Early in 2014, a drought in Brazil caused a surge in coffee prices, affecting businesses a world away catering to latte-loving crowds. As the cost of coffee beans doubled, Starbucks was able to maintain its profitability—without raising prices—because it had locked in a year’s worth of supply at pre-drought prices. Green Mountain Coffee Roasters wasn’t as lucky; rising costs threatened its ability to turn a profit. Situations like this highlight the fluctuating nature of raw material prices – and the importance of “buying right.” This is especially true when a large portion of your raw material is made up of a commodity; for example, metals, energy, grain or coffee beans.
Raw Materials: A Top Worry among Manufacturers
Manufacturers consistently identify raw material costs as one of the top concerns driving profitability. Why is this such a pressing issue?
- Unlike other large components of their cost structure (labor for example), manufacturers don’t believe they have as much control over raw material prices. Green Mountain Coffee, for example, can roast a mean breakfast blend, but it can’t do much about droughts.
- Raw material costs are the largest cost component for most manufacturers, averaging 45 percent of the total cost structure in a recent survey of manufacturers in the Pacific Northwest . As companies become more efficient through lean, continuous improvement and other operational enhancement programs, this percentage will continue to grow.
How Do You Know If You Are Buying Your Raw Materials “Right”?
The grain trade has an adage: “Buying Right is Half Sold.” Grain merchants, as part of their industry role to efficiently distribute the annual harvest, have developed two key strengths: 1) to assess price risk, and 2) tools to manage those risks. For example, futures markets and forward contracts provide tools for the merchants to take or reduce risk. In contrast, manufacturers’ typically have key strengths that relate to designing, building and distributing products. Their strengths typically don’t include taking or hedging the price risk in their raw materials.
Taking a long position in raw materials could turn out to be a boon, as in the Starbucks case. Or—depending on the weather, politics, international affairs, and a plethora of other factors—it could result in writing off obsolete inventory, large capital requirements if sales get delayed, or margin pressure if prices decline after you have committed to buy and before sales are made.
In a another real time example, the recent plummet in fuel prices has eroded the margins for trucking companies that went “long” fuel this past summer but didn’t sell corresponding forward fixed rate freight contracts.
A Good Buy
So, how can manufacturers “buy right”? Sound purchasing decisions require:
- Inventory systems that track and report purchase commitments and physical balances.
- Inventory systems that forecast usage.
- Sales order and forecasting systems that allow accurate projections of raw material needs.
- Supplier relationships that allow you to shift some price and volume risk up the supply chain.
- Customer relationships that allow you to shift some price and volume risk down the supply chain.
- Real or near time links that connect your sales quotes to market raw material prices. Use replacement cost to price your product not historical values that either give away an earned margin or make you uncompetitive in the market place.
- Explore the use of 3rd party hedging tools – forward contracts, futures or other means to fix your margin as sales are made rather than taking on raw material price risk.
- Creative ways to increase your purchasing leverage, such as buying consortiums or extra bank lines for specific price break quantity purchases.
Raw material procurement presents a significant opportunity for effective margin management; when you implement a sound buying process, you can give your business the advantage it needs to “buy right,” mitigating risk and ensuring your business is well-positioned—and well-stocked—to meet demand and maintain profitability.
An experienced financial professional can help your business develop necessary processes for sound purchasing. Get the high-level advice you need to insulate, as much as possible, against the vagaries of the raw materials market.