Everywhere you look you hear about high inflation, a 40-year record Consumer Price Index (“CPI”) and a 50-year record Producer Price Index (“PPI”). The conversations are about fear and uncertainty and financial performance risk.
That is all true.
But how a business chooses to react to this inflationary period will separate the winners from the losers. A successful business will anticipate the cost increases and manage margins and expenses. The unsuccessful businesses will wait to see what happens, will deal with one-off situations, and will not develop an overall revenue and cost management plan.
To have been 20 years old when the US last experienced the level of inflation of 40 years ago, the business manager would now be 60 years old. That means most business leaders have not experienced this type of inflation.
The CPI in January 2022 is 7.5%. The categories with the highest increases are energy at 27.0%, gasoline at 40.0%, and food at 7.0%. Clearly the stress on employee budgets is high.
The PPI is at 9.7% in January 2022, with the highest increases in foods at 12.8%, energy at 28.8%, and transportation/warehousing at 15.7%. It's easy to see the stress on the financial performance of businesses is high, and the PPI indicates inflation will continue to flow through to consumers. With the PPI higher than the CPI, businesses should expect inflation to continue.
Combining the CPI and PPI levels with the Fed’s indications of rising interest rates and shrinking the Fed’s balance sheet, means businesses will be confronted with increased costs, increased need for working capital, and increased financing costs. The next graph shows the prime rate from 1955 to the current period. During this period the highest prime rate occurred on December 19, 1980 at 21.5%. A person who was 20 years old in 1980 is now in their early 60’s.
The last period of high inflation resulted in overall changes to the US economy, and most business managers today have not lived through this type of economic climate. According to Andy Serwer of Yahoo Finance:
The population of the U.S. is 329 million and the number of Americans over 50 is about 116 million, which means that 213 million Americans, or some two-thirds of us, have never lived with inflation.
The period of high inflation in the 1960’s and 1970’s was caused by the combination of the cost of the Vietnam war and the cost of the social programs President Johnson wanted to implement, while not increasing taxes. The federal deficit increased during this period. Oil prices increased in 1973 and again in 1979 because of OPEC and upheaval in the Middle East. This combination drove inflation. It wasn’t until Paul Volcker began raising rates and dealt with the money supply that inflation came down.
We are now experiencing increased spending at the federal level and high energy prices. This sounds like a replication of the backdrop for the inflation experienced in the late 1970’s and early 1980’s.
This does not mean we should give up. We can tackle inflation and survive. Also, according to Andy Serwer of Yahoo Finance:
Among other developments back then, higher prices led to the creation and/or proliferation of generic brands (private label), dollar stores and even the rise of Walmart and other discounters, as consumers searched for low-priced goods to mitigate inflation. If inflation persists today I would anticipate Newton’s third law — for every action an equal and opposite reaction — coming into play.
The businesses that attack this situation head on will be the ones that have the best outcomes. The analysis tools and techniques business managers employ, and the strategies the business undertakes in response to the analysis, will separate the winners and the losers.
It will be important for business management to move past the excuse of inflation and develop an analysis and a plan. Senior management needs to ask questions of the entire management team and challenge the team to anticipate issues and plan for solutions. A management meeting where the discussion topics are inflation’s impact on each line item of the income statement will be an important first step. Here are some examples of questions.
Contracts:
What contracts are tied to changes in the CPI, or components of the CPI?
Are there some contracts that are not tied to the CPI that should be?
Bidding:
What escalation clauses are in the existing price quotes?
What should be included?
What opportunities does a business have to increase prices?
What is competition doing with pricing?
Utility Costs:
If natural gas is used for heating or production, what does the spike in price mean for utility costs?
What does the fuel price mean for transportation expenses?
Food Costs:
If the business uses food in its operation, the changing food prices must be evaluated.
Commodity Price changes:
Does the business have fixed input or fixed sale prices?
Are there ties to commodity prices?
Is hedging being used?
How is each expense line item on the income statement being impacted?
Uniform prices?
Cleaning costs?
Travel and entertainment?
Every line item is impacted by upward price pressure.
Second, management needs to track and analyze performance.
Month end reporting:
Waiting three weeks after month end for month end performance reporting does not give management time to respond to issues.
Consider tracking key prices weekly.
Consider tracking volumes weekly.
In addition to the typical budget to actual reporting monthly, reforecasting for the remainder of the year must occur. In the middle of the current quarter, a business needs to reforecast the remainder of the year. Continue to track performance to the original plan but be aware of the impact of changing prices and costs on performance as the year progresses.
Weekly reporting: Weekly working capital tracking is key.
Use roll forwards of working capital components.
Accounts receivable.
Inventory.
Accounts payable.
Cash.
Weekly cash flow management and BBC tracking.
KPIs (Key Performance Indicators):
Are the current KPIs sufficient?
Are they being produced fast enough to allow time to react?
Is this a period of uncertainty? YES
Are businesses being challenged to adapt? YES
BUT
There are tools and techniques that can be implemented to survive and possibly thrive, even in the worst economic environments.
We are ready to help businesses evaluate options and adapt to this environment. Don’t accept excuses. Develop strategies.