How to Control the Impact of Commodity Prices on Your Costs

Commodity prices are a constant concern for business owners and leaders, procurement professionals, and supply chain managers. While we can’t control commodity prices themselves, we can take strategic actions to mitigate their impact on costs. Here’s a step-by-step guide to managing the effect of commodity price fluctuations on your bottom line.

1. Identify High-Impact Commodities

Start by pinpointing which commodities have the most significant influence on your purchase prices. This insight helps prioritize where to focus your efforts and resources. For example, if steel makes up a considerable percentage of your product cost, this is where you start.

2. Find the Right Index

Most commodities have an index that tracks their market value. For example, Pulp & Paper Week publishes several indices that track commodity prices. They are based on the type of material and buying location, such as the US, Europe, and Asia.

Select the index that best correlates with the price fluctuations you’re experiencing. Accurate index selection is critical, as this becomes the benchmark for monitoring price changes and negotiating with suppliers.

Select the index, but then be sure to check the index's correlation to the purchase price. Don't assume that the index tracks the purchase price; this should be verified. I do see examples where price changes are not at all correlated to the underlying commodity.

3. Incorporate the Index into Your Supplier Agreements

Work with your supplier to include the chosen index in your pricing mechanism. This ensures transparency and a fair alignment between market trends and pricing changes.

4. Set a Starting Price

Establish a baseline price for your commodity anchored to the current market value. This will serve as the reference point for all future price adjustments.

5. Define a Price Fluctuation Band

To prevent constant price changes, define a small range or band around the index starting price within which no adjustments to the purchase price occur. This minimizes administrative burdens and provides more price stability.

6. Adjust Pricing for Larger Fluctuations

For price changes outside the agreed band, determine how much the purchase price will adjust relative to the commodity’s movement. For instance, a $10 per ton rise in the index might trigger a proportional increase in your costs and vice versa.

7. Set Adjustment Frequency

Decide how often to review and adjust prices based on the index. A quarterly or semi-annual schedule balances responsiveness to market changes while not becoming overly burdensome to manage.

8. Sign and Implement the Agreement

Finalize the agreement with your supplier and integrate the new pricing mechanism into your procurement process. This approach creates a structured way to deal with commodity volatility.

Bonus Tip: Financial Hedging

If you’re managing a particularly volatile commodity, consider placing financial hedges against the index. Hedging can help stabilize costs and provide an extra layer of protection against market unpredictability.

Why This Works

This method leverages market-based mechanisms to manage cost uncertainty while fostering better supplier relationships. Suppliers appreciate the transparency and shared risk while you gain more predictability and control over your costs.

By implementing this strategy, you transform commodity price volatility from a threat into a manageable aspect of your procurement process.