In my last post, I talked about basics of Index based costing model in 2024.Today, I want to build on the basics and introduce a concept used in financial trading/hedging industry.
The concept is to combine Options (Call/Put) with Index based costing models in Procurement especially while buying Raw Material Commodities or their derivative products (i.e steel, copper, crude or products where these commodities influence more than 60% of the price)
Limitations of Future contracts and Spot contracts!
- Both are equivalent to taking a “bet” on the market movement.
- You are locked in and have to execute the contract (favourable or unfavourable).
- Index based costing model is better than spot as it factors in all the market related pricing model but there is no price protection for buyer as well as seller.
Welcome, Options (Call and Put)
- At Supernegotiate we think Index based pricing can go either ways. It works in Buyer’s favour if the market is trending downwards, however, it can quickly escalate and backfire in a volatile market.
- One powerful approach could be combining index-based pricing with price collars - a tactic that links contract pricing to market indices while establishing protected minimum and maximum price boundaries.
- In simple terms,
A “put” option allows you to set a floor price.
A “call” option allows you to set a ceiling price.
When you combine the two options together, it create a “collar”.
- So, PURCHASING PUT options AND SELLING CALL option protects both downside and upside of price movement.
- Purchasing put options to set a floor price, while Selling call options sets a maximum ceiling price.
Lets see an example:
We need to purchase 10,000 tons of steel over the next year.
Steel currently trading at CNY 3,500/ton but prices are volatile.
We can structure a pricing collar by:
- Buying put options at $2,500/ton
- Selling call options at $4,500/ton
- This hedge would ensure our maximum purchase price is $4,500/ton by capping the upside.
But more importantly, Seller is also protected if prices crash, with a price floor locked in at $2,500/ton.
- The premiums paid for the put options would be offset by premiums received from selling the call options.
You may ask, why fix the downside (i.e $2,500).
I think you need a good relationship with suppliers in order to establish a long term Index based costing model. Hence, it is extremely important for you to de-risk the supplier side as well. Otherwise, the model will fall apart in an event where supplier has to bear a significant loss.
As a Procurement manager in 2024, You will have to find an optimum balance between various costing models.
A suggestion:
1) 40% volumes: Spot Market Purchases
2) 40% volumes: Index based long terms contracts
3) 20% volumes: Index based + Pricing collar based long term contracts
Thoughts?
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