Case 020Macro and commodity sensitivityCore
Crude-linked raw materials are 55% of Rangora Paints' cost of goods. Crude rises 20% and price hikes follow one quarter later. What happens to gross margin over the next three quarters?
1The situation
Rangora Paints has a gross margin of 42%, so cost of goods is 58% of revenue. Crude-linked materials, solvents, resins and some pigments, are 55% of cost of goods. Crude rises 20%, and assume those materials rise 20% with it and reach Rangora's costs in the first quarter.
Rangora's practice is to raise prices one quarter after costs move. Its first hike, in quarter 2, is sized to restore rupee gross profit per litre. A second hike in quarter 3 takes the cumulative increase to 9%. Ignore any fall in volume from the higher prices.
2Your task
Trace gross margin quarter by quarter, explain why the first quarter is the worst, and say why the lag matters more than the size of the shock.
Quick check
What is Rangora's gross margin in quarter 1, before any price hike?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Gross margin falls from 42.0% to 35.6% in quarter 1, then recovers to 39.5% and 40.9% as the hikes arrive. Crude-linked costs are 31.9% of revenue, so a 20% rise adds 6.4 points of cost. The one-quarter lag leaves all of that unrecovered in quarter 1. Even after hikes restore rupee gross profit, the margin percentage stays below 42% unless prices rise about 11%.
Step 1How big is the cost shock as a share of revenue?
Work down from revenue, not up from crude. A 20% rise in an input matters in proportion to how much of revenue that input is. Cost of goods is 58% of revenue and crude-linked materials are 55% of that, so they are 31.9% of revenue. Twenty per cent of 31.9 is 6.38 points. A restaurant whose cooking oil is a third of its food cost feels an oil price jump that way: large, but smaller than the headline.
Step 2What happens quarter by quarter?
Quarter 1: costs are 64.38% of old revenue and prices have not moved, so gross margin is 35.6%. Quarter 2: a 6.38% hike restores the rupee gross profit per litre, but on a larger revenue base the margin is 39.5%. Quarter 3: with hikes totalling 9%, it is 40.9%. Getting the percentage back to 42% needs a cumulative hike of about 11%, because costs are now a larger number and the margin is a ratio.
| Per 100 of pre-shock revenue | Before | Quarter 1 | Quarter 2 | Quarter 3 |
|---|---|---|---|---|
| Revenue | 100.00 | 100.00 | 106.38 | 109.00 |
| Cost of goods | 58.00 | 64.38 | 64.38 | 64.38 |
| Gross profit | 42.00 | 35.62 | 42.00 | 44.62 |
| Gross margin | 42.0% | 35.6% | 39.5% | 40.9% |
Step 3Why does the lag matter more than the size?
Compare two worlds. In one, crude rises 20% and prices follow a quarter later: quarter 1 margin is 35.6%. In the other, crude rises 25% and prices move at once: quarter 1 margin is 38.9%. The bigger shock passed on immediately does less near-term damage than the smaller shock passed on late. That is why analysts ask paint and consumer companies how many weeks of inventory they carry and how quickly dealers accept a price list, and why the stock often falls on the cost spike and recovers before the margin does.
Where candidates lose it
The usual slip is applying the 20% crude rise to all of cost of goods, or to revenue, and forecasting a margin collapse to the low twenties. Only 31.9% of revenue is crude-linked.
The second is assuming a hike that restores rupee gross profit restores the margin percentage. It does not: the percentage returns to 42% only with a hike of about 11%, which companies rarely take in one go.
What the interviewer asks next
- Rangora carries two months of inventory bought at old prices. How does that shift the quarter 1 margin?
- Volumes fall 3% after the second hike. What is quarter 3 gross profit?
- Why might a market leader take the full hike faster than smaller rivals?
Company names and figures are illustrative.