Raw materials are the lifeblood of many manufacturing industries. However, raw material prices are often highly volatile and can fluctuate rapidly, sometimes even doubling or tripling in price within a matter of months. This can put immense pressure on manufacturers, who need to find ways to maintain profitability while dealing with rising costs.
One solution to this problem is price hedging. Hedging is a risk management strategy that can be used to protect businesses against price fluctuations in raw materials such as KOH, potassium sulphate, and sodium hydroxide.
But how does hedging work and how can manufacturers use it to protect their bottom line?
What is hedging?
Hedging is a financial strategy that means that a company can protect themselves from higher prices in the future by buying a form of insurance. This insurance guarantees that the company can buy a product, commodity, or raw material at an agreed price, even if the price goes up in the future. This way, the company can make sure they can still afford what they need in the future, even if market prices go up.
Types of hedging strategies
There are several types of hedging tools that manufacturers can use to protect against price fluctuations in raw materials. Some of the most common include:
· Futures contracts: Futures contracts are agreements to buy or sell a specific quantity of a raw material at a specified price and date in the future. By purchasing futures contracts, manufacturers can lock in a price for their raw materials and protect against price fluctuations.
· Options contracts: Options contracts are similar to futures contracts, but they give the manufacturer the option to buy or sell a specific quantity of a raw material at a specified price and date in the future. Options contracts provide more flexibility than futures contracts because the manufacturer can choose not to exercise the option if the market price is more favourable.
· Forward contracts: Forward contracts are similar to futures contracts, but they are customized agreements between two parties. Forward contracts can be used to protect against price fluctuations in raw materials.
· Swaps: Swaps are agreements between two parties to exchange cash flows based on the price of a specific raw material. Swaps can be used to protect against price fluctuations in raw materials by locking in a fixed price for a set period of time.
How to hedge against price fluctuations in raw materials
With a variety of strategies to hedge against price fluctuations in raw materials available, the best strategy will depend on the specific needs of the manufacturer and the raw materials being used.
Here are a few examples of how different manufacturers have used hedging strategies to protect their profit margins:
1. Tyson Foods: In 2019, Tyson Foods used hedging to protect its profit margins from rising feed costs. The company purchased corn and soybean futures contracts to lock in the price of its animal feed, ensuring profit margins were maintained even as the cost of feed increased.
2. Procter & Gamble: In 2016, Procter & Gamble used hedging to protect its profit margins from currency fluctuations in emerging markets. The company used financial derivatives to offset its losses as the value of emerging market currencies fell against the dollar.
3. Boeing: In 2019, Boeing used hedging to protect its profit margins from rising fuel costs. The company purchased oil futures contracts to lock in the price of fuel for its planes.
4. Nestle: In 2017, Nestle used hedging to protect itself from volatile commodity prices. This was achieved with financial derivatives which offset its losses as the value of cocoa and coffee fluctuated.
5. Ford Motor Company: In 2018, Ford used hedging to protect itself against foreign exchange risks in the European market. As the value of the euro fell against the dollar, financial derivatives offset losses allowing the company to protect its profit margins and maintain competitiveness.
In today's volatile markets, manufacturers face the challenge of rising raw material costs that can leave them struggling. Price hedging offers a solution to this problem.
While many of the options discussed may seem most suitable for large, multinational companies, small and medium-sized manufacturers can also negotiate longer term purchases with their regular suppliers. With more stable price agreements in place, these smaller businesses are then free to make investment plans based on a certainty of how much their raw material costs will be, whatever happens in the market.
As shown by examples such as Tyson Foods and Nestle, hedging can be an effective risk management strategy that enables businesses to protect their profit margins and remain competitive in their respective industries.