Like it or not, official figures or not, inflation is back with us.
Inflation consumes cash like a ravening beast, but often goes unremarked until the 11th hour, by which time it is often too late.
Official figures always lag reality, and forecast models are only as good as the input data. My models are based on conversations with the owners and managers of SME manufacturers, very sensitive to rising input prices, and the ways they are responding.
Every input to manufacturing is in the beginning of an aggressive price surge that may see many go to the wall. Many SME manufacturers, those with whom I interact most frequently will see that wall close up for a number of obvious reasons, sadly mostly obvious only with hindsight.
- They use a standard cost model. Whether this be in a fancy enterprise tool, or excel, the product costs spat out are a function of the input costs. Typically, a standard cost system is reviewed and updated on a schedule, most often half yearly. When input costs are increasing rapidly, you quickly fall behind, and play catch up not only too ,late, but to the point where the input costs stood when the review started.
- Variances are insufficiently recorded and understood. A good standard cost model will throw variances from the standard. These may be reviewed monthly, but are they sufficiently well understood, and more importantly, does anyone take action to address the negative variances in input costs?
- Too few have visibility both forward and backwards into their own supply chains to understand the impact of rising inflation on both the supplier and customer side. In the absence of this insight, the forecasting tends to be both slow, and understate the impact.
- There is a strong resistance to increasing prices, not just from the sales force, generally over sensitive, but from senior management who do not get rewarded for rocking the boat. This results in price increases being too low, and too late. Do the maths and calculate the relative impact of losing a few sales by increasing prices, to keeping them low to retain sales at a lower margin. It almost always pays to increase the price.
Apart from addressing the 4 points above, what else should you be doing?
Act faster.
When you act faster than your competitors in a volatile environment, it leads to competitive advantage. The OODA loop at work. The enabler of speed has become digitisation, which requires investment in capability and takes time, but can deliver real time information, vital in a volatile environment.
Direct communication.
Direct and concise communication with others in the supply chain, and your own procurement people, dealing with supplier invoices every day, is essential. Being close to the action enables you to move quickly in response to changes and opportunities that emerge.
Reconsider your pricing model.
Most businesses have a price list that for ease is general, being the base from which various discounts and promotional opportunities flow. Being general means that you are probably leaving money on the table, as different customers will have unique needs and levels of price elasticity. Understanding these differences and pricing accordingly is both challenging and profitable. You might even take the opportunity to change completely your pricing model, usually extremely hard to change when things are predictable.
Change prices more frequently.
Find a way of enforcing some sort of dynamic pricing process. Developing the processes that will enable dynamic pricing will become a necessary competitive tool, impossible until recently, simply because the degree of data granularity was not available. Now it is, so there should be no excuse to at least embarking on the journey.
Understand the whole supply chain.
Develop a whole of supply chain understanding, knowing where the profit pools and points of stress hide to be able to anticipate and adjust to them, as the impact of inflation rolls through.
Operational Flow.
Removing choke points in all your processes releases capacity you have already paid for. This observation is as valid in the support and revenue generation processes as it is in manufacturing.
Apply Pareto
We all accept that 80% of your profit comes from 20% of your customers. In times of inflation, the need is for real growth of revenue and margin, not the inflated numbers, while holding costs. The most effective way to do this is to prune activities that fall in the tail of the Pareto. Double down on where the real margins are. The same logic applies to the products you supply. Weeding out those legacy products that no longer play a valuable role in the value proposition of the business will release capacity that can be used more productively.
The aggressive application of the Pareto principal always removes transaction costs that are hidden simply because they are hard to quantify. The choke points removed to enhance flow, will also remove transaction costs.
Strategic priorities
Focussing on strategic priories while managing a crisis is a very challenging double act. When time is not on your side, acting decisively is all that is left. Capex is one of the first things to be delayed when times get tough, along with advertising. While it is an understandable reaction, it is also the wrong one. History tells us that those that double down when others are pulling back benefit in the medium term. Do not let the organisation lose sight of the long term, this coming crisis will be over at some point, replaced by the next one.
Innovation.
Innovation is an investment in future cash flow. While it is usually expensed through the P&L, which is in my view a misleading treatment of an investment, it often suffers the same fate as marketing activity and capex. I break it out separately as it is even more often dismissed than either of the others, and is arguably at least as important.
Cash management.
All of the above are about the management of activities as they all impact on cash flow. This is critical at any time, but never more so than when there is a spurt of inflation coming at you. Managing by the P&L as many do, can be very misleading. Set aggressive targets for working capital, and aggressively apply them. Your suppliers and customers will be feeling the same pain. The risk of blowing out debtor days is real, as your customers will be looking to extend their payment terms, as you try and extend yours.
The risks associated with inflation are huge if you are too slow, or ignore it completely and hope it goes away. On the other hand, many opportunities will open up for the agile amongst us.
Header cartoon credit: Scott Adams and Dilbert. Again.
