Price risk is not just for Wall Street anymore
Supply chain professionals are used to thinking about demand risk. Sophisticated tools are widely available for optimizing inventory and supply flexibility to manage demand uncertainty – but how about price risk?How much could changes in material costs impact your company’s quarterly earnings? What is your company’s tolerance for earnings surprises? As Figure 1 shows, in a low margin business a 1% change in cost could have ten times the earnings impact as a 1% change in revenue. Not only is price risk an unfamiliar topic, but the bottom line impact can be much more direct than many other supply chain risks.
Outside of a few niche industries, most supply chain executives do not have strategies for measuring and managing material price risk. Increasingly, the problem is no longer limited to traditional commodity-based process industries (those that process an agricultural, chemical, or metal input into a derivative product). As the use of internet-enabled markets and spot market brokers matures, and as industries like hi-tech drive towards greater standardization of components, material prices will be more responsive to changing supply and demand conditions. That means that manufacturers are exposed to greater material cost volatility. For example, Figure 2 shows the dramatic increase in the short-term price volatility of DRAM memory in the past ten years. That may be a boon for market efficiency in matching supply with demand, but it means that supply chain professionals now have a new type of risk to manage: price risk.
Sizing up the risk
The first step towards managing price risk is in understanding its source. A manufacturer’s price risk can result from either long or short positions. A long position results when material purchase prices are committed without any sales price commitments. Like owning a stock, if material prices go up, profits go up. A short position results when sales prices are committed without material price commitments. If material prices go up, profits go down. Most manufacturers, by default, take a short position without even realizing it. Sales typically has limited flexibility in adjusting prices, while procurement will typically prefer to negotiate around “market” pricing with its material suppliers. For example, sales may submit price bids on big commercial deals that may not be delivered until 6 months later or more. They will base the bid on an uncertain forecast for component costs 6 months later. If procurement is not matching that commitment on the cost side to lock in margin, then the company’s profit is directly exposed to any error on that 6-month cost forecast. Manufacturers wouldn’t think of short-selling stock in their suppliers – why should they take short positions on materials supplied to them? The two positions are equivalent.
Once the nature of the price risk is understood, the degree of risk can be measured. A rigorous measurement of the risk would try to estimate the “earnings at risk”: a worst-case scenario for quarterly profit impact with a defined probability (e.g., 90%) that the profit impact would not be worse. A rough cut measurement could be made by considering the range of cost forecast errors, and the forecast horizons to which profits are exposed from the short positions. A more rigorous measurement would consider various “portfolio” effects that could dampen the impact due to offsetting cost forecast errors. Portfolio effects could occur between different materials, between sales bids made at different horizons, and between different months in a quarter.
With an estimate of quarterly earnings at risk, an organization needs to ask itself if that risk is acceptable. Managing the risk comes at the expense of added processes and added complexity. The perceived benefits of more predictable profits must offset that expense.
Managing the risk
The primary means available to a manufacturer to hedge price risk will be supplier price agreements. Some commodities, like oil or grains or metals, will have well developed futures markets in which prices can be hedged through purely financial transactions. However, many direct materials used by manufacturers, like memory and LCD display panels for example, have volatile prices but no available futures market. In those cases, a manufacturer can negotiate a hedge directly with its supplier. This may take the form of a fixed price agreement or a price cap agreement (in which the lesser of market price or a negotiated capped price is paid). When matched to sales bid profiles, such agreements lock in the product margin and protect it from any cost forecast errors (going from short to neutral position).
While relatively straightforward in theory, building internal support for fixed or capped prices can be a change management challenge. For example, procurement metrics on volatile commodities typically measure cost savings against a market price benchmark. Fixed price agreements would mean that a commodity manager risks looking bad if prices fall below the agreement. That metric is tangible and visible, while the margin that was locked in by the fixed price agreement is much less visible. For that reason, price caps are more attractive to procurement. Even then, price caps, like any form of insurance, typically come at some cost. For example, in return for a price cap, a supplier may ask for an upfront payment (option premium) or a price floor.
Managing price risk requires new tools and a change in mindset. For example, Hewlett-Packard’s Procurement Risk Management team develops tools and provides internal consulting to help the business units measure and manage risk. Overcoming the metrics and change management challenges also requires support from senior finance and supply chain management. Measuring the risk in a data-driven fashion can help management decide what actions to take, and convince internal stakeholders that price risk is worth managing. The alternative may be to convince shareholders why they should not punish the stock price for unpredictable earnings.
Unforecasted changes in material costs can have much bigger impacts on earnings than unforecasted changes in demand in a low margin business.
DRAM memory price history.
Dr. Thomas Olavson works within Hewlett Packard’s Procurement Risk Management group.