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Commodities prices require new strategies for manufacturers

MANUFACTURING INSIGHTS  | 

Respondents to the Spring 2011 edition of the McGladrey Manufacturing & Distribution Monitor Report indicated that the rising costs of commodities and other key inputs would present significant challenges in the coming year. Two-thirds of those respondents anticipate that these increased costs would negatively affect margins, as it will be problematic to pass on costs to consumers in an economy that continues to deal with high unemployment. Meanwhile, 40 percent of respondents worry that rising commodity prices could adversely affect their entire business model.

The significant and rapid increase in oil prices in recent months, driven partly by political upheaval in the Middle East, may get the most attention, but prices of everything from cotton and other agricultural products to metals and rare earths have been increasingly volatile as the global economy continues its unsteady rebound from the recent recession.

That’s not all bad news. One reason that many commodity prices are on the way up is that increased consumer sales associated with the recovery means the manufacturers once again are seeing demand for their products. So, while increased demand means increased commodity costs, it also means increased sales. In an economy where it is still difficult for many manufacturers to pass costs on to their customers, however, volatile commodity prices still require a disciplined look at sourcing practices.

How should manufacturers respond? First, take a close look at your entire supply chain to understand what your inputs are and where they are most subject to volatility. The answers aren’t always obvious. One company that uses a high volume of polyesters to develop specialized protective fabrics for military and other applications found its margins unexpectedly impacted by the fashion industry. As cotton prices spiked, apparel manufacturers were turning to polyester as a lower cost option. This company suddenly was competing with new players for its raw material, creating unexpected pricing pressure. Companies should try to anticipate whether they could expect new competition for their materials – and also should look for lower-cost replacement options.

Make sure you are looking across your entire organization. One company had two different plants that manufactured significantly different products, but products that were made from substantially the same material inputs. Yet sourcing for the two plants was handled by two different managers who rarely if ever coordinated their efforts. By combining the sourcing operations, the company was able to create substantial economies.

Your customers are certainly pushing you on price. There is no reason not to push your suppliers. If you have been dealing with the same suppliers for years, take a fresh look at other options. Competition goes both ways.

Some companies are building larger inventories of products, and trying to stock up before prices rise further. The Institute for Supply Management reported that February 2011 broke a string of seven straight months of rising inventory levels. Of course, carrying more inventory creates its own risks and challenges. The benefit of buying stock at a lower costs has to be balanced against the costs associated with carrying the inventory for longer periods and the potential risks of obsolescence or a future downward swing in product costs.

Companies are also considering forward contracts and hedging strategies. Southwest Airlines famously locked in lower fuel costs with such strategies during the last big run up in oil prices. And if commodity prices always moved predictably upward, this would be a simple strategy. But volatility is as big an issue with commodity prices as are increases. In fact, in the first quarter of 2011, we are seeing downward movement in some of the commodity prices that had spiked late in 2010. Hedging can be a useful strategy, but it takes careful consideration and should not be approached in a purely speculative manner.

Of course, all companies should take a fresh look at everything from their shop floor to their supply chain and transportation costs to eliminate waste. Strategies to reduce waste that might have seemed too expensive a couple of years ago may be worth another look now. A variety of tax credits are available for companies taking steps to reduce energy expenditures. These also may be worth a look.

For many manufacturers, the real goal in managing commodity costs is as much to create predictability as it is to control costs. Strategies like forward contracts and hedging, approached responsibly, can build some predictability into your costs structure even if they don’t end up beating market prices. That predictability can allow you to plan operations for a set period with some confidence about what your costs will be.

Finally, in an uncertain cost environment, try to build more leeway into your contracts. Long-term deals at static prices can quickly turn from profitable deals to losses.

Commodity price volatility will continue to be a challenge for manufacturers for the foreseeable future. Those companies that move to manage these costs most aggressively will have a leg up on their competition.

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