The Hedging Corner: Higher margins for you, price certainty and price protection for customers

"I believe resins are actually 70% or higher of most converters' total costs. Hence, a big jump in resins prices can lead to disaster. Strong overseas competition has made this difficult situation worse. I also agree processors' gross margins average less than 10%." Member of Specialty Plastics Organization

Response: All the more reason to control resins costs and seize the opportunity to provide product price certainty to customers.

"20% gross margin? I'm ecstatic when the numbers fall out to 10%. How do I convince my customers to buy at 20%?" Anonymous Processor

Response: The idea is for margins to not just 'fall out'. It's for processors to use hedging tools to provide customers product price certainty while capturing higher margins - a proactive approach.

Further, customers only see your product price -- with has no 'cost adder' strings attached - not your gross margin.

Rule to process by: "The market doesn't owe you a profit. Be a profit-maker and taker, not a profit-hoper."

Smart-Poly becomes Poly-Smart

As discussed last week, our fictional polypropylene processor Smart-Poly offers customers a fixed product price with no cost-adder for any contract term. They are able to do this using available hedging tools and strategies, and they increase margins and sales providing a service to customers who are not happy with higher resins costs being passed through to them by other processors. Many customers appreciate the price certainty as they look to control their costs and meet budget or other cost objectives.

Smart-Poly receives positive feedback on its new pricing program, but learns there are customers who are averse to long-term fixed-price contracts even without cost adders. Those customers are concerned about buyer's remorse - locking in a product price and missing the opportunity of lower product prices over the contract term. Can Smart-Poly do business with those customers and still achieve higher margins? Yes!

After reading the Hedging Corner on Plastics Today, Smart-Poly learns about options - puts and calls - and their many advantages and applications. Smart-Poly uses them to offer customers two more pricing choices: the fixed price with a floor, and a capped price. Smart-Poly is so impressed with the results that the company changes its name to Poly-Smart.

Fixed Price with a Floor or a Capped Price

Poly-Smart's version of the fixed price with a floor requires a customer to pay a premium equal to the cost of the floor. The premium is included in the fixed product price. The lower the floor, the lower the premium, but the customer chooses the floor price and Poly-Smart calculates the premium - not profiting on the premium, but passing the cost through. Whatever the floor costs Poly-Smart (i.e. the put option premium) is the premium paid by the customer. At product delivery, the customer pays the fixed price - however, if the market price of the product is below the floor price, the customer is reimbursed the difference between the fixed price and the floor.

As for the capped price, the customer specifies a ceiling price for the product and, as before, Poly-Smart calculates the premium and charges the customer the cost of the ceiling. The higher the ceiling, the lower the premium. The customer pays the premium up-front, but the product price isn't known until delivery. At delivery, the customer pays the lower of the capped price or the market price.

As mentioned before, Poly-Smart uses hedging tools and offers pricing choices that are standard in other markets. They're capturing higher margins and increasing utilization; and they are better able to focus on product improvements and technology - and consider opening a new facility - while competitors continue to fret.

If you would like more information on how pricing choices will benefit you and your customers, email me at [email protected]. Be poly-smart.

About the author: Tom Langan is a risk management consultant who operates WTL Trading. He specializes in commodity cost control, margin improvement, and revenue expansion for manufacturers and their customers.