To hedge or not to hedge: is that a question if your profit margin is at risk?
For strategic or competitive reasons, if you can't or don't want to pass along higher commodities' costs (resins, fuel, metals, etc.) to your customers, what are your reasons for not hedging or for hedging fearfully? Is it preferable to be in a product price-increase quandary like P&G, Unilever, and Colgate-Palmolive? [Missed "It's all about the margin, Part I"? Read it here.]
From Raising Product Prices Is a Margin Call (Wall St. Journal, April 28, 2011 issue): "Battered by rising costs for raw materials such as pulp, resin and fuel, and already running lean operations, these companies [P&G, Unilever, Colgate-Palmolive] have signaled in recent months that price increases are vital to protect profit margins. Staying the price-increase course may be tough, though. Consumers are in a bind: Gasoline prices are eating into household budgets even as food costs continue to rise.
... P&G said in February it could face at least $1 billion in increased commodity costs this year and cautioned that margins will be lower than expected."
The article didn't provide enough information to conclude one way or the other, but it begs the question: can a company as sophisticated as P&G not be hedging its resins costs? Highly doubtful, leaving me with two thoughts: either P&G et al didn't hedge their costs enough to protect margins, so they have no choice but to pass along higher costs to their customers if they want to maintain profits (and protect their shareholders), or their risk management department is keeping hedging gains to themselves.
Not passing along hedging gains to customers is standard procedure among most companies with active hedging programs. (Think oil companies and retail gasoline prices.) Imagine the good will and customer loyalty engendered by companies if they did share hedging gains, and rightfully communicated that fact to customers? Those companies would immediately set themselves apart from their competition (how much is customer loyalty worth?) while still protecting margins. Further, the risk manager would take his rightful slot in the pantheon of superheroes (yeah, right).
The Bottom Line
Don't bother hedging your profit margin if -
1. You can easily pass cost increases along to your customers without concern about their costs or competitiveness. You have a lock on their business.
2. Your margin is so wide that higher resins costs and volatility don't matter. You can absorb higher costs for however long it takes for the market to turn around or for your competitors to cry uncle.
3. You're subsidized by patient investors or protected by the government.
4. You can just make your product smaller and charge the same prices like sellers of milk, Coca-Cola, Pepsi, and an array of other products in China are doing (The Incredible Shrinking Bottle; WSJ, May 20, 2011)
(Cartoon credit: WSJ)
If, on the other hand, the above exceptions don't apply to your business and your profit margin is at risk, hedge to secure and improve margins. Start by establishing a set of rules (a risk management policy) approved by management. (Some rules in the post in this space next week.) Once the rules and the right person or team is in place to implement them, hedging is easy - a lot easier than manufacturing itself in the U.S. or most anywhere else too.
About the author: Tom Langan is a risk management and trading consultant who operates WTL Trading. He specializes in commodity cost control, loves to trade options, and enjoys teaching others ways to protect and increase the value of their manufacturing and personal portfolios. He has worked with private and public entities, as well as individuals, in helping control and take advantage of volatile oil and gas, electricity, resins, and metals prices. More background information here.