Automotive companies operate in a highly competitive and volatile industry susceptible to fluctuating input costs. These costs, including raw materials, can significantly impact automotive manufacturers’ profitability and cash flow. There are several tools that an automotive procurement manager or risk manager can use to determine the extent of the risk embedded in production costs. This article will explore why automotive companies may consider hedging their input costs as a risk management strategy and the steps needed to create a risk management process.
Input costs for electric vehicles (EVs) differ from combustion engine vehicles, due to battery technology, maintenance and repair, residual value and charging infrastructure. While EVs tend to have lower fuel costs and reduced maintenance needs, the upfront cost of purchasing an EV may be higher, mainly attributed to battery technology. These input cost differences may change as the EV market evolves and technological advancements accelerate.
Material costs in the automotive industry, such as steel, aluminum, lithium, cobalt and nickel, are subject to price volatility influenced by global economic factors, market demand, geopolitical issues and other unpredictable forces. By hedging their price risk, automotive companies can protect themselves against sudden price spikes or prolonged periods of elevated costs. This mechanism helps stabilize profit margins and allows for better planning and budgeting.
Commodity hedging allows automotive companies to predict their budget more efficiently, which is crucial for long-term strategic planning and decision-making. By locking in prices for essential inputs, auto manufacturers can accurately forecast production costs, set competitive prices for their vehicles, and avoid sudden financial shocks. This plan helps improve business performance and offers a competitive advantage in a dynamic marketplace.
Get your copy of this special 35-page report that breaks down the complex topic of price risk management, offering insights into the historical and projected volatility of the materials used in the production of automotives, and illuminating their price interplay.
Global supply chains in the automotive industry are vulnerable to disruptions caused by natural disasters, political conflicts, labor strikes, or unexpected events like the Covid-19 pandemic. By hedging input costs, automotive companies can mitigate the price risk of a supply chain disruption on manufacturing costs. This risk mitigation process can help create a competitive advantage, maintain customer satisfaction and protect revenue streams.
A risk management strategy can give automotive companies a competitive edge by improving their profitability. Effective hedging mechanisms help manage expenses, optimize procurement strategies and stabilize pricing. With controlled input costs, manufacturers can offer competitive prices to consumers, invest in research and development and allocate resources for innovation and product improvement.
Financial stability is a significant factor for investors when assessing the viability of automotive companies. A robust risk management strategy can demonstrate that a company has taken proactive measures to manage risks and protect its financial position. When management uses a risk management strategy, their efforts can instill confidence in investors, establish credibility and enhance the perception of the company’s ability to navigate uncertainties in the market.
Automotive companies often face pressure from stakeholders, including investors, customers, suppliers and regulatory bodies, to ensure sustainability and responsible business practices. Hedging input costs can contribute to a more sustainable and accountable approach, as it helps mitigate financial risks, ensures the stability of operations and supports long-term business viability.
There are a few steps to design a risk mitigation plan.
Step one: Risk measurement
Price risk measurement refers to assessing and quantifying the potential volatility or variability in the prices of commodity input costs. It involves analyzing the potential fluctuations in prices and understanding the associated risks.
Various methods and tools are used for price risk measurement, including statistical analysis, historical data analysis and mathematical models. The objective is to estimate the potential losses or gains that may arise from price movements and assess the risk exposure level.
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Step two: Preparing for action
Once you have measured your input costs risks, you can set up your operations to accommodate your risk management program. You likely need to consider:
Step three: Risk management
Once your risk mitigation operation is set up, you can start considering the appropriate financial products that you should use to hedge your risk exposure. An appropriate strategy would be to match your future physical procurement with financial derivatives that will mitigate the variability of these physical prices. Automakers can use financial derivatives such as exchange-traded futures and options contracts and over-the-counter swaps and options to hedge price risks.
In an industry as complex and competitive as the automotive sector, hedging input costs is a prudent risk management strategy for automobile companies. By mitigating price volatility, ensuring cost predictability, safeguarding against supply chain disruptions and enhancing profitability, input cost hedging provides essential benefits that strengthen automotive manufacturers’ financial stability and resilience. Embracing effective hedging practices helps companies adapt to market changes, improve planning and secure their position in the global automotive industry.
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