As the global economy started to recover, it was perhaps inevitable that commodity prices would rise in line with increased demand.
Yet no one could have foreseen the level of increase in food commodities (see box below), with a poor harvest in large parts of the world in 2010 sitting alongside longer-term trends such as the increasing use of crops for biofuel and the soaring demand for meat, dairy and a much more “Westernised” diet from emerging economies, such as China and India.
Spiralling oil prices, too, have hit the food sector hard, resulting in unexpectedly high increases for both distribution and packaging costs. With an exceptionally dry spring in Europe, freak weather conditions in the US already in 2011 and commodity speculators driving prices up, it appears that higher food prices are here to stay.
For many food buyers, the issue of price inflation – along with security of supply – tops the business agenda. “About 40 per cent of our turnover is bought-in raw materials so it’s had a massive impact on us,” says Alison Farrar, procurement director at
Jordans Ryvita.
“We have seen considerable increases in grains, but also nuts, seeds, fruits and oils. I don’t think we have a raw material where we’ve actually had a good story this year, and we’re not expecting to see prices drop for next year either. It’s the biggest challenge for the business going into the next financial year.”
The impact of higher prices is felt not just by those directly buying raw commodities. Retailers, manufacturers and restaurants are all feeling the pain. “The biggest impact has been on meat: we’ve seen double-digit increases, which is pretty much unheard of,” says Alyson Scott, head of supply chain at UK restaurant chain
TGI Fridays. “I’ve been in food buying for 20 years, and it really is shocking when you have suppliers who you’ve been doing business with for a number
of years coming in with 25 per cent price increases.”
The pressure, then, is on CPOs and the broader business to try to find coping strategies for such unwelcome increases.
One option that is often used in such situations is changing
specification. But in the current climate, when increases are across the
board, this is less effective and can create additional headaches that
the business could well do without, such as altering recipes and
packaging.
A more interesting option for food
manufacturers involved in purchasing raw commodities is to work more
closely with farmers and producers, believes Uwe Schulte, executive
director at the
Social Innovation Center at INSEAD and former vice
president of global supply management at Unilever.
One
example of this strategy, he says, is Nespresso’s partnership with
coffee-growers located in parts of the world that can grow top-quality
beans, by offering small producers a premium to switch from growing
standard beans to the higher-quality ones required by Nespresso.
“They’re giving farmers a better income so it’s a brilliant marketing
campaign. It actually secures supply with a fixed price, and they’re
getting it cheaper than anybody else,” he says.
Another
option, suggests Schulte, would be to buy crops direct from farmers
before harvest. “You’re giving the farmer a fixed price to not play this
game any more,” he says. “The problem is you carry the risk of a bad
harvest so you would never do this with 100 per cent of your supply, but
you can dilute the effects of the price increase.”
An
appropriate strategy for some businesses might also be adopting a
hedging strategy, using financial instruments such as futures and
options. This approach was explored by Nigel Draper – currently client
services director at
Prestige Purchasing – in his former role as
procurement director at Allied Bakeries.
“Since
the credit crunch, banks have developed instruments that allow you to
hedge in commodities where markets previously didn’t exist,” says
Draper. “These tools are still being developed. The knowledge required
to manage them, and to understand financial instruments such as options,
futures and swaps, is not generally available within procurement
departments. It is a specialist skill, and it is high-risk.”
David
McLain, chief procurement officer at US-based food manufacturer
Del Monte, uses hedging tools where the business recognises it is likely to
be short for certain commodities. “At certain levels we’ll just be in
the market as cash buyers, and at others we move in with certain tools
based upon competitive moods,” he says. “If the markets really get
aggressive on us, we lock even further.”
Such
techniques can be applied even where there is no market for that
specific commodity. “When a commodity trades relative to something else,
we contractually enforce correlation and then we hedge it with the
other item,” says McLain.
Those
higher up the food supply chain will inevitably face requests for price
increases from suppliers, if they have not done so already. One option
here could be to resist these where possible. “During the downturn, when
we asked for cost concessions, we were told by a lot of suppliers that
the commodities have only a limited input on the price,” says McLain.
“We
asked for formalised communication to that effect. So when the markets
went back up, we handed them their letter and asked why we were having
this discussion. But it is a tough time, and you have to watch suppliers
really carefully.”
Major
retailers, in particular, can adopt strategies to persuade suppliers to
drop or minimise requests for increases by effectively playing them off
against each other, suggests Roger Davidson, former senior vice
president of global food procurement at Wal-Mart and currently president
of Roger Davidson Associates in the US.
“If
you’re looking at cereals, you may have four suppliers,” he says. “As a
retailer you can say the one that passes on the least increases will be
favoured and get more sales, and the ones that don’t get really hurt on
sales. So next month they will come back and take more out of their own
margin to try and keep their sales from eroding.” Another option is for
retailers to push their own private-label programmes, he adds, which
are already starting to grow again in the US.
Price
rises can also be mitigated through the use of long-term contracts,
which can prove particularly effective if conducted at a time when
prices tend to be lowest, such as around harvests. Scott at TGI Fridays,
for instance, has recently signed a long-term deal with a steak
supplier based on annual pricing reviews.
“It
gives our supplier the confidence of knowing that they have our
business and that will enable them to mitigate some of the cost,” she
says. “But you can’t say that prices can’t go up by more than 5 per
cent, because the market might jump 20 per cent so the contract becomes
pointless.”
Stripping out any
flexibility that may have been built into the deal by suppliers can also
drive down the price, although this inevitably places more risk on
buying organisations should markets rise over the term of that contract.
“An intelligent supplier will add risk premiums to the price; they’re
hedging through margins,” says McLain. “We pull those out and negotiate
lower rates on that contract because we’ve taken the risk away from the
supplier.”
For some CPOs, there
may be other strategies that can help to mitigate the additional costs
that are likely to filter through from either higher commodity prices or
suppliers. Scott at TGI Fridays, for instance, says consolidating
distribution from four providers to just one has enabled the company to
absorb the higher costs without having to increase prices for customers.
“It’s saving us money every year for five years,” she says. “Some
companies might have already done that or might not be in such a strong
position to find substantial savings, but it’s come at the right time
for us.”
“People are working
harder in those areas where they can take cost out to try and mitigate
these increases,” says Draper at Prestige Purchasing. “Businesses are
still saying they want to mitigate inflation, so if chicken has gone
through the roof they need to do something dramatic somewhere else.
There’s a stronger interest in those areas of food or drink that may not
have inflationary pressures – and there are still some about – and also
in non-food areas.”
For some
food manufacturers – and even retailers – passing on costs to customers
may be a possibility. Procurement can have an important part to play in
instigating those conversations within the business. “If these things
are publicly traded and it’s all transparent, then you have an excellent
case to say ‘what do you expect me to do?’” says Schulte. “If you have
that ability,
you should inform and influence the business.”
In
these cases, there may be no alternative but to take the hit until it
gets to a point where contracts become unprofitable. “We have managed to
move up some prices,” says Farrar at Jordans Ryvita. “But we haven’t
been able to recover the increases that we’ve seen, so we’ve been
squeezed. We’ve had market movements put on to us without any choice,
and retailers have not been particularly receptive to receiving it all.”
There
are some indications that in certain categories prices could be
flattening out. But there can be no escaping the longer-term upward
movement, or the fact that with greater global demand, this trend is
only likely to continue.
“There’s
a resignation that the world has totally changed and that we won’t go
back to those long periods of zero inflation,” says Draper. “I was at
Whitbread for eight years, and during that entire time we never had any
inflation. Each year I was targeted to reduce costs. Those days are
gone.”
What lies behind rising commodity prices?
The prices of leading agricultural commodities have rocketed across the
board over the past two years, with cotton, coffee, corn and wheat
showing the strongest growth, says Kona Haque, commodity strategist at
Macquarie Bank.
Many commodities are interlinked, as
they share the same land and compete for the same end-user, driving
prices up across the board, says Haque. “When corn prices go up you’ll
often see soybeans and wheat prices go up too, so feedstock for animals
would also see increases as well,” she says. “You have this substitution
effect, which ultimately means the whole complex moves up together.”
Prices
have also been affected by the impact of El Niño in 2009-10 and La Niña
in 2010-11, which together caused widespread disruption to harvests
across the globe. The drought and subsequent wild fires seen in Russia
last summer also caused havoc with the price of wheat and other
commodities, with the Russian government banning exports to meet the
needs of its internal market.
This
could also have an impact of this season’s harvest, says Haque, as the
seeds were planted into very dry soil, while Russia’s “herd and hog”
programme is generating additional internal demand.
