Weathering the Storm

1. Management Consultants 20 March 2007 Weathering the Storm MANAGING THE VOLATILITY OF PURCHASING COSTS Celeste Mastin, VP of Growth and Development, Ferro Bob Bruning, Principal, PRTM

2. Natural Gas ($ per 000 ft^3) Low = 5.8 High = 15.1 Diesel Fuel (cents per gallon) Low = 114 High = 316 Steel Coil Sheet ($/mt) Low = 285 High = 750 Corn ($/mt) Low = 89.0 High = 165 Pricing Volatility: A Headache for Purchasing 2000–2007 Quarterly Average Pricing Source: World Bank Commodity Price Data

3. Purchasing Volatility Management (PVM) • Definition • Development and implementation of strategies to manage the profit risk associated with pricing volatility of purchased goods and services • Goals • Increase predictability and stability of profits • What it is not • A comprehensive risk management program for managing other company risks

4. PVM Goal: More Stable, Predictable Profitability • More predictable profits are achieved by minimizing the amount of profits “at risk” • PVM is not about beating market prices to achieve lower costs Projected 2007 Operating Profit (No Volatility Mgmt.) Projected 2007 Operating Profit (With Volatility Mgmt.) Illustrative Probability Probability 5% 5% Worst Case = $5MM Expected Case = $20MM Worst Case = $12MM Expected Case = $20MM At risk = $15MM, 95% Conf. Level At risk = $8MM, 95% Conf. Level

5. PVM Importance: Higher Firm Value • Empirical Evidence • Study by Weston and Allayannis (2003) • A one standard deviation increase in earnings volatility is associated with a 6–21% decrease in firm value • Core Financial Theory • According to the Capital Asset Pricing Model (CAPM), risk is negatively related to firm value since higher discount rates yield a lower value

6. PVM Approaches: Three Broad Categories Finance Based Customer Based Hedging Pass Through Risk Supply Based Fixed Price Contract Forward Purchase Contract with Price Caps Risk Avoidance/ Substitution Contract with Smoothing Formula Value Chain Integration

7. Linkage Between RM Costs and Product Pricing High exposure to volatility Product Price • High value in managing volatility M2 RM Cost M1 Low exposure to volatility M1 = M2 M2 Product Price • Low value in managing volatility M1 RM Cost

8. PVM Best Practice: Setting Targets Projected Operating Profit with Current PVM Baseline PVM (% of Purchasing Spend Covered) Mean = $50.4 M OP at Risk = $25.2 M Targeted PVM (% of Purchasing Spend Covered) Projected Operating Profit with Improved PVM Mean = $50.4 M OP at Risk = $5.7 M

9. Ferro Case Study

10. Ferro Corporation in 2005 • $1.8 billion in revenue, NYSE-traded specialty materials company • Four autonomous business units: Color and Glass, Industrial Coatings, Electronics, and Performance Chemicals • Decentralized purchasing by business unit, and sometimes by site • Highly volatile raw material base ranging from petrochemicals to mixed metal oxides

11. The Transformation of Purchasing • Ferro Purchasing Initiative (FPI)—2005 • Reduce cost of direct and indirect purchases • Increase predictability of returns (volatility management = “VM”) • Expand and upgrade procurement practices and scope • Capability Development: • Purchasing Function post-FPI—2006 • Centralize and leverage spend across business units and regions • Institutionalize FPI • Implement five key strategies to drive sustainable functional excellence, including Volatility Management

12. Volatility Management Model • Focus on 30, highest volume material categories—(60% of our spend) • Strategic Sourcing owns the action plan by material • Business Unit must agree with the method as it should complement the business model • Hedging policy is set by the Board • Treasury group owns trading execution, reporting and regulatory compliance management

13. Index of Daily and Hedged Prices 300% Metal X Daily Price Metal X Hedged Price Metal Y Daily Price Metal Y Hedged Price Index to 12/31/05 Price 200% 100% Time

14. Index of Daily and Hedged Prices 400% Metal X Daily Price Metal X Hedged Price Metal Y Daily Price Metal Y Hedged Price 300% Index to 12/31/05 Price 200% 100% Time

15. Simple “How To?” • Identify material candidates for VM and annual purchase amount by material • Set baseline: Establish current VM techniques and pricing protection in place by material • Rate level of VM in place: “No, Low, or High” • Identify new/additional VM techniques by material that fit with the business strategy and implement • Measure level of protection in the portfolio as percent of spend covered by “No, Low or High” protection

16. Volatility Profile in “A” Materials 2005 Baseline VM Profile (% of DM spend covered by N/L/H VM protection “A” material categories 60% of Corporate DM spend) 2006 End of Year VM

17. Key Considerations • The role of leadership should include determining how much volatility in the portfolio a company can accept • Some materials or all? • Which businesses? • Direct spend? Indirect spend? A subset or both? • There is a high-side earnings trade-off for lower volatility • The concept of VM is complicated and often counter-culture • Change management required • Shared training about VM required to really communicate on the topic and make informed decisions across functions • Takes time to achieve desired protection: Implementation may be hindered by current contract terms, unwilling vendor participation, etc.