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15.06.11 – Director of Finance: Regaining power over rising commodity prices

How financial directors can regain power over rising raw material costs impacting their organisations’ profits.

The findings of the latest FT and The Economist Business Barometer research come as no surprise: over the coming months leaders foresee the biggest risks to their businesses to be rising costs of oil, commodities prices and interest rates. This prompts greater scrutiny of organisations’ profit margin and higher expectation of financial directors to perform in challenging times.

The rising material prices are putting ever-increasing pressure on the costs of bought-in goods and services, and at the same time, increasing interest rates have the potential to dampen sales demand. The outcome is a negative impact to their P&L and a reduction in earnings before interest and taxes.

While the heat is on, financial directors are not powerless to prevent the impact of these increases on their profits. However, a good procurement function managing, controlling and mitigating the effects is critical.

Biggest lever
Procurement is the biggest lever to improve an organisation’s profit and one which is often overlooked and undervalued. The key is that procurement improvement goes straight to the bottom-line; it is a simple fact that every pound of expenditure saved improves EBIT by a pound.

For example, consider a £100m turnover manufacturing company. With 60% made up of purchased costs and a 3% margin, a procurement improvement program delivering only a conservative 2% saving would net savings of £1.2m – a healthy 33% improvement in EBIT. But, to achieve exactly the same impact through sales growth, you would have to increase sales turnover by a staggering 40% – growing the company to £140m turnover.

In a world where cost pressure seems to be relentless, the impact of procurement to manage, control and mitigate is absolutely fundamental and should be an integral business capability. Procurement can’t control the underlying economic factors but it allows a business to manage the impact. And it’s up to financial directors to ensure that they have a best-in-class procurement function that can do that.

Key areas
Understanding the size and sensitivity of your exposure to raw material allows you to build strategies to either reduce volatility, reduce cost, or both. But financial directors need to know what kind of questions they should be asking of their procurement departments.

There are three key areas financial directors should focus on:

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 and, hence, my business?
Management. What strategies are we using to reduce cost and volatility?

The answers should be clear and quantified, with clear metrics and analysis. The first question is key and will give financial directors immediate insight into the level of capability within their procurement function. Quantifying exposure to raw material purchased directly will be obvious, e.g. a manufacturer buying polyethylene, but much will be indirect, so for example, the same manufacturer may have additional exposure to polyethylene price movements through sub-assemblies and components, or even in the purchase of packaging materials.

A best-in-class procurement organisation will have a complete understanding of an organisation’s spend and a close relationship between finance and procurement is key here – particularly so for the management of raw material costs. Some strategies that could be employed are commercial, some technical, whilst others, such as hedging, will be financial, so it is fundamental that considerations of all aspects of a business are taken into account.

Raw material volatility is a fact, and volatility is increasing over time, but good procurement gives organisations both the ability to manage and control rising raw material costs, and to drive savings from other areas of spend. Organisations that have developed excellency in procurement can use this as a source of significant competitive advantage. And their financial directors can feel in control in the face of surging commodity prices.

Written by Richard McIntosh, UK Managing Director of INVERTO

Homepage: http://www.dofonline.co.uk/component/option,com_frontpage/Itemid,152

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