Buying Products with your Crystal Ball

Starbucks “Second most important commodity” is milk. If you visit Starbucks, you know how many of their coffee products contain milk. Lately, the price of milk has been rising. Unlike coffee, Starbucks cannot hedge against price changes for milk. What is a hedge, and how can it help my business?
Consider this example: Bob is considering buying Joe’s lakeside property. Bob will not have funds available for three months for the down payment. Joe has had the property for sale for some time and would like to sell if to Bob. How can they reach an agreement? They create an option contract. For $300, Bob buys the right to buy Joe’s land for $100,000. Bob owns the right for 3 months. Bob has several choices: (1) He can buy the land for $100,000 anytime in the next 3 months; (2) He could let the three months pass and not purchase the land; or (3) He could sell the right to someone else for whatever price they are willing to pay. In summary, Bob has “locked in” a purchase price for a given period of time- he has hedged the risk that the price of the land may increase. In a way, paying for an option allows you to buy items using a “crystal ball”. While Starbucks can hedge the price of coffee (using option contract), they cannot hedge milk prices.
The Lesson: The ability to hedge the risk of price changes can lead to more certainty in your business, better planning and improved profit. If you certain about the cost of your goods, you can accurately plan your price and profit margin.
Your Homework: If you have the ability to negotiate with suppliers, consider asking them to provide a price by contract- particularly a contract that allows for a fixed price for a period of time.
(Source: “Starbucks May Become Tastier As Time Passes”, Wall Street Journal, 5/3/07)