Why do supply chains have so much trouble with the term “commodity”?
For firms across a multitude of businesses—agriculture, beverages, transportation and others—the management of commodity purchases is frequently the focus of the chief procurement officer (CPO). But there are different definitions of what constitutes a “commodity”: supply chain advisors tend to use the word to mean any supply that has a common specification or characteristic. Therefore, in this broad definition, commodity category management can include items as disparate as vehicle tires, electric power and concrete blocks.
On the other hand, many risk professionals use the term commodity to describe a supply that has a fungible contract—one that can be transferred from one party to another easily—as well as an external market with frequently observable prices. A futures market is the simplest example. Therefore, what a risk professional and a supply chain professional call a “commodity” can be quite different.
When thinking about commodities, it’s useful to think of them in two buckets: “procurement commodities” for those that meet the standard supply chain definition and “tradable commodities” for those that meet the risk professional definition. In some firms, these different classes are handled by separate groups. In others, they are handled by the CPO organization. In still others, the physical purchases and logistics are handled by the CPO and the financial transactions that can be undertaken in a transparent market (such as futures) are managed by treasury. All of these models have different benefits and weaknesses.
The important distinction is that procurement commodities usually have little or no variation in price over short time periods (commonly changing less than once in several months’ time period, e.g., contracts without monthly pricing), whereas tradable commodities may have a price that changes several times a minute. The term of reference would be that procurement commodities have little or no price volatility in the short term, while tradable commodities may have very significant price volatility in the short term due to demand and supply fundamentals.
Price volatility causes uncertainty in the cost of acquisition of an input. This in turn causes uncertainty in the margin to be generated for a finished good using that input. A greater percentage of inputs that have tradable commodity price volatility create a greater uncertainty in the margin for the finished good using those inputs. The desire to remove that uncertainty is the impetus for hedging—using fixed physical or financial contracts to lock in prices for a certain period of time. However, not all firms have processes and systems in place that can pinpoint and monitor the causes of price uncertainty throughout the supply chain. In some firms, the communication of this uncertainty to firm management has not created traction for undertaking activities to manage that margin uncertainty.
One simple test for whether you have these price uncertainty risks in your supply chain and their impact on predictable earnings is to ask: Do you find procurement activities are easier to manage within plan to protect margin when input prices are rising (or falling) and harder to manage within plan when they move in the opposite direction?
If you answer yes, then you likely have a procurement commodity/tradable commodity mix. If no, then it is more likely you have solely procurement commodities or your business model allows all tradable commodity risk to be borne by your suppliers (i.e., you have fixed price contracts) or flow to your customers. What causes this inverse relationship to happen?
Many supply chains have a significant lag between the time the supplier ships the input ingredient and the time production utilizes the ingredient. That lag can cause a shift in price between when the supplier prices the product and when the production group utilizes it. The negative impact from this relationship on the business can come from a number of causes: for example, it can come from inability to pass these prices on to the customer or the lack of connection between the price at time of acquisition and the market price for the tradable input at the time of use. Many CPOs are looking to address these issues through a strategic sourcing transformation—gaining greater insight and control over the procurement function to drive down cost and increase earnings.
For the CPO managing the entire chain of a tradable/procurement commodity mix—or even the CPO managing all physical purchases while treasury manages the financial transactions—the implementation of a strategic sourcing and supply chain analytics initiative requires a coordination of the supply chain and commodity risk skill sets. The procurement commodity and tradable commodities can be considered to be a “round peg/square peg” situation. Classic procurement analytics focuses on direct and indirect spend controls, supplier rationalization, contract rationalization and other cost reduction techniques. Commodity risk should focus on volatility control, access to liquidity, credit risk control and other predictable earnings management techniques. Certain common resources, such as transportation logistics, need to be carefully examined; cost rationalization of transport in a supply chain “lane management” structure can be completely inappropriate for tradable commodity logistics where the transport is an integral component of the transaction pricing mechanism.
Finally, the development of this integrated capability also can enable the procurement office to better align with the rest of the organization—forecasting, planning, production and marketing—to better identify where tradable commodity risk is acquired, transformed, retained and removed across the organization. In that way, the best structure for managing volatility impacts of tradable commodities and the uncertainty they can create on earnings can be determined.
We have found that a collaboration of supply chain and commodity risk professionals—bringing both square and round pegs to the problem—can create an operating model that both allows the CPO to better manage the discrete market structures and enables more effective communication to the rest of the organization, including the leadership team, of the impacts of the supply chain activities. The proper alignment of people, processes and technology to the type of supply chain issue being addressed is a critical factor in the success of the strategic sourcing initiative.
Tom Lord is executive director and Joseph Chang is senior manager of Ernst & Young LLP’s Financial Advisory Account Services, Commodity Markets.