In a previous article, we discussed the importance of having a margin management plan and how it can benefit a producer by establishing a roadmap to help you get where you are trying to go. We receive many questions on how to put this plan together and what should go into it so that opportunities can be captured to protect attractive levels of profitability. While every business will be different in how they want to approach this, there are certain features in common that all margin management plans should incorporate.
Components of a Margin Management Plan
First, a margin management plan should state in simple terms what the business is trying to accomplish with their approach. This may be what some would refer to as a mission statement, and may read something like this: “We strive to maximize profitability in our business, and limit the impact of volatility on our returns over time.” We like to think of this as a top-down approach, starting with an executive directive that strategically defines a goal then methodically spells out how that goal will be accomplished and carried out. If the goal is trying to maximize profit margins, a starting point may be to define a level of profitability that is acceptable. This may be a specific return on investment, dollar figure, or percentile of historical profitability. Whatever the goal, we first need to define it so we have a target to shoot at.
Next, we have to establish how to monitor opportunities so that we know when a target has been achieved. In order to do this, we need to construct a model that accurately represents our business and takes into consideration all of the unique costs, revenues and other factors in our operation. Once we have refined that model so that it captures the present state of our operation as it exists today, it then must be maintained and updated as we move forward in time to incorporate any changes that will impact our forward profitability. This gets us to the next point which is defining who will be responsible for maintaining the model to make sure that it accurately reflects our forward opportunities.
All margin management plans should specifically define the roles and responsibilities of those individuals within the organization who will be carrying out the plan. This may be as few as a couple such as a husband and wife in a family business, or as diverse as a whole team in a large company with specialized roles. In either case, strong communication will be necessary to assure that the plan is being carried out as envisioned. A good discipline to foster strong communication is determining a set time to review and discuss the plan on a regular basis. This will help assure that all of those involved with the process are kept informed on how the plan is being executed and how everyone’s individual contributions to the process are being coordinated.
A margin management plan should also define all the methods that will be used to contract for both purchases and sales, as well as a means to track these such that coverage of both inputs and outputs are kept in balance. This is a complex process that also will vary a great deal from one business to another. For starters, all the various contracting means should be spelled out along with what parties will be contracted with. If for example the company will be using exchange-traded derivatives as part of their margin management plan, who will they execute these strategies with? Moreover, what are the capital requirements of various positions they may use and where will this capital come from? It may be necessary for instance to engage a lender and obtain a line of credit specifically for hedging forward margin opportunities. How far forward in time will margin opportunities be identified and what percentage of production will be contracted? All of these considerations may help refine the types of strategies and contracts a business will use depending on the level of capital available to allocate to the effort.
Once the strategies to be used have been identified, it then becomes necessary to determine how they will be employed in executing the margin management plan. Perhaps for example a business will choose to scale into coverage at incrementally higher historical margin percentiles as opportunities present themselves. They may also elect to make adjustments over time to positions previously contracted as margins and/or prices change. What events might trigger these adjustments? A margin management plan can help spell out the more granular details of this strategy execution. At a minimum though, a basic component of any margin management plan should clearly state under what conditions positions will be both initiated and offset to help ensure the integrity of the contracting process. Finally, like any business plan, a margin management policy should be evaluated periodically to make sure it remains relevant to the goals and objectives of the business in addition to the roles of those of those involved with it. We have certainly seen that those operations with clearly defined plans get the most out of the margin management approach.