Manage commodity risk or perish: Choices before MSMEs
Micro, Small & Medium Enterprises (MSMEs) silently contribute to the reduction of income inequalities across the world. As on 14 July 2024, there are about 27.4 million MSME units registered, employing about 180 million individuals, contributing to about one-third of India’s gross domestic product – some 40 per cent of India’s manufacturing gross value added and about 45 per cent of its exports. Ever since Covid-19 hit the world, MSMEs are relentlessly navigating a volatile, uncertain, complex and ambiguous business environment.
The already challenged MSMEs have been facing heightened volatility in commodity prices during the last five years, coupled with foreign exchange rate fluctuations and supply chain disruptions. The world’s commitment to net-zero targets is creating shifts away from commodities that pollute to those which facilitate achieving the target. Programmed approaches to shift from the use of polluting fuels to greener fuels is widely discussed and visible across the world. All these trends point to transitional uncertainties to the world economy and price fluctuations of significant primary commodities, such as fuel, agriculture produce, minerals and basic metals.
Commodity price risk
Commodity risk arises when any enterprise mines, refines or produces primary commodities; or uses them as raw materials for their final products; or stocks them in any form for trading. Though MSMEs can differ in terms of the quantum of risk they bear, fluctuations of commodity prices are going to impact them. Fluctuating commodity prices does not allow businesses to plan their activities, set their prices, forecast their sales volumes and budget their costs.
The Wholesale Price Index of primary commodities and manufactured products (which consume these primary commodities as raw materials) have been showing a disturbing trend since 2019. While the primary commodities’ monthly price fluctuations range between -15 per cent and 15 per cent, the manufactured prices vary only between -2 per cent and 2 per cent. This conveys the difficulty of passing on the price fluctuations in the raw materials to the final products.
Fluctuating commodity prices can put any organisation to risk, when there is considerable time lag between the date of order and date of receipt of stock of commodity (on procurement side), when the enterprises hold inventory in anticipation of demand, when the enterprises adhere to a convention of flexibility in choosing the pricing date other than the date of deal fixation (on the sales side), or when the markets conventionally do not encourage long-term fixed price contracts with staggered deliveries.
The MSMEs
A majority of MSMEs (in terms of proportion), undertakes jobs that are outsourced by the major players, or deliver project-related contracts, or offer generic products and services catering to the local or regional markets in India. A minority of them has its own branded or non-branded unique products, which it offers directly in the B2B segment, enjoying an original equipment manufacturer (OEM) status, or export to the world.
Being small and nimble makes them agile to shift gears of business when needed, without hurting many stakeholders and creating negative externalities. However, this agility can translate into advantage only when the entrepreneurs have the vision, and their employees have the necessary skill-set to adapt to the changing trends.
The following significant commodity price-related vulnerabilities were identified by the authors, based on a pan-India research project they had undertaken. The field research involved personal interviews of large number of promoters and senior management personnel of large corporates and MSMEs entities, commodity traders, free-lance consultants, leaders of industry associations and promotion councils, covering 17 states of India.
MSMEs may be small, but they can think big, MSMEs may be vulnerable, but they are the strength of any economy
Vulnerabilities to commodity risk
• MSMEs can neither fully pass on the commodity price fluctuations to their customers, nor negotiate price variation clauses, due to insignificant value addition to their final product.
• MSMEs have neither the liquid cash nor generous lines of bank lending, to stock more commodities when the prices are low to capture the following price appreciation.
• MSMEs operate with thin margins, their profits get hurt when commodity prices go up by 5 per cent unexpectedly. Most of the times, they undertake fixed price orders based on average historical prices given by large corporate customers, without having stock of raw materials. Further, they are unable to negotiate fixed price contracts with their suppliers.
• MSMEs lack expertise, time and interest to monitor and forecast the prices of commodities beyond one month. Many of the MSMEs do not believe in futures prices and forecasting. Many consider it as not their business to have a view about future prices.
Therefore, they avoid taking long-term contracts with staggered delivery from large companies from India or Importers. Therefore, it is often a matter of time before MSMEs lose their market share to other suppliers who can give long term fixed price contracts.
• MSMEs depend a lot on short-term financing. Any sudden change in the commodity prices affect their net residual cashflows. Demanding repayment schedules of these short-term financing creates an eternal vicious circle of borrowing and repaying, ultimately leading to distress.
• MSMEs often prefer cash-based transactions and informal arrangements to buy the commodities in the recycled markets to remain discreet. When the prices of commodities move against them, the suppliers either do not deliver or demand higher prices.
Considering their meagre profit margins, and inability to pass the risks to downstream players, MSMEs should believe that professional risk management not only protects them but it creates sustainable long-term value
Best practices
• Monitor spot and future commodity prices by referring to price quotes of commodity exchanges regularly, and hedge when there is likely uncertainty.
• Focus on productivity, quality, and innovation, to develop new value-added products and develop the pricing power with higher margins and create possibilities to cross subsidise between customers or products.
• Shift the price risk by asking the large-sized customers to provide commodity raw materials and agree to just execute value addition part of the order.
• Consciously visualise the next one-year sales orders, to time the purchase of inventory and also to maintain inventory.
• Refer to futures prices quoted by commodity exchanges for pricing to customers. It is better than completely leaving things to rigid historical faiths and myths.
• Practice complete hedging using exchange traded futures contracts to begin with. Once the business is stabilised and commodity price fluctuations are understood, then consider selective hedging.
• Consider adoption of digital transactions to build a record of financial transactions that facilitates lending by channels other than Banks.
• Educate a critical group of staff members – involved with procurement, production, and marketing and finance – on commodity price risks, their management and prediction of commodity prices to sensitise the importance of it.
• Hedge and not speculate on commodity prices.
Though MSMEs can differ in terms of the quantum of risk they bear, fluctuations of commodity prices are going to impact them
Wake-up call
Testing times don’t last forever. However, only those who survive the storm reach the coast. Considering their meagre profit margins, and inability to pass the risks to downstream players, MSMEs should believe that professional risk management not only protects them but it creates sustainable long-term value.
India is poised to experience significant economic growth in the coming decade and the world is ready to partner with it. India is aiming to be the third largest economy of the world by 2030 and Forbes says it could be as early by 2027 itself. If India becomes the world’s growth engine, other economies of the world need to engage with it through collaborations on various fronts.
MSMEs should capture this opportunity and collectively bargain for an enabling environment to be a part of this prosperous journey. MSMEs may be small, but they can think big, MSMEs may be vulnerable, but they are the strength of any economy. MSMEs may face financial hardships, but they still create value for their partners. MSMEs need to internalise these thoughts and act.
The authors are professors at ICFAI Business School (IBS), Hyderabad