It is amazing to think how much technology has changed the way we do things.
On a recent trip to Denver with my wife, we relied heavily on our smart phone’s navigation app to get us around and find directions to various places we were visiting. I think back to the time I would have packed a road atlas for a similar trip, although unfortunately it would not have told me about real-time traffic conditions or allowed me to punch in a specific business or address and navigate to it from my “current location.” Many of you reading this can probably identify with how navigation applications have changed the way we travel and move around. The purpose of any road map is to help us find the best way to get from point A to point B, and this also applies to managing profitability.
In considering how a business exposed to variable input costs and revenue value can manage their profitability over time, the idea of having some sort of road map or plan can help bring clarity to this challenge. Just as a map can help make sense of road configurations to aid travel efficiency, so too can an objective approach to marketing which helps one navigate the various contracting alternatives available to manage input costs and revenue values. On a map, you might look at your destination and consider several possible roads you could take to help you get to where you need to go. In a similar way, you might consider all of the various contracting alternatives that exist to protect both input costs and sales prices.
Just as a modern navigation app might help you prioritize different travel options to minimize travel time, distance, limit tolls, etc., you might also find it useful to have an objective way to look at your contracting alternatives when you look at managing forward profit margins. How can you begin to sort or prioritize what contracting alternatives to use in managing forward costs and revenues? One way to start is to look at your overall profit margin from a historical perspective, and rank it in terms of where it exists within this context. Over a specific range of time for instance, you can observe what the strongest and weakest margins were for this period and determine where the current margin ranks within this historical range.
This will give you an objective measure of how good the current opportunity is for that particular time period which can begin to direct contracting choices. Let’s say for example that the current forward profit margin opportunity exists at the 90th percentile of the previous 10 years. What this means is that 10% of the time the profit margin has been stronger than the current value within the past 10 years, and 90% of the time it has been weaker. By extension, this also implies that the perceived risk that the profit margin will deteriorate over time is probably 9 times the perceived opportunity that it will continue to improve from current levels.
As an alternative, let’s assume that the projected forward profit margin instead is at the 50th percentile of the previous 10 years. This implies that half the time the margin has been stronger than the current projection over the past 10 years and half the time it has been weaker. From this perspective, the perceived risk and opportunity are equally balanced – there is about a 50-50 chance that things will either get better or worse than where they stand today.
The two scenarios just laid out suggest two very different contracting alternatives when I begin to consider the various ways I can protect my input costs and sales revenue. If I am not looking at the risk this way, I may be inclined to guess on when it may be optimal to secure my input costs independent on when I should lock in a sale price to secure my revenue. This might be akin to driving by “feel” and trying to guess which road might be faster in heading towards a destination without regard for other considerations like what traffic might be like on a connecting road or how a certain route might take me out of my way.
By approaching my risk from a margin perspective and looking at margins within an objective, historical context, I can begin to prioritize what types of contracting alternatives I may want to use in order to protect my profitability. As an example, with profit margins at the 90th percentile I might want to lock in those margins to secure my forward profitability. Alternatively, with only average margins, I might want to use a more flexible set of contracting alternatives to help protect my forward profitability while retaining the opportunity for the margin to eventually improve.
What this begins to get at is developing an organized, methodical plan. We believe it is critical to establish goals and objectives in helping to refine the decision making process, and this all starts with a clearly defined plan. What is an acceptable return for my operation? How much risk am I willing to accept in trying to achieve this return? How much capital do I have access to that can assist me with margin management strategies to protect forward profitability?
These are some of the questions that come up in drafting what we refer to as a margin management policy that clearly spells out what the goals and objectives are, and how we intend to achieve them. This does not have to be overly complicated, but serves as a roadmap for determining where we want to go and how we plan on getting there. Just as you might plan a driving trip and consider all the possible roads or routes that can bring you to your destination, you might similarly lay out all of the different marketing tools at your disposal to protect both input costs and sales revenue. This might include an array of cash market contracting alternatives such as forwards, hedge-to-arrives, basis contracts, min/max combinations, etc. It might also include derivative alternatives including exchange-traded futures and options.
What are the features of these various contracts? What are their costs and limitations? When might I choose to use one alternative over another? This is where some of those initial questions come back into play such as how much risk I am willing to accept or how much access to capital I have to allocate to the process. A more refined approach to marketing starts to present itself when certain alternatives can be eliminated which may not fit with my tolerance for risk or level of capitalization. What about my goals and objectives? Perhaps I can define forward profit margin levels that represent returns for my operation which are attractive based upon the investment that I have in the business. What if I could set targets that trigger alerts telling me when this level of projected profitability has been achieved in a forward time period?
I might consider in advance what types of strategies or positions I would elect to use in the market to protect my forward profitability should an opportunity present itself, such that I was ready to take action once that event occurred. What I am describing is the process of crafting this margin management policy so that the decision making becomes objective and clearly defined. While a margin management plan cannot promise that you will “hit the highs” or “catch the lows,” it can bring a lot more structure and objectivity to the decision-making process.
It can even become quite granular and sophisticated, spelling out what types of strategies to use on each piece of the margin depending on what levels of historical profitability are on the table for instance, or under what circumstances those strategies may be adjusted over time. Regardless of how simple or complex the plan is though, one major benefit of having it in place is to remove the natural emotion that comes into play when faced with making key financial decisions for your business. You put a lot of care and attention into your operation. Similar attention should be paid to how you are securing forward profitability to continue operating successfully into the future.