11/20/2013 | Chuck Leddy

Most middle market companies are exposed to risk from changing commodity prices, whether they use commodities (raw materials like metals, chemicals, or agricultural products) directly as inputs in their production or rely on oil-hungry transportation for logistics and distribution. Changes in commodity prices can thus "have a direct impact on [your] profit margins" and overall bottom line, says a report from consulting firm PWC, because it's difficult to simply transfer your higher costs on to customers by increasing prices. In today's highly competitive business climate, many middle market companies absorb the cost by decreasing their margins, leaving them less money to invest in other areas.

As Volatility in Commodity Prices becomes the New Normal, You need a Strategy to Meet It

Commodity prices are a primary driver in the variability of earnings for many middle market companies. In consumer-product companies, for instance, the cost of commodities can be more than half of total production cost. While commodity prices are volatile and subject to unpredictable changes in global demand, you do not need to be reactive by slashing your profit margins. If you follow these four recommendations, you can turn your exposure to commodity cost volatility into a competitive advantage. Here's what you should be doing right now.

1. Think of commodity procurement as risk management, because it is. Seek to limit and mitigate your exposure to changes in commodity prices by planning for contingencies based on differing scenarios. For example, can you change your product and production process by substituting a cheaper raw material for a more expensive one? If aluminum prices go through the roof, might you be able to switch to steel? Of course, there are tradeoffs related to quality and cost. Consider them carefully before cutting profit margins. Plan ahead and proactively adapt to commodity costs based on your needs and a solid analysis of what is happening in global commodity markets.

As consultant firm Oliver Wyman Group wisely summarizes, "developing a deep understanding of [your] company's exposure to unpredictable raw materials prices and revamping procurement processes to mitigate their potential impact is not just a good idea: It's now a must."

2. Change your products, if necessary. Some options you might consider include reducing the size or weight of products while maintaining existing prices, reducing the amount packaging to lower costs, or developing product innovations to add value and thus justify price increases. For example, one industry analyst estimated recently that French food producer Danone could offset the increase in commodity costs simply by reducing packaging or making better deals with its milk suppliers. Such changes are highly strategic but sometimes necessary.

3. Reconsider contract relationships with suppliers so that you're less exposed to volatility. Consolidate purchasing as much as possible to increase your buying volume and negotiating power and reduce your costs. If possible, and based on your analysis of future trends in commodity markets, seek to lock in a fixed price for the longer term. Of course, your analysis of trends can be wrong, but at least you will have the certainty of a fixed price moving forward and can plan accordingly.

You should also consider, when you negotiate supply contracts, the possibility of including sophisticated, dynamic formulas based on the changing costs of commodities, which can act as triggers and give you more cost flexibility as commodity costs change. In this way, you equitably share the risks and benefits of volatility with your supply partners.

4. Use hedging strategies, such as securing supplies through a futures contract if your forecasts show higher commodity costs looming, to gain the certainty of a fixed price. You are taking a risk by hedging, but you're also taking a risk by not hedging. The key is to understand what works best for you. You will need to thoroughly analyze your cost structures before making any hedging decisions and locking in a fixed price.

Get help, too, in the form of investment advice and up-to-date forecasts on where commodity markets are heading. If you believe that commodity prices for the materials you need will be dropping, for example, you might move in the opposite direction by choosing to source through the spot market, where you expect to buy through single orders at falling prices. Here, you will gain a competitive advantage over rivals who have locked in a (higher) fixed-price through a futures contract. Again, your forecasts may be wrong, so consider your options and strategy carefully while being prepared to change.

You need to understand that volatility in commodity costs is not going away anytime soon. Manage change with good planning and an adaptable approach to procurement. By following the four recommendations offered above, you will better control your costs and reduce the impact of commodity price changes on your profit margins.

Boston-based Chuck Leddy is an NCMM contributor and freelance reporter who contributes regularly to The Boston Globe and Harvard Gazette. He also trains Fortune 500 executives in business-communication skills as an instructor for EF Education. Circle him on Google+.