The Effect of Commodity Price Increases on CPG Manufacturers

Spend Matters welcomes a guest post from Bryan Cochie and Len Prokopets (see full bios at the end of this piece) of The Hackett Group.

In recent years, CPG manufacturers have experienced squeezed profit margins as a result of a tough market environment. On one side, the global recession has created a great deal of demand volatility for CPG products. Developed markets like North America and Western Europe have shown little to no growth. Emerging markets like China, India and Brazil, which were expected to backfill the slow growth of the developed economies, have themselves experienced slow growth rates. On the other side, manufacturing input costs have been steadily increasing as global commodity prices increase. The result of these two pressures is a squeezing of profit margins for CPG manufacturers in an increasingly competitive market.

Commodity prices, as measured by the IMF's Non-Fuel Price Commodity Index, have grown 55% since the height of the global financial crisis at the end of 2008 (see below graph). However, during this same period, consumer prices as measured by the US Bureau of Labor Statistics increased by only 10%. The resulting fivefold increase in commodity prices versus consumer prices has forced CPG manufacturers to aggressively seek cost savings opportunities in an effort to avoid unpalatable price increases to consumers and retailers.

What's causing the rise in commodity prices?
A number of factors are likely contributing to the rise in commodity price including weather-related supply problems, currency fluctuation and alternative crop use (i.e., corn for ethanol). However, one major factor that cannot go unnoticed is the rise of the middle class consumer in emerging economies. As incomes rise in emerging markets, there is a greater demand for commodity-intensive products like processed foods, cars and houses. Global supply markets for commodities that make up such products will find difficulty keeping pace with the demand growth without significant productivity increases.

The growth of the "global middle class" is likely to continue playing a role in commodity prices for years to come. According to the OECD, the size of the global middle class is expected to rise from roughly 2 billion consumers in 2012 to over 3 billion in 2020 and nearly 5 billion by 2030. Much of this growth will come from Asia, particularly China and India.

What are CPG manufacturers currently doing to counter the rise in commodity prices?
In the past, CPG manufacturers have been able to preserve and grow margins despite commodity price volatility. When commodity prices rose, the higher costs were passed along to consumers in the form of higher prices. When commodity prices declined, manufacturers could hold prices steady and reap the benefits. In today's environment, however, the combination of powerful retailers and a change in consumer behavior toward more value-minded products has made it difficult for CPG manufacturers to pass on commodity price increases to consumers.

Without that option, many CPG manufacturers have been seeking out alternative tactics to reduce costs and increase value to consumers.

Here are three popular tactics we're currently seeing practiced by CPG manufacturers:

  1. Product Value Engineering: The value of a product can typically be increased in one of two ways: lower the cost of the product or increase the functionality to the consumer. Many CPG manufacturers have aggressively pursued value engineering as a means to not only find cost savings but also to focus on improving product attributes that are truly important to the customer. CPG manufacturers have successfully lowered costs through product specification changes such as the introduction of smaller product sizes or substitution of higher cost to lower cost materials. These practices are most successful when the specification changes add more perceived value to the consumer. For example, a smaller product may be deemed as more convenient to the consumer while packaging improvements designed to save costs may be perceived as more efficient and innovative.

    This practice, however, does not come without risk. Recently, a CPG manufacturer decided to shave an ounce off a standard size bar of soap while maintaining the same price point. The manufacturer received backlash from one of its largest retailers who did not want to sell the smaller bar size, and the manufacturer was forced to revert to the original bar size for just this one retailer.

  2. Gain Greater Control of Input Prices: Major CPG manufacturers are increasingly employing tactics to gain greater control over the price they pay for commodities. One way to do this is to standardize the specifications of the commodities needed, thus creating a larger pool of volume that can be leveraged during supplier negotiations. Increasingly, these manufacturers will form commodity purchasing contracts directly with lower tier suppliers, thus taking advantage of their large scale to secure lower commodity prices over longer periods of time.

    Some CPG manufacturers have also taken a slightly riskier approach and adopted hedging strategies as a means to minimize the effects of major commodity price swings. This tactic, however, should be used only with a strong knowledge of the market as a sharp downward shift in prices could turn out to be devastating in a competitive low-margin environment.

  3. Supply Chain Optimization: CPG manufacturers are also increasingly seeking out reductions in indirect product costs. Many have re-evaluated their supply chains networks in an effort to lower overall cost of goods sold. By improving distribution networks and making better decisions on where to source materials and finished goods, many CPG manufacturers have been able to lower inventory, reduce product obsolescence and limit costly expedited product movements.

In summary, the growth of the emerging market middle class and a tightening supply market will continue to put upward pressures on commodity prices in the absence of robust productivity improvements. Powerful retailers and changing consumer behavior will continue to put downward pressure on prices, thus placing the squeeze on CPG manufacturers. Those that succeed in this margin-squeezed environment will be the ones who can successfully execute strong category strategies for each major commodity while best employing the tactics mentioned above.

- Bryan Cochie and Len Prokopets, The Hackett Group

Bryan is in the Strategy & Operations practice at the Hackett Group. He spent over seven years in the third-party logistics industry in various operational and advisory positions in Asia and North America. Most recently, he worked with clients across various industries to develop efficient and responsive end-to-end supply chain solutions. He has extensive Supply Chain and Operations expertise, with particular focus on providing clients with supply chain strategy and optimization, distribution network design, carbon footprint measurement and total landed cost analysis. His experience has spanned across the retail, apparel, aerospace & defense and consumer product goods industries.

Len Prokopets has over 17 years of experience in consulting to Fortune 1000 clients. Len specializes in supplier relationship management, supply chain improvement, procurement transformation, working capital optimization, customer and supplier collaboration, and performance management. He is a frequent speaker and author on Supply Chain and Procurement topics. He holds an MBA from Carnegie Mellon University and a BS and BA from University of Rochester.

Share on Procurious

Discuss this:

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.