Sewing up lower costs from falling commodity prices

In the past year the prices of many commodities—including cotton and oil—have fallen 30 to 50 percent. That should be good news for most apparel and footwear companies, since these are key raw materials for the production of yarns and the synthetic rubbers used in footwear. Companies are asking themselves how these price falls will translate into cost reductions from their suppliers, and how fast that will happen.

The basic estimates look promising. In a typical, mid-priced knit garment, raw cotton represents around 50 to 60 percent of the total cost of cotton yarns, yarn accounts for about 60 percent of fabric, and fabric for about 50 to 60 percent of the cost of a finished garment. Therefore, given the 30 percent drop in the price of raw cotton in the past year (Exhibit), a buyer might expect a 5 to 7 percent drop in apparel cost, depending on the complexity of the garment. The picture is similar in synthetics, with the price of PET¹ dropping around 25 percent between March 2014 and February 2015.

Few apparel and footwear companies have captured significant commodity-related savings from their suppliers, however. Some companies don’t have a structured process in place to ask for supplier cost reductions when commodity prices fall; others don’t know what cost reduction to ask for when they do. Of those that do ask, many receive small reductions of 1 to 2 percent from some suppliers, while others receive no savings at all.

When pressed to offer commodity-related cost reductions, suppliers may argue that the effects of raw material prices on their own costs have been smaller than estimated, have been diluted by other players in the value chain, or have yet to trickle through to them. (In practice, changes in cotton yarn prices typically lag commodity prices by one to three months.) Without a deep understanding of the whole value chain and such facts at their fingertips, companies find it very hard to counter these points.

To claw back the full savings potential offered by commodity price drops, companies need to develop a detailed picture of the end-to-end value chains of their products, and of the way input cost fluctuations percolate through that chain. That is a complex business, requiring an understanding of the underlying chemistry of key raw materials, the structure of the industries that produce those materials, and the evolution of supply and demand over time. The sidebar below (“From oil to polyester”) describes some of the complexities surrounding the production of PET, one of the most important apparel inputs. A similarly complex value chain exists for many important polymers used in the footwear industry, like EVA (ethylene-vinyl acetate), PU (polyurethane) and SBR (styrene-butadiene rubber).

From oil to polyester

While most apparel companies understand the cotton value chain relatively well, the value chain for polyester is often more of an enigma. Polyester fiber is made from PET (polyethylene terephthalate) that has been melted and spun. PET, in turn is made of two materials: Purified terephthalic acid (PTA) and mono ethylene glycol (MEG). Both these materials are made from oil, and their price tracks the oil price. MEG can also be made from natural gas, but since the marginal producers, especially in East Asia, currently use oil as a feedstock, the MEG price tends to follow the oil price rather than that of gas.

Analysis of the value chain shows that when oil was at $100 per barrel, it constituted approximately 50 percent of the cost of PET. If oil prices stay around $50 per barrel, PET prices should remain around 25 percent lower than last year. Moreover, overcapacity in the industry means the PET market is highly competitive and prices are set by the marginal producer, resulting in price declines over the past ten years. Thanks largely to overcapacity in China, the PET industry is currently running at only 66 percent of its full utilization. With demand projected to grow at 3 percent a year, overcapacity is likely to continue to keep prices down. Together these factors suggest that polyester prices will stay low at least until the end of 2015.

Companies that have taken such a fact-based and structured approach to supplier negotiations in the response to commodity price changes have been able to capture savings of 4 to 6 percent from their suppliers in a wide range of categories. One large apparel retailer did this by building a “rapid response system” based on detailed analysis of the effect of commodity price changes on the costs of different yarn and fabric types. Significant swings triggered assertive communications with its suppliers, asking for price adjustments within 30 days. The company was able to support subsequent negotiations with the data from its analyses.

The bigger picture

Beyond the specific opportunities related to a better understanding of commodity price effects, a procurement approach built on a deeper understanding of the whole value chain has the potential to offer more than just quick wins. It can also help the industry meet some of its most enduring challenges. For a decade or more, apparel companies have been fighting rising costs, driven by increasing labor, raw material and energy prices, as well as compliance costs in Asia. Their main weapon in this war against inflation has been to move production to lower cost countries and regions. But this strategy has many drawbacks: Supply chains must be reconfigured, and companies need to expend time and effort ensuring new suppliers meet the required standards of quality and environmental and social responsibility. Worse, by focusing so much on where their products are manufactured, these companies may not be paying enough attention to how they are made—and to the opportunities to reduce costs, manage risk and improve efficiency in their existing value chains.
There is also a significant opportunity for the apparel sector to make use of procurement best practices from other sectors. For example, the automotive and electronics industries for years have used advanced sourcing approaches such as Design to Value (DTV) teardowns, cleansheet “should cost” modeling and supplier collaboration. We will show in subsequent articles how these approaches can be adapted for apparel and footwear companies, and how leading players have driven 10 to 20 percent savings through their use.

Source: http://www.mckinsey.com/insights/operations/sewing_up_lower_costs_from_falling_commodity_prices

Golden acres: Why Kansas and Somerset farmers should toast the Chinese

FARMERS tend to be a gloomy lot. “Worse than last year, better than next” is their characteristic response when asked about economic conditions. But they should be a bit more cheerful at the moment. American farmland values have doubled since 1990 in real terms; on the same basis British farmland prices are up by 135% over the past decade.

Even more remarkably, farmland prices have been much more resilient than residential and commercial property values in the wake of the credit crunch. British prices are more than 15% above their early-2008 levels.

In a way this is rather odd. Economists agree that this is the worst crisis since the second world war; there has been talk of another Depression. Yet farm values have held up much better than they did in the 1930s or even in the 1980s, when prices fell by around a third in real terms as commodity prices dropped and the Federal Reserve used high interest rates to squeeze inflation out of the system.

The Federal Reserve Bank of Kansas City, situated in the heart of America’s farm country, concluded earlier this year that the surge in farmland prices had been driven by a combination of low interest rates and high commodity prices.

In the past low rates would probably have been accompanied by low commodity prices. After all, central banks usually cut interest rates in response to weak demand and low inflation. In this cycle, however, there is a contrast between weak demand in the developed world and booming demand in emerging markets. American and European consumers are no longer price-setters for commodities. They are price-takers.

Though this is bad for consumers, whose wage rises are lagging prices, it is good news for farmers. They can also thank Asian central banks for helping to keep interest rates low in rich countries as they recycle their foreign-exchange reserves into government bonds. The next time American and British farmers raise a glass of moonshine (or scrumpy), they should toast the Chinese.

But has the boom gone too far? Robert Shiller, a Yale economist who has presciently issued warnings about overpriced equities and houses, has already suggested that farmland might be the subject of the next bubble. In an article on the Project Syndicate website last March, Mr Shiller wrote that “there has been no increase in the supply of farmland, and the stories that would support a contagion of enthusiasm for it are in place, just as they were in the 1970s in the US, when a similar food-price scare generated the century’s only farmland bubble.”

Farmland has been a decent, if not outstanding, long-term investment. Since the Department of Agriculture first conducted a census in 1850, the value of farmland has risen at an annual rate of 3.4%. Since 1967 the annual rise has averaged 6.2%, according to David Ranson at Wainwright Economics, a consultancy. In real terms American farm prices have risen by 150% over the past century.

That gain has substantially outpaced food prices, a process that has accelerated over the past 20 years. What is also significant about the more recent increase is that prices have outstripped rents. In Britain the rental yield on arable land fell from 3.4% in the second half of 2003 to 1.75% in the first half of 2011, according to the Royal Institution of Chartered Surveyors. In America the Kansas Fed says that prices have risen by 40% since 2004; rents are up by just 17%.

That suggests there is a speculative element to the boom, with financial investors regarding farmland as a bet on higher commodity prices or as a hedge against more general inflation. Mr Ranson says that relative to the bullion price, American farmland has cost around 2.4 ounces of gold per acre on average since 1919. Halfway through this year, the ratio was just 1.6 ounces per acre. But that may not necessarily mean that farmland is cheap; it may simply be that gold is expensive.

The dangers of a reversal are acute. Farmers normally respond to higher food prices by planting more crops. If corn (maize) prices return to more “normal” levels as a result, the Kansas Fed warns that farm prices could fall by 20%. And if the future is Japanese-style stagnation, there will be no demand for a hedge against inflation. Worse still would be a combination of a return to higher levels of interest rates combined with a decline in crop prices. That could push down farmland values by half, a recipe for ruin for those who have borrowed against the value of their property. Farmers may yet have reason to be glum again.

Source: http://www.economist.com/node/21534791