How to Manage Volatile Raw Material Prices
How do business leaders assess the current market situation? Do volatile raw material costs pose a danger to economic recovery? What determines spikes and trends in raw material prices? “Fluctuating Raw Material Prices,” a recent survey from Simon-Kucher & Partners, asked more than 250 European managers from the chemical, construction and base material industries these questions. The current variations in raw material prices are primarily driven by supply and demand, according to approximately 60% of the surveyed managers.
Traditional factors such as market activity, reserve levels, free capacities and the current inventory definitely influence the situation. But there is another key factor at play: speculation. In an effort to hedge risk and take advantage of opportunities, even the more traditional funds are investing in commodity markets. Yet only 40% of the survey respondents believe that speculation is the cause of higher raw material costs. Still, it is clear that speculators contribute to the volatility.
“Fund and insurance companies do not set a specific trend, they simply go wherever looks best,” said Karl-Heinz Sebastian, senior partner of Simon-Kucher & Partners.
Even Little Price Differences Can Cause Big LossesBefore the economic crisis, raw material prices knew only one direction: up. Now the situation has changed and no one can forecast with confidence which direction raw material prices will go.
“Volatile raw material costs and ineffective price management pose an acute risk to a company’s performance and long-term success,” said Desmond Sullivan, director of Simon-Kucher & Partners. If companies only delay or pass on a proportion of the increased costs, or if rising raw material costs coincide with falling sales prices, a squeeze on margins is inevitable. The German corporation Bayer, for example, expects a loss of approximately €500,000 in 2010 due to higher raw material costs. For a leading steel manufacturer, a price difference of 25 £/t (~ $40/t) for the remaining capacity of the year is enough to cause either a small profit gain or a huge loss of about £25 million (~ $40 million).
Annual Fixed Price Contracts Are No Longer Appropriate“Facing increasing volatility, companies must move away from rigid and fixed systems,” Sullivan said. For example, 70% of the survey respondents confirm that annual contracts are no longer appropriate or up to date with the current volatility in raw material prices. Moreover, 80% are sure that the elimination of annual contracts will further exacerbate the price dynamics. In a dynamic market and cost environment, shorter terms-quarterly and monthly prices instead of annual contracts-allow companies to quickly and accurately assess the price opportunities and adapt prices accordingly. The gap between contract and spot prices should then start to narrow. One-half of the respondents said that they feel that shortening the negotiation cycles and moving away from annual contracts will not necessarily lead to higher prices.
How European Managers Deal with IrregularityTo overcome cost and price dynamics, 62% of the managers feel that the price formulas-“costs up, price up”-work as an effective means. This percentage is particularly alarming, warns Andrea Maessen, industry expert and partner, Simon-Kucher & Partners. “Formula pricing, in fact, turns active price management into passive pricing-by-the-rules.”
Price formulas are not necessarily the cure-all. “Initiating and setting price changes should not be based solely on price formulas,” Maessen said. “This is the responsibility of management.”
Inventory management, according to 78% of the respondents, is seen as the most important means of dealing with raw material cost fluctuations. A total of 68% of the managers, the base material producers especially, feel that active price leadership on the part of the market leader is another important solution. Contract optionalities (regarding dates, volume, standards, fees, etc.) are seen as important by 58% of the managers. Only every second respondent considers surcharges as a means of managing cost and price dynamics.
According to Sebastian, “Clearly defined pricing guidelines help to manage the complexity of pricing.”
Three Recommendations for the Raw Materials Industry1. Boost the efficiency of dynamic price management. Pricing processes must become faster, more transparent and effective in responding to changing market environments. After all, monthly or quarterly contract negotiations and the cost dynamics are not the only factors that determine the price; the customer size and negotiating power, the order behavior of customers, and the customer value all have impact.
2. Forecast supply and demand developments. Making price forecasts is difficult, but not impossible. This is especially relevant for market leaders who set the market tone and need to possess strong pricing competence and expertise.
3. Avoid escalation clauses as cure-alls. Initiating and setting price changes are the responsibility of management, which should review the options of time-restricted surcharges as price-relevant factors. Price formulas are recommended only if raw material costs are the main or sole price driver.
About the SurveyThe online survey “Fluctuating Raw Material Prices” was conducted by Karl-Heinz Sebastian, Ph.D., and Andrea Maessen, Ph.D., in May/June 2010. More than 250 European managers from the chemical, construction and base material industries were asked how they address higher costs, inflation, and collapsing margins.
About the CompanySimon-Kucher & Partners is a global consulting firm with 450 consultants in 20 offices worldwide focusing on Smart Profit GrowthSM. Founded in 1985, the company has 25 years of experience providing strategy and marketing consulting and is regarded as a leading pricing advisor.
For additional details, visit www.simon-kucher.com.