Understanding Commodity Price Volatility Mitigation from Transaction Cost Economics:
Preliminary Results
George A. Zsidisin, Virginia Commonwealth University, School of Business, 301 W. Main Street, Richmond, VA,
23284-4000, phone: 804-828-1488, e-mail: [email protected]
Barbara Gaudenzi, University of Verona, Department of Business Administration, Via dell’Artigliere 19, 37129
Verona, Italy, phone: +390458028623; e-mail: [email protected]
Janet L. Hartley, Bowling Green State University, Supply Chain Management Institute, 3026 Business
Administration, Bowling Green, OH, phone: 419-372-8645, e-mail: [email protected]
Lutz Kaufmann, WHU – Otto Beisheim School of Management, Burgplatz 2, 56179 Vallendar, Germany,
phone: +49 261 6509-320; e-mail: [email protected]
Understanding Commodity Price Volatility Mitigation from Transaction Cost Economics:
Preliminary Results
Summary
Most firms are exposed to price volatility associated with commodities, which can significantly
affect the price paid for raw materials, energy and component purchases. The purpose of this
paper is to examine how organizations mitigate the risk of commodity price volatility (CPV) in
their organizations and supply chains. Initial findings from case studies support prior theory that
as uncertainty and risk increase, organizations are more likely to create hierarchical structures to
manage the effects of CPV. Likewise, when CPV does not pose a significant risk, there appears
to be a greater use of approaches to offset or pass this risk to markets or other supply chain
actors.
Key Words: Price volatility, Risk assessment, Supply risk mitigation, Case studies
Submission category: Working Paper
Introduction
All organizations including those in the private sector, non-profit entities, and governmental
agencies, are exposed to commodity price volatility and risk at some level. Risk exposure is
either from direct raw materials and energy purchases or from risk upstream in their supply
chains from commodities purchased by their suppliers. Commodities are usually categorized into
energy, metals, refined petroleum products, food and non-food agricultural products.
The challenge associated with mitigating CPV is a relatively recent phenomenon in supply chain
management (Zsidisin et al., 2014). For many years the prices of most commodities were
relatively stable. However, within the last 10 years, many commodities have experienced
significant price fluctuations (Dobbs et al., 2013).
The purpose of this working paper is to build a framework of commodity price volatility and risk
mitigation strategies based on an initial analysis from thirteen case studies. The paper presents
insights to firms’ practices for mitigating commodity price risk that emerged utilizing a grounded
theory approach.
Abbreviated Literature Review
Commodity price volatility (CPV) is the measure for any variation of the price of a commodity
and is typically classified as a type of financial risk (ISO Guide 31.000, 2009; AIRMIC et al.,
2010). This form of risk is influenced by different factors related to purchases markets, demand
(Sodhi et al., 2012; Jüttner, 2005), operations (Cigolini and Rossi, 2009), financial systems and
government policies (Kalari and Power, 2013). However, the literature in Supply Chain Risk
Management (SCRM) is nascent in describing the relationships between commodity price risk
mitigation approaches and supply chain strategies (Choi et al., 2009; Zsidisin et al. 2014).
Transaction costs represent key factors in decision-making processes about when and how to
monitor and mitigate CPV and risk. Transaction costs typically occur when decision makers
search for cost information (about suppliers), take decisions (about purchases) and adopt
mitigation strategies (Wever et al., 2012). Initial theoretical and empirical investigations utilizing
Transaction Cost Economics (TCE) as a foundation focused on organizational structures and
ownership – specifically with regard to determining if vertical integration and ownership
provided greater efficiencies than market transactions (Walker and Weber, 1984; Williamson,
1979). More recent applications of TCE utilize relationships, which reduces the threat of
opportunism, as a surrogate for hierarchical structures (Ellram et al., 2008; Geyskens et al., 2006;
Wever et al, 2012). It is this latter view that we adopt in our study investigating which
commodity price volatility mitigation strategies and approaches are appropriate from a TCE
perspective. Variables germane for grounding commodity price volatility from a TCE perspective
are asset specificity, uncertainty, and transaction frequency.
Commodities are not generally thought to be highly asset specific. However, many different food
groups, such as corn and wheat, are considered commodities and are traded as futures contracts in
the commodity exchange markets, but can also be differentiated depending on characteristics
such as texture or flavor, which subsequently affect the taste of the final product (Klein et al.,
1978). Another manifestation of asset specificity in terms of commodities is associated with the
processing and operating practices of commodity producers. For example, steel processing plants
are capital intensive and have a tendency for continual operations. Depending on the current
prices and perceived balance of demand and supply, steel processing centers have the flexibility
of shutting down their operations, which can either lead to a stockout for firms that purchase steel
from a specific processing center, or significantly increase the total landed costs for acquiring
steel from processing centers located longer distances from the focal firm. Asset specificity may
also be applicable with regard to special processing or systems (as later discussed with
substitution and forward buying, respectively).
The level of uncertainty concerns unanticipated changes in the environment or marketplaces
associated with the transaction. The risk to organizations is their inability to adapt to these
changes in the exchange (Gulati and Singh, 1998; Wever et al., 2012). Williamson (1991)
distinguishes between responses to uncertainty that require a coordinated response by two or
more entities, such as the adoption of new technologies, and issues such as price uncertainty
(akin to commodity price volatility, the focus of our study), in which he argues that each of the
transaction parties can autonomously adapt to these changes. However, some organizations are
not well-equipped to handle or mitigate commodity price volatility, especially when those
changes result in the significant increase of the commodity price.
Transaction frequency has traditionally been operationalized as the overall number of
transactions, whereas more transactions constitute higher transaction costs for firms (Maltz,
1994; Williamson, 1985; Ellram et al. 2008). However, transaction frequency as a construct has
received less attention in empirical studies as compared with asset specificity and uncertainty
(Rindflesch and Heide, 1997; Macher and Richman, 2008). In the case of commodity price
volatility mitigation, the issue of frequency from a TCE perspective may not necessarily be from
how often the transaction is made (Ellram et al., 2008, p. 151). Instead, with regard to commodity
price risk mitigation, the frequency of transactions dimension of TCE may be more appropriately
viewed in terms of how frequently these tools need to be monitored and implemented to rectify
and adjust contracts and processes to mitigate commodity price risk.
Methodology
In order to gain an in-depth understanding of firms’ practices for mitigating commodity price
risk, we adopted a grounded theory approach (Glaser and Strauss, 1967; Strauss and Corbin,
1998). The unit of analysis is the buying firms’ commodity price risk management practices.
Medium-sized and large companies from the U.S. and Europe that purchase a range of
agricultural and industrial raw materials provide a particularly information-rich setting
(Flyvbjerg, 2006) for our study. Our sample includes six medium and seven large-sized
companies, five of them from the U.S. and four each from Germany and Italy. For each of these
case studies we focused the discussion on only one or two key commodity purchases for both
direct commodity purchases, and significant value stream commodity purchases (key
commodities that suppliers purchase).
Preliminary Results
From a TCE perspective, and particularly considering the variables of asset specificity and
transaction frequency (since price uncertainty is the focus of the study and is assumed in the
model), the CPV and risk mitigation strategies can be categorized as indicated in Figure 1. Each
of these will be discussed in depth at the conference, and are briefly reviewed below. A more
complete description of each of these approaches can be found in Zsidisin et al. (2014).
Financial Hedging consists of acquiring futures, options or other derivatives to offset anticipated
future commodity price increases. Firms that engage in this practice utilize financial instruments
solely as a risk management approach, and not as a speculative tool. For example, a case study
firm in the consumer package goods industry has a highly structured decision-making process to
make hedging decisions that determines what level in the organization can make which decisions
about using financial hedging. Several firms participating in this study do not utilize this
technique because of the nature of their purchases or due to the lack of knowledge and experience
with this hedging strategy. This approach is mainly used for high-volume purchases.
One of the primary drivers for financial hedging appears to be associated with established
industry practices. For example, the four companies in the food production industry all use
financial hedging to a significant extent to offset price increases for agricultural products like
coffee, wheat, and corn. These commodities have a rich history of trading in financial markets
and are clearly defined with regard to their specifications and market liquidity.
The firms that engage in financial hedging appear to frequently utilize this tool – for some firms
even on a daily or weekly basis. Likewise, these contracts are very standardized, thereby having a
very low degree of asset specificity, as shown in Figure 1.
Cross Hedging is used to offset price risk with a commodity that has similar price movements in
situations in which no commodity exchange exists or the market liquidity for a commodity’s
financial derivatives is low. However, the use of cross-hedging has specific legal requirements
that must be met in order to implement it as a risk management tool, thereby limiting the extent
to which it is deployed. Among our study participants, only two firms in the food industry are
notably experienced in utilizing cross-hedging. As shown in Figure 1, the utilization of this
commodity price risk approach has a higher degree of asset specificity, since it is usually more
difficult to find highly correlated commodities with regard to price movements, and, at least from
a U.S. perspective, requires additional legal justification and is limited in its application.
Switching Suppliers is also sometimes done to reduce commodity prices. The companies that
engage in supplier switching tend to have long-term agreements in place with suppliers but
flexibility within the contract to shift volumes among these suppliers. All three Italian-based
companies and one US-based firm use this approach. Although they shifted volumes between
suppliers, all four companies emphasized the importance of maintaining long-term relationships
with a limited number of suppliers that can meet their quality and other requirements.
Staggering Contracts by using contracts for different quantities and time periods is another way
to reduce the effects of commodity price volatility. For example, one of the firms in the
packaging industry uses fixed price contracts are that staggered throughout the year with more
contracts locked-in as the product time frame approached. Another firm in the furniture building
industry also staggers its contracts from 30 days to up to almost a year depending upon price
forecasts.
Both switching suppliers and staggering contracts are done on a relatively frequent basis in
managing commodity price volatility, often on a monthly or quarterly basis, depending on prices.
However, this approach does not require a significant degree of asset specificity, since both
approaches are done interchangeably with multiple supply sources and are often easily replicated.
Overall, these two approaches serve to dampen the effects of wild fluctuations over time due to
the timing and quantity of the commodity purchases.
Utilizing Escalator Clauses in contractual agreements with suppliers and customers is the most
common approach for managing commodity price volatility found in this study. Key decisions
that must be made when developing contract clauses include how often the prices are reviewed
and changed, the base cost/price, what the prices will be compared to, if past or future prices will
be changed, and if there is a band in which no adjustment is used. The escalation clause might
relate to commodity price variations; other variations might be based on energy/oil costs or labor
costs. The definitions and weights of the different price components depend on the specific
product, its characteristics and suppliers.
For organizations with many customers or suppliers, the price adjustment process can become
very complex if different customers and/or suppliers have different contract clauses. For
example, some of the case study firms’ customers allow monthly while other use quarterly
adjustments, some use published indices and others use actual prices paid, and some use
surplus/rebates on previous prices, while others change the next period price. Further, typically
changes have to be made manually. Hence, as shown in Figure 1, there appears to be some
variation as to how frequently this approach is exercised in sharing price volatility with
customers and/or suppliers. In addition, there appears to be different levels of complexity and
specificity in creating these contracts, and hence, the range shown in Figure 1.
Forward Buying involves acquiring commodities well in advance of anticipated need during
times when prices are considered very favorable but anticipated to increase in the future. In
addition, for the six firms studied that utilize this strategy, forward buying is almost always
focused on short-term needs, and more often implemented as a method to assure supply
continuity, rather than in response to anticipated price increases. The firms that engage in
forward buying use it selectively, and only for very specific commodities. For example, one of
the firms uses forward buying only when financial hedging or contract agreements cannot be
used. Forward buying consumes working capital, increases carrying costs and has a direct effect
on the balance sheet. In addition, it is largely impractical for perishable commodities. Therefore,
by definition this is a hierarchical approach since the firm takes ownership, and is highly asset
specific since capacities must be established to inventory larger commodity purchases. This
approach is not as frequently executed due to all the additional transaction costs necessary for
implementing a forward buy.
Substituting Commodities concerns the ability of the purchasing firm or supplier to use different
materials in the product based upon the price movements of the commodity itself. Ideally, the
different commodities should be preapproved so that they can be easily switched. However, easy
switching from one commodity to another is often not technically feasible or economically
viable. For example, when sourcing tires for its products, a firm in the equipment manufacturing
industry allows its tire suppliers to switch the percentage mix of styrene butadiene rubber and
natural rubber quantities within strict bounds, based in part on the prices of these commodities.
The actual tire formulation is left up to the suppliers’ discretion as long as they stay within the
agreed-upon specifications. Additional examples include one firm having flexibility in the ratios
of butter and milk powder that are used in its products, and another organization creating the
flexibility to switch between sugar and other types of sweeteners.
In most cases, we found that switching from one commodity to another requires engineering
design and extensive testing to confirm that the product with the new material meets performance
requirements. It is absolutely essential that prior approval is obtained from customers, including
the final consumer, in these types of decisions — and that no detrimental technical effects result
from the substitution. In addition, new equipment and tooling are often needed. For example, one
of the case study firms has been encouraging its customers to switch their products to a resin that
has a more stable price. However, this switch is not a painless one; for one thing, there are some
technical advantages to the current resin relative to the alternative resins. If the resin is switched
on an existing product, new molds are needed. Further, prior to switching, customers have to
conduct tests to confirm that the packages perform to their specifications. All of these factors
result in substitution being classified as having a high degree of asset specificity. Further, once
the formulas or processes have been established for allowing substitution, proactive mitigation of
price risk utilizing this tool is only done when prices fluctuate to the extent where switching
provides financial incentives.
Directed Sourcing is an approach in which an organization enters into contracts with commodity
upstream suppliers for a specific purchase volume and price. With directed sourcing, the
organization’s direct suppliers are then required to purchase their commodities off of this contract
(also referred to as “piggy-back contracts). There are several benefits to this approach. Volumes
can be combined across suppliers so volume discounts can be obtained. In addition, the
purchasing organization knows the actual price that is being paid for the commodity by its direct
suppliers. However, in our study we only found two firms that were using this approach.
Directed sourcing as a price mitigation strategy has a high degree of asset specificity since it
frequently requires a closer relationship and higher degree of trust between the two firms, and
both the buyer and supplier have a need for the same commodity. Once the decision for suppliers
to directly source based on their customer’s contracts is established, there is little need for
actively updating how price risk is mitigated with the supplier, and hence, the frequency of
utilizing this tool is relatively low.
Vertical Integration is an approach in which an organization owns its distribution channels or
production of its raw materials. In our study, only one firm decided to vertically integrate by
bringing the production of raw materials in-house. This was primarily done for supply
availability reasons rather than price volatility, as the raw materials had low profit margins.
However, companies also may choose to buy from vertically integrated suppliers. An advantage
of vertically integrated suppliers is that the supplier is not exposed to direct market pricing for its
raw materials, reducing volatility. Three other firms in our study purchase from some vertically
integrated suppliers, and even then, one of them chose this option primarily for supply assurance
rather than pricing reasons. This approach is very asset specific since it requires ownership.
However, once that ownership is established, there is little need for actively utilizing and
updating this approach.
Conclusion
In this working paper we classified the mitigation strategies for firms to implement given their
exposure to commodity price volatility and its subsequent financial risks to the firm. In addition,
adopting a TCE perspective from case study data of 13 firms in three countries, we classified how
firms can manage commodity price volatility on the basis of market and hierarchical-type
approaches, derived from the degree of asset specificity and frequency of utilization required in
implementing the risk mitigation strategy. Not all price risk mitigation strategies are the same,
and it is our intent with this working paper to begin a dialogue as to which price risk mitigation
strategies are appropriate under various circumstances.
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Figure 1: a TCE Taxonomy of CPV and risk mitigation strategies
Hierarchical
approaches
High
Substitution
Cross Hedging
Vertical
integration
Directed
sourcing
Forward
buying
Asset
specificity
Escalator
clauses
Financial
Hedging
Low
Switching
suppliers and
Staggering
contracts
Market
orientation
High
Low
Frequency