Comprehensive value management: How consumer packaged goods companies can tame volatility in commodity prices
Commodity markets have always endured volatility, but turmoil in the prices of nearly all commodities has reached unprecedented levels over the past 10 years. As a result, consumer packaged goods (CPG) companies that rely on agricultural produce, oil, metals, and other raw materials are facing continuous financial instability. Profit margins are shrinking and becoming harder to forecast as prices of key ingredients swing wildly up and down. In this environment of aggressive volatility, traditional cost and volatility management tools (e.g., hedging with futures and options contracts, and long-term supplier and customer contracts) have lost their effectiveness and can be extremely costly. Managing this volatility requires a high level of cross-functional coordination, but unfortunately, commodity cost management efforts sometimes get lost among conflicting agendas of various functional groups. Within the same company, inevitably certain divisions are focused on increasing sales volumes while others are interested only in expanding profit margins. CPG companies need an end-to-end approach to managing commodity costs and product pricing — something we call comprehensive value management.
Comprehensive value management (CVM) engages key functions across the organization in a systematic, coordinated effort to dilute the impact of commodity price changes on profitability. Such a system helps stabilize profit margins, fosters strong customer and investor relationships, and creates a competitive advantage. A CVM capability has four interlocking elements: an overall commodity hedging and pricing strategy, supported by cross-functional processes and clear organizational structures that define roles and responsibilities, as well as tailored tools for tracking key data and guiding decision makers.
The need for smarter pricing
Rising prices and increasing volatility in commodity markets are squeezing profit margins at many consumer packaged goods (CPG) makers. Though commodity markets have always seen their fair share of volatility, over the past 10 years the swings up and down have become more extreme. Part of the reason is the economic rise of China and India, which has fueled greater demand for commodities overall but also sharper pullbacks in prices when demand from those countries seems to soften. The wild ride for oil prices has brought excessive uncertainty and volatility into the market. Historically, commodity price fluctuations have had a very moderate impact on the profit margins of CPG companies. But swings today can evaporate 25 to 50 percent of a company’s margin.
Companies that adopt CVM can turn volatility into a competitive advantage.
At the same time, companies often overlook opportunities to mitigate commodity volatility by adjusting their own prices. Many don’t raise prices when commodity costs increase, opting to absorb profit margin impacts rather than risk losing sales to rivals that hold the line on prices. Others pass along commodity cost increases in a sporadic, seemingly random manner that confuses retailers and partners. Still others anger customers by passing along cost increases but not declines. Retailers are becoming more astute in seeking price reductions when commodity prices go down, especially for categories that are traffic drivers and/or are a large portion of their sales.
For all of these reasons, CPG companies need a comprehensive strategy for handling commodity volatility. They need to be able to link cost management and pricing tactics in a coordinated approach that protects profit margins, keeps prices competitive, and maintains good relationships with customers and partners. Companies that adopt this approach — which we call comprehensive value management (CVM) — can turn volatility into a competitive advantage over rivals still riding the commodity seesaw. In today’s business environment, CPG companies can no longer be reactive to commodity prices. They must be proactive.
A CVM capability has four interlocking elements: an overall commodity hedging and pricing strategy, supported by effective, repeatable cross-functional processes and clear organizational structures defining roles and responsibilities, with tailored tools for tracking key data and guiding decision makers. To be clear, this framework for managing commodity volatility is not a one-size-fits-all solution. The specifics will vary for each company. But a well-designed CVM strategy, supported by the right processes, organizational structure, and tools, gives companies greater insight into how commodity prices affect the organization, mitigates fluctuation in operating margins, manages market share and profitability, and creates significant value.
Traditional hedging strategies are inadequate
Between 2010 and 2014, prices of key raw materials used in packaged foods rose roughly three times faster than prices for finished goods, fluctuating dramatically along the way (see Exhibit 1). With labor costs relatively steady, commodities are the main reason that average operating profit margins for consumer goods companies have declined. Logically, commodity-driven price increases grow revenue but not earnings. From 2010 to 2014, overall food industry revenue rose 7.2 percent while earnings grew just 4.5 percent — with 23 percent of the industry suffering an actual decline in earnings.
Exhibit 1: Historically, CPG companies have struggled because of higher and volatile commodity prices
CPG companies have tried to ease the impact on profit margins in several ways. They’ve cut overhead, launched innovative products with higher price tags, and looked for other opportunities to raise prices. But commodity volatility and the complexity of managing many different commodities at the same time can overwhelm these and other traditional cost containment tactics.
A CPG product based on a single ingredient that is widely traded on the Chicago Mercantile Exchange (CME) can benefit from hedging. Companies that package orange juice, for example, can use futures and options trading to contain the prices they pay for their products. But often a finished product is manufactured from several commodities, not all of which are traded on the CME. Meat-based products such as hot dogs, corn dogs, or lunch meats, for example, use a wide range of cuts that are not traded on the CME, so a direct hedge is not possible. Or take a company that makes frozen pizza; it might be able to hedge major components such as wheat and cheese, but there will be other ingredients — tomatoes, for one — that are traded regionally or locally rather than on global commodities markets. Other commodities commonly used by CPG companies that are traded only on local markets include peanuts, almonds, and sunflower seeds.
Furthermore, the prices of all commodities can fluctuate independently of one another. Accurately predicting the bottom-line impact of divergent price moves in various commodities is extraordinarily difficult. To be effective, financial hedging strategies require liquid markets as well as strong correlations between futures prices and cash prices of commodities. Unfortunately, these correlations can break down over time, particularly when volatility rises. Exhibit 2 illustrates the divergence between cash-market prices of a common pork ingredient and the futures contract many CPG makers have used to hedge that ingredient. As correlations weaken, companies face greater risk that unexpected cost fluctuations will affect profit margins.
Exhibit 2: Many CPG companies have tried hedging commodities, yet historical price correlations don’t always hold
Internal and external challenges
Besides the difficulty in creating financing hedging strategies, CPG companies face several other challenges when managing commodity volatility. Ideally, prices should move in some degree of correlation with commodity movements. But companies often simply absorb rising commodity prices without passing along any portion of the increase to customers. Or they may wait until the profit squeeze has become too painful, and then surprise customers with a big, sudden price increase. Others raise prices when commodity costs climb, but don’t pass through cost declines, an approach likely to sow confusion and mistrust among customers.
Part of the problem is siloed decision making. The finance and procurement divisions are typically responsible for hedging and cost management at CPG companies, but pricing decisions lie with the marketing and brand teams, even though these groups often lack the tools necessary to decipher the true impact of commodity price fluctuations and/or competitors’ price moves.
What’s more, commodity cost management efforts sometimes get lost among the conflicting agendas of various internal functions. Some managers (those in sales, particularly) will emphasize increasing sales volumes, whereas others (those in finance, for example) focus on expanding profit margins. As a result, companies often fail to align internally on the right metrics to track for themselves and to share with customers.
There can also be internal resistance from managers who consider commodity costs one of the few ways to gain a few percentage points of operating margin in intensely price-competitive markets. And they aren’t eager to give up those incremental profits by cutting prices when commodity costs drop.
Several external factors can also complicate any attempt to absorb commodity cost movements through price changes. CPG makers can encounter resistance from retail chains that prefer locking in prices under long-term contracts. Consumer choice and price elasticity are other factors that limit the ability to pass through commodity cost increases, especially for non-staple items.
The bottom line is that any attempt to recover commodity costs through price increases must be based on a thorough understanding of marketplace dynamics. For example, a rival might be willing to accept smaller profit margins in one particular product line as part of a broader product marketing strategy, or the rival might leverage an inherent cost advantage (e.g., vertical integration or a different bill of materials) to undercut competitors and build share. If that product line produces a big share of your profits, you’ll need an effective long-term strategy to protect margins.
Comprehensive value management
Comprehensive value management engages key functions across the organization in a systematic, coordinated effort to dilute the impact of commodity price changes on profitability. It’s a well-defined, proactive cost management capability that links buy-side risk management with market-based pricing to neutralize volatility and create a competitive advantage.
As noted earlier, a CVM capability has four interlocking elements: an overall commodity hedging and pricing strategy, supported by effective, repeatable cross-functional processes and clear organizational structures defining roles and responsibilities, with tailored tools for tracking key data and guiding decision makers (see Exhibit 3).
Exhibit 3: Comprehensive value management
We recently worked with a major food company that put CVM in place to great success. The company began designing its strategy — which included cost containment techniques and pricing levers — by determining how much the prices of various commodities affected product costs. One cannot overstate the importance of identifying the commodities with the most significant cost increases, volatility, and impact on profit margins. But this can be difficult; some products incorporate multiple commodities whose prices move in different directions at different times. The net effect of all these price movements must be calculated to determine their overall effect on profitability.
The next step for the company was to identify and evaluate the various tools available to manage the costs of these commodities. These included traditional hedging in commodity futures markets, long-term supply contracts, physical hedges, partnership with key vendors, and vertical integration through the purchase of a commodity producer. Other levers that CPG manufacturers should consider as part of the strategic planning process include downsizing, adjusting price-pack architecture, and changing product formulation to use relatively cheaper (or less volatile) commodities.
At the same time the company was developing this cost-side strategy, the leadership began developing a strategy for passing commodity price changes into their product prices. On this front, the options included passing through prices dollar-for-dollar as soon as possible after commodity market prices move. This approach all but eliminates the effect of commodity volatility on profit margins. Another option is to use price adjustments to keep profit margins within an acceptable range and change prices only when commodity costs move past preset “trigger points.” This latter, more balanced approach reduces the administrative burden of changing prices when the change is not substantial. Not all brands, however, can raise their prices and continue to compete successfully. In some cases, a company might have to change the way it procures raw materials.
In the food company’s case, the cost management strategy also included a commitment to clear communication with customers and investors. Consumers and customers tend to react negatively to both sudden, significant price hikes and continual minor adjustments. But companies can win their customers’ trust by communicating policies on passing through increases and decreases in commodity costs.
The goal is to become less reactive to commodity swings by adjusting to conditions in the market.
As part of this communication, it’s critical to emphasize that the company is not using commodity volatility to pump up profits at the customer’s expense, but rather is employing a rational, predictable approach that protects margins on both sides. Companies should also be open with investors, explaining how commodity costs affect profit margins and how they will respond to volatility. This will enable them to project earnings more accurately, potentially boosting the stock valuation.
Overall, the goal is to become more proactive and less reactive to commodity swings by adjusting to conditions in the market — price elasticity, customer switching options, competitive dynamics, and marketplace pricing discipline (i.e., the likelihood that competitors will follow suit if you adjust prices). Branded coffee and orange juice makers are particularly good at managing this process, though they have the advantage of involving a single, very liquid commodity. But because commodities have remained volatile for several years now, more CPG companies that produce complex products are building sophisticated hedging and commodity cost management expertise.
A CVM program must also establish cross-functional processes to gather commodity price signals, assess their likely impact on margins, and facilitate timely decisions on cost management actions and pricing changes. The major food company we worked with created effective hand-off mechanisms to keep information flowing from group to group (procurement/sourcing to brand management to sales to finance, etc.), and established protocols for escalating issues to higher-level decision makers. This kind of rapid information transfer is essential because price data and estimates of margin effects quickly become outdated as markets fluctuate.
At the same time, at many companies it’s important to leave room for ad hoc processes that can be set up as a need arises, allowing for flexibility and speed. A cross-functional approach is absolutely critical. Procurement teams bring knowledge of commodities markets and expertise in hedging and other cost management tactics. Brand managers know products, market conditions, and pricing dynamics. Customer account teams have critical relationships and insights needed to craft and present pricing strategies that customers will accept. The finance team has the responsibility of tracking and proactively managing the company’s performance and communication to investors.
Cross-functional teams can manage commodity cost volatility far more effectively than any individual group.
At the food company, these cross-functional teams meet regularly to share information and insights, evaluate potential cost/price trade-offs, and inform senior management of margin trends. More important, the goal is to make cost management and pricing decisions at the product and brand level on a monthly basis. Monthly cross-brand reviews are being held to evaluate portfolio-wide choices. Whenever possible, these meetings are being integrated with existing operational and financial planning processes.
Together, the cross-functional teams can manage commodity cost volatility far more effectively than any individual group working in isolation. But they need support from governance structures that create authority for cross-portfolio decisions. The food company, for instance, defined the roles and responsibilities of each group and established clear decision rights for every aspect of the CVM program (see Exhibit 4).
Exhibit 4: Organizational ownership of key CVM capability components
Companies need to dedicate people to CVM only in extreme cases, such as periods of high volatility for key commodities that represent a significant share of a product’s selling price. In most cases, however, CVM can be an add-on/facilitation role. The best candidates for this role are typically in the revenue management groups or sales/brand finance teams because they are central, are closest to data, and have a holistic view of commodity price changes and competitive price moves.
Tools and dashboards
Making the right information easily accessible to different functional groups is critical to the success of CVM programs. Once the company has developed a robust process and operating model, including clear decision rights, the cross-functional teams can use technology to keep cost and price information flowing through the organization with customized reports and dashboards tailored to the needs of each decision maker. Putting information up on dashboards is not a substitute for a comprehensive CVM strategy, however; it is a tactic for engaging different functional areas with one another once they have already begun to realize the importance of communicating across the organization. But a company with a good CVM program in place can use dashboards to show current and projected commodity prices and translate them into potential cost impacts for key products.
A procurement manager’s dashboard, for example, might display side-by-side commodity pricing information on alternative ingredients such as chicken, pork, and beef and aggregate them into unit cost impact. A brand manager’s dashboard might track price and volume trends across products, along with competitors’ price actions. Meanwhile, the dashboard for a senior executive could aggregate this data and present the overall financial results of the CVM strategy.
By pulling in data from a range of sources — including internal ERP systems, commodity price services, and market data — well-designed dashboards present an up-to-the-minute, 360-degree view of cost/price trends and how they are affecting profit margins. And, what’s important, they will provide for one “version of the truth.” “Drill-down” data fields support decision making with rich detail such as breakdowns of average selling prices by product line, region, and distribution channel.
Enabling long-term growth
For CPG companies, it’s not only possible but essential to shield their business from commodity price swings. And given the increasingly extreme and unpredictable movements of commodity markets, a new approach to commodity cost management is necessary. CPG companies need to implement tailored comprehensive value management systems that use both cost and price levers to neutralize the bottom-line impact of commodity volatility. Managed correctly, CVM will allow the company to focus on building sustainable competitive advantages to drive profitable growth over the long term.