Given the broad based surge in commodity prices recently, maintaining profitability has emerged as a major challenge for the corporate, especially for the SMEs, who generally grapple with the problem of rigid end product price. Further, when the raw material prices become volatile, managing the business process in a cost effective manner becomes difficult for the small scale enterprises that usually lack the bargaining power as compared to large corporate. Even the cluster studies conducted by Dun and Bradstreet have revealed that fluctuating raw material prices is one of the major challenges faced by the SME?s across clusters. SMEs can resort to a number of strategies to mitigate the risk of fluctuating prices, some of which are discussed in the article.
Given the broad-based surge in commodity prices recently, maintaining profitability has emerged as a major challenge for the corporate, especially SMEs, who generally grapple with the problem of rigid end product price. Further, when raw material prices become volatile, managing the business process cost-effectively becomes difficult for the small-scale enterprises that usually lack the bargaining power compared to large corporates. Cluster studies conducted by Dun and Bradstreet have revealed that fluctuating raw material prices is a major challenge faced by SMEs across clusters. However, SMEs can adopt several strategies to mitigate the risk of fluctuating prices.
When raw material prices rise, a viable option before the SMEs to keep their profit margin is to reduce the operating cost. The operating cost can be reduced by cutting down the employee cost, automating the production process, selling or leasing out the less efficient machines, and the like.
SMEs can also mitigate the impact of price volatility by improving the efficiency of supply chains, substituting costly raw material components with lesser expensive varieties, cutting down on general and administrative cost, and automating the production mechanism to get an edge over manually-run competitors. Companies that have an edge in the market pass on the price rise to its consumers or end users. A handful of companies hedge in the commodity market, using futures and option contracts to minimise the risk linked to volatility.
During the time of volatile raw material prices, SMEs can look for alternative vendors to source raw materials cheaper. Managing the supply chain and reducing the cost could even help them to maintain their margins. Where an intermediary is involved in the supply of raw materials, direct sourcing can be explored. Sourcing from a nearby vendor would help reduce the cost of logistics. SMEs can also look at importing the raw material through an overseas vendor, if prices are cheaper.
SMEs usually require working capital to mitigate the risk of price rise. Inflationary pressure usually increases the credit repayment period of their clients. Hence, SMEs require working capital financing.
Government initiatives play a key role when raw material prices continue to rise. The government should ideally fix a price range across industries, beyond which it will have to provide subsidy to these SMEs. Government can relax the tax and other charges associated with the purchase of raw material across industries and across clusters during times of volatile raw material prices.
Government can also decrease the tax involved in the end product, which will compensate for the increase in raw material prices.
To mitigate the risk of price rise SMEs can enter into long-term contracts with the suppliers. The contracts are usually for one year or more. Through this contract, SMEs protect themselves from the rise in input prices. However, the raw material supplier usually agrees on the contract if the purchases are of a larger size, which is generally not the case for the small companies. Hence, there can be an intra- or inter-cluster integration among companies across industries using a similar kind of raw material. This will enhance the bargaining power of SMEs with the supplier.
The most feasible solution to mitigate the risk of price rise is that companies should integrate across industries located in various clusters. They can share their resources available and mitigate the risk of price rise. A better understanding of the market dynamics will enable these SMEs to formulate better strategies of mitigating risks.
The writer is senior economist, Dun & Bradstreet India