We explain specific advanced tools and practices for dealing with demand-supply uncertainty, including probable forecasting, capacity and consumption commitment contracts, real options as risk mitigation strategies, and hedging strategies.
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This is Part Two of a three-part series. In Part One, we looked at indicators of volatility and introduced a framework for mitigating risk in high-uncertainty scenarios. Here in Part Two, we look at specific tools for dealing with uncertainty in demand and supply. The series is organized as follows:
The traditional approach for allocating demand-supply mismatch risk is blunt. Typically, suppliers take all of the fixed cost risk and may take much of the variable cost risk, while buyers take all of the capacity shortage risk. The fixed cost of putting capacity in place is factored into the per-unit cost by the supplier. If the forecasted demand doesn't materialize, the supplier is usually left with few options but to eat their investment.1 If demand is well above forecast and the supplier cannot fulfill demand, the buyer is left scrambling, losing business and market share in the meantime. The supplier loses during downturns and the buyer loses during upturns. Probability forecasting, capacity and consumption commitment contracts, real options, and hedging provide some means of mitigating these risks to an extent. In the past, these have been viewed as rather esoteric practices only for a few advanced companies. In the age of uncertainty, companies who master these techniques may develop competitive advantages and financially justify the investments in these tools.
Figure 1 – Probability Forecast
The most common type of forecast is the traditional ‘point forecast’, which provides a single point number to predict demand (e.g., we will sell 104 widgets next quarter). In contrast, ‘probability forecasts’ are constructed as probability curves rather than single points (see sidebar Figure 1). They express how much uncertainty there is in the forecast and enable planning for a range of scenarios, instead of planning for just a single scenario.
Most forecasting packages can only handle point forecasts. Range forecasts are a simpler alternative to probability forecasts that can work with traditional forecasting systems, although with somewhat less information than the probability curve gives. A range forecast has a high, middle, and low range of possible demand, estimated to be within a certain confidence level (e.g., 90%).
Psychologists have found that people tend to underestimate uncertainty, and so intuitive estimates usually yield distribution curves that are too narrow.2 More accurate distribution curves result by calculating the probability curves based on historical demand variability and factoring in known potential events that have an impact on demand. The latter (factoring in potential events or impacts) is critical in times of high volatility. Probability forecasts are more realistic, capture more useful information, and are less "brittle" than point forecasts, allowing planning for the possibilities of low and high ends of the range.
Capacity and Consumption Commitment Contracts
Providing a probability forecast to a supplier doesn’t have much meaning unless both the buyer and sellers are sharing the upside and downside risks.3 Capacity and consumption commitment (3C) contracts help mitigate upside and downside demand risks by explicit quantification and commitments to sharing of risks, via things like availability guarantees and fixed cost risk sharing (usually through a combination of upfront payments and purchase commitments). A typical 3C contract might include:
At the low-end range of the forecast—price discounts on firm, non-cancelable, earlier commitments, for consumption of quantities that the buyer considers to be nearly certain;
At the high-end of demand scenarios— pre-purchased capacity options or capacity availability guarantees for higher quantities, in exchange for a higher price, enforced by supplier penalties, sufficiently large to make compliance likely in the face of significant capacity constraints; and
Within the boundaries of forecasted demand ranges—lead-time guarantees, enforced by supplier penalties for non-performance.
Figure 2 - Conceptual Example of 3C contract (Simplified)
Developing and using 3C contracts involves:
creating a range or probability forecast;
analyzing, negotiating, and agreeing to specific terms for different ranges of the demand forecast, and (optionally) capacity options;
executing and purchasing off the contract; and
periodic re-evaluation, adjustments, and extensions to the contract (this is important, since conditions always change).
3C contracts are proactive and help both sides be more prepared. Being very explicit in the contract forces both sides to plan for uncertainty across a range of demand scenarios, and make the tradeoffs proactively, before demand ups and downs hit. Suppliers get clearer planning information for capacity, prices tied to flexibility, and firm commitments. The buyer, by making financial commitments, takes the forecast much more seriously and tries to accurately predict the level of uncertainty and the range of demand scenarios. In exchange, they are able to commit to less upfront while in essence buying an option to hedge against upside demand risks. Because there are actual financial commitments, suppliers get more reliable and complete upfront information so they can be prepared for a range of potential demand scenarios.
Both sides will think seriously about capacity guarantees provided by the supplier—the supplier must quantify the cost and risks they are taking, while the buyer quantifies the value to them of these capacity guarantees. Conversely, the supplier will think about the value to them of consumption guarantees from the buyer. It reduces the risk to the supplier in making capital commitments and reduces the risk to the buyer of being caught without needed capacity/supply.
Ironically, having more structure in relationships gives more flexibility to trading partners and reduces risks. In times of increasing demand and limited capacity scenarios, 3C contracts bring more predictability to allocation, allow smaller players to secure their share, and give suppliers earlier warning signals to build more capacity. The result is fewer lost sales in upturns and lower liabilities in downturns.
Designing these contracts and coming up with the right numbers is not an easy task, and results are sometimes counter-intuitive. Technology can help in evaluation, management, and execution of 3C contracts. In the negotiation process, the buyer may give the supplier a range of contract possibilities. Systems can quantify the business impact of different terms and build portfolios of 3C contracts to meet specific business objectives. In addition, systems can help in making decisions about how to optimally use options within the contract and identify the best way to perform against commitments over time, with evolving business conditions. Some of these systems can craft almost any kind of "insurance policy" —from high deductible to high premium—against risks of significant changes to lead time, allocation, price, etc., tailored to a company’s specific business objectives and market position.
3C contracts provide the ability to efficiently and effectively respond to changing events by proactively putting the right resources and incentives in place ahead of time. As with any new way of doing things, 3C contracts and risk management initiatives are often met with resistance in the organization. One of the key success factors will be selling the concepts and value to the organization, focusing initially on a few commodities to get some early successes, payback, and momentum.
Real Options as Risk Mitigation Strategies
What is a Real Option?
Real options are simply embedding flexibility (choices or options for the future) in your decisions and investments. People implement real options every day without knowing it—but usually without rigorous calculation of the value of the real option. Real options include things like second sourcing, adding production capacity to meet possible surges in demand, designing a workforce with ability to flex the number of shifts and/or overtime, designing flexible configurability into products, building plants that can produce a range of different goods to match demand, and lining up outsourced capacity. All of these provide some additional options (flexibility) that can be exercised at some point in the future, usually with some incremental option cost today and some "exercise price" in the future. Formal techniques for calculating the value of various real options are not worth the effort for most of these decisions but can be very useful for some quantifiable key decisions. It is particularly useful in placing a value on various options within a 3C contract.
Informed negotiations about and optimum use of 3C contracts leverages real option techniques, a different way of thinking about forecasts and constraints. Real option thinking and techniques are also useful for developing risk management strategies by modeling and evaluating alternative "what-if" scenarios and hedging strategies.4
What-if models can be run for various plausible scenarios, allowing sourcing and production to hedge against the upside and downside probabilities. What-if scenarios require Decision Support Systems (DSS) tools that are sophisticated enough to model the key constraints of your production and sourcing environment and help pinpoint the bottlenecks, so that appropriate hedging strategies can be developed—such as should we invest in adding another line to our plant or look for a subcontractor that could give us that capacity. The effort to run alternate scenarios makes more sense for mid-term planning than for tactical planning, in which the level of detail required makes it not worth the effort. The rigor of calculating the value of real options can help planners understand the true value of building flexibility into processes, plants, product designs, supply chains, and labor forces.
There are many different ways a company can hedge to minimize losses across a wide variety of circumstances. The 3C contracts mentioned earlier is an example of a hedge. Done with proper diligence and intelligence, hedges can provide cost-effective protection against uncertainty.
An Example Approach to Hedging
One CPG company has a sophisticated hedging strategy for managing supply price risks for a wide variety of commodities such as natural gas, coffee, electricity, pulp/paper, etc. They use a combination of traditional approaches—knowing supply markets well and tracking the fundamentals—along with treasury instruments for mitigating currency and interest rates. They have a four-person organization with expertise in treasury to manage currency risk, and in procurement to understand what is going on with the commodities across the company and manage that risk. There is synergy in combining these two disciplines. Having treasury and purchasing working together instead of arguing about who should call the shots is a good practice.
The firm has preferred ways of hedging. Their priorities provide some examples and insight into the basic approaches available:
Customer surcharges—Their first choice is to have contracts with their customers that enable them to pass on the commoditypricefluctuations. However, some retailers, Walmart for example, refuse to accept that risk.
Supplier Price Guarantees—If the customer will not agree to a surcharge, their second choice is to get price protection or price guarantees in the supply contract. But it is important in that case to ensure that the suppliers can support those price guarantees (see below: Price Guarantees Should Be Vetted for Viability).
Hedging Instruments—When price guarantees are not possible or adequate, their third choice is buying hedging instruments on the financial markets. For agricultural commodities such as coffee and bean oil, they can use normal futures options. If necessary, they will negotiate an over-the-counter instrument (see below: Over-the-counter Derivatives).
Price Guarantees Should Be Vetted for Viability
This CPG company will only ask suppliers to include price guarantees in contracts if they are confident that the supplier can financially support the guarantee for a period of time. It is important to understand how the supplier is able to offer the price guarantee. If the supplier is vertically integrated, with their own sources of raw materials, they may be insulated from raw material fluctuations. Alternatively, the supplier may purchase hedging instruments in the open market. But absent either of those, the supplier is exposed, and may not have the financial resources required to absorb big increases in raw material prices. This CPG firm learned its lesson the hard way when natural gas prices increased dramatically for a period of time (as we are seeing again now, especially in Europe). Some of their distributors hadn’t purchased hedging instruments and as a result went bankrupt, at which point the price guarantees were worthless. Since then, this company’s buyers require suppliers to hedge their price guarantees and show how many months out they’ve hedged.
Figure 3 - Natural Gas Prices in Europe Are 4X Normal and More Than 10X Early 2020 Prices
Derivative financial instruments are used to hedge risks, such as interest rate risk, foreign exchange risk, and commodity risks. Accounting for these derivative instruments is covered by FASB rules in the US and IFRS standards in some other countries. Changes to the market value of derivatives can cause significant P&L volatility. This P&L volatility can be mitigated using hedge accounting to provide an offset to the market movement of the derivative. However, hedge accounting requires a large amount of compliance work documenting the hedge relationship and proving that it is effective. For more on hedge accounting rules, see FASB Accounting Standards Update No. 2017-12 (aka ASU 2017-12) and IFRS 9.
When exchange-traded derivatives are not available for hedging a particular commodity, companies may opt to buy an over-the-counter (OTC) derivative, which is a contract negotiated directly between two parties, without going through an exchange or other intermediary. Products such as swaps and forward rate agreements are usually traded this way. There is an industry standard over-the-counter base instrument for hedging, created by the ISDA (International Swaps and Derivatives Association).5
OTC derivatives may be paid for upfront, or their cost may be built into the price the buyer pays for a commodity (such as paying a premium in exchange for a guaranteed price). In either case, the buyer should look at the total cost and risk involved, to determine if it is worth the level of price risk mitigation they are buying.
These derivatives can have a big impact on P&L, unless hedge accounting is used. But hedge accounting carries its own set of compliance issues and challenges. See sidebar “Hedge Accounting” for some details on this. The sourcing person does not need to be the expert in these intricacies but should learn enough to intelligently participate in the decision-making about the best hedging strategy.
It is important to understand the derivative you are buying, so that you can make sure it is doing the intended job, i.e., intelligently hedging against changes to commodity prices or exchange rates. Companies get into trouble when they trade in derivatives they don’t understand.6
Currency Exchange Rate Hedging & Natural Hedging
In addition to hedging against commodity price increases, companies may need to hedge against exchange rate fluctuations. Without a hedge, the impact of changes to exchange rates is equivalent to a change in the price of the commodity, component, or product being bought or sold in that currency. One approach taken by many companies is natural hedging. The concept is pretty simple. Companies match their revenues made in a particular currency against their costs in that same currency. This way they only have to worry about hedging the difference between revenues vs. costs, since that is their true exposure. The rest is covered by the “natural hedge” inherent in those transactions.7
There are several reasons that companies may want to use natural hedges. Derivatives can be expensive if overused. In addition, complying with hedge accounting can be burdensome, although not quite as onerous recently as in the past. Natural hedges allow a corporation to reduce their use of derivative contracts, while achieving their risk reduction goals.
The use of natural hedges is enabled by the centralization of treasury operations in multinational firms. Centralized data on inter-company and third-party transactions across the various countries in which a company does business allows the enterprise to understand how transactions in one currency offset those in another, and thereby create natural hedges.
In summary, hedging is an increasingly important part of overall risk management. Hedging is all about balance—not too much, not too little, not too long, not too short. For those kinds of judgment calls, it is best for hedging strategy to be formulated by a cross-functional team that includes treasury, product, and market expertise.
In Part Three of this series, we will look at strategies for achieving supply chain resilience including: mapping out your multi-tier supply chain; monitoring events around the world for early warning of events that will impact your supply chain; supply chain finance’s role in creating resilience; and building adaptability into physical infrastructure, systems, processes, and people.
1 For custom components, the supplier may renegotiate with the buyer, but usually with an unsatisfactory result for both parties. -- Return to article text above
2 A wider and more accurate range can result by creating range forecasts for various drivers (economy, product features, competition, etc.) and combining them together, provided the drivers’ forecasts are accurate and the means of combining is understood. -- Return to article text above
3 Without a 3C (Capacity and Consumption Commitment) contract, the buyer is tempted to expand the range of probabilities to get free flexibility. Some companies don't bother sharing the probability forecast, because the necessary demand information is communicated via the 3C contract, stated in the concrete terms of what the buyer is willing to pay for and commit to. -- Return to article text above 4 There is an International Real Options Conference that takes place every year. -- Return to article text above 5 See http://www.isda.org for more information. The ISDA created these standards in part in response to the debacles in the mid-90s over derivatives bought from Bankers Trust and others by Orange County, P&G and others. Some of those deals were essentially highly leveraged gambles on interest rates. -- Return to article text above 6 Buying derivatives for commodities that your company doesn’t actually use is not hedging—that is speculation. -- Return to article text above 7 Things are a bit more complicated for the internal financial metrics when there are multiple P&L centers involved—i.e., where one P&L center may be doing all the selling while the other is doing all the buying in that currency—but the natural hedge still works out for the overall corporate P&L. -- Return to article text above
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