Pressure building from ingredient price swings

by L. Joshua Sosland
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A spike in sugar prices to 30-year highs was highlighted on the cover of the Nov. 9 issue of this magazine, detailing the impact of weakness in the U.S. dollar, concerns over availability in the current year and uncertainty about prospects for the 2011 U.S. beet crop because of a ban on planting of bioengineered seed.

The situation in sugar headlines what increasingly has become a difficult situation for food processing companies. Hardly an exception, sugar is one of but a number of important ingredients that have seen prices move sharply higher in the past several weeks. Particularly notable has been the rally in corn and soy complex futures prices reflecting successive U.S. Department of Agriculture production reports estimating crops smaller than anticipated in the trade. As a result, the most recent stocks-to-use ratio for corn in 2010-11 was projected at a paltry 6.2%, down from 9.8% as recently as August and from 13.1% in 2009-10. It would be the smallest stocks-to-use ratio in recent history (5% in 1995-96). With prospects for an extremely tight carryover, corn futures prices have surged, peaking recently above $6 a bushel for the December contract, up from just above $4.50 in late August. Trading has been extremely volatile.

To really understand the pressures facing food processing companies, it may be instructive to look at the indexes published in this magazine for a wide range of food products. Since June alone, costs for the ingredients going into vanilla ice cream are up 13%, mayonnaise up 35%, white bread up 57% and cake donuts up 58%.

The latest surge creates something of a collision course with food retailer efforts to keep a lid on food prices. Throughout 2010, food manufacturers have been squeezed by retailers and competitors, reflecting intensifying consumer efforts to demonstrate thrift, a reluctance to raise prices so soon after a major run-up in 2007-08 and heightened efforts among food companies to avoid surrendering market share to competitors.

That retailers are so intent to keep prices competitive is hardly a surprise. Recent data indicate price as the leading influence determining where consumers choose to shop.

At some point, though, food prices must realistically reflect input costs. Profit margins for most food products are slim to begin with, and while ingredient costs may not account for a large portion of a finished good price, they almost always account for a major share of the profit margin. When ingredient costs move higher, profits often fall sharply or disappear.

Additionally, ingredients hardly represent the only cost moving higher for food manufacturers. Health care cost increases for 2010 are estimated at 10%, and crude oil prices also have risen 10% (while natural gas prices have declined).

Making analysis of the price situation especially confounding is that most ingredient prices remain below the extraordinary highs reached in 2007-08. Still, more meaningful is that recent prices are up sharply from five-year averages. Bread ingredient costs are up 10% from the five-year average, saltine cracker ingredients are up 29%, pork sausage ingredients are up 32% and chocolate bar ingredients are up 75%.

The latest cost surge ought to prompt serious introspection for any company that continues operate without comprehensive risk management policies. Of course, no food company ever gains full protection from rising prices. As the adage goes, “all good hedges come to an end.” But plenty of tools are available from ingredient suppliers and others to protect against price volatility. Using these tools adds a cost that ingredient buyers traditionally have resisted, particularly during extended periods in which commodity/ingredient markets have shown little volatility. Buyers need to move beyond this reluctance. The latest price swings show the spike in volatility two years earlier was not a short-lived aberration and must not be ignored.

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