How to Cope with Unpredictable Raw Materials Costs

Managing the cost of raw materials remains a top priority for manufacturers. Here we look at factors driving price fluctuations and ways to handle cost volatility to achieve a competitive advantage.

Although the cost of raw materials used in manufacturing has eased somewhat since hitting a historic, mid-recession peak in 2008, the raw materials market remains volatile both in the United States and abroad. Manufacturers continue to be concerned about coping with these pricing fluctuations, and many firms are seeking new ways to mitigate risks associated with raw materials instability.

"Companies have a hard time correctly judging the risk of strongly fluctuating raw material costs. If they pass on increasing costs only minimally, delayed or too conservatively, or if increasing raw material costs coincide with decreasing sales prices, a margin squeeze is inevitable," chemicals research publication CHEManager explains. "Highly fluctuating raw material costs and ineffective price management can greatly endanger a company's success."

According to a recent survey from Prime Advantage, the cost of raw materials remains the top overall concern among small and mid-sized manufacturers, cited by 51 percent as their main priority in 2012. Although this was down from 66 percent in 2011, it indicates continued doubts about the raw materials market. When asked solely about cost pressures, raw materials were also the most frequently cited concern at 55 percent, down from 76 percent in 2011.

Moreover, 81 percent of respondents ranked raw materials costs among their top three concerns this year. Cost pressures on base materials used for components were cited as the second-highest concern, with 52 percent including it in their top three.

Issues on the supply side and rapid changes in the global economy - spurred by rising demand and consumption rates in emerging markets - are generating uncertainty, as well as being major factors in the volatility of raw materials prices.

"Raw material prices are experiencing unprecedented volatility. Driven by growth in places such as Asia, uncertainty about growth in Western Europe and North America, and raw material supply markets that are gradually tightening, prices will continue to be volatile well into the future," management consultancy A.T. Kearney notes. "For companies with significant raw material exposure - particularly manufacturers and those in the process industries - mastering raw material volatility has become essential to short-term growth and long-term competitive advantage."

These price fluctuations can have a significant impact on manufacturers. Approximately 15 to 20 percent of a typical original equipment manufacturer's total costs derive from raw materials. Moreover, in the process industries, raw materials account for 50 to 60 percent of overall costs. The influence of raw materials means that developing a comprehensive strategy to manage their costs should be a priority in the industrial sector.

"Firms that master raw material management can improve earnings margin by 2 to 5 percentage points, increase security of supply and improve supply chain operations, among other things," according to A.T. Kearney. "For companies that preemptively manage these risks, effective raw material management can be a source of competitive advantage."

Professional services firm AlixPartners provides the following helpful strategies for keeping down costs and mitigating risks associated with the raw materials market:

  • Understand the real quantities used. Don't assume there is a fixed material percentage across all components and products. Raw materials input costs can cover a wide range, so assess all purchased goods for their material composition and the price volatility of those materials. Keep this information in a database to allow management to analyze the contracted weights and costs for all components, subsystems and whole goods.

  • Establish clear terms with suppliers. All supplier contracts should incorporate the gross weights and net weights for the raw materials used, as well as the cost basis, which can be represented by a market-based, published price or index. The contract terms should also explain when pricing is subject to adjustments and include regularly scheduled reviews.

  • Determine which commodities need a dedicated strategy. Raw materials that are purchased in large volumes and experience price volatility, such as steel, copper, plastics, rubber, aluminum and lubricants/hydrocarbons, should have a specific commodity strategy in place. Purchasing and engineering departments should remain aware of commodity-price trends and consider them when creating future designs.

  • Implement a risk-mitigation plan. Risk management strategies should focus on three key areas: financial hedges to help avoid significant unexpected price increases; operational hedges, such as design changes, end-product pricing changes, and inventory management, to control how raw materials are purchased; and price increase controls that rely on a team with strong analytical and negotiation skills to protect against increases and reduce costs when raw materials pricing decreases.

  • Set distinct savings goals. It's important to distinguish between raw materials costs and value-add savings costs and to develop separate goals for each. Raw material savings targets should be established relative to market prices, while value-add cost reduction goals should be more consistent year-over-year. This allows companies to tie performance to market conditions and understand when price increases are necessary to maintain margins.

  • Track price changes. While prices for individual materials can be monitored, it may be more useful to create and track an index for groups of raw materials that represent your key product lines. This provides an aggregate view of numerous price fluctuations and can yield insight on supplier cost management and discount policy.

"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?" Risk Management Magazine advises. "For companies that find that their collaboration is limited, now is the opportune time to pursue a comprehensive strategy."

 

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