Many companies have seen their margins being seriously hit as a result of sharply higher raw material prices in 2010-11. While this has increased the value of inventories, few companies carry sufficiently large inventories for this to make a material difference.
Instead, the real impact is a double whammy, with some (Chinese) suppliers holding up or reneging on shipments while buyers, of course, remain resistant to price hikes. Fortunately, in some industries there are pass-through contracts, but even these are subject to renegotiation and most companies, caught between raw material markets, on the one hand, and customers, on the other, find their margins getting squeezed.
The situation does not get meaningfully better if raw material prices fall suddenly. Here the double whammy is of a decline in the value of inventories and buyers demanding price reductions or, worse yet, declining prices in the product markets.
Since this is a key business risk, most companies have strong materials and purchase teams that work to manage this squeeze, but these efforts are often constrained by the fact that there are no (or limited) hedging markets for most raw materials and, very often, because companies have inadequate risk monitoring systems. This is further complicated by the fact that companies sometimes try to judge markets without a singular focus on the risk they are carrying. While this sometimes ends up in windfall gains, the sharp volatility in the underlying commodities often ends up eroding margins dramatically.
Most companies do, of course, have an informal risk management system of co-ordination among finance, purchase and marketing, that work together to manage the input/output price squeeze. However, there are often gaps as a result of incomplete or inadequate information flow across departments, inability to agree on the best way forward, differing market views and so on. Indeed, corporate politics also comes into play, as the most aggressive or the most important of the three business heads often gets to call the shots.
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Technically, a sound risk management framework needs a special node for risk monitoring — the middle office, in financial parlance. It needs to be separate from and independent of both the back office, which tracks and records business transactions, and the front office, which comprises both materials and sales, and works to mitigate price risk, either through back-to-back hedging (in either the paper market, if it exists, and/or the physical market), and/or through contract and price negotiations with customers and suppliers.
While billion dollar-plus companies can afford to – and sometimes do – designate an independent chief risk officer who would run the middle office, it is usually not a cost-effective investment for a mid-sized company. In these cases, the job falls to the CFO, who needs an objective tool to enable disciplined monitoring of the risk on the company’s margin, while balancing the needs of both sides – materials and sales – of the business operation.
Creating this risk monitoring tool is not a trivial job, since it needs to be customised to the company by building in the specific micro-structure of each business segment (contract terms, sales cycle and so on) as well as of the particular raw material and product markets. For instance, for a manufacturer of conductor cables, the risk profile is complicated because there are different benchmarks for buying and selling aluminum. Further, some sales contracts have price variation clauses requiring the price to be hedged at the average of a fortnight (or a month, in some cases).
On the other hand, for a lubricant manufacturer, back-to-back hedging of commodity risk is very difficult since the lead time for raw material buying is much more than the lead time for delivering on customer orders. Again, there is no strong short-term correlation between the company’s raw material price and the underlying (petroleum) market. Here, risk has to be managed on a portfolio basis.
Clearly, managing raw material price risk is much more complex than managing risk in financial markets, not least because there are few benchmarks against which risks can be hedged or performance can be measured. Nonetheless, there are processes from financial risk management that can – and should – be translated into companies’ inventory and gross margin management operations.
While it is impossible to eliminate raw material price risk – and there are some views that investors actually want companies to carry these risks – I believe it is prudent to build some kind of objective risk monitoring system. It is equally prudent to implement it in a disciplined fashion – a tall order, in many cases – to minimise the impact of being hit on both the swings and the roundabouts.