Q&A - How do changes in commodity prices affect businesses?

A change in commodity prices has too main possible effects on a business:

(1) An effect on sales revenue (2) A change in raw material and other operating costs

For some businesses, a change in commodity prices directly affects sales revenue. Take the example of a dairy farmer whose revenue is directly linked to the price that he/she can obtain at the farmgate for a litre of milk or a kilogramme of cheese.

The cocoa farmer in Ghana too is concerned with the selling price that can be obtained per tonne of cocoa beans – particularly if the farmer does not benefit from Fairtrade schemes where a minimum price is available.

However, for most businesses, the main effect of changes in commodity prices is on their operating costs.

For manufacturers, commodity price changes can be particularly significant, since a large proportion of costs will arise from buying raw materials or using energy in the production process. Businesses have relatively little control over the price that they for their raw materials – they are exposed to changes in commodity prices which can often move up or down significantly over a short period.

One important thing to consider is the proportion of total costs that are accounted for by raw materials.

For many service businesses, the main operating costs will by employment-related (e.g. wages & salaries), marketing-related (e.g. advertising, commission) or arising from the choice of business location (e.g. rent, rates). Raw material and energy costs are likely to be relatively insignificant. So changes in commodity prices for these businesses are not likely to be significant.

Another consideration is whether a business is able to pass on increases in its costs to customers. Imagine that a carpenter experiences an increase in the price of his raw material – wood. However, because his service is a specialist (niche) one, the carpenter may find he is able to persuade customers to accept a higher selling price which takes account of higher wood prices. In this example, the change in commodity price does not turn out to be significant.

In most cases, businesses look to absorb small or temporary changes in raw material costs, rather than look to increase the selling price charged to customers. However, if they choose to do this in the medium/long-term, then the result is likely to be lower profit margins.