Cost Management Must Extend to Currency and Commodity Volatility

- December 11, 2012 12:12 AM
Categories: Commodities, Jason Busch, Strategic Sourcing | Tags:

More and more businesses, including many small and middle market organizations, are beginning to think about how they can “smooth” costs associated with volatility, taking supply risk and distraction off the procurement table. Unfortunately, the cost management skill sets required for effective hedging often don’t reside (even physically) within the same offices as core procurement teams. As one example, consider how Alcoa’s trading operation is housed away from company HQ in Pittsburgh. Of course if you’re one of the world’s top market makers for Bauxite, among other commodities, you can house your trading operation in the middle of nowhere if you feel like it. But in most organizations, especially those that aren’t as sophisticated at trading and commodity management, it makes sense to be closer together.

This is true at the very small end of the cost management spectrum as well, and in targeted areas of volatility, such as a currency risk. A recent Wall Street Journal article from last week highlights how small businesses are taking currency risk off the table in cross-border transactions, citing one example of a $2.5MM Sake import company that was losing as much as $10,000 per month thanks to currency swings. The company in question, “couldn’t raise prices fast enough to counteract the exchange rate … [and] had monthly losses as large as $10,000 in 2010 … [before] decid[ing] to embrace a new strategy … [embracing a] formal currency-hedging strategy to lock in yen rates ahead of sake payments.”

Through hedging, the organization was able to save as much as $4,000, the WSJ points out. Yet currency swings (and cost management dangers) are potentially trivial compared to the swings some commodities have seen. As a sector, commodity management approaches, as consumed/used by procurement and supply chain groups of all sizes, is nothing new. Yet knowing where to begin is hard, especially for smaller organizations and those (e.g., manufacturing) that have not adopted hedging approaches in the past.

As Spend Matters observes in our research, organizations (of all sizes) should focus on a number of key areas of investment – from both data and solutions perspectives – in investing in volatility management approaches focused on both currencies and commodities. These include:

  • Price indexes and commodity market intelligence
  • Broad-based commodity management platforms for hedgeable commodities
  • Demand aggregation and visibility
  • Spend analysis that can break out material from value-added components
  • Sourcing optimization/advanced sourcing technology
  • Contract management
  • Total cost management/product costing

When it comes to underlying raw material volatility, part of the challenge in knowing where to get started is simply understanding the impact of commodity swings on pricing. While the chart below is small, it shows how one spend analysis provider, BravoSolution, can use pricing index data, in this case MetalMiner IndX content, embedded via API, to automatically show volume and trending data in the context of specific price points impacting a commodity purchase (or the purchase of components, parts, finished, and semi-finished products).


Source: BravoSolution and MetalMiner

As you’ll see in this case, a large volume purchase (the vertical bar in the middle of the chart) coincided with one of the highest price points for the underlying commodity (the horizontal line) in the year. Had the company engaged in a formalized hedging program – or simply paying a distributor or mill a premium to lock-in pricing over a longer-period – it might have avoided this volume and high-price timing issue.

Data is sunlight (and the first step) to transparency and cost management savings and risk reduction when it comes to any type of underlying cost element that can move with the market – and which is outside of our control as business owners, procurement executives or category managers. For further reading on the subject, we encourage you to download the following Spend Matters papers:

Beyond Sourcing and Supply Chain: Commodity Management Solution Fundamentals
Manufacturing and Direct Materials Sourcing: A Planning Guide for the Next Decade
A Direct Materials Guidebook – Six Key Principles for the Manufacturing Road Ahead
Minimizing Commodity Volatility Through Advanced Commodity Management and Hedging Approaches

- Jason Busch

Comments

  • Tamir Druz:

    This is a very nice piece. I think businesses of all sizes are coming to realize that currency and commodity hedging is no longer prohibitively expensive for just about anybody, and can be done for just a few dollars per contract these days, and executed against extremely tight bid-offer market spreads. There is the margin issue for cleared products, but here too we are only talking about a need to post something like 1/10th of the notional value being hedged. So as long as a business has a consistent and systematic approach to managing its exposure, it really can significantl improve its income/margin predictability and volatility at very little cost.
    Tamir Druz
    Druz Energy Risk Solutions

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