Of Big Macs and Metal Exchanges: Strategies for Dealing with Commodity Price Fluctuations

Spend Matters would like to welcome a guest post from Efficio.

Commodity prices are a hot topic right now. Many basic materials have increased in price dramatically in the last couple of years, presenting big challenges for procurement people -- and the trend looks set to continue along with significant fluctuations. As Jason noted in a recent Spend Matters post, McDonalds have been forced to raise prices because of increases across a basket of commodities including various meats, bread products, dairy and so on -- pretty much everything you'd expect to go into a Big Mac.

Analysts point to events in the world economy like the earthquake in Chile, floods in Australia, and fires in Russia as the main causes. But whatever the cause, the business of predicting price changes has got a whole lot harder of late. For those dealing with raw materials, the effects of rapidly changing prices are immediate. For those buying "near commodities" (manufactured items including a high component of raw materials such as metals and plastics) the effects are less immediate, but just as real.

In a survey of grassroots opinion we carried out recently here at Efficio, more than 55 percent of procurement executives said commodity price instability was their single biggest challenge. The question, of course, is how to deal with it. Like most strategies, effective management of commodity volatility depends on how much risk you are prepared to carry. The lower the risk, the less impressive the results are likely to be.

Broadly, there are four strategies to choose from. The easiest option is to do nothing and hope commodity prices start to fall and that your suppliers will pass these prices on to you. A bit of a no-hoper: suppliers are good at passing on increased costs, but aren't so keen to pass on corresponding decreases.

You can try fixing prices with your suppliers for a limited period (a year, for example). Again, maybe not the best move. Your suppliers will inevitably build a buffer into their pricing model to protect themselves in a fluctuating market. A similar approach is hedging, usually used either for budget security or to speculate on what prices will do in the future and build this into your procurement strategy.

The final option, and the one in my opinion most likely to produce the best results, is to unbundle the costs of the commodities in the products you are buying and index your supplier's prices against them. If the cost of, say, copper, goes down in the London Metal Exchange, you will want to see this reflected this in the price you are paying for a piece of equipment with a high copper content. Conversely, if the price of copper goes up, you will be prepared to accept an increase in the prices you are paying.

If you have a good relationship with your incumbent supplier you can ask them for the breakdown. Or you can ask your potential suppliers. Many will be eager for your business and want to help. Following this strategy, you are back in the driving seat and less vulnerable to continuing rises and fluctuations in commodity prices.

Mine's a Quarter Pounder with cheese, by the way. If it's not too expensive!

A report on the full results of the Efficio Grassroots Procurement Survey is due to be published in early March 2011.

-- James Jenkinson, Vice President, Efficio

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