Why rising commodity prices increase pressure on labor costs

Over the past year I’ve noticed a significant increase in calls from manufacturers and distributors whose products are primarily composed of primary metals. They are telling me that they really need to focus on their operational labor costs.

This was a bit of a change as normally these types of manufacturers have very low levels of labor compared to the cost of materials in their products. They are typically interested in talking to me about administrative efficiencies and compliance with company policy and government regulation. I’m talking about manufacturers who forge, stamp, extrude and cast their products.

At first blush it would seem that rising commodity prices would be a good thing, manufacturers and distributors can pass them down the supply chain and if they are fortunate they might even increase their profits. When you read about gas prices going up, the message of increased profits at oil companies always rises to the top of the media headlines.

As I listened to these manufacturer’s stories however, it became clear why the increased interest in actively managing their workforce was rising as fast as their raw material costs.

When gas prices rise we have choices, we can drive less, carpool or take public transportation. As food prices rise we trade down on brands or substitute hotdogs for steak. We have choices when our wallets can’t absorb the price increase.

Unfortunately for the consumers of metal products there aren’t many economical substitute products. They have spent many hours and dollars engineering these products into their own products and services and are fairly locked in. In many cases both the manufacturers and their customers have contracts that fix the price of their products down through the supply chain. So when prices rise, the entire supply chain feels the pinch. Unlike food or gas, there are very few substitute products or services that can lower a particular company’s costs. Aside from pushing back on the manufacturer, customers are left with two choices. They can absorb the higher prices and reduce their profits or they can look to see if they can source a similar product through another company.

One might question the viability of finding a similar product at a lower cost when the entire industry’s costs are rising. But the reality is that different manufacturers of the same products, even using the same equipment with the same debt levels do have different costs and resulting prices.

Savvy manufacturers know this is good news. It opens up an opportunity for them to attract new customers. Loyalties fade fast when profits start drying up. These manufacturers also know that everyone is scraping for every penny so it’s important to not only price aggressively but to also have the underlying cost structure to maintain their own profitability.

Getting the pricing right is challenging. Should they value their products based on the current market value of the raw materials or at the price they purchased those raw materials (probably lower)? It may seem tempting to delay re-valuing the inventory, but this sword is double-edged and cuts hard the other way when prices start falling. Secondly, exactly what part of the product cost is comprised of material? There are still labor and overhead costs. During this new customer feeding frenzy, inaccurate costs might increase revenues, but also eliminate profits.

The second challenge is ensuring the company’s cost structure is competitive in the market. Customers are doing some heavy price comparison and products are viewed through a commodity lens like never before. If a company isn’t as efficient as their competitors, everyone soon knows it with a result being reduced revenue or lower profits.

So what can a company do? Some will try to hedge the price of their raw materials so price change is less of a factor in their business. But for all the Southwest stories (the airline that effectively hedged fuels prices and won increased business and profits) there are many more untold stories of hedge strategies that left more money in someone else’s pockets than their own.

The second strategy is the one I’m discussing with companies, and it goes as follows:

  1. Labor is the most controllable cost in the product. Identify waste in your workforce and eliminate it. This doesn’t mean lost jobs because in this environment the opportunity to increase revenues with a lower cost product through new customers will keep those people at work.
  2. Understand your labor costs very accurately. It’s relatively easy to know the material cost in a product. But do you know exactly how many hours were spent on this product in both direct and indirect labor? How about the hourly rate or if they were overtime hours? How about total delivered costs from engineering through distribution? Knowing this will allow a company to cost and price products accurately, ensuring it wins profitable business and walks away from unprofitable deals.
  3. Shrink inventories. Don’t stuff the supply chain with inventory exposing the company to price swings. Management will spend too much time trying to deal with the impact of rising and falling commodity prices rather than focusing on adding value to their customers. Shortened lead times and increased employee agility will decrease the need for raw materials, WIP and finished goods. This strategy will help win business no matter what raw material prices are doing.

It’s always exciting when a market heats up and companies get to compete for new customers. It becomes fun when you have competitive cost advantage.

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