A Piece of Cake: Unwrapping the Financial Risk of Food Products

As the economy grapples with higher prices for almost everything, one can look at this year’s super cycle across all commodities as a significant factor to sticker shock in the food aisles. According to the US Labor Department, in October consumer prices in North America rose by the most in 30 years. But where the consumer sees a food product and thinks: nourishment, treat, value for money, or ‘healthiness’, the food manufacturer’s perspective is much more complex.

Beyond considering the product’s customer appeal, the manufacturer’s thinking must also entail commodity prices and correlations, optimal manufacturing choices and downside margin protection. Or at least it should, if they want to manage risk effectively. Higher raw material and ingredient costs are now taking a bigger bite out of its profit margins, because with increasing competition, there is a limit to passing costs onto the consumer.

Next time you’re strolling the aisles of your  supermarket, take a moment to pick up a packaged item from the shelf and study its ingredients. For a change, look beyond the calorie content and simply add up how many individual ingredients are listed. If the item you’re looking at happens to be a processed product, chances are the list runs a lot longer than you might have expected.

There will likely be a handful of everyday ingredients such as flour, eggs and water, for instance. But there will also probably be mention of many other, less familiar, ingredients. Maybe a pinch of sodium acid pyrophosphate, which helps baked goods rise, but also prevents potatoes from darkening, or a dash of sodium stearoyl lactylate, which helps stabilise emulsions – suspensions of oil in another liquid; think mayonnaise. So far, so good. But now, what if you discovered that the item in your hands had doubled in price from when you last purchased it? You may well put it back on the shelf faster than you could say “partially hydrogenated soybean oil” (a common shortening ingredient).

Risk management

In fact, food manufacturers have only limited ability to pass on increases in the cost of raw materials to the consumer, without pricing themselves out of a competitive market, particularly for non-essential items. The trouble is, over the past decade, episodes of elevated volatility and surging prices have been witnessed in wheat, corn, sugar, cocoa and virtually every raw ingredient used in processed foods, as well as fuel to manufacture and bring the product to market. And don’t forget about the effect crude oil prices have on plastics used for packaging. Ingredient and packaging costs represent 60% to 65% of total cost basket of a branded cake-mix and frozen-meals manufacturer.

Faced with all this, what more can food manufacturers do to protect their bottom lines? And prevent the cost of our favorite goodies from spiking? In fact, they can do quite a lot.

To better explain how a food product looks through the lens of risk management, let’s conduct a simple thought experiment. Consider for a moment that we decided to develop a long-life cake snack product for the mass market. Let’s call it the Chocolate Risk Cake (ingredients list below). How might one begin to get to grips with the financial and operational risks associated with the new product that we have developed? How could a vertically integrated food company with multiple crop-growing, processing and storage facilities, and an in-house fleet of haulage vehicles risk manage the tour de force of confection we have created?

The first point to note is that one can financially model future price uncertainty through a probability distribution – a piece of mathematical machinery that assigns a likelihood to all possible price moves. In this way, the future of each ingredient’s price could, in theory, be modelled. For some of the main (sometimes referred to as macro) ingredients, such as flour, sugar and cocoa, there are established futures and options markets that can convey much about where the market thinks prices are headed.

The majority of the remainder, that is, the micro ingredients which tend to be more expensive per ton, such as stabilisers, preservatives, food dyes etc. can also be modelled with a probability distribution –their prices tend to be less volatile. And that’s only part of the story. Typical raw materials used in packaging such as paper, plastics and aluminium are also subject to (sometimes significant) price volatility. Meanwhile, food processing can be an energy-intensive process and transportation costs for delivery of raw materials or distribution of finished products are highly dependent on fuel prices; energy price volatility is an important factor. And if the product is exported, manufactured or consumed abroad, its profit margin can be dramatically affected by volatile exchange rates and shipping costs.

Complex correlations

So, it can be seen that, in addition to being a mixture of ingredients, our cake can be viewed as a highly complex blend of different risks, each with different price volatilities and with varying correlations to each other. The latter point introduces an important additional layer of complexity we need to consider when modeling prices. Not only is there uncertainty around how the price of individual ingredients, packaging materials and energy will vary in the future, but the way that these prices move in relation to each other is also uncertain.

For example, sugar price moves have historically tended to be fairly correlated with the strength of the US dollar, but in recent years this relationship has broken down as sugar prices have become highly volatile. Prices of commodities are affected by supply-and-demand dynamics. In recent years, rapid economic growth, urbanisation and an emergent middle class in countries such as China, India have driven strong demand. Over the same period, extreme weather, political turmoil, and the global pandemic have led to severe supply issues in key commodities. Clearly, if the food company is able to view the cake as a complex set of risks across the supply chain – from seed to cake snack – then they have the potential to make their operations more efficient and find the right balance between improving profitability and mitigating financial risk.

Predictable options and scenarios

When viewed in this light, business decision-making around the product certainly becomes more rational and, hopefully, more optimal. In the parlance of the financial and energy markets, food companies will start to see that their operations include “real options”– in other words, their ability to make different ingredient and production choices and dimensioning the associated risks can have a real dollar value.

For example, maybe the company has the choice between buying one of the ingredients for future delivery into one location and processing it nearby, or drawing down its inventory from elsewhere and transporting it for processing. Making the ‘right’ decision requires consideration of uncertainty around fuel prices, storage costs, replacement costs, power prices, and logistics, in addition to a view of future commodity price dynamic.

Another scenario could be imagined where processing some of the ingredients for cakes produces by-products whose current market price has surged due to a shortage. Should the company increase its processing operations now to sell off the by-product and profit from this opportunistically, or would this decision likely be a net negative for overall profit, compared with if they stick to their current schedule? Meanwhile, if one ingredient has become much more expensive, does it make sense to find a substitute and adapt manufacturing processes? Interestingly, food manufacturers have in recent years begun to introduce cellulose (aka wood pulp) which can thicken and stabilise foods and subsequently enable the reduction in use of more expensive commodities.

More generally, should a manufacturer hedge out future input commodity price risk with futures or options contracts, or should they wait and buy in the spot market? Why might hedging 100% in a given period not be a good idea? Such complex questions occur at many points across the supply chain. Can they obtain a single version of the truth by bridging the gap between treasury and procurement?

Food companies can only hope to begin to answer such questions if they have a holistic view of risks. In this way they can then begin to identify and unlock hidden value in their supply chain and hopefully improve their management of profit and risk. Good news for price-conscious cake eaters everywhere.

It’s a race to the future for companies, where evolving market demands make change a necessity. Therefore, embracing technology that enables you to adapt at speed sets a company apart from its competitors. Making a chocolate birthday cake should be no surprise. With more than a decade of experience in helping firms in the financial and energy markets monitor and manage highly complex risks, FIS believes commodity-intensive corporates, not just food and beverage companies, but industrial manufactures and consumer packaged goods (CPG) businesses  are in the early stages of adopting a similar risk management paradigm. Evaluating when, what, and how much to hedge going from a reactive stance to a more proactive risk management and ensuring margins are protected and upsides taken advantage of.