Hedging: The Powerful Tool in the Supply Chain Management Manager's Repertoire

Written by: Abdullah Al-Tasan (Vice Chairman of the Board of Directors /Supply Chain and Procurement Society)

Nowadays , the competition between companies will not be in sales revenues, but rather the competition is between supply chain organizations . Therefore, there is consensus among academics and professionals in supply chain that updates and complexity in supply chain will increase during the years coming. Some still view supply chain as part of the manufacturing system but they do not understand that supply chain plays a significant role in the financial flow of companies. Moreover, most supply chain managers have not been able to understand the extent of the financial risk and its impact on their business.

What is hedging in supply chain?

Hedging is a term that refers to caution and risk mitigation. In economics, it refers to a situation that the investor makes certain decisions in order to compensate an exposure to price fluctuations in another market for risk reduction.

Hedging in prices is the prediction of the price level in the long and near term when conducting purchases in supply chain. Therefore, forecasting for currency rates have a direct impact on imported materials from other countries. Accordingly, procurement practitioners in the supply chain must select the appropriate time to commit with foreign suppliers, taking into account the currency exchange rates during contracting or issuing purchase orders.

Hedging in commodity prices covers sets of analysis about the conditions affecting the production and extraction of commodities. Examples are: hedging in minerals prices, raw material for agricultural products, oil, feed ,and dairy prices. Moreover, hedging is used in currency and shares trade. Additionally, analysis covers products seasonality, environmental, political conditions , and the supply and demand conditions for the goods to be purchased or supplied.

The impact of hedging in reducing costs to the companies:

The Purchasing and Supply Departments (in large industrial companies and/ or companies that depend on large volume of imports) focus on hedging activities. Some of these organizations create department or section responsible about hedging. Their role is to ensure close follow up on prices for updates and accuracy. Some other organizations outsource this activity to experts. .

It is known that global market exchanges rely heavily on hedging and monitor prices on an ongoing basis, which is the main tributary to FORWARD BUYING. Moreover, such kind of contracting will be based on proper price levels studies and forecasting according to the market data and the opportunities available in the future.

There are number of hedging practices applied in the past by organizations (companies I worked for) using (Chicago Mercentile Exchange (CME)), especially in contracting to purchase corn, soya bean and others. Moreover, hedging was used in the field of buying packaging materials that raw material were aluminum , paper and others. As a result of applying hedging practice, for the purchase of raw material and packaging the company managed to save between 10% to 20% in their purchasing. Subsequently, the cost has been reduced by the rate which is higher than the savings obtained through purchasing. Such saving and cost reduction has positive impact to the company’s profitability. The company’s financial statement has a record of net profit in which some of the profit was a contribution from Supply Chain organization. Procurement PRICE VARIANCE (PPV) tool was used to calculate such contribution.

When can organization use hedging?

Hedging is used during the following circumstances:

1- Large volume of purchase exists (Economies of scale)

2- Seriousness of international prices and market exchange monitoring

3- Follow up on supply and demand in the global market.

4- Existence of Risk management department and applying policies within the organization for risk mitigation.

5- Commitment by higher management regarding Hedging and risk management for purchasing .

Conclusion:

One of the most important future directions for purchasing and supply managers is the shift from traditional purchasing to strategic purchasing. Therefore, when using FORWARD BUYING), hedging must be taken into consideration specially with strategic planning. Moreover, Hedging is used in setting up budgets for companies, mainly in products that depend on raw materials or product components during manufacturing and production