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Six Steps to Managing Raw Material Price Volatility

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Building shelter from the commodity-pricing storm

With net margins typically less than 10% and COGS swallowing up to 70-80% of revenues, OEMs do not have much capacity to absorb raw-material commodity price swings. In this industry, purchased goods tend to be large, heavy components with significant raw material content; the cost of the raw materials without any value-add included can be as high as 20% for complete whole goods. Given this high cost percentage and the volatility of raw material prices in recent years, Heavy Equipment companies need to have a plan to mitigate the associated supply chain cost risks. There are six steps these companies can take to better understand their exposure to raw materials and to help preserve their profit margins.

  1.  UNDERSTAND the true quantity used. Don’t assume a fixed material percentage across components/products. Raw material input costs can range from 10% to more than 60%, depending on the component. Assess all purchased goods to understand their composition of significant raw materials and the price volatility of those materials. Store this information in a raw materials database (see Figure 1 for an example of an off-highway vehicle’s RM breakdown); this enables management to understand the contracted weights and costs for all components, subsystems and whole goods.


     

  2. UNDERSTAND YOUR SUPPLIERS’ raw-material costs and share risks appropriately. All supplier contracts should include the gross weights, net weights, and cost basis for the raw materials used. The cost basis can be in the form of a market-based, published price/index, or transparent negotiated Tier 2 contracts (openly shared between OEM and Tier 1 supplier). Contract terms should articulate when pricing is subject to adjustments, with regularly scheduled reviews and pre-set adjustment triggers. Consider timing carefully. For example, a change in Q1 raw materials prices may not impact the buyer until one to three months later as the changes make their way through the supply chain and related inventories.

  3. IDENTIFY WHICH commodities need dedicated strategies. Raw materials purchased in large volume and subject to price volatility need dedicated strategies. Steel is agiven; other commodities worth examining include copper, plastics, rubber, aluminum, and lubricants/hydrocarbons. With commodity strategies in place, Purchasing and Engineering need to work together to ensure that the design function is aware of commodity-price trends and considers that information when creating future designs.

  4. IMPLEMENT RISK-MITIGATION STRATEGIES. These strategies should focus on three key areas: Financial hedges: Futures, swaps, options, and fixedprice agreements can all be employed for a cost to help avoid significant unexpected price increases. These methods require a very specific skill set beyond that of a typical Purchasing professional. Operational hedges: These enable a buyer to change the nature of how raw materials are purchased. These include design changes, end-product pricing changes, and inventory management strategies. Price Increase Management teams: A dedicated team with strong analytical and negotiations skills can employ a rigorous, consistent, databased approach to defend against increases and also reduce costs as raw materials pricing decreases.

  5. DIFFERENTIATE SAVINGS GOALS. Organizations should differentiate between rawmaterials costs and value-add savings cost, and should develop separate savings goals and strategies for achieving each. Raw-material savings targets should be established relative to market prices (e.g., market prices less X%); value-add cost reduction targets should be more consistent year over year (e.g.,Y% productivity gains). This enables companies to tie performance to raw material market conditions and to understand when price increases are necessary to maintain margins.

  6. TRACK COMMODITY PRICE MOVEMENTS. Individual key raw materials can be easily tracked, but a more useful approach can be to create and track an index of raw materials made up of a basket of goods that represent your key product lines. This allows an OEM to understand the aggregate effect of numerous fluctuating raw materials and can provide valuable inputs not only to supplier cost management approaches, but also to pricing and discount management policy changes.