+44 (0)20 7202 2620

Forward Contracts: Why it Pays to Plan

Forecasting has always been a difficult task. Knowing exactly what you need at a certain point in the future is something that has forever been hard to get right. Technology and access to better and more up to date information is changing that but even so, it’s not an exact science. When you throw Covid-19 into the mix, a difficult task becomes even harder. However, this article will argue that although forecasting is difficult, the positives of making forward contracts outweigh those of being a pure spot buyer, even when you have a global pandemic in the picture. The benefits of planning ahead ripple through the supply chain spreading certainty, joy and profit as it moves.

We are going to use a case study of a cooperative in Peru called Inga, DR Wakefield as the importer, Toasty as the roaster and Spros as a coffee shop chain to illustrate why forward contracts are of huge benefit to all parties in the supply chain.

Coffee Forecasting

The owner of Spros loves the Peruvian Inga coffee they get from Toasty, who in turn buy it through DR Wakefield. Spros uses it as their house espresso in their shops and sells it as ‘Inga blend’ to their customers. Therefore, it’s of the utmost importance that they are always able to get access to Inga coffee from Toasty, as Spros is selling the provenance and story of the cooperative to their customers. Toasty has worked with Spros for many years and has a good idea about the volume of coffee Spros demands. Spros is also very open with Toasty about how their business is developing and if they plan to open any more stores; or any other factors that could affect his rate of consumption in the future.

How does Toasty guarantee that they are able to supply Spros Inga all year round? For Toasty to ensure security of supply, they need to make a contract with DR Wakefield for a certain number of bags per month for the next 6 months or perhaps till the next crop that Inga produces. However, in order to reduce the risk for Toasty and share certainty across the supply chain, Toasty needs Spros to make a forward contract with them saying that for the next 6 months, or till the next crop of Peru rolls around, they will buy their Inga from Toasty. Toasty explains the situation to Spros and Spros, being very reasonable, confirms they would like to make a contract.

Forward Contracts

Now Toasty has the certainty of business and volume, they can then forward contract with DR Wakefield their required amount of Inga coffee for the next 6 months, or till the next crop rolls around. By doing this they have taken out uncertainty in the supply chain by making a contract both upstream and downstream. What this does is ensure they can supply their customers and it means they are able to plan, making sure they have all their needs to fulfil Spros’ requirements. However, the contracting does not stop there.

DR Wakefield needs to go out and buy the Inga coffee to make sure they can deliver to Toasty the volume that is agreed. Now DR Wakefield rings up Inga and makes a contract to buy a container of Inga coffee to arrive in time for when Toasty needs it.

With DR Wakefield’s purchase contract, Inga can now go to their bank and show it to them. With the purchase contract, they can raise pre-finance to either buy the coffee if the contract is for coffee that is due to be purchase in the near future, or raise capital for other requirements that the cooperative might have at that time.

The Benefits of Forward Contracts

The crucial takeaway here is that the forward commitment that the contracts represent give the Inga cooperative access to finance and it also reduces their uncertainty, as they have sold a % of their upcoming crop. This was all made possible due to Spros contracting with Toasty, and Toasty contracting with DR Wakefield.

I don’t believe we talk enough about the role that forward contracts play in pre-finance for coffee producers. Without them, it can be very hard for producing groups to raise capital. If they don’t have enough capital at the beginning of the harvest, there might not be enough capital to pay producers for their coffee; if there is not enough capital outside the harvest then there will be other big problems. The bottom line here is that banks look very favourably on contracts with international buyers and the sooner we can send these contracts up the chain, the better.

In this example, due to collaborative forward planning, every party in the chain’s risk and uncertainty is reduced and they can all trade profitably as they have an idea as to the demands of the future. With the volume and quality of coffee already agreed, the Inga cooperative are better able to pick, process and deliver coffee that meets Spro’s requirements, whilst the shipping, logistics, warehousing, releasing and roasting of the coffee can be forecasted, eliminating any unexpected hiccups.

The Risks of Forward Contracts

Up to now, it all sounds rosy, but like with all things, there are negatives as well as positives. If anyone in the supply chain makes a poor forecast, then this could result in not enough coffee being available or too much coffee on contract that takes much longer to be consumed than was forecasted. If not enough coffee is available then perhaps Toasty will not be able to access the Inga they need. If too much Inga was contracted, then it’s possible that Toasty will be taking delivery of Inga that is starting to taste old as it’s been sat around for too long in the warehouse.

The latter is a reality that many faced recently due to Covid-19. Are there ways to mitigate these risks? Absolutely. It could be that you only contract for 6 months at a time which means even if demand does drop off you don’t ever have too much stock on order. Alternatively, Toasty could contract less than 100% of their forecast for the season and work closely with origin and DR Wakefield to monitor how much Inga is left before it all gets sold. Additionally, if DR Wakefield carries a spot position of Inga, then this is something that could be tapped into should Toasty need to top up his contracted coffee volume.

It Pays to Plan

Buying spot will always be an important tool in your armoury, especially for smaller volume filter options that get rotated. However, by planning a portion of your purchasing ahead, the benefits not only accrue to you but also go back to origin and this is one of the many benefits that arise from a supply chain that is built on strong relationships and understanding.

It does pay to plan, and if you want to dig deeper into spot versus forward buying, please check out this article here.