By Dwight Cass
These closely related challenges are best tackled by treasury and procurement groups working closely together.
Treasury risk managers have had their share of headaches in the last six years. One chronic source of pain has been the historically high level of commodity price volatility. This has complicated planning and made hedging expensive. It has also taken a toll on supply chain members. When the financial crisis made it impossible for smaller companies to borrow, price swings in crucial inputs, or components that required rare commodities to make, drove many out of business.
This experience caused companies to re-think their approaches to supply chain and commodity risk management. Several changes have been taking place as a result, with three of the most profound being attempts at recasting supplier relationships as partnerships, the shift in ownership of commodity price risk from supplier to the original equipment manufacturer level, and a reconsideration of how procurement and treasury should work together to most efficiently hedge both commodity price and procurement risk.
YOU GET, WE HEDGE
Market observers expect a joint treasury-procurement approach to grow in popularity, since it allows each to focus on the areas where they add the most value.
“Before the financial crisis it was common for procurement departments to manage both the physical procurement and the price risk of the commodities,” says Krishnan Iyengar, a VP at treasury and risk technology firm Reval. “Since the financial crisis, procurement departments of many large companies have shifted to focus only on the procurement aspect of the equation; and the treasury is managing the price risk.”
That makes sense, since treasury is in a position to manage commodity price risk in the context of the company’s overall risk profile. That means the ability to hedge net risks, understand and manage both market and counterparty exposures and more efficiently deploy capital to margin and collateral needs.
With commodity price volatility high, and important product inputs like rare earth metals becoming scarcer, treasury also has taken a more active role in onboarding price risk from supply chain members. This can be as simple as offering a cost-plus contract, and it allows the treasury of the larger and more market-savvy player to manage the price risk more efficiently than the smaller supplier could. And by removing that risk from the supplier, this approach reduces the chance that a supplier will face a liquidity crunch and go toes-up.
Meanwhile, procurement can better focus on negotiating access to the commodities or components the company needs—a job that has become increasingly difficult as competition for specialized intellectual capital has increased, and scarce commodities like rare earth metals have seen demand increase, or supply become constrained.
HOLISTIC REMEDIES
While it’s not always clear where the operational piece should reside, there are areas where a partnership between treasury and procurement can really pay off. An obvious one is in the due diligence of a potential supplier. Procurement can ask treasury to analyze the business standing and credit of potential suppliers.
The next step, further governance integration of the two—in particular, having procurement report to treasury—has both proponents and critics. Fans point to advantages garnered by having one oversight entity able to decompose both direct and indirect commodity risks.
Critics of the approach say this insight can be gained by establishing a liaison between the two departments, which can gather gross exposure data and report it to treasury and procurement. Treasury, they say, lacks the product knowledge and supplier relationships to manage procurement.
THE CHAIN HOLDS THE KEY
The debate over the appropriate governance structure for commodity risk management is important, but a dynamic that’s changing the nature of procurement risk management more profoundly is the relationship between companies and their supply chain members.
“It used to be the case that companies would look at supplier relationships and try to extract as much margin as possible,” Reval’s Iyengar says. “Now, post-global financial crisis, with a lot of suppliers having gone out of business, you are seeing a lot of companies approaching the procurement relationship as more of a partnership.”
Losing crucial suppliers to the financial crisis was a wake-up call for many procurement executives. And suppliers themselves have been building muscle in their relationships for some time. The trend of embedding powerful technology in everything from phones to cars has given the purveyors of components based on specialized skills or patented intellectual property and/or the often-rare commodities these components require, much more power in the relationship.
NASTY, BRUTISH AND SHORT(SIGHTED)
If multiple industries are competing for a crucial part of an electronic component, and these are in short supply, face high demand and are hard to make, a company two or three steps removed from the OEM’s supply chain could be the critical player determining procurement risk. “So allocation of the finished good is being controlled and driven by second and third-tier suppliers,” says Gary Lynch, managing director and global leader of supply chain risk management at Marsh Risk Consulting. “They’re the ones doing the innovations.”
Treasury is not in the best position to manage this situation. That’s because these suppliers are not solely interested in price—they do not choose their customers via auction. They want a guaranteed, stable demand for their product so they can create the facilities and hire the people to make it, and so they can finance R&D. “The big companies are looking for less supply volatility, and the downstream suppliers are looking for more predictable demand,” Lynch says.
So procurement risk management also involves ensuring the company’s business plan facilitates sustainable relationships with key suppliers—even those lurking outside the circle that directly contract with the company. It also involves engineering a manufacturing process that can tolerate the loss of an important supplier.
All this works toward a strong alliance of treasury and procurement in dealing with these issues, though not necessarily a hierarchical one.
If there is one lesson from the last six years of outsized commodity volatility, it is that companies have to stay nimble if they want to ensure their businesses aren’t disrupted by the cost or scarcity of necessary inputs. A partnership of treasury and procurement—and, wherever possible, the suppliers themselves—is the best way to do so.