments.   The risk tolerance must be agreed upon by all the top level executives with clear goals and communication to the entire organization.  In conjunction with this a risk management committee should be chaired to set the guidelines and policies.

Secondly, such a strategy requires an analytical support team. This team will help to identify the risk drivers and monitor performance indicators to forecast future market fluctuations.

Thirdly, recommend the initiation of cost curves.  These can identify margins at risk, evaluate the costs involved and their impact on the customer as well as mapping high and low cost producers.

Lastly, companies must establish transparency within each function and within the entire organization. With such an infrastructure I and shared information all managers can update and adjust decisions for market shifts while maintaining the risk policies.  In addition, management can establish targeted capability-building programs in risk management affecting purchasing, supply chain management, and sales to guarantee the skills necessary to develop, implement and maintain the new strategy.

For companies without internal and external collaboration, may I suggest now is the time to pursue this collaboration.  The markets for many raw materials have gone down considerably but the view is still a cloudy one.  Those companies that have policies and best practices in place will be well positioned for the next round of market volatility to outdistance their competitors.