Procurement -- Managing Commodity RiskPublished: July 07, 2008 in Knowledge@Wharton
The Importance of Procurement in a Global Environment
Until recently, procurement was a necessary, but seldom celebrated, component of multinational corporations. But times have changed: These days, procurement organizations within companies are playing pivotal roles in the success of global firms in ways that old-fashioned purchasing managers could never have imagined. In this special report, Wharton faculty and procurement experts at The Boston Consulting Group discuss why the procurement function has risen to such prominence in a highly competitive global environment, and how, as supplies of critical commodities tighten and prices rise, companies can strategize to mitigate these and other risks.
Part 7: Managing Commodity Risk
Managing commodity risk has emerged as a key issue in today's economy. Consider airlines, which have seen fuel costs rise seven-fold over the last few years, says Bob Tevelson, a partner and managing director at BCG. In this interview, Tevelson says commodity risks are associated with both price volatility and supply availability. More and more companies may wish to turn to hedging strategies to manage commodity risk, he notes, but such strategies can pose risks themselves unless they are properly implemented.
Knowledge@Wharton: You've spent considerable time thinking about managing commodity risk. How big a problem is commodity risk for most companies, and who is most at risk?
Tevelson: I think that the commodity risk issue is significant and growing in importance for many companies. I think that if your P&L (profit and loss) is subject to variability, based on what's being bought in commodity markets where you don't have a lot of control, this is an important issue. You're kind of at risk.
We think that anything above 10% in terms of exposure of what you buy in commodity markets means that it's something to look at, something to invest in, and see where you sit at the moment and what improvements you might be able to pursue.
Knowledge@Wharton: Are there certain companies or certain industries that are more at risk than others?
Tevelson: Yes, I think the industries that are closer to the raw material sources are at greater and greater risk. The automotive industry -- with steel and a lot of the plastics and the materials that they use -- is clearly at risk. The airlines, with their number one cost item in recent months being fuel, clearly have to understand the risks they are exposed to, what the implications are for their P&L, how that impacts their strategy, [and] how they manage their loads and the like.
Knowledge@Wharton: What types of risk can be addressed, and how do firms go about addressing them?
Tevelson: I think the main commodity supply risks are associated with price volatility, and one that I think will grow in importance ... is supply availability. With respect to price volatility, it's that many buyers acquire commodities very much needed to make their product or deliver their product, and they are not able to influence or control that commodity directly because they are a smaller player in a much larger market.
On the supply availability issue, [the question is]: What are the risks to my ability to deliver to my customer based on the ability to acquire what I need, when I need it, and the right quantity and quality? That has always been an issue, but as companies have moved closer and closer to single and tighter supplier relationships, the degrees of freedom you have -- when you have a failure in your supply chain -- really have shrunk considerably over time.
And then, another issue on the horizon is that, with supply chains extending, there are more points of failure in a normal system, and you are finding a growing constraint in terms of the available capacity for getting materials from Point A to Point B. Years ago, the strike at Long Beach [involving] the dock workers caused major disruptions. So, supply availability is not just being able to acquire what is needed -- it's being able to acquire it in the right time frame, quality and the like.
Knowledge@Wharton: In terms of managing commodity risk, what practices are leading edge?
Tevelson: I think in terms of the supply risk, it's really understanding your supply market at a very detailed level and making sure that your sourcing strategies reflect the risk that exists today and consider what risks might arise in the future -- whether they be natural disasters or changes in the supplier market whereby one of your core suppliers may be acquired by your competitor, through vertical integration, for example.
So, it's really understanding and building from the supply strategy a reasonable supply base and set of sources -- meaning suppliers as well as locations -- and through that process defining where the points of failure would be and then developing a plan that allows you to escape the hazards, if in fact you have one of those events happen. And then, from a price volatility perspective, it's really [about] trying to understand what exposure [is], what drives the prices of the commodities, and then coming up with a specific strategy to address it.
Knowledge@Wharton: What types of practices make you nervous?
Tevelson: What makes me most nervous is when companies go ahead and get excited about hedging while not fully realizing what they are getting involved with. Hedging sounds very interesting, and if it's done without a lot of thought it's really gambling.
What I like to see is companies pursue hedging strategies as an insurance policy -- going into the market or arranging their supplier relationships in such a fashion whereby they add predictability, they add stability to their input pricing so they can manage pricing in the marketplace and not be surprised by sudden changes -- versus coming in and saying, "I'm going to be able to hedge fuels and I'm going to be able to beat the market in terms of the direction of fuel on a day-to-day or month-to-month basis."
What makes me most nervous about people approaching hedging is not thinking through the implications on the front end [and] not involving the right constituents in terms of stakeholders. For example, a hedging program really requires a cross-functional approach. It requires senior management attention and careful thought around the accounting requirements to make sure that no one gets into any questions with the SEC, especially for publicly-held companies.
Knowledge@Wharton: Before we began recording our conversation, you and I were talking informally about who actually devises and implements the hedging strategies. Can you take just a minute or two to talk about that?
Tevelson: In typical organizations, there is a finance function that gets involved in currency hedges. In more sophisticated, best-practice companies, you will find that there is a commodity trading desk or operation. And that operation is typically procurement-type folks or financial types who develop thorough understandings of the supply market and put together a recommended hedging strategy based on an assessment of the supply market, potential conditions, risk factors and what's anticipated going forward. But they just put together the facts and the options. They typically meet with a cross-functional team -- sometimes with marketing and sales -- because there are implications around the hedging strategies for how we set prices, but also with senior management from an operations perspective and clearly from a finance perspective.
Those companies meet in those forums. They review what the commodity trading desk is finding in the marketplace and what they think their options are going forward. And it's in that forum that they make their decision, and then it is carried out typically between the commodity desk and finance, to make sure all of the i's are dotted and the t's are crossed.
Knowledge@Wharton: Getting back to our general discussion, how does a firm know which kind of risk management techniques to apply?
Tevelson: In terms of the supply disruption risk, I think it's a matter of understanding your core commodities and being able to understand what real risks exist versus what risks are perceived, and then for those, deciding what the best strategy would be. If we're concerned about a single plant or a single supplier situation causing a problem, maybe you can dual-source in terms of location from one supplier. Or maybe you need to introduce a more proximate supplier, even if it has to be done at a premium, so that if your more distant supply chain partner is not able to deliver, you have a backup plan.
Knowledge@Wharton: What should a company do to increase the odds that it will be successful?
Tevelson: I think increasing the odds of success is having clear objectives. And that's more so on the pricing/hedging end, which is understanding what it is we are trying to accomplish, what are the objectives of the program, what degree of risk we're willing to take on, and then basically investing appropriately in resources to ensure that we have a solid foundation of fact [and] we have a good perspective on what may happen in the future. Obviously, the more speculative it is, the more informed it is [and] the better the strategy and hopefully the better the result.
Knowledge@Wharton: What changes do you foresee in commodity risk management in the months and years to come?
Tevelson: I think companies are going to get more sophisticated as their P&Ls are exposed every day to more and more of this volatile raw material input cost. So I think companies are going to increase their sophistication. I think you'll see more companies engaging in hedging.
I think one thing that we haven't talked about [that] I'd like to touch on is the types of hedges that you can get involved with. The most simple of course is a financial instrument in a liquid market, where you could just basically buy the insurance in the marketplace. What's more interesting to me and somewhat trickier is when the liquid market doesn't exist. And then you look at: How do I hedge my price through, for example, longer supplier relationships, meaning contract duration?
Or, two, looking at potentially vertical integration: Am I best suited to buy the raw materials to assure supply and manage the price? You are seeing a lot of consolidation in the steel market at the moment and also a lot of concentration in the raw materials, in terms of ore and coke going into the industry. And I think that that's a very, very interesting dynamic.
And then finally, another thing that companies are doing is trying to identify things that are correlated in terms of performance, a proxy hedge if you will, hedging one item because it is correlated to another. And those get to be tricky because there are a lot of accounting issues. But I think the non-financial-instrument hedging strategies are the most interesting because they're pretty strategic and require creativity.
Knowledge@Wharton: Do you think that the hedging strategies you've just discussed briefly will continue to be important in the years to come?
Tevelson: I think they'll increase in importance. I think what we are seeing in the commodity markets right now is exposing companies to what the marketplace has been doing in maybe a smaller subset. And I think the impact, in terms of the growth of prices and the volatility up and down, is getting people to think more and more about what needs to be done.
So, I would suggest that commodity hedging strategies are growing in importance and you'll see more and more people pursuing them. I think what will be interesting is to see what the evolution is on the more creative side, how industries may restructure based on commodity risk management, and how people will come up with innovative ways to work with their suppliers to offset that to a degree.
Knowledge@Wharton: Finally, do you have any views on where commodity risks are heading? What I mean by that is, we know that the price of oil has been soaring in recent months, for instance, and it is a key commodity to everyone, every business, every industry in the world. Are there other sectors where you see risks increasing in terms of supplier price that organizations should be aware of?
Tevelson: I think oil is a great example [as well as] precious metals, with gold where it is at the moment -- some people are predicting it to be $1,000 an ounce. I think it's at $823-plus this morning. So I think it's a broad range of commodities which will be exposed to this.
I think part of it is the dynamics of the world economy -- India and China pulling a lot more of the natural resources in terms of demand. Their economies are growing at a rapid rate and their consumption of basic commodities is growing. And I think it's that kind of draw in growth that will continue to increase pressure and will continue to get companies thinking differently about commodities and commodity risk management.
Knowledge@Wharton: From what you are saying, it sounds like no company is immune from these risks -- that pretty much, it's going to affect everyone who's doing business.
Tevelson: I think it will affect companies, some more so than others..... I was talking to a senior executive in procurement just yesterday from one of the major [airline industry] players in the U.S., and fuel this year has eclipsed labor as the number one cost element in their business. It has increased seven-fold over the last few years. That's just a phenomenal growth rate. And I just think that it's absolutely critical that companies get on top of it, and I think it will just increase in importance.