When should you sign commodity contracts?

Lee Plotkin

Over the past several years, we have seen a fairly significant increase in commodity costs, mostly due to weather-related issues (drought, floods, etc.). While no one has a crystal ball, looking at historical data can provide guidance on what type of buying makes the most sense for your operation.

When this topic arises with my clients, I discuss what I consider the pros and cons of contracting. Understanding your needs is critical to the success of any buying strategy. Are you seeing strong usage and volatile costs throughout the year for key ingredients? Has supply been an issue for you? What about maintaining a solid specification? Are you purchasing this product through one primary distributor or a number of bidding parties?

In my opinion, contracting (or hedging) can be a fundamentally sound practice to protect your profits when the market makes sense. The main purpose is not to save money, although this is a desired outcome. Contracting at a set price allows you to lock in a key ingredient price and always be able to make your profit margin without having to raise menu prices.

If you are more comfortable riding the market and being able to take advantage of lower swings in pricing, then contracting for commodities may not be a good move. Commodity costs rise and fall with the market, depending on supply and demand.

Some of the pros of contracts include:

• The ability to set a fixed ingredient price for a specific period of time and make your profit margin. Note: for some produce, like lettuce, high-low types of contracts offer a “floor” and “ceiling” for prices, but still allow pricing to follow the market within those guidelines.

• As mentioned above, taking the volatility out of key ingredient costs.

• Having a committed source for a product that guarantees a certain volume for your operation. This is especially important during product shortages.

Among the cons of contracts:

• Pricing markets for key commodities typically rise and fall with seasonality along with supply and demand factors. If you are locked in at a higher rate, you lose the ability to take advantage of the low points during the year.

• You lose the flexibility to change specs and volumes midstream.

If you find that contracting (where the market conditions warrant it) provides you with peace of mind, then you should do your homework beforehand.

Start by working with your distributor to identify opportunities based on your current volumes. Ask them if they have contracts for these ingredients already in place that you may be able to join.

Also, talk with the poultry, meat, produce and other experts at your distributors. Ask them to provide historical pricing data by month or other period in previous years. What are the projections for the upcoming year (e.g., will the supply be short)? What was last year’s average price for those commodities? What times of the year are best to consider contracting, and what time frame makes the most sense? Will the distributor hold product for you (if so, is there a cost involved)?

Gathering your information upfront will allow you to make informed decisions about your buying strategy and could afford some level of protection for your profits.