20.09.10 – Procurement Leaders: Commodity-cost management
Imagine the scenario: the CEO walks into your office and drops the Financial Times on your desk. The front page declares, ‘Steel prices to rise by 20%’. The CEO looks you straight in the eye and asks, “What will this mean for us, and what are we doing about it?” As CPO, can you honestly say you have the answer?
We’ve all experienced wild fluctuations in raw material and commodity prices. Oil prices oscillating from $40 to $140 a barrel in the past 18 months have shown what it’s like at both ends of the spectrum. As well as an obvious, direct impact, this volatility affects an organization’s spend indirectly too. For example, buyers of high-density polyethylene (HDPE) will be well aware of the link to the underlying oil price if they’re buying HDPE as a direct material, but indirect exposure to commodities might be less obvious. Walking round the business might enlighten them. Piles of pallets, skips of discarded plastic packaging and a line of trucks waiting to be unloaded, should all prompt analysis of exposure to the underlying base commodities of wood, HDPE and oil.
For your buying teams, this isn’t fiction. At a tactical level, suppliers are increasing prices based on commodity-cost movements at every opportunity. But are your buyers driving cost reductions based on downward commodity-cost movements? Many price increases are accepted based on a single rising commodity price, without questioning the other elements that make up the delivered cost.
These costs aren’t related simply to production businesses. Take a financial services company with high category spends in marketing print, paper and printed materials. The costs for paper, ink, pallet, wrap and logistics are not directly visible, but they are significant.
There are three key questions you should ask:
Transparency. How much of my spend is made up of underlying commodities. Which ones and how much?
Exposure. What is the impact of the underlying commodity-cost movement on my overall spend?
Management. What strategies am I using to reduce cost and volatility? If the answer to the first two questions is “very little”, then rest easy. If not, then managing these commodity costs will give you an advantage.
Why is it important?
Very simply, commodity costs can account for a significant share of your company’s total spend. It varies by sector, but as a general rule, the lower a company’s value-add in process, the higher the commodity cost impact. A typical company in the engineering sector would have commodity costs totalling 27% of their external spend – 17% of the company’s total costs, while an industrial packaging company would typically experience 62% of external spend on commodity costs – 36% of their total costs.
How do you work out the exposure of commodities on your business? Simply take your portfolio of purchases and boil them down to their constituent raw materials, list them, consolidate by raw material in a matrix and then add them up. You will have transparency of both direct and indirect exposure.
In reality, the industrial packaging company in question had a steel spend of €30m across its total €260m spend. When the underlying commodity index (which is directly linked to 70% of its steel materials spend) increased by 53% in two years, the knock-on effect was an €11m increase in cost; 4% on total external spend and 2% on the total costs of the company. A significant impact on its bottom-line, and one that procurement had to tackle.
How to manage commodity costs
There are three stages to implementing commodity-cost management. The first two stages create transparency and tactical advantage, the third is strategic action.
Undertake a structured spend analysis. Identifying representative parts and building a cost breakdown for each part develops a detailed material cost analysis. Consolidating the analysis for a representative range of parts builds a raw material spend matrix that can be used to identify common commodities and quantify the levels of dependency. Now you have material transparency.
Link the commodity costs to market indices. This gives you an instant tactical advantage to negotiate with suppliers. You now have a should-cost model for any time period, based on how individual cost elements change with market movement of the underlying commodities. Now you know what the impact is and you can model scenarios to understand what the exposure could be in the future.
Implement actions to reduce volatility and cost. Understanding the size and sensitivity of your exposure to commodity movement allows you to build strategies to either reduce volatility, reduce cost or both. Strategies for managing volatility include hedging instruments, aligning pricing systems for both buying and selling, and developing new products to eliminate high-exposure commodities
Reducing volatility by aligning pricing systems allows procurement to show its value. Linking prices to commodity indices on both sides passes through the exposure and mitigates the risks. Taking that strategy forward a step, by implementing the right commodity-cost management strategies, companies are often able to buy below those indices, making an improvement to margin.
Strategies to reduce cost are more in the traditional comfort zone of procurement, from tactical negotiation and market testing to bundling demand. Most of these strategies are based on increasing competition. However, even procurement organizations bringing multiple sources on stream to increase competition, ignore the potential for currency to make a difference. They could learn something from the BMW Group, which exploits differences in regional pricing between North America, South America, Europe and Asia to source from different suppliers.
Reducing cost and volatility can be by material-based strategies such as make-or-buy decisions, reduction of material inputs or even the complete substitution of the critical material. Copper is a common aesthetic construction material in China, but when copper prices skyrocketed in 2008, it was replaced by copper-plated material. Costs were kept down without affecting the end product.
Commercial strategies can also be used to impact both cost and volatility. Long-term price agreements can be beneficial in a rising market. With the cost of iron ore expected to rise more than 50% this year, procurement managers who defined fixed-price agreements in December for their 2010 steel requirements are currently looking good. In other commodities, the ability to spot purchase or purchase to stock allows advantage to be taken of excess supply at opportune market prices.
The key to many of these strategies is the ability to optimize the frequency of price definition. There is always a built-in lag effect from the point where the buying price is fixed, plus the time taken for the material to pass through the supply chain, to the point where the selling price is fixed. With fluctuations in commodity costs, comes risk and with an increasing trend towards ever-increasing volatility in underlying commodity costs, the greater the risk carried. Minimizing the lag will reduce the risk, either through shortening time, or through the optimum setting and synchronisation of buy and sell-time points.
Picking the right strategy
Decisions on strategy should be taken through consideration of all aspects of the business – current and future – which is why it should be a cross-functional process and include input from treasury, finance, production, quality and sales. In our experience, procurement should be the driver of this process and can provide the detailed analysis and understanding of the supply market that is the foundation of choosing the right strategy.
System-based management – how to implement rapidly
Procurement strategies matter, but any strategy is only as good as its implementation. Commodity-cost management by its nature is, on the one hand, detailed and analytic, while on the other, high level and strategic.
Creating transparency at product level requires the distillation of internal knowledge to build the initial cost structures. A cost breakdown for every part is unrealistic, but selecting a representative selection provides an excellent model on which to base your analysis.
The quickest, most efficient way to manage commodity costs is to use a system-based tool. This ensures that, instead of depending on the skill of individual buyers, your organization benefits from a centrally co-ordinated departmental programme that shares data and rolled-up management information. By linking these tools to published market indices for each commodity, such as the London Metal Exchange for non-ferrous metals and MEPS for steel, the process can be further automated leading to further savings.
A source of competitive advantage
Commodity-cost management is clearly a source of competitive advantage for companies. However, it is interesting to understand, when facing the current situation of significant price volatility and scarcity of supply, just what companies are doing and how professional their approach to commodity-cost management is.
The results of an Inverto survey of more than 230 procurement managers makes interesting reading. Although the majority of companies consider themselves to have achieved transparency in terms of their raw materials spend and are monitoring price movements, very few are using any form of modelling or statistical analysis to simulate price movements and derive price trends. Even fewer have systemized this approach or use any form of specialist software to assist them.
It is very clear that companies are lacking expert knowledge to deal with commodity-risk management, with less than one-in-five companies having dedicated internal specialist resource. In relation to strategies, most companies are relying on long-term price agreements to eliminate volatility, with many forwarding-on increases to their customers. Hedging is applied only selectively and mainly for energy.
Volatility in raw material markets – both the range of price fluctuation and frequency of change – is increasing. Commodities have now become financially traded instruments and the long-term trend indicates that volatility will increase. Commodity-cost management provides an increasingly essential approach to a company’s spend, both as a tactical weapon for day-to-day purchasing and as a strategic approach enabling procurement to deliver significant competitive advantage. Are you dreading that CEO visit, or are you taking the commodity agenda to them?