Current Issue

Over the past few years, highly unstable prices in commodities markets have put financial pressure on many producers. Between 2003 and 2008, prices for many of the raw materials used for making industrial products (such as crude oil, steel and aluminum) and consumer packaged goods (such as paper, wheat and milk) rose at double-digit rates only to fall dramatically in the following year. Some sectors have recovered while others remain depressed, but the consensus is that more volatility and uncertainty can be expected going forward.

Many manufacturers lack the flexibility to quickly respond to market volatility. Traditional approaches often leave decisions in the hands of a single function at each step in the value chain: product development and R&D determine the required feedstocks and materials specifications to use for the given product; procurement determines supply availability, negotiates with suppliers and bears the most responsibility for acquiring materials; manufacturing determines the production process and requirements; finance provides hedging strategies; and the marketing and sales provide demand signals and sets the price for the finished product.

The failure to integrate these functions can lead to costly misalignment of efforts. A lack of coordination between supplier and customer sales contracts is a common example. If purchasing renegotiates a higher price for a particular raw material to ensure availability when prices are rising, but sales has already locked the company into non-negotiable customer contracts for the same time period, the higher prices cannot be passed on to customers. In effect, the company assumes the full cost of mitigating the supply risk, rather than being able to share some of that cost-and risk-with the customer.

In one case, an aluminum products manufacturer set price ceilings for customers without capping supplier contracts, and as a result, was unable to pass along raw materials price increases. When these prices rose to unprecedented levels, the company's financials collapsed, market capitalization dropped by approximately 35%, and the company lost $1.1 billion over four years.

Moreover, companies without departmental cooperation struggle to develop production methods that can respond to cost fluctuations. Deploying a new technology in the production process, for example, can allow a manufacturer to substitute alternative feedstocks as prices seesaw, freeing it from relying on a single feedstock or sole supplier. But at many companies, sales, purchasing, product development and manufacturing do not work together enough to exploit these opportunities.

Another pitfall is over-relying on hedging as the primary way to manage raw materials price volatility. Typically the exclusive domain of finance, hedging is often carried out with limited visibility into the terms of sales contracts being negotiated by marketing, sales or procurement. Companies that make the wrong bets can pay a heavy price, becoming locked into contracts while prices fall. When natural gas prices fell from a short-term high, for instance, one specialty chemicals company hedged using six-month forward contracts. As gas prices continued to drop, the company's cost disadvantage doubled.

As with any good risk management strategy, companies looking to mitigate raw materials price volatility must look up and down the value chain. Consider all the risks-from supply-chain concerns of transporting cheap raw materials from distant locations and storing large inventories to the capital-expenditure perils of refitting plants and altering production processes for different feedstocks.

After these risks are assessed, companies can then choose from among four categories of risk transfer and mitigation techniques:

1. Upstream Risk Transfer to Suppliers
Companies can employ sourcing and contracting techniques to limit suppliers' ability to pass on additional costs. For example, diversifying the supplier base for priority raw materials gives companies negotiation leverage and limits the power of individual suppliers when prices spike. In some circumstances, it is possible to partner with suppliers to share supply chain risk (such as using fixed, long-term contracts).

2. Downstream Risk Transfer to Customers
Companies can include terms and conditions in contracts to adjust the timing of contract expiration and the risk exposure, where both let them pass on additional costs to consumers. For example, when volumes are agreed to for the long term, pricing can be updated frequently as the market changes. Other approaches include using public indexes or developing synthetic indexes for prices (that is, trending prices to a market price for a particular class of commodities or underlying cost drivers), using "collars" to restrict price changes to a specified range, and matching the contract terms with those of supplier contracts.

3. Risk Transfer to Outside Entities
Although companies should not rely on them exclusively, hedging strategies that transfer risk to counterparties in the financial markets can be critical. But companies must have in-house finance departments that understand the sophisticated positions they need to take--otherwise they may end up creating more risk for their organization. Companies can also transfer risk externally by collaborating with other companies in pursuit of shared goals. Such cooperation can create a win/win situation that reduces both cost and risk. For instance, a manufacturer can gain access to raw materials outside its home market by contracting to swap or share raw materials with another manufacturer, allowing both companies to reduce costs and giving them the flexibility to minimize supply chain risk.

4. Internal Risk Mitigation
For internal mitigation, the key is developing flexibility in product-development and manufacturing operations. This lets companies switch to cheaper raw materials when prices rise or shift production to different geographic locations that have cost advantages. Companies can also stockpile an inventory of raw materials when prices are low and draw on these when prices spike. While there are costs associated with maintaining high volumes of inventory, they may be justified by the benefits when prices for raw materials are highly volatile.

To mitigate risk through flexibility, one company developed an analysis tool to identify where it should buy a particular raw material and whether it should change the specifications (i.e., quality or grade). Balancing input costs, demand requirements and market prices enabled the company to approve multiple catalysts for its production process and choose which to use based on the regional prices of its product, thereby reducing cost and risk. When its supply costs rose, the company bought a higher-performing catalyst that created a higher yield. Although the company was paying more for its raw materials, the higher yield was large enough that it actually resulted in higher profits. When prices declined, it shifted back to a material that produced slightly lower yields but at a significantly lower cost.

For one specialty chemicals company, a collaborative effort between product development and purchasing led to 25% to 35% savings in manufacturing costs for one product. Engineers and purchasing experts worked together to determine that a substitute feedstock could be used in the manufacturing process; it required a 10% lower volume (due to molecular weight) to produce an equivalent yield. The company requested supplier bids for both the original and substitute feedstocks. One supplier offered the substitute feed stock at a 25% lower cost than the original one.

In another specialty chemicals company, product development and procurement created a way to identify the preferred raw materials and possible substitutes that could be used to manufacture its highest-demand products. Over a 12-month period, this method helped the company standardize the raw materials it purchased, reduce inventory and move to the lowest-cost materials. The approach also gave the company the flexibility to switch between raw materials as prices fluctuated. Overall, the company was able to quickly save 3% to 5% on these variable costs.

But for it to work, companies must support the risk strategy. First, strong governance is needed to coordinate the strategy across business units. Commitment from the top is critical. Top-level executives and senior managers should agree on the tolerance for risk, set clear objectives and communicate those throughout the organization. Companies will then be able to develop short-, medium- and long-term initiatives that meet the organization's risk profile. Companies should also establish a central risk management committee to set policies and guidelines relating to risk exposure. These same committees will lead enterprisewide initiatives to ensure consistency. A calendar of cross-functional meetings and review sessions should be established to maintain regular communication.

Second, a risk management strategy requires an analytical support system to become operational. This system will help identify the key risk drivers and monitor indicators to predict future market conditions and prices.

There are many tools to identify margin at risk, evaluate the costs involved and determine the impact on customers for any chosen course of action. Cost curves, for example, provide visibility into the marginal cost for materials and map high- and low-cost producers. Clean sheets provide a model of a product's total cost based on estimates for each component and determine cost benchmarks for materials (and how risks relating to raw materials could affect costs). Index price assessments are used to develop an internal perspective on costs, manage price escalation from suppliers and set formulas to reduce variability.

Finally, companies should establish ways to share information among functions. By establishing such an infrastructure, managers can continually adjust decisions based on market shifts while adhering to the risk policies and corporate objectives. Management should create targeted capability-building programs in risk management, purchasing, supply management and pricing to ensure that the organization has the skills required to develop, implement and sustain the new strategy. Performance measurement should include metrics for tracking progress and enable the company to flag areas in which it is not performing up to the predetermined indicators, so that it can maintain the capabilities to respond to market changes.

The markets for many raw materials have hit a low point and recovered, but the outlook is still uncertain. Companies that have policies and practices in place to manage raw materials will be well positioned to deal effectively with this volatile market and outperform their competitors during its fluctuations.

Senior executives can gain an initial perspective on how well prepared their company is to manage raw materials volatility by asking a few simple questions: Do all senior functional and business unit managers have a shared perspective on the current direction of commodity prices? Do their current responses to market conditions complement one another? How well do they coordinate or collaborate in making decisions that will have significant impact on cash flow?

For companies that find that their collaboration is limited, now is the opportune time to pursue a comprehensive strategy.
Jeff Shulman is a partner in the Dallas office of McKinsey & Company, Inc. and a leader of McKinsey's purchasing and supply management and energy and materials practices.
Andrew Corr is an associate principal in the Chicago office of McKinsey & Co. where he works in the company's global energy and materials, and industrial practices.
Patricio Ibanez is an associate principal in McKinsey & Company's Cleveland office and is a member of the purchasing and supply management, global energy and materials, and capital productivity practices.