CPG’s Exposure to Commodity Volatility
Participants in the Fast-Moving Consumer Goods (FMCG) or Consumer Packaged Goods (CPG) sector are exposed to the volatility of commodity markets. In an industry where price elasticity is high and there is high availability of substitute goods, industry participants are unable to pass on adverse commodity market movements to the consumer. The result is that market risk can erode already thin margins that are common in this sector.
Market Risk Management in S&OP
Given the industry’s direct exposure to exchange traded commodities, there is a need for robust market risk management approaches to protect margins. Long-term, fixed price supplier contracts no longer suffice as a way to hedge away those risks as these arrangements are less available as they once were. Where they continue to be available, the supplier charges costly hedge premiums to the procuring CPG entity.
The Sales and Operations Planning (S&OP) Process, though well handled in most ERP systems, does not natively account for market risk management practices. ERP systems have native functionality to capture all aspects of the S&OP including Sales Forecasts, Demand Forecast based on product definitions within the Bill of Material (BOM), production constraints, inventory among other pieces of the S&OP. However, there are significant gaps in the typical ERP that are needed to accurately account for market risk considerations in the S&OP process.
At most CPG companies, the procurement function’s mandate is to purchase raw material requirements at a cost that represents a cost savings on a volume-adjusted year-on-year basis. Procurement needs to buy cheaper.
Achieving this goal requires an integrated S&OP process that accounts for volatility in commodity prices. Integrated S&OP is a process designed to ensure that Sales, Procurement, Hedging Desks, Manufacturing and other key functions within CPG are fulfilling their mandates using the same single source of information and the output from one function is the input for the next.
Such a process begins with the Sales Forecast. This forecast is then processed through product compositions or recipes as defined in the Bill of Materials in order to generate the raw material demand. The objective of this step is to define how much of a given commodity or set of commodities is required to produce the amount of finished goods required to satisfy the sales forecast.
After the raw material demand forecast is generated, procurement is required to identify how much of the forecast is covered (known as Covered Percentage) by inventory, committed price fixed long-term contract and how much is open or uncovered. This is also known as Open Percentage.
The Open positions represent market risk that needs to be hedged. For exchange traded commodities, the hedging might be done with options, futures, Swaps or any combination of these. Hedging could also be accomplished using market price indexed physical contracts and other physical pricing mechanisms that are common in the commodity trading industry.
The ERP Gap
Most financial hedging instruments do not have a static value. Their values change with market prices. It is common practice to work around this by representing these hedging instruments as static values that are updated periodically.
There are a number of issues with this workaround including data maintenance burden, data integrity issues among others. The most critical issue with this is that these inaccurate numbers end up skewing financial statements, especially in volatile markets when drastic changes in the value of these instruments are highly likely.
Furthermore, accurately tracking enterprise wide market risk profile as described by such measures as Value-at-Risk (VaR), Mark-To-Market and other metrics become challenging as these values would have been calculated based on out-of-date information.
CTRM to the Rescue
Commodity Trading and Risk Management (CTRM) systems help manage all aspects of the commodity trading lifecycle from trade capture to settlements to transportation to invoicing. CTRM software is designed specifically to handle the intricacies of the commodity business.
A good CTRM package can natively capture a near infinite combination of commodity contract types varied by pricing terms, payment terms, trading location, units of measure, currencies, quality specifications among other contract attributes and accurately calculate exposure, positions, PnL among others.
One of the many complexities that CTRM software handles natively is the calculating and maintaining the value of various types of commodity financial instruments, commonly used to hedge commodity price risk.
There are a number of different approaches that could be used to achieve the goal of ensuring that all transactions are recorded and processed correctly in order to generate the correct values for financial reporting purposes. One approach is ERP-led and the other is CTRM-led.
The ERP-led model keeps legacy systems as-is and interfaces commodity procurement information into the CTRM system for risk reporting. This approach maintains the ERP as the system of record and is generally less effortful and certainly achieves the same results as an approach in which the CTRM becomes the system of record for all commodity procurement activities.
Under the CTRM-led approach, all activities related to commodity procurement and risk management are completed and maintained in the CTRM. The CTRM is the system of record for commodity transaction. These transactions are then processed, summarized and interfaced into the ERP for financial reporting.
The recommended approach will depend on factors that are usually reviewed during the design phase of a Commodity Procurement and Risk Management program.
The Candymaker’s CTRM
Recently, the Essentia team helped our client, the world’s largest candy maker to implement CTRM system, Allegro Horizon. The implementation was completed in 3 man months and did not increase the client’s technology landscape complexity as the next CTRM instance was cloud hosted by Essentia.
Before we helped our client implement Allegro Horizon, our client relied on SAP as the system of record for fixed price physical commodity contracts, inventory and excel for managing derivative contracts. The client was risking human error, inaccurately calculated metrics as well as very high latency between when hedging activity takes place and when it is reported leading to the inability to respond market price shocks should they occur.
Upon going live, the CTRM was used to determine what new derivative contracts to purchase based existing inventory, price fixed physical contracts and existing derivatives. Existing positions were obtained from SAP, compared to demand forecasts in order to calculate additional hedge positions requirements.
About the Author
Ayo Sopitan is a CTRM professional with extensive experience in the Consumer Packaged Goods industry, having successfully led implementations, workshops and seminars at some of the world’s largest CPG companies. His experience includes having delivered projects at North America’s largest dairy producer, the world’s largest diversified food and beverage company, Europe’s largest grocery chain among others. He over a decade of experience in the commodities industry including leading provider of CTRM sytems, OpenLink Financial, Accenture, EY and Bank of America. He is currently a Director at Essentia Advisory Partners in Houston, Texas
Essentia Advisory Partners LLC is a full-service energy consulting firm headquartered in Houston, Texas. Our depth of experience in the energy sector has made our team a trusted advisory source for clients ranging from high-growth emerging companies to the Fortune 500. Our understanding of operational, commercial and regulatory environments in the energy industry is key to delivering relevant solutions that ensure compliance, promote efficiency, and create value for our clients.