Carl Williamson, manufacturing sector lead at Lloyds Bank Commercial Banking, Mid-markets, discusses the impact volatile commodity prices are having on manufacturers.
As the UK recovery continues to gather pace, manufacturers are gaining confidence with order books filling up – bolstered by stronger domestic and export demand. Over the last four to five years the manufacturing sector has suffered a double blow from a structural shift in its cost base through material increases in commodity prices, either as raw materials or energy input costs.
First, profit margins have been squeezed through a significant increase in the cost base, especially where manufacturers are unable to pass these increases on in product prices. Secondly, profit margins have become more volatile, even without further increases in commodity prices, as the impact of commodity price volatility on the bottom line is magnified.
This forces management to focus its efforts in three areas to mitigate these effects.
First, it is increasingly important to control the non-market costs in the supply chain, driving for efficiency and stability in supply arrangements. Manufacturers should be testing efficiency of their supply chain, in particular, shortening supply chains to reduce exposure to transportation costs and time, as well as the risks of energy price fluctuations. If appropriate, ‘just in time’ production can help create efficiency and flexibility for a buyer and ensure that a manufacturer can respond effectively to changes in demand.
Secondly, with surplus cash squeezed, it becomes ever more important to manage liquidity by using tailored trade finance to manage cash-flow. By taking control of cash-flow imbalances, a business can protect against cash squeezes and increase its flexibility in supply arrangements, potentially accessing favourable deals with suppliers.
Thirdly, managing commodity price risk feeds directly into managing profitability volatility. Using mechanisms to pass on costs to customers is in principle a simple and effective way of achieving this, but has its own difficulties. It may not be feasible, but even when it is, it can have an undesirable impact on demand – it’s of little use if the price is right but the customer goes elsewhere.
Fortunately, financial derivative markets exist for a wide range of commodities, particularly in energy, such as diesel, and industrial metals, such as aluminium and copper, which allow a company to manage these market risks. These derivative contracts have the effect of fixing or capping the cost of commodities. By using such financial hedges, a company can therefore directly reduce the volatility in its cost base, protecting margins and allowing the business to make secure financial plans.
By removing financial risks beyond its control, the company can then focus its energies on running its business. Further, because these contracts overlie the day-to-day business, they have no impact on the relationships with either suppliers or customers, keeping the running of the business separate from its financial management.
With a recovery in the UK seemingly underway, and the recent positive indicators within the Manufacturing sector set to continue, business can focus on its core activities, invest in its future, grow capacity and capitalise on the opportunities that the economy presents. While input commodity prices will continue to fluctuate, manufacturers must understand how to implement a range of strategies in which to control them, or at least protect themselves against any potential rises.