Rising cost of raw materials — forging strategies to address its impact
Volatile and unstable global markets have widespread implications for manufacturing organizations. From rising energy costs to unexpected fluctuations in raw material costs, unforeseen obstacles are destabilizing supply chains and making it difficult for manufacturers to remain in the black. With supplies of many raw materials becoming harder to secure, commodity price volatility may not be just a temporary phenomenon, and it is up to manufacturers to either absorb additional costs, find new ways to mitigate the expenses, or pass price increases along to customers who are already reluctant to spend.
Organizations that resort to a policy of waiting for processes to normalize are setting themselves up for inevitable failure, while those that adapt and adjust to new market conditions grow stronger and more profitable. Manufacturers must move from today’s linear economy, where they mine, manufacture, use and throw away, towards a more ‘circular economy’, where one industry’s waste becomes another’s raw material. Collaboration with suppliers and customers can keep used products, components and materials in circulation, while new business models that rethink ownership can shift value along such a supply circle. For instance, some companies have even begun to pioneer new business models that enable them to retain ownership of the materials used in the products they sell. By following a systematic approach that focuses attention on resources throughout the value chain, manufacturers can exploit a broader landscape of opportunity than they initially thought possible.
Depletion or ebb-and-flow?
The panorama of the world’s geological and ecological resources is a tale of two centuries. The unparalleled economic growth of the 1900s, facilitated by near boundless access to natural materials, has reaped stinging consequences in the first decade of the new millennium.
Scientists may debate whether inflection points have been reached but, undeniably, the future will not be one of unlimited access to water and energy, abundant agricultural and mineral inputs, unfettered emissions, nor unconstrained manufacturing waste. It’s now fifty years since President John F Kennedy’s assassination, but his vision serves as a reminder that history can be forged; similarly, trends – even megatrends – are not pre-ordained but can be shaped and indeed capitalized upon. It is incumbent upon business leaders to take prescient action to future-proof shareholder value for their companies. This task is inextricably linked to, and illustrated by, the cost impact of raw material inputs. As such, this makes the issue both a pressing current concern as well as a longer-term imperative.
Rising raw material costs – fact or fiction?
Averages – across categories and time frames – can mask significant deviations and can appear to temper the real impact of price shifts. Consider non-food agricultural materials: on average, across seven inputs, raw material prices have increased by 117% since 2000.1 This is approximately 6% per annum, which does not appear precarious. However, manufacturing industries using rubber will have been massively impacted by an increase of 359% since 2000, whilst cotton spiked alarmingly in the first quarter of 2013.
The nominal price increase of steel, up 167% since the turn of the century, is notable given its knock-on effect within a range of industries such as Construction, Automotive, and Transport. Among thirteen indexed metals and minerals, steel has actually risen marginally below the average; copper, for example, increased by the equivalent of 13% per annum. This has had ramifications for the generation and transmission of power, as 60% of copper’s application is in electrical wiring and cabling.
The cost of electrical power, of course, is of direct relevance to every industry and every company. But probably the starkest proof-point of escalating raw material costs is the energy sector – across crude oil, natural gas, coal, and uranium, nominal prices have surged 10% per annum, or more than 2.5 times their 2000 prices. The crux is that commodity prices are reflecting close correlation with energy costs – in particular oil.2 Agricultural commodities such as corn, wheat and beef now have extremely close correlative coefficients to oil and this link is also evident for steel and timber.
Unambiguously, resources comprise a consequential component of input costs to other resources. A logical illustration is that energy comprises 25% of the cost of steel; similarly, steel is estimated to account for 30% of the capital cost of new oil exploration projects.3 Extrapolated further, a 10% energy cost hike can be causally linked with a 5-6% increase in fertilizer inputs for agriculture, a 4-5% increase in extractive costs for precious metals, and 1% for non-food raw materials. This inter-relationship also means that volatility in just one resource component will trigger fluctuations in others. Thus, irrespective of industry sector or company-specific circumstance, raw material price escalations are a daunting reality.
Understanding the background
Assessing the drivers of the resources ‘super-cycle’
Some analysts argue that raw material costs have surged as part of an overall, extended commodities cost cycle. They point to the 2008-2009 drops in commodity prices, caused by the financial crisis, as evidence that market forces will ultimately see raw material costs stabilizing. Others assert that this assessment fails to properly merge the socio-economic causes within the context of fundamental shifts in the world’s environment.
Environmental scientists, climatologists, and the range of other scientific experts involved, have collated a profusion of evidence that mankind is approaching the limits of the earth’s carrying capacity.4 This is manifesting in ways which will profoundly affect business – right down to a basic operational issue such as raw material availability, and thus its cost. For example, population growth and economic development provide spurs and opportunities for business, especially as they relate to massive developing nations like China, India, and Brazil. But increased global trade, urbanization, transport requirements and energy needs translate to further pressure on finite abiotic resources, whilst biotic resources are threatened in compound ways such as overfishing, biodiversity loss from deforestation, and water and environmental degradation due to chemical pollution. These issues cannot be seen as divorced from business; they supersede financial market forces, and they are unprecedented in the history of the world’s economic development.
The United Nations Environmental Program (UNEP) GEO-5 Report 2013 succinctly phrases the issue: “The current economic system, built on the idea of perpetual growth, sits uneasily within an ecological system that is bound by biophysical limits.”
Grasping the implications
Planning for future resource scarcity
Among midsized US manufacturers, over 90% rated raw material costs as a top-3 concern for 2013.5 But concern is one thing; planning for action requires deeper assessment and projection over a 5-10 year horizon, and then beyond.
In two resource categories there is a reasonable prospect of cost stabilization. Firstly, in the case of energy, the last decade has seen major expansion in US shale gas production and new hydraulic fracturing technologies. To an extent this has capped energy costs in the North American region. However, North America’s share of estimated undiscovered global oil and gas reserves is just 10%, and there are political and social obstacles to furthering discoveries in areas such as the Arctic and South America.6 Biofuels substitution – although impacting negatively on agriculture – could play some role in widening energy supply options, but with global energy demand envisaged to increase by over one-third by 2035, and a swing away from nuclear power in important industrial countries such as Germany and Japan, a projection of minimal power cost escalations may not be realistic.
Secondly, hopes for decelerating raw material cost inputs for metals and minerals hinge, in part, upon geological assessments. These are optimistic inasmuch as they relate purely to existing and untapped resources. For example, iron ore – the main component of steel – is estimated at 500 years remaining global supply, and is diversified in terms of geographic availability.7 However, increasing complexities in the extraction of these resources means that geological availability is not the only variable: soaring exploration costs, labor price hikes related to global skills shortages, relationships between governments and mining companies, and transportation are just some difficulties in bringing these raw materials into supply. Aware of these intricacies, the European Automobile Manufacturers Association (ACEA) recently warned its members to anticipate ongoing resource cost spikes, and recommended holistic raw material risk analysis and technological innovation to hedge against what it termed the ‘oligopoly’ of the metals and minerals supply chain.
The future supply of agricultural raw material inputs, food and non-food, is the most clear-cut. Apart from climate change effects, and population growth impacts upon demand and arable land availability, the key factor is decelerating yields. Research and investment into agriculture and aquaculture techniques has stalled, and the last decade has seen slow transfer of best practice methods into developing countries. This draws a clear line to significant and ongoing supply-side risks.
Managing the volatility – towards a greener economy
Business leaders need to formulate a two-pronged strategy to counter what is evidentially a new regime of commodity- and resource-cost volatility and escalations: short-term mitigation of risk, and a longer term sustainability vision. To an extent the short term actions are easier, because they involve working capital protection, cost control, and the bottom line – challenges which companies constantly face. Broad measures should include the following:
Financial modelling of all raw material inputs
This should incorporate detailed cost tracking, projections under various scenarios, and risk analytics. Procurement departments need to become agile and adept within the full gambit of derivative instruments. This will facilitate widest possible hedging opportunities.
In-depth supply chain interrogation
One area of focus should be on the proximity to raw material sources and their value-to-sustainability quotient. Upstream investment should be considered if corporate finances and capital permit, as a means to ongoing access to a crucial raw material input. An imperative, too, is the investment in waste minimization technologies and programs. These will generate compelling cost savings after modest payback periods.8
Ensure measurability for the foundations of sustainability, and target immediate improvements
The lexicon of financial reporting is shifting to embrace wider valuation techniques. Issues such as carbon emissions, water and energy efficiency, and chemical waste management are vital for reputation management – but they also demonstrably affect the bottom line.9
However, it is increasingly evident that the world’s leading companies are those that remain ahead of the sustainability curve.10 These organizations use the following brushstroke guidelines to leverage current competitive advantage including, by default, mitigation of risk relating to the inelasticity of raw material supplies:
- The company’s sustainability vision must be embraced as a Board directive
Targets, metrics and accountability must be mandated.
- A business case should be examined for sustainable products
Companies need to extend R&D and innovations into areas such as recyclables, re-engineered product life cycles, and new products that meet consumer (or industry) demands for ‘green as the new normal’.
- Partnerships and collaborations are key
Long-term and demonstrably fair agreements with governments can create policy frameworks amenable to smooth supply opportunities – the mining industry being one obvious example. Cooperation with competitors can assist in stabilized raw material sourcing and cost efficiencies throughout the raw material-to-end-user continuum.
Is it feasible to decouple economic growth from natural resource use?
Based on current trends, in less than 20 years the world will need between 40% and 50% more energy, water and food. In this scenario, concerted and ongoing pressures on the availability and prices of raw material and energy inputs are inevitable.
In September 1962, referring to the lunar mission, President Kennedy expressed the nature of the problem as such: “We choose to go to the moon… and do other things, not because they are easy but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone …”
Business leaders need to embrace the spirit of this vision and adopt stewardship measures towards a greener economy. It’s not yet five minutes before midnight, but the ecological clock is ticking down.
1 World Bank, International Monetary Fund, UN Comtrade, as tracked by McKinsey Global Institute MGI Resource Index 2013
2 Pearson’s correlation coefficient. Source: IMF, OECD FOA of the United Nations, MGI Commodities Index
3 McKinsey Global Institute: “Resource Revolution – tracking global commodity markets”, 9/2013, p8
4 UNEP: GEO-5 for Business: “Impacts of a Changing Environment on the Corporate Sector”, 2013
5 Prime Advantage consortium of midsized US manufacturers in 25 industries. Survey conducted 2013
6 US Department of Interior report “Assessment of Potential Additions to Conventional Oil and Gas Resources of the World”, 2012
7 BHP Billiton report “Mineral Deposits and Their Global Strategic Supply”, 2011
8 Hewlett Packard 2009 financial results as reported in Accenture case study “Sustainability as a Competitive Advantage.”
10 Unilever 2010-2011 as reported in UNEP report “The Business Case for the Green Economy”, 2012