In every physical commodity trade, the calculation of a deal’s margin is entirely based on the information available at that point in time: purchase and sales prices, expected logistics costs, financing, volumes, and delivery terms. However, a great deal can change between signing the contract and completing the transaction.
In an earlier article, we looked at a specific example in which an unforeseen delay in a grain shipment could put significant pressure on the original deal margin. In this follow-up, we would like to explore this further, as the example illustrates a broader challenge in our industry: not only understanding how a single, often unavoidable, real-world variable can affect a margin, but also being able to explain, track, and, where possible, take corrective action as a deal’s profitability evolves throughout its entire lifecycle.
Which factors explain the difference between the margin on paper and the final financial result? And how can commodity companies use this information to make better decisions?
From expected margin to realised results
Throughout the lifecycle of a commodity trade, different departments within a company assess its profitability at different stages. At the outset, the trader calculates the margin based on the available data relating to commercial terms and estimated costs.
These assumptions — because that is ultimately what they are, representing the deal as it exists on paper — are gradually adjusted as new data becomes available on transport, volumes, quality, and financing. Logistics developments are also taken into account, such as the delay in our example. At the same time, market movements affect the valuation of open positions, hedges, and other financial variables.
A realistic and complete picture of the result only emerges once sufficient data is available and the financial processing has been completed. It is therefore important to distinguish clearly between several key concepts in this process:
- Expected margin: The anticipated profitability based on the assumptions made when the deal is concluded.
- Current margin estimate: The latest estimate of profitability, taking into account the most recent information.
- Mark-to-market result: The current valuation of open positions according to the methodology applied.
- Realised result: The result ultimately attributable to the transaction.
In an ideal situation, the initial estimates for all these components, together with the amounts allocated over time, will align with the final result. Problems arise when different reports use different definitions without making it clear why their outcomes differ. Factors that can explain these changes include missing costs, accruals, allocation differences, and the timing of postings.
A more reliable margin analysis therefore does not come from producing more reports, which inevitably create more discrepancies, but from having a clear understanding of these definitions and precisely what they measure.
The Margin Bridge: what happened?
A current margin estimate, provided it is calculated correctly, offers insight into the expected profitability of a deal. Comparing it with the original expected margin shows what has changed. That is straightforward enough. However, explaining the deviation requires more: an understanding of the factors that contributed to it.
This is precisely what a margin bridge does. It explains the observed change by attributing it to individual contributing factors. A margin bridge, often referred to as a gross margin walk, is a financial analysis and visualisation tool that explains why gross profit or profit margin has changed between two points of comparison, such as one year versus another, or budget versus actual results.
Let’s revisit a hypothetical grain transaction similar to the one in our previous article, but with a different scenario. When concluding a deal involving approximately 10,000 tonnes of grain, the trader expects a margin of €20 per tonne, equivalent to €200,000 for the entire transaction. As the deal progresses, however, several costs turn out to be higher than budgeted.
Margin component Impact
Expected margin at deal inception €200,000
Higher freight and handling costs −€30,000
Volume and quality discrepancies −€15,000
Additional financing and storage costs −€10,000
Other allocated costs −€5,000
Current margin estimate €140,000
As a result, the expected margin decreases by €60,000, or 30%. The margin therefore falls to €14 per tonne, down from €20 per tonne. So far, this is not much different from our earlier example, in which the final result was 15% lower. However, the point is not simply to identify the decline. It is also to understand exactly which factors caused it.
The value of reliable data
A margin bridge is only as reliable as the figures on which it is based. A missing freight invoice, storage costs that have not been allocated to the correct shipment, or a volume that has not yet been adjusted can all affect the margin picture.
That reliability is equally dependent on the transparancy of definitions. If a trader calculates margin based on the expected costs of the entire transaction, while his coworker in finance derives his reporting from costs that have actually been posted, it will be difficult to compare.
There are three takeaways here that are necessary for a clear picture:
- Costs must be assigned to the correct transaction, with transparent and consistent allocation methods for shared expenses.
- There must be a clear and transparent distinction between actual costs, expected costs, and accrued liabilities as the deal progresses.
- The commercial margin analysis must be reconcilable with the relevant financial records. Discrepancies may arise from legitimate differences in valuation methods or posting dates, for example, but they must be traceable and explainable.
Better decision-making
Agiblocks takes the ‘RM’ part of CTRM very seriously. Our software offers a wide variety of risk management tools, including Value at Risk, Mark-to-Market valuation, hedging tools and position management. A great example here is our What If-Analysis, a powerful decision-making tool that helps you to understand what kind of business impacts can arise from dynamically changing one or more variables, greatly assisting you in risk management decisions. It let’s you run stress tests for the exact kind of scenario we have provided here – what if a shipment is delayed?
A margin bridge can aid in the same way. If you can get a better understanding of your margins, more specifically the evolution of your margings, then you can act accordingly.
For instance, if you start to notice that logistics costs on a preferred and oft-used route are consistenly higher than initially budgeted, it might be time to revisit transport agreements.
If financing costs regularly turn out higher, it could serve you to address schedules, storage agreements and payment terms. And if the differences come from price changes, it might be worth reassessing the assumptions behind the hedge.
Enter CTRM
A CTRM software solution such as Agiblocks can help connect commercial transactions, physical commodity flows, positions, costs, and risks more effectively.
Where the previous article demonstrated how CTRM can provide insight into the consequences of a specific operational disruption, this article focuses on a broader question: how can you explain the development of a deal’s margin throughout its entire lifecycle?
The real measure of performance
In physical commodity markets, an attractive margin at the time a deal is concluded is only the beginning. The final result also depends on execution, changes in costs and risks, and how these elements are processed and reported.
As the earlier article about the delayed grain shipment demonstrated, a seemingly straightforward operational event can have a significant impact. And yet, the daily operations of an average company in our industry are certainly not defined by a single transaction. As much as half of a commodity company’s workforce may be dedicated to logistics and operations because of the complexity of managing shipments. What’s more, up to two-thirds of the budget may be allocated to administrative paperwork. This involves hundreds of processes, emails, phone calls, and a labyrinth of documents – all multiplied by the number of individual shipments. The next step is to understand how the inevitable changes that occur in day-to-day operations collectively determine the final result, and how the organisation can learn from them.
We hope it has become clear that the final margin simply doesn’t tell the whole story. It is important to understand why the deal – any particular deal – has over- or under delivered compared to the initial calculations and expectations. And to act accordingly. By comparing commercial agreements, operational developments and financial results, companies can identify where differences arise and where adjustments may be needed.
A CTRM system helps bring this information together, giving companies a better understanding of what drives their results and helping them use those insights to prepare for and manage future deals more effectively.
