Organizations – small and large, anywhere - continue to struggle with the volatility of costs due to commodities and other resources’ fluctuation. Despite their defenses, they do suffer significant hits as the task is daunting. No wonder they are busy developing even better defenses.

 

While IT intensive solutions and financial hedges are useful, there is a little known but substantial opportunity that some companies have starting using – enhancing their management accounting simulations and scenarios with the help of analytics-savvy, specialized services providers.

 

The approach we use is pragmatic yet powerful: apply cost-effective, “massive force” to the forecasting of commodity prices, supply chain accounting and end-price elasticity analysis so that the impact can be simulated end-to-end - in a much more accurate, granular and frequent way than previously possible. The sourcing function, apart from improving its own practices and increasing its capacity to cope with a more complex environment, can act as an agent of change by injecting visibility into the volatility of the cost of the most material components of the BOM. Harnessing this wealth of data isn't just a spend analytics job - it requires reengineering the information flows between the sourcing organization, finance, the rest of the supply chain, and sales & marketing.

 

Combating the profitability battle in “the new normal”

Though the shockwave that struck global markets in 2008 is receding, it laid bare a number of structural imbalances that CFOs must face and adapt to in order to succeed. One of the primary causes of these imbalances is the global decline in natural resources coupled with a bigger and more prosperous world population that is fueling a growing demand for food, goods and energy. This demand is predicted to be 60% higher by 2030, two-and-a-half times the expected population growth rate. As a result, we will see prices for raw materials, production, transport and distribution continue to rise, putting increased pressure on companies across every sector to remain competitive yet profitable. To be successful when facing this higher demand, or what we call the “New Normal,” companies must focus on better supply chain management, adopt new procurement strategies and broaden their approach to managing risk and profit volatility.

 

Advanced Visibility and Simulations

Being successful in the New Normal marketplace means understanding new risks and finding better ways to manage them. As rapid fluctuations in commodities impact cost and profitability, financially savvy executives must re-evaluate their organization’s financial risk profile and develop a robust means of simulating and predicting the impact of various scenarios.   In addition, their supply chain and marketing counterparts must be empowered to react jointly, to ensure that the organization is able to react quickly and efficiently to minimize profit volatility.

 

Major food companies, for example, were already been forced to raise prices due to the skyrocketing cost of wheat and other commodities, with
plans to further increase prices in the near-term. For these companies, traditional profit forecasting and management strategies are proving inadequate and a new means of prediction and simulation are needed.

 

The New Normal marketplace has created increased risks for organizations across their entire supply chain. For example, most global supply chains
currently in place were engineered to manage stable, high-volume production by capitalizing on the advantages of low-cost countries such as China. However, the relative attractiveness of specific manufacturing locations and their ability to produce large volumes of goods economically is likely to change quickly in the future.  As a result, these supply chains, once painstakingly created, are no longer optimal for the rapidly changing and increasingly globalized economy.

 

Adapting procurement policies and shaving costs, however, are only part of the answer. A more sustainable solution requires more resources to be engaged in a robust product profits optimization program. Despite the apparent need for detailed scenario planning, companies typically attempt
to manage profit risk with lean, cross-functional teams using enterprise resource planning systems without detailed scenario planning capabilities and based on standard costing derived from past data only. For the most part, this aggregate and ad hoc forecasting is done using spreadsheets with input from sourcing, logistics and other cost owners, rather than with forward-looking data applied to robust test scenarios. While these practices are understandable given the typical cost and time constraints, they also sometimes lead to imprecise and coarse forecasts and unnecessarily simplistic, across-the-board price increases. Specifically, by using such traditional methods, neither sales and marketing nor finance can fully factor future cost volatility to optimize a product P&L. The result are suboptimal marketing mix decisions, often conducted only at local rather than regional levels, potentially resulting in a drastic loss of profit.

 

New Strategies for a New Era

Profit volatility protection is a tenet of the financial value of a company. It hinges on analytics that provide clear insight into cost inputs and respective impact to produce more accurate, timely and granular forecasts.

 

A true profit management program looks across the organization—from supply chain to finance to sales—to identify cost inputs and impact, produce profit forecast scenarios that identify the impact and respective timing, and finally, simulate the effect of product-specific margin regain and volume mix changes in order to maximize profits for the entire portfolio. Such a program must also dynamically provide feedback from marketing back to the supply chain, validating decisions and providing input with regard to procurement, development and production decisions.

 

Most importantly, these programs will simplify the work of various stakeholders by precisely identifying the biggest levers -- the activities and the products that should be targeted in order to maximize profit. The chart below shows how to map the portfolio’s products (or SKUs, if needed) in order to drive prioritization before further analysis.

 

Adapt or Die

 

Adapt or die—it is true in the world of nature, and in the world of business. And as in the world of nature, adaptation may require better symbiosis with the surrounding ecosystem. Every company exposed to production input fluctuations, especially when those inputs are numerous and impact the various products differently, will need to develop more sophisticated cost and margin management capabilities. The “New Normal” marketplace will require more collaboration between companies and specialists to understand the myriad of components that can affect cost and profit, and model a range of scenarios well beyond what was sufficient in the past – but it is an effort well worth its cost.

 

Gianni Giacomelli

Senior Vice President, Product Innovation, Genpact

 

For more information on how to contain the effects of COGS volatility visit us on www.genpact.com/FinanceAndAccounting/volatility-solutions.aspx

For more on how Genpact supports Sourcing and Procurement organizations, visit www.genpact.com