Do you believe annual inflation will stay around 2%? What are you experiencing in your personal and business expenditures? It seems every article you read these days has a slightly different take on the nature and extent of inflation. Recurring issues include labor shortages, increasing transportation cost, and entry level double digit wage increases. There is also a great deal of uncertainty about where interest rates are headed. In all cases, the common theme is that costs are rising.
According to the Bureau of Labor Statistics (www.bls.gov/cpi/):
“The Consumer Price Index for All Urban Consumers rose 2.4 percent from March 2017 to March 2018. That was the largest 12-month increase since the period ending March 2017 and higher than the 1.6-percent average annual rate over the past 10 years.”
While low inflation is viewed as a good thing, the last ten years were not all that great for business. The annual rate of Real GDP growth never exceeded 3%, and businesses worked hard just to stay even. It was often difficult to raise prices even with inflation rates at rock bottom. Going forward, it will remain difficult just to stay even, much less to get ahead, as inflation rates rise above the low levels of the past ten years.
While we can debate the specific rate and timing of inflation pressures, in our view, it will eventually manifest itself at materially higher levels than the recent past. Businesses that fail to get ahead of and offset escalating costs now will soon suffer the consequences of lower profits and decreasing cash flow.
Are the good times rolling?
Hopefully the “good times” are rolling in your business and revenue and profits are up. Rising costs may not be your biggest concern as you navigate the challenges of growth and a tight labor market. You may have different problems right now, or you may be focusing less on costs and more on other areas. Unfortunately, a downside to the “good times” appears when the benefits of growing revenue begin to mask the impact of rising costs and other operational issues in your business. We believe the good times are the best times to implement a balanced and proactive approach so that you can better deal with the inevitable impact of rising costs on your business.
Over the next three months, we will share a series of articles on topics that represent our current thinking and recommend approaches to help you stay ahead of escalating costs. At Storm, we have successfully executed these same strategies in both crisis and targeted improvement engagements. When business conditions are deteriorating, your options are always limited by financial and time constraints. By acting now, when times are still good, you will have broader sets of options and much longer timeframes to develop and successfully mitigate the impact of escalating costs on your profits and cash.
Are We There Yet?
Waiting to see…
Rising sales or a recent break in tax and regulatory policies that boost your bottom line can often create a false sense of security. This can encourage complacency and a bias for delay or inaction in the early stages of rising inflation. Gauging the broad impact and risk of rising inflation to your business is much more difficult than assessing a change in a specific commodity cost, and does not easily correlate into bottom line impact. Instead, the impact of rising general inflation will often show up gradually and inconsistently, first in supplier waves and eventually more wide spread when those who waited too long finally do react.
There are multiple indexes the government uses to measure inflation, but you should not rely on these as a good proxy for exactly how or when cost increases will show up and impact your business. Often, your costs of goods inputs might behave one way, your labor and benefit inputs in another, your general expenses with an entirely different dynamic. Your business model may have migrated to a sizeable component of outside services and subscription-based software and systems, where cost components are bundled and lack visibility. The rate-of-cost increases that you experience in services could be quite different than in other areas. The result of all of this is a mosaic of possible outcomes and impacts that you must figure out yourself.
It is likely during an extended period of low inflation that you only dealt with a handful of vendors increasing prices at a given time. Now, imagine key segments of your supply base all wanting price increases simultaneously, all while various elements of your general supply base want to implement increases as well. The final wave will be those who waited too long to address their rising costs. They will be more desperate and so more difficult to deal with. This is what can happen in periods of rapidly rising costs.
THE POINT: If you are waiting to see the exact timing and impact of rising inflation in your business before you act, then you will have to play catch up when you do figure it out, and you may never actually catch up at all. Just a percent or two of unexpected cost increases can significantly dent your bottom line.
Inflation similar, but more difficult this time around
The last time the annual CPI rate exceeded 4% was in 1990. Inflation has been low for so long, there are management teams that have never experienced annual inflation in excess of 2%. At Storm, we have experience dealing with periods of double-digit and low single-digit inflation. We have managed businesses in both environments, and we know that they are very different. Having observed both cultural and broad-based changes in business dynamics over the years, we believe that, this time around, recovering even moderate increases in cost will be much more difficult than ever before.
When inflation was much higher, the primary offset tool was regular periodic price increases, and companies came to expect this. During the past twenty years of relatively low inflation, the offset tools have been internal productivity and “cost out” initiatives, layoffs and downsizing, and, as a last resort, moderate and periodic selling price increases. Unfortunately, this means that customers have been effectively trained not to expect or accept price increases. Other considerations we believe will make recovering cost increases more difficult going forward include:
- It’s a Global Economy – Relying solely on “across the board” price increases to address your rising costs can be a risk to your top line and total gross margin dollars. Customers in today’s global economy have more sourcing options than ever before. You may get the first price increase without much noise from your supply base, but if that is your only tool to offset cost increases, coming back too soon for another increase may get your products and services quickly resourced to your competition.
- Customer Push Back – Companies are more sophisticated than ever in negotiations. Strategies and tactics that were once the province of very large companies in specialized industries are now common throughout both large and mid-market companies. Achieving any level of price relief for your rising costs will be met with aggressive push back and tactics to eliminate, delay, or significantly reduce what you need.
- Incremental Actions May Fall Short – Costs rising at less than 2 percent were often offset with a series of modest incremental improvements. An inflation rate rising another point or two and approaching 4% can quickly create gaps in your ability to develop and execute internal actions to fully offset escalating costs. When costs do increase, they often increase much faster than you can implement changes to offset them in the short term.
- Tight Labor – Labor is the largest expense for most businesses and the “usual suspect” to offset cost issues. A business with growing revenues and operating at full capacity in a tight labor market will find it difficult to decrease labor costs. With labor reduction options limited, you will need significantly more impactful initiatives, along with longer timeframes to execute them, in order to stay ahead.
Businesses that wait and rely only on past practices may find themselves coming up short this time around. In today’s environment, we believe that you must start immediately to create a broad base of cross-functional and cumulative improvement initiatives to mitigate the impact of rising costs.
THE POINT: Inflation at rates could easily double from recent history, and it will become significantly more difficult to offset them. Rising costs are not just a sourcing problem, and all levels of management in an organization must be proactive in developing and executing multiple actions. Having too few options and not enough time will certainly result in decreasing profits and cash.
Partner and Managing Director
Storm Consulting LLC.