What it means
The exposure has two directions. A manufacturer, retailer or transport operator is hurt by rising input prices, while a farmer, miner or energy producer is hurt by falling output prices, and some businesses sit on both sides at once.
What turns a price move into a real problem is the gap between when costs change and when selling prices can change. A firm with annual customer contracts and monthly ingredient purchases is carrying up to a year of unhedged exposure, whereas a firm that reprices weekly may barely notice the same move.
Measuring the risk starts with quantifying volume. Multiply the annual quantity consumed or produced by a plausible price swing, then compare the result with gross profit rather than revenue, because that comparison shows how much of the actual earnings cushion is at stake.
The usual responses fall into three groups: commercial, contractual and financial. Commercial responses include reformulating products or finding substitutes, contractual responses include indexation clauses and fixed-price supply deals, and financial responses include futures, options and swaps.
A common and important nuance is that hedging does not remove risk, it exchanges one risk for another. Once you fix a price, you accept the risk that the market falls and your competitors buy more cheaply, which is why most policies hedge a proportion of expected volume rather than all of it.
In practice
Real-world examples
Example 1
A commercial laundry business buys natural gas on a variable tariff while charging hotels a fixed price per kilogram of linen. When gas prices double over a winter, the whole increase lands on the laundry's margin because its customer contracts have twelve months left to run.
Example 2
A copper mining company sells at spot prices and has fixed extraction costs. A sustained fall in the copper price cuts revenue with almost no matching fall in costs, so the finance team sells forward part of next year's production to protect debt covenants.
Example 3
An online furniture retailer prices delivery as a flat fee. Rising diesel prices push carrier surcharges up sharply, and because the retailer advertises free delivery over a threshold, the cost increase is absorbed entirely rather than passed to shoppers.
Think of it
Imagine driving a car with a floating fuel gauge that changes the price of petrol at the pump every minute. You might set off with enough money for a full tank, only to find the cost has doubled by the time you arrive, forcing you to rethink your entire journey.
Formula
Calculation
Exposure = quantity per period x expected adverse price movement per unit. Hedged exposure = exposure x (1 - hedge ratio).
A bakery group uses 4,000 tonnes of wheat a year at a current price of $250 per tonne, so its annual wheat spend = 4,000 x $250 = $1,000,000. Revenue is $3,000,000 and gross profit is $600,000, a gross margin of 20%.
Suppose wheat rises 20%. The price increase per tonne = $250 x 0.20 = $50, and the exposure = 4,000 x $50 = $200,000. If none of that can be passed on, gross profit falls to $600,000 - $200,000 = $400,000, and the gross margin falls to $400,000 / $3,000,000 = 13.3%, a loss of nearly seven percentage points.
Now assume the group hedges 75% of its volume, so 3,000 tonnes are protected. The hedge saves 3,000 x $50 = $150,000, leaving an unhedged cost increase of $200,000 - $150,000 = $50,000 and a gross profit of $550,000.Case study
Seen in the real world
Pallavere Ceramics is an illustrative and clearly fictional tile manufacturer whose kilns make gas roughly 18% of total cost of sales. Its sales team had built the business on three-year fixed-price agreements with builders' merchants, which customers loved and the board had never questioned.
When gas prices climbed steeply, the mismatch became painful: costs reset monthly, prices reset every three years. The illustrative finance team modelled the exposure, found that a 30% rise in gas would remove more than half of operating profit, and took the analysis to the board with two proposals.
The board adopted both. New customer agreements gained an energy indexation clause that adjusted prices if the published gas benchmark moved more than 10%, and treasury was authorised to hedge up to 70% of forecast gas volume for the coming eighteen months. Neither measure stopped costs rising, but together they turned an uncontrolled exposure into a bounded one the board could plan around.
Watch out
Common mistakes
- Comparing a potential cost increase with revenue instead of gross profit. A cost swing that looks like 3% of sales can easily represent a third of the profit actually earned.
- Assuming a price increase can always be passed on to customers. Contract terms, competitor behaviour and customer tolerance usually mean only part of it moves through, and rarely straight away.
- Hedging 100% of forecast volume. If demand comes in below forecast you are left over-hedged and effectively speculating on a commodity you no longer need.
Questions
People also ask
How do I know whether my business has commodity price risk?
List your top ten cost lines and your revenue drivers, then ask which of them are set by an external market price rather than by negotiation.
Is a fixed-price supplier contract a form of hedging?
Yes, it transfers the price risk to the supplier for the contract term, though the supplier normally builds a premium into the price for accepting it.
Should a small company use futures to manage this risk?
Usually not directly, because contract sizes and margin requirements are demanding; indexation clauses, staggered purchasing and supplier fixed-price deals are more practical starting points.