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The assessment of the need for risk management strategies progresses in a logical manner from the examination of business practices and requirements for any organization. The progression starts and ends at logical points:

1. Identifying practices that create the risk;
2. Determining if risk is internally or externally generated;
3. Examining if the assumption of risk is a necessary component of the process of creating economic value for the organization;
4. Quantifying the costs and benefits of managing risk and determining if an alternative organization may exist – either supplier or purchaser – that is more efficient at managing risk;
5. Determining if the transfer of price risk management to the supplier or buyer effectuates the transfer of risk;
6. Examining if existing supplier and purchaser contracts are sufficiently structured to ensure that risk management practices are capable of progressing to completion and settlement once initiated (provided that the determination is made to manage risk internally);
7. Once the source, amount and path of risk is sufficiently identified, examining available risk management tools and systems, and determining if they can be applied and economically justified by the organization.

This process of examination should be both focused and comprehensive. Because earnings risk arising from price movement is in existence at the present time, either from supplies or sales, the luxury of waiting for a comprehensive, enterprise-wide risk management solution may not be practical. Instead, an immediate identification of input costs that have wide ranges of value is a priority, especially those with wide ranges over short time periods.

However, it is also important to correlate the variation in price movements to earnings per share (“EPS”) impact. Input costs with high variability do not, a priori, require a price management solution. Only a highly variable input cost that has a negative impact on EPS because output prices are constrained requires an immediate risk management solution.

However, the solution may not have to be internal. If the supplier or the purchaser is willing to contract on a basis that removes the price movement from the organization – by tying the sales revenue to the variation of the input price – then the cost and effort of installing a price risk management system may be unnecessary. The examination of the optimal method for risk transfer, either through contracts or through the use of risk management tools, is an important process step. The internal earnings risk of price movements always arises from a practice where the supply and sales prices do not correlate and do not result in the desired gross margin from sales.

This transfer I am talking about is the transfer of the risk management action that has been taken internally. Outsourcing the process of risk management is a different topic. Please not that outsourcing the risk management decision process if energy is 15% of all costs in company with a 20% gross sales margin means – in essence – a company has outsourced the ability to wipe out all EPS to a non-employee. Volatility Managers is a firm believer that advice may be critical, execution can be helpful but the decision authority must be internal.

Another important point of examination is the earnings impact of price movements. In some industries, adverse input price movements are rapidly transferred to purchasers, where on the other hand beneficial price movements are less rapidly transferred to purchasers. This situation leads to a positive expected value from price movements, and price risk management actions would be counterproductive to earnings. In this example, the assumption of risk is a necessary component of earnings creation.

If a price risk is identified to have a negative earnings impact and it is not transferable to a supplier or purchaser, either due to unwillingness of other parties to assume that risk or due to a need to retain the risk, then the cost of risk management must be examined. If the maximum potential risk is $0.01 per share and the ongoing cost of risk management is $0.50 per share, then a rational decision would be not to implement a risk management program. The only justification for pursuing internal risk management is that it provides an adequate economic benefit to the organization. The cost of risk management must reduce the range of EPS results to an extent greater than the EPS cost of the internal risk management effort.

Once the decision is made that implementing a risk management program is economically justified, the ability must be secured to transfer the results of those practices to the organization’s customers. The use of risk management practices reduces the ability of customers to receive economic benefits from the beneficial movement in the organization’s purchase prices. In other words, if price risk management is implemented, the customer will not receive some or all of the benefit of price movement when general market purchase prices go down. If the customer has the economic and legal leverage to require the organization to pass through those economic advantages – even though, due to the risk management actions, the organization is incurring losses by doing so – the price risk management will actually increase the negative EPS expectations of price movements.

Stated another way, if sales contracts are either not enforceable or inaccurate, price risk management actions will, in the long run, have a greater negative impact on EPS than the decision not to implement a risk management program. This is a critical point of clarity in the process.

An examination of appropriate risk management tools and processes, decision systems, risk quantification methodologies, and control structures should be performed only if price risk management is determined to be economically rational and commercially viable for the organization. The “what” of risk management is less important than a rigorous examination of the economic rationales and justifications of price risk management.

Comments or questions regarding this article can be directed to value@volatilitymanagement.com.