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- Oct. 19, 2010 -

Supply Chain News: Companies that Do Not Manage Commodity Price Swings Well Leave Lots of Dollars Off the Bottom Line

Cross-Functional Collaboration is Key, McKinsey Consultant Says; Reducing Margin Volatility 20-40%



SCDigest Editorial Staff

SCDigest Says:
Companies have been able to achieve an average reduction in margin volatility of between 20 percent and 40 percent and an increase in EBITDA of between 3 percent and 5 percent.

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Rising raw materials and other input costs are a significant and growing concern - again - in terms of corporate financial performance, just as they were in the years before the 2008 financial collapse. This time around, however, companies are operating in an environment where raising prices to cope with those increasing input costs is even more difficult. (See Little Reported Amid Still Wobbly Economy, Commodity Price Shocks and Supply Concerns Surging Again.)

Whether commodities prices are rising, as they are now (partly in response to the falling value of the dollar) or falling, procurement managers are in an era of dynamic price levels that are unlike anything most of them have seen in their careers.

Lack of robust, integrated processes to deal with this price volatility often results in leaving profit dollars on the table, according to Patricio Ibáñez, an associate principal at McKinsey & Company, in a recent article in ISM's Inside Supply Management magazine.

"Traditional approaches to raw materials management often leave decisions in the hands of a single function at each step in the value chain," Ibáñez says. For example, product development controls decision early in the cycle, procurement later, manufacturing after that, etc.

That can cause all sorts of problems, Ibáñez says, especially in a lack of alignment between contracts signed with suppliers and those with customers. For example, a company might be locking in prices for 12 months key raw materials, at the same time its sales organization is selling the finished product at prices that fluctuate with the market one month at a time.

While under this scenario the result can sometimes be favorable for the company, it also can represent a lot of financial risk. Ibáñez cites an example of one beverage company, for example, that had signed contracts for key ingredients that established fixed volumes and prices. During the global recession, demand for the company's products slumped and it had to reduce net prices — while still being forced to buy more material than it needed, at more than the open market price.

As with so many other areas of the supply chain, Ibáñez says the key to improving this situation is better cross-functional collaboration.

When contracts come up for renegotiation, collaboration among the finance, procurement and sales functions is particularly critical, Ibáñez says.

"Procurement should review supply contracts and, together with experts from finance, propose modifications that will protect against raw materials price spikes while maximizing gains when prices fall," he says.

Procurement strategies can include choosing a pricing scheme based on an index of key raw material prices, having purchase and payment terms in the same currency, and choosing expiration dates that enable supply and customer contracts to be renegotiated at the same time. Supply management should then collaborate with sales to ensure that contracts with suppliers are aligned with the terms of customer sales contracts.

That sort of cross-functional collaboration is especially critical to rethinking manufacturing processes to enable maximum supply flexibility. For example, it may be possible to develop more flexible product designs or formulations, as well as production methods, to respond to fluctuating raw materials costs, switching between inputs or suppliers as market conditions change.


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Ibáñez cites the example of one rubber products company, whose chemists developed a range of formulations that used different mixes of natural and synthetic ingredients to deliver similar physical properties. This range of recipes allowed the company's purchasing function to take advantage of fluctuating ingredient prices by boosting the purchase of natural rubber when prices were low, and substituting synthetic ingredients when it was more cost-effective to do so.

Three-Phased Process

To reach this level of supply management flexibility, Ibáñez recommends a three-stage process:

Initial Risk Assessment: Identify the company's most critical raw materials needs, net risk exposure and key drivers of volatility, both quantitatively and quantitatively.

Strategy Development: Companies should then determine their overall risk appetite and the types of risk they are willing to bear. They can then programmatically review possible risk management strategies and assess the feasibility and benefits of each proposed strategy, in the end determining the combination of levers that are most effective to optimize earnings and reduce risk exposure under highly volatile and inflationary market conditions. For example, companies can evaluate fixed price versus index-based pricing and the value of diversifying the supply base across regions.

Implementation: Companies should begin to implement the risk management strategy, develop the processes necessary for cross-functional collaboration and set up the organizational enablers needed to support the changes.

To achieve maximum results, Ibáñez  says, it generally takes 2-3 years before a company is fully mature in this more integrated approach. But the results are compelling: depending on the starting point, "companies have been able to achieve an average reduction in margin volatility of between 20 percent and 40 percent and an increase in EBITDA of between 3 percent and 5 percent," Ibáñez says.

That is enough to get any CEO or CFO's attention.


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