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In our previous article, we discussed how elevated commodity prices are a signal of the current mismatch between demand and supply, and ensuring the availability of critical raw materials is the first action to safeguard production.
In the weeks since, oil prices continued a steady climb from $40 a barrel in November 2020 up to the current $70+ a barrel. With the price of oil having a knock-on effect on so many other commodities, from transportation to utilities to agriculture products, any company that buys raw materials is affected.
To navigate the storm ahead, companies should renew their commercial relationships with suppliers and engage in value re-engineering of their existing products to reduce their dependency on commodities in short supply. In the long term, a culture of value engineering should be embedded in the organisation, and in the product development process.
In the context of increasing commodity prices, it’s important to share fairly the increase across the value chain. Suppliers are the place to start - they have the most knowledge and can take actions to mitigate price increases because they are closer to the commodity. Giving them the right incentives is essential.
How to reduce exposure to commodity price increases
Here are the key steps that companies should follow to reduce exposure to a commodity price increase:
- Review contractual agreements and categorize them based on two criteria. The first is contract length: short-term (up to 12 months) vs long-term (more than one year). The second is whether the price is fixed per unit or is a function of the value of an index, also called “indexing”.
- In a commodity supercycle, any short-term agreement potentially exposes your company to a tough contract renewal at a time when prices will be higher. At the same time, contracts that are indexed leave you directly and immediately exposed to price increases. The best protection comes from long-term, fixed price contracts.
- Engage Procurement functions with the objective to move as many contracts as possible towards fixed-price, long-term. Prioritise suppliers with whom you have a positive working relationship and that see you as long-term partners in their growth.
- When it is not possible to move to fixed-price, long-term agreements, renegotiate supplier margins. When margins are defined as a percentage, an increase in unit price will also increase supplier margins, magnifying the impact. Establish contracts where the margin or “block price” – including conversion, logistics and overheads cost – is defined in absolute terms, irrespective of the underlying commodity price. Negotiate margin components separately (profit, yield loss, fixed costs absorption etc.) and ask your suppliers to back up any cost claims.
Value Engineering and New Product Development
Improving commercial terms is a fast way to reduce exposure, since it doesn’t involve any change in the product or process. However, Value Engineering can deliver a deeper and more sustainable improvement by reducing dependency on high-cost raw materials, with a specific focus on those that are in danger of increasing further in price:
- Create a detailed database of your products composition. For each raw material that goes into each product, include their usage (in quantity and price), the process yield and their cost. Highlight the raw materials that have increased in price in the last six months and the ones that you believe are likely to further increase in the near future.
- Set up a multi-functional team including Procurement, Product, Manufacturing and Finance with the mission to value-engineer the product portfolio to reduce the dependency on the “flagged” raw materials.
- The main levers for a Consumer Products company in a “standard” Value Engineering exercise are Packaging, Composition, Volumes, Size, and Distribution. To keep the team laser focussed on reducing the impact of the commodity supercycle, most of the energy should be spent on Packaging and Composition.
- Split the process in two phases: the first, where all ideas are “thrown in”, and the second where these are prioritised based on ROI, customer acceptance and feasibility.
- In the first phase, challenge the team to come up with creative ideas to re-engineer your products. Assess the BOM of your products and check if they contain the raw materials previously highlighted. Are they fundamental? Can they be substituted? Can the quantity used be reduced? Would customers accept a different composition?
- In the second phase, build detailed business cases for each initiative and assess them with the oversight of Marketing and senior management teams. Calculate ROI, evaluate customer acceptance and assess feasibility.
- Finally, prioritise this list of initiatives and optimise your product portfolio accordingly to minimise the commodity supercycle risk.
- Correctly resourcing the multi-functional team will be the key enabler in Value Engineering.
Example: increase use of low-cost raw materials and decrease use of high-cost materials until they sit on the ideal line that moves from high-cost/low-volume to low-cost/high-volume.
For New Product Development, the Product team must internalise the Value Engineering methodology and apply it to the development of new products. This will eliminate redesign costs and ensure all future products already minimise their exposure to commodities that are rising in price.
Supply and demand issues were at play in commodities before the pandemic arrived, and COVID-19 further shook the system. We are seeing a price increase in several commodities, now sustained by high oil prices. We previously discussed how securing the availability of critical raw materials is the first step to take. With that activity under way, commercial levers and value engineering can further reduce exposure to this commodity supercycle.
In our final article, we will explore two more levers that companies can utilise: Production process performance and Revenue management.
