How Businesses Can Hedge Against Increasing Inflation
Inflation is on the rise. According to a recent Economic News Release from the U.S. Bureau of Labor Statistics (BLS), the Producer Price Index for final demand grew by 1 percent in March. February saw “final demand prices” grow by 0.5 percent; and January’s final demand prices increased by 1.3.
According to BLS, the Producer Price Index (PPI) consists of many indicators and evaluates the mean difference over a period of time for the “selling prices received by domestic producers of goods and services.” In other words, PPI is a way to gauge how much manufacturers and similar businesses face in increased costs due to inflation.
This inflation gauge takes a broad survey of approximately 10,000 unique manufactured items and the amount of inflation businesses face. The BLS’ PPI measure looks at items produced by fisheries, food growers, miners, manufacturers, etc. It also includes 72 percent of production of the service sector, as the 2007 Economic Census found.
Hedging with Futures
One way to reduce risk is by hedging. A popular example is with futures contracts. Much like buying an insurance policy, futures contracts can reduce the impact of a negative event, such as a spike in commodity prices.
If a company is worried about the price of oil for their planes or coffee for their cafes, they can enter into a futures contract to buy a designated quantity of that particular commodity at an agreed-upon price, with the ability to exercise it on or before the expiration date.
With a futures contract, a company can better plan its budget based on the contract’s parameters and the cost of the contract. If the price of the commodity rises in the future due to increased demand or limited supplies, the business can save money by taking delivery of the particular commodity at the originally agreed upon price through the futures contract.
Since the goal of hedging is to protect against losses, it’s important to weigh the cost of the futures contract. If the price of the commodity falls for the above-mentioned futures contract example, the company would still be forced to buy the commodity at the contract’s price, which would be a poor investment. If, however, it sells the futures contract before its expiration to avoid receiving the physical commodity at a poor price, that would lead to a loss. Having a contingency plan to reduce losses in futures contracts is always a good part of a hedging strategy.
Negotiate with Suppliers
Much like businesses enter into specified timeframes with suppliers, companies can do the same with their purchased supplies to provide more predictable prices. When the PPI measurement is used, the purchasing company can contract with its supplier to settle on the initial product’s price, and how price fluctuations will be determined going forward. Since the PPI is released monthly, the price can adjust accordingly (decrease or increase, depending on the PPI) for the supplier and purchasing company. It can be re-evaluated every three, six or 12 months, for example.
While there’s no predicting the future and if and how much commodity prices may rise and impact businesses, the more tools that businesses have to mitigate increased costs, the more likely they are to survive rising inflation.
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