CHAPTER 6

Managing Commodity Price Risk—Value Chain Purchases

Overview of Risk Characteristics and Approaches

In Chapter 5, we examined various approaches firms can implement for managing commodity price risk from direct commodity purchases. However, risk exposure can come from other sources, such as energy purchases, packaging, transportation, as well as from upstream in supply chains from commodities purchased by suppliers. For example, in the trucking industry, passing on price increases to customers in the form of fuel surcharges is a common practice.¹

The focus of this chapter is to examine several approaches you can consider for managing commodity price volatility stemming from the commodity purchases made by your component and subassembly suppliers in your value/supply chains. These approaches include creating firm fixed-price contracts, piggyback contracting, inserting escalation/ deescalation clauses in contracts, improving product designs and production processes with suppliers, and vertically integrating as shown in Figure 6.1.

Similar to Chapter 5, we have ordered the various approaches for managing commodity price volatility by their level of complexity in implementation and execution, from easiest to most difficult. There are several factors as well, related with and beyond complexity, influencing which approach to use. One factor, supply chain expertise, partly influences the choice of approach for managing commodity price volatility with supplier purchases. Approaches such as utilizing firm fixed-price contracts and piggy back contracting are rarely complex, and can often be accomplished solely by the supply management function of the firm without too much difficulty. However, improving products and processes or vertically integrating operations are almost always complex. These are crossfunctional and cross-organizational strategic processes many firms may not necessarily have the all of expertise, influence, or resources to execute.

Figure 6.1 Approaches for managing commodity price volatility—direct purchases

A second factor influencing the adoption of risk mitigation approaches is the power in the supply chain. For example, in the competitive appliance industry Whirlpool finds it very difficult to fully pass on material price increases to customers without losing market share to foreign rivals.² In the automobile industry, it has been estimated that steel represents approximately 4 percent of the cost of a car, for example, $1,000 of a $25,000 car. A 20 to 30 percent rise in steel costs would have a parallel cost increase of $200, but many companies in this industry would be more likely to absorb those increases than to pass on those costs to consumers and thereby potentially lose business. In our cases, we found that in the chemical industry organizations chose to pass commodity price increases to customers only for innovative products, and are likely to absorb raw material prices for standardized products.

Several approaches require the buyer to exert some degree of influence on the supplier or customer. Approaches such as inserting escalation/ de-escalation clauses and improving products and processes often require significant supplier (or customer) input and “buy-in,” which may not happen if the buyer has limited influence within the supply chain. The buying firm’s size and amount of spend also influence the selection of commodity risk management approaches for value chain purchases. Small organizations, and those with limited spend levels may not have the resources available to engage in approaches such as directed sourcing contracts or vertically integrating to manage commodity price volatility.

Creating Firm Fixed-Price Contracts

Firm fixed-price contracts are used to ensure supply, reduce administrative costs, and are sometimes required by customers. Two firms that we have studied use firm fixed-price contracts with some suppliers to ensure supply. Food manufacturers can face supply challenges because farmers often switch among crops to improve their margins; by guaranteeing a specific price, companies can ensure that suppliers will grow the specific crops that they need. Another firm that we have worked with uses firm fixed-price contracts with its low-spend suppliers to reduce the administrative costs associated with price changes. However, some suppliers are not willing to enter into fixed-price contracts because they bear all the price risk. Further, suppliers with limited resources, lower margins, and lack of risk management expertise may not be able to absorb or effectively manage price risk. When prices increase, these suppliers may lower costs in other areas reducing quality or delivery performance, exit the business, or even potentially become bankrupt—all of which negatively impact the buyer. This is especially true in circumstances where buyers have limited options in finding and selecting new supply sources.

Piggyback Contracting

Piggyback contracting is an approach in which an organization enters into contracts with upstream commodity suppliers for a specific purchase volume and price. With piggyback contracts, the organization’s first-tier suppliers are then required to purchase their commodities off of this contract. If the organization spends a significant amount on the commodity and is able to take advantage of volume leverage purchases, then the supplier, who also requires that commodity, may be able to “piggyback” off your contract. In this case, the purchasing organization acquires enough of the commodity to meet its requirements, as well as those of the supplier, and thereby assumes the price risk of the commodity. This approach is often used when the buyer uses a much higher level of the commodity than its suppliers. If your organization has more resources and expertise in understanding the commodity and managing price risk than your suppliers, this may be an attractive alternative.

There are several benefits to this approach. Volumes can be combined across suppliers so volume discounts can be obtained. In addition, the buyer knows the actual price that is being paid for the commodity and thus has a better understanding of the supplier’s cost structure. In our research we have found several firms implementing this approach, particularly for mitigating price fluctuations of commodities such as steel, aluminum, and several oil-derived products. These companies use piggyback contracting almost always with component suppliers that are much smaller in size and influence as compared to the buyer. This approach is often used in conjunction with other approaches, such as escalation/ de-escalation clauses and financial hedging, since the approach does not necessarily mitigate the price risk, but often instead provides the purchasing firm greater price transparency and control for managing commodity price volatility exposure from supplier firms.

Including Escalation Clauses and Formula Pricing in Contracts

Negotiating escalation/de-escalation clauses in contractual agreements with suppliers and customers is a common approach for managing commodity price volatility. The escalation clause might relate to commodity price variations or labor costs but our discussion focuses on commodity prices. Key decisions that must be made when developing contract clauses include how often the prices are reviewed and changed, the base cost/price from which adjustments will be made, what the prices will be compared to, if past or future prices will be changed, and if there are upper and lower limits (bands) between which no price adjustments will be made. These decisions must be agreed upon when negotiating contracts with customers or suppliers.

Escalator/de-escalator clauses with suppliers are generally reviewed and adjusted monthly or quarterly. The decision on the frequency of review and price adjustment requires analyzing the trade-off between administrative costs and responsiveness to price changes. For example, price changes are typically made manually in enterprise resource planning (ERP) or e-procurement systems. Reducing the frequency of these changes—quarterly rather than monthly, for example—may have a positive impact on administrative costs for the buyer and suppliers. A drawback with less frequent changes is that the time lag between the actual prices paid and the adjustment, which can be a concern when prices are highly volatile.

Our research suggests that prices are reviewed and adjusted with customers once or twice a year. The frequency of price changes with customers is based on factors such as overall cost structures, market conditions, and competitor behaviors. When reviews are less frequent, buyers depend more on forecasted commodity prices to determine their overall pricing strategy. Inaccuracies in forecasted commodity prices can detrimentally affect overall profitability of products and product lines, since prices charged to customers are fixed for a period of time.

Another factor that must be agreed upon is the base price of the component that will be adjusted. It is important to determine the amount of the commodity in the part or component and the initial purchase price. The point of reference for the price adjustment also needs to be negotiated. Typically published indices such as those on the London Metals Exchange or other commodity markets are used. The index may change depending upon the location of the supplier. To reduce administrative costs, price bands can also be negotiated. For example, a price band of 5 percent means that the price must increase or decrease more than 5 percent relative to the initial price before any adjustment is made.

Let’s review an example of how the price adjustment process works. Assume a company manufactures wiring harnesses and just signed a 2-year contract to provide those components starting February 1, 2016, for a specialty heavy equipment transportation manufacturer. The negotiated price for the wiring harnesses is $100 each, and each component contains five pounds of copper. Copper is purchased by the wiring harness manufacturer in the spot market once a month, and due to manufacturing lead times, 1 month prior to delivery of the component. Contract terms for payment are net 30, and deliveries are scheduled on the first of every month, or the next workday if the first of the month is on a holiday or a weekend.

An escalator clause was negotiated to share the burden or benefits of copper price increases or decreases, respectively, if they rise or decrease by more than 5 percent from the initial Copper Futures cash spot price observed on January 1, which was $2.06 (U.S. dollars). Further, during negotiation, it was agreed that the purchase price would be re-evaluated on a monthly basis on the first of the month or the next appropriate workday. The buyer and supplier agreed to share any change in price 50/50.

Table 6.1 shows how purchase prices are adjusted based on the escalator clause. The purchase price for the February 1st delivery date is $100 per wiring harness, since the copper price is based on the original negotiated purchase price of $2.06. However, as can be seen for February 1, the copper cash price increased to $2.13, a 3.40 percent difference from the January copper spot price. Since this 3.40 percent difference does not exceed the 5 percent threshold, no price adjustment is made.

Table 6.1 Purchase price changes based on copper cash prices (US$)

Source: www.investing.com/commodities/copper-historical-data³

In continuing this example to the next month, we can see that the price of copper on March 1 rose again to $2.18 in preparation to meet the customer order on April 1. Compared with the price on January 1, this is an increase of $0.12 per pound, or a 5.8 percent difference, thereby exceeding the requirement of a 5 percent increase or decrease. For five pounds of copper per wiring harness this comes to a total cost increase of copper of $0.05. Since it was agreed to split copper price increases or decreases evenly, or 50/50, the overall total price increase would be $0.05 or a sales/purchase price of $100.05 (rounding up in this example) for a March 1st delivery and payment on April 1.

As we can see from this example, it is imperative to select an appropriate index or price source. Whichever one is selected should be the one that best reflects the actual spot price increases the supplier pays and can even include their actual purchase prices, if you are confident in the sourcing process and expertise of the supplier.

Revisiting Improving Product/Production Designs and Systems

In Chapter 5, we discussed how organizations can improve their respective products and production processes to reduce commodity demand, thereby reducing the firms’ overall financial exposure to price fluctuations. Improving product designs and production processes, however, is not limited or constrained to just direct commodity purchases, but can also be implemented for value chain purchases. Although this approach can be implemented regardless of exposure to increasing commodity prices, it is the threat and concern of commodity price volatility that can serve as an impetus for pursuing continuous improvement initiatives.

Several companies that we have studied have many of their supply chain professionals participating on various commodity teams. Within these teams, conference calls are made every one to two weeks to look at raw materials, which often extends beyond operations and often includes suppliers. For example, one firm has reduced its inventory levels of steel from several weeks to approximately two days of supply on hand. However, with regard to other commodity price risk management strategies, this process improvement has eliminated their ability to forward buy due to a lack of inventory space.

Another approach used in the value chain is to encourage and reward suppliers to continually improve product design and production processes to reduce, in part, the content of a commodity used. For example, another firm we studied works with radiator suppliers in finding ways to use less material, which also often results in reduced equipment weight. In another example, a firm we have worked with continually considers product and process redesigns to increase vehicle fuel efficiency, with a side benefit of reducing commodity price risk. Many of this firm’s products were designed decades ago using zinc, aluminum and steel. Most of the zinc parts have been converted to aluminum to reduce weight and improve vehicle fuel efficiency.

In addition, this company has been successfully redesigning metal parts to be made out of plastic. One challenge is that plastic prices are also volatile, and there is no standard index to use with it as there is with steel and aluminum. The approach being used with plastics part suppliers is that the supplier notifies this firm of a planned price change 90 days in advance and the two companies then negotiate the price change. In addition, they work with suppliers to use different grades of materials that are lower cost. Similarly, they evaluate whether the thickness of a part or its overall design can be changed to reduce weight and improve part manufacturing. The primary reason for this is to reduce weight, but it also reduces the amount of raw materials in the part, and hence, financial exposure to commodity price volatility.

Vertically Integrating

Vertical integration is an approach in which an organization owns its distribution channels or production of raw materials. In this approach firms can decide to produce raw materials in-house, or may choose to buy from vertically integrated suppliers to avoid price volatility from market exposure.⁴ This is a strategic decision that requires a commitment of capital, increases the assets of the firm, increases managerial complexity, and can cause loss of focus on core competencies. The reasons for investing in vertical integration go beyond the management of commodity price volatility, and are taken at the higher level of top management. Nevertheless, these decisions can be strongly influenced by the need to mitigate commodity price risk. For example, many oil companies such as ExxonMobile and Royal Dutch Shell are vertically integrated owning upstream exploration and production and downstream refining. However, Marathon Petroleum and Marathon Oil, which were once vertically integrated, split into two companies: one focused on downstream refining, distribution, and retailing, and the other focused on upstream exploration and production. Considering these examples, we remember—once again—that “one size does not fit all.”

Looking at the upstream supply chain, companies also may choose to buy from vertically integrated suppliers. An advantage of vertically integrated suppliers is that the supplier is not exposed to direct market pricing for its raw materials, reducing volatility and also does not pay for the supplier’s margin. However, the choice of vertical integration is often more focused for supply assurance rather than as an approach for managing commodity price volatility.

Summary

This chapter provides a discussion of approaches and techniques that supply chain professionals can implement for managing price risk associated with value chain (supplier) commodity purchases. Similar to direct commodity purchases, there is “no one size fits all” approach for managing price fluctuations of value chain purchases. Firm size, supply management expertise, power in the supply chain, customer requirements, and a myriad of other factors influence the ability and availability of approaches for mitigating this risk. The approaches described in this chapter are provided in order of complexity or difficulty in implementation. The more complex processes are, generally, the more expensive or difficult to implement.

Section IV of this book will provide greater insights to the forecasting processes discussed with regard to technical and fundamental analysis in Chapters 3 and 4, and the commodity price risk management approaches examined in Chapters 5 and 6 by providing further details on several of the approaches previously discussed, as well as specific examples of how firms have created strategies in their organizations, supply chains, and environments in addressing commodity price volatility.