Is Today a Good Day to Hedge?

This morning, I’d like to welcome Jeff Koenig, Director of Commodity Sourcing at Connell. Jeff provides management consulting, sourcing and category management services related to commodity food ingredients and has over twenty three years of experience that includes extensive time in futures and risk management. Please join me in officially welcoming Jeff to the blogosphere.

When someone says the word hedging my guess is that 95% of you will immediately recall a picture of an exchange pit packed with people crazily waving hands, shouting, spitting, throwing paper and maybe an occasional argument. If you happened to have visited on a particularly busy day years ago you may have even witnessed a desperate runner diving into the pit with a handful of orders for closing time. Words like chaos, risky, gambling may come to mind.

Because of the word association illustrated above, we attribute a maligned view of risk management to the word hedging.

The perspectives I relate are from consumer packaged goods food manufacturing, however, the principles are applicable in any industry.

So let’s say I reflect the question back to you "So you are really asking me, is today a good time to take action to protect our enterprise from adverse risk?". Hopefully your answer would be yes. Allow me to dissect this line of thinking and put it back together again.

So "what are we protecting our enterprise from?" The purchasing department answers could be "risk to market" (whatever that means), budget, margin, profit, operations, to name just a few. In many companies there is more than one answer and at times the answers will change depending on the circumstance.

During the first half of my career, while working in the grain trading industry, every company position was succinctly represented in a document called a "long/short". In the grain business we managed futures, basis, locations, space, logistics and other positions but in the case of food manufacturing or other enterprises, similar reporting is useful because at any time an enterprise has purchases (long) and sales (short). When these commitments are set side by side in a report, you have a type of long/short balance sheet that begins to reveal your enterprise exposures to price risks. Capacity planning would be a good example of an operational version of a long/short and the tactical work needed to manage it.

For example, let’s say a company sales department makes a substantial product sale for a fixed price and quantity over the next twelve months. Purchasing doesn’t know about this sale so they continue their business status quo … managing to this year’s budget. Sales doesn’t realize that only 50% of the key direct materials have been protected at budget, enough to protect current sales. At the current time raw material prices have gone up substantially -- but sales doesn’t know that -- they are pricing to budget.

So you see the impact of the organization that has no real-time understanding of changes to price exposure except after the fact. As long as input costs don't move much, management doesn’t care and the discussion of potential risk is considered a waste of time. However, over the past three years we’ve felt pain that has revealed this weakness in many organizations. So the “long/short” principle can be used to understand numerous types of risk including risk to budget, risk to margin, risk to market share, change in volumes, etc.

Now let’s start to close the loop … in this example does it take a futures contract to create a hedge? No. Hedging only requires knowledge of the risk exposure and an equal and opposite transaction to offset the risk -- in this case setting the price of the direct materials.

Of course hedging doesn't eliminate all risks and all risks can't be hedged. Hedging at best trades your risks for more manageable ones and creates an opportunity for the category manager to deliver even more value to the enterprise. We see the best companies making "hedging" a deliberate long-term commitment to a proactive management effort that involves strategic partnerships with critical suppliers.

Finally, meeting your enterprise objectives may require using other tools to accomplish effective hedging, such as derivatives like futures or swaps, but let’s leave that for another discussion.

Is it a good day to hedge? Yes it is.

Spend Matters would like to thank Connell’s Jeff Koenig for his contribution.

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