The smart response to inflation

24th October 2022
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Inflation is back. With prices rising at the fastest rate for 40 years, many businesses remain unprepared. In this article, CIL’s Pricing Director, Mike Gorham, explores what’s happening behind the headlines and how businesses can protect margins.

Input producer price inflation (PPI) has climbed to over 20%, but output factory gate prices lag. With businesses recovering just 16% through price rises, margins must be suffering.

Inflation forecasts continue to change rapidly. In the last six months, forecasts for peak CPI inflation have risen from 6% to 13% and continue to swing substantially.

These price increases are driven by shortages of energy, container transport and critical materials.

For businesses using stable prices and unfamiliar with supply-chain shortages, this can make planning difficult and create an elevated risk of sustained low profitability.

Inflation is forecast to come back down to around 2% in 2024. That means that consumer prices will be on average 26% higher in Q4 2024 than they were in Q4 2020, when taking the August 2022 CPI forecast. While inflation may return to “normal” levels, this simply means that prices will stop increasing – not that prices will return to their earlier levels.

Inflation may come down, but prices will stay high

Inflation is forecast to come back down to around 2% in 2024. That means that consumer prices will be on average 26% higher in Q4 2024 than they were in Q4 2020, when taking the August 2022 CPI forecast. While inflation may return to “normal” levels, this simply means that prices will stop increasing – not that prices will return to their earlier levels.

The effect on producer prices will be even more pronounced. PPI inflation is not officially forecast by the Government or Bank of England, but as an example, the recent data for construction material and products shows material costs have already risen by 40%.

Inflation exposure varies significantly between businesses

The war in Ukraine has pushed up energy prices. Semiconductors, certain types of skilled labour, and container transport have all been in shortage. In recent weeks we have seen currency volatility further increase the cost of imported materials. All these factors are playing out at different times and with varying levels of severity.

Shortages of critical inputs, such as labour and semiconductors, amplify inflationary pressures, as those companies that do have availability can charge increased prices. For instance, airports have struggled with labour shortages in the last year, leading Michael O’Leary, CEO of Ryanair, to forecast a 25% increase in his company’s fares.

Not all businesses are immediately affected, as many do not rely directly on these markets. However, every business will feel the consequences of inflation as second- and third-order effects work their way through the economy.

Second-order effects change competitive position

Second- and third-order effects occur as inflation flows down value chains: for example, increased crude oil and energy prices (first-order effects) have pushed up the price of bulk plastics, creating second-order effects. Down the value chain, automotive suppliers and toy manufacturers making moulded plastic products will later raise prices, creating third-order effects.

Second-order effects are quickly spreading through the economy and where they are most pronounced is sometimes surprising. Recent ING research reveals some of the sectors most affected by second-order inflation due to energy cost increases: the rubber, plastics and travel industries are all heavily reliant on oil-based inputs, so are understandably high up the list.

However, at first sight, the high impact on the food and hospitality industries may be unexpected – until we consider the energy intensity of agriculture where rising energy costs are dramatically increasing the cost of fertiliser and related products. For example, CF Industries had to shut its fertiliser plant in Billingham, UK as high energy costs made production uneconomic. This has further disrupted the beverage industry by dramatically reducing the supply of CO2, which is a by-product of fertiliser manufacturing and a key material for brewing, food packaging and soft drinks.

As second- and third-order rounds of inflation ripple through the economy, the potential impact on competitive position amplifies and becomes more uneven. This is because competitors in an industry will have different sourcing strategies – variations in suppliers and contractual terms. These variances influence the timing and amount of inflation seen by each business, driving changes in competitive position.

The complexities of inflation and its timing are not just evident at the top level of a business – different products and service ranges within a business will have cost changes too. Profitability and competitive position will vary by customer segment, and it is at segment level that businesses should plan a response to inflation.

A smart response to inflation is based on a detailed understanding of pricing power

Inflation affects the segments and products of a business differently, so the response must be targeted too. Simple solutions are not sufficient. An across-the-board price increase will leave money on the table in one part of the business and may cause excessive churn and share loss in another.

To maximise business performance in tumultuous times and be prepared for the return to stable, but higher, prices, CIL recommends five steps:

1. Plan for a range of inflationary scenarios

Model how your business will be affected by the cost increases you know about. Engage with key suppliers to gain visibility of expected changes and allow for uncertainty in both the degree and timing of these cost changes. Define key triggers that indicate you may be moving from one scenario to another.

2. Understand what your customers really value

Customer feedback gathered through the normal course of business is always biased: customers don’t say when they are prepared to pay more. Anecdotal feedback only gives an incomplete picture of customer purchasing preferences. It is critical to invest in sophisticated and objective market research so that you can understand where a customer really finds value and how you can adjust your offer to capture the highest value at the lowest cost.

3. Assess perceived competitive strength through the eyes of the customer

Perception is reality. You live and breathe your business, but for customers the purchasing decision may be made in a few minutes once a year. It may not be the full picture, but the customer’s perceptions – including any misunderstandings – will drive their behaviour.

4. Use customer and competitor insights to identify pricing power

With over £1.7tn per year invested in R&D worldwide, companies expend huge efforts innovating products, services, technology, and processes to create value for customers. However, most companies invest remarkably little time in understanding how to capture their fair share of value.

A business that has a clear understanding of what its customers value and how it is perceived versus its competitors can unlock its hidden pricing power.

CIL was recently engaged by a healthcare business that had implemented two recent price rises. The management team was unsure whether the market would accept a third. The analysis found that the company’s B2B offering was already optimally priced, but the B2C offering had considerable pricing headroom. A “one size fits all” price rise approach would have delivered poor results in both cases, but the deeper analysis unlocked substantial margin potential.

5. Analyse customer switching costs and anticipate the sales conversion cycle

For any business building an inflation recovery plan, understanding pricing power is a vital first step. Just as important, however, is a consideration for the time and effort required to affect change. Sales teams can be reluctant to pass on price increases and sales cycles can be long. The most valuable and sticky customers can take time and much sales effort to win over. Businesses that plan for and embrace these facts will have the best inflation recovery results.

To discuss any of the points raised in this article, please get in touch.

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