Reducing energy and commodity costs

Many manufacturers are too busy filling orders and focusing on sales to analyze their energy bills—at least to any great depth. But certain aspects of energy charges shouldn’t be overlooked as all too often, they lead to over-payment and a lag on the bottom line. Check out some of the most common over-payment scenarios below, and proven strategies to uncover savings.

Billing errors: Whether you have purchase agreements in place or are paying spot rates for electricity or natural gas, there’s always the chance of being overbilled. Utilities and suppliers typically use sophisticated billing systems that rely on manual input from employees, so the systems can be error prone.

Solution: The good news is with a little homework and a careful eye, you can detect the error. The utility or supplier is often happy to reimburse you the overpayment. We once found a billing error in Ontario that resulted in a $400,000 credit. The customer is still enjoying the ongoing cost savings, amounting to more than $1.6 million so far.

Over-hedging: The most common reason manufacturers overspend on energy is hedging. They assume the next one to five years usage will be the same as the current year, thereby taking too aggressive of a position against a particular commodity. Sounds more like gambling than risk management.

The idea makes sense—fix your price because energy prices always increase right? Not during the past five years, though these markets trade hourly and fundamentally reflect supply and demand curves.

In fact, energy prices for electricity and natural gas have decreased 50 percent since 2009. You can’t blame the recession but you can blame advances in technology and an increase in supply, which are fundamentals you can track.

If you contracted to buy 100 percent of your volume for a two-year term, that’s an aggressive commitment and you essentially need demand to outpace supply consistently for two years for that position to be in-the-money. The approach is more like a bet, not effective risk management.

Solution: It’s more strategic to incorporate current market conditions, an understanding of future fundamentals and forecasted future consumption. Rule number one and two: never fix 100 percent of your volume, and unless it’s the greatest price ever, never commit for longer than a year.

Commodities must be managed proactively, not reactively. If prices start to increase and you want to manage your risk, it’s already too late. You might consider a two to three-month partial coverage product, because the market will likely correct itself but you don’t want to be stuck with a high long-term contract rate.

You need to monitor the market daily and assess any situation that may cause prices to increase in the future. If you see an opportunity, don’t wait. Jump on for a short term, such as three to six months. And while you’re enjoying your proactive position, continue to monitor to either add to your position or put something in place for when your position expires.

Advice: Another common source of overspending is advice. Unfortunately, the quality of your advice can affect the company’s overall profitability. Most companies spend so much money on these commodities there’s none left to hire employees qualified to manage them.

Any commodity such as industrial gases, petroleum products, electricity, natural gas, and propane need executive-level attention because there’s so much overpayment today that it often has a significant impact on a company’s profits or losses.

Typically, a middle manager sources all the information and brings a strategy to the executive for signature. The problem is the individual’s main source of information and advice is often suppliers. But suppliers are compensated based on how much of a particular commodity is sold. Therefore, they often advise fixing 100 percent over two to five years.

Plus, the salesman likely adds a few pennies to the commodity for himself. Since the recession, we’ve seen an increase in the number of sales positions with a small base salary and high commission. So in short, companies often have an unqualified individual receiving advice from a sales person on how to buy millions of dollars worth of energy. The sales person is compensated on volume and term. By design, they can only make a living by tacking on to the underlying fair market value.

Solution: Nowadays, we’re seeing companies join the fad of driving profit by becoming more efficient and cutting costs. It sounds easy but efficiencies require training and attention. Respect must be given to the volatility of commodities and employees must be properly trained and have access to appropriate resources to make informed decisions.

When dealing with commodities there’s always a lowest cost/best quality option. In order to compete in the current business landscape your staff must understand how these commodity markets work and how to spot opportunities.

If you don’t know where to start, hire outside consultants and have them add value and accurate information to the mix. Information is power and your employees will have the tools they need to spot savings such as a $400,000 credit and $1,200,000 future cost avoidance.

Murray Sheehan is senior director of North American Commodity Consultants Group Inc. in Whitby, Ont. He can be reached at (416) 333-6012 or via email. For more information visit www.naccgroup.com

This article is part of the Financial Management Success Centre, which showcases leading strategies for cost control and preservation of working capital in manufacturing.