This is the second article of a 5-part series on How to Embed Forecasting Capability into Aluminum Sourcing Practices. Read Part 1, on assessing your price risk and exposure, here.
How to Identify Cost Drivers
When placing metal purchase orders, manufacturers need to have a solid understanding of the cost breakdown of their purchases. In this manner, they can understand where increases/decreases in their raw materials purchases come from. The graphic below illustrates an example of cost breakdown for aluminum purchases:
So let’s break out each aluminum cost driver, shall we? Then we’ll get to the best practices.
Midwest Premium + LME Price
The primary aluminum cost is usually linked to the LME 3-month price at the time the order is placed, in addition to any physical delivery premiums agreed upon between seller and buyer.
The US market typically uses the Platts Midwest premium on top of the LME price upon order placement.
Aluminum Conversion Cost
The conversion cost includes the cost of converting primary aluminum into the desired semi-finished product and alloy required by the buyer. The cost of conversion varies depending on the product complexity. In simple terms, highly commoditized aluminum products (such as gutter coil) that require less processing cost less than the conversion to a heat-treat aerospace alloy as an example.
The freight cost represents the cost of shipping the “converted” or semi-finished aluminum products from supplier to buyer.
These include other specifications that buyers may require, such as narrow slit widths or certain packaging requirements.
Companies need to understand the cost breakdown of their aluminum purchases. Once they understand the cost structure, they can negotiate each cost separately with their suppliers.
One best practice involves the use of fixed contracts to lock the costs of conversion, freight and adders. Consequently, the only cost changes that remain include changes to the 3-month LME price and the Midwest premium. In this manner, buyers have better visibility into the increases or decreases of the costs of their purchases.
With value-added costs locked in or held fixed, buyers can use short-term (8-week) forecasts to place their orders. By effectively timing orders, buyers can reduce the cost of the first bubble explained in the chart above. Consequently, the buying organization can achieve an additional overall raw material cost reduction.
Continued in Part Three.
Raul de Frutos Tinoco is MetalMiner’s lead forecasting analyst. Hear Raul and other experts speak at our upcoming commodity conference: