Situation: A European company from the food industry sector faces prices volatility and is not able to transfer those extra costs to its clients. The client manufactures products based on more than 20 commodities. All commodity related strategies and operations are currently managed by the purchasing department. The top management of the company wants to establish a full financial risk diagnostic in order to avoid unexpected potential losses which could affect the global profitability of the firm. In addition, the client desires to identify new risk mitigation strategies.
Approach: By performing an analysis of the company’s risk exposure an processes, we implemented our commodity risk management approach.
We started by the assessment of the current risk situation. By analyzing purchasing, sales and market mass data, our consultants identified 2 main commodities (wheat and palm oil) representing a financial risk for the client of 14 Millions Euros.
In parallel, we analysed and proposed an improvement of the risk management procedures, including:
- Risk quantification (link between purchasing costs and sales prices of the final product and volume forecasts)
- Risk maximum limits(according to the financial situation of the company)
- Definition and implementation of action plan (definition of mitigation strategies and support on implementation)
- Decision rights (levels of approval, roles and responsibilities liked to risk management decisions
- Customized tools and dashboards (to ensure a good application of the procedures)
To ensure a continuous improvement of the commodity risk management policy, a risk management committee has been created to follow and define annual threshold levels, review the dashboards, and escalate decisions when needed.
Which department is involved in a risk management project?
Traditionally, commodity price risks are managed by the purchasing departments through their procurement strategy and sometimes at an operating units level (plants, factories). In this case, it is a common way to manage exposures primarily on usage volumes and notional amounts. But this approach leads to apply short term strategies and coverage strategies while the company needs a sustainable approach to satisfy its long term targets. This is the reason why our market risk management projects involve three key departments: Purchasing, Sales and Finance.
Which are the typical mitigation strategies available ?
There is not one unique solution to cover the risk but the different alternatives can be grouped into four levers:
- Margins Management: manage profitability through price changes and raw material price transfer to customers.
- Procurement strategies: control purchasing costs through long-term agreement and fixed prices with suppliers or anticipate purchasing volumes and store the raw material.
- Hedging: transfer the price risk to third parties with financial instruments (futures, swaps, option and other instruments) to manage the residual exposure.
- Strategic management: innovate and modify the marketing mix by developing products with a lower ratio risk vs margin. Invest on upstream or downstream businesses (e.g. invest on corn production for a stark manufacturer).
TALA consult can also provide your organization with customized training and coaching regarding commodity and currencies risk management. Please contact us for further information.