First, let’s get something straight: rising prices and inflation are not the same thing and should not be used interchangeably. Businesses often see inflation where there is really only rising prices for a limited set of goods.
In Merrill Lynch’s words: “Actual inflation over any time period (as opposed to a couple of months of one-time higher resets of prices) requires a sustained increase in inflation expectations reflected in higher prices more generally - including the price of labor.”
Since inflation is not as pressing as prices, and since it got ample coverage in the Fed’s first press conference, I will save that issue for another day.
What’s Going on with Prices
Businesses of all sizes and across several sectors are feeling the pinch of higher raw material costs stemming from high-growth economies’ demand, natural events, and macroeconomic/political unease. Smaller companies are the least well prepared: they don’t have the same mindshare dedicated to forecasting, and they don’t buy large enough quantities to use their buying power to control higher costs coming down the supply chain… or do they?
Several small businesses have followed the best practices of their big company brethren and have gotten positive results. I have surfaced three general rules for how others can repeat their successes.
1) You Must Know Your Costs
A consultant friend recently told me about one ice cream maker who managed his commodity risk by watching raw materials markets and stockpiling more of certain ingredients in anticipation of rising prices.
He balanced rising costs of one commodity by buying more of another, lower cost one. He analyzed, based on his current pricing, how much he’d have to decrease his supply costs by in order to maintain his profit margin. By keeping track of costs, he knew how much more air he’d need to whip into his ice cream to produce the same amount of ice cream with fewer ingredients (thus allowing him to keep his costs down). Before you judge, know that many larger companies use the same approach.
2) Ask What Your Suppliers Can Do for You
Many companies have learned that if you are a good customer your suppliers will want to help you. Ask your suppliers to help you forecast costs - from commodities to distribution. (For those commodities that are rising, consider a longer-term contract.) Suppliers are better positioned to control costs since they have a better view up the supply chain. They can also suggest changes in terms of the delivery schedule and the number of orders they have to fill on your behalf.
In consulting, we call this “cost to serve”. You see, if you make it hard for suppliers to serve your business, they probably won’t be amenable to helping you reduce input costs. If you try to make their lives easier by aspiring to consistency in how you order and when you pay, you will find that they will be willing to work with you (e.g., agreeing to pay early can often lead to discounts).
3) Cut the Waste
It seems obvious, but you can cut a lot of cost out by reducing, reusing, and recycling. Don’t order more than you need, and use what you order.
Follow the lead of the best restaurants: try to use everything. In the book Heat, written by a reporter who took a year to work in the kitchen of a top restaurant, there is ample description of how top chefs waste nothing. Food that goes unused one day will make it onto a plate the next.
Finally, try to find someone who wants your waste (e.g., scrap metal, boxes, biomass for compost, etc.); they may be willing to pay for it or at least remove it for you. Many big retailers get paid for their waste by partnering with recycling companies.
Aside: While writing this, I was reminded of Chris Rock’s Cheap Pete from In Living Color (funny, but not appropriate for all audiences).
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Marx wrote that “the production of too many useful things results in too many useless people.” If you watch Downton Abbey, you can see that tension playing out through the British class system of the early 20th century.
Fast forward to today, and the story is far more complex. Yes, there are too many qualified people who cannot find steady employment, but there are also many companies that can’t find the talent they seek.
Fear of inflation and commodity costs abound, but should it change a company’s outlook? Maybe not. But what about labor costs? For many companies, the answer is yes. I have summarized four points below to help business owners, casual economists, and investors make sense of the current business environment.
- Pricing power and profits do not always go hand-in-hand. Profits depend on relative pricing power (growth in prices relative to unit costs). Rising profits, therefore, imply that selling prices are improving relative to production costs. With high unemployment rates and unprecedented productivity, costs have been low for many companies. But they are rising alongside demand for scarce talent, as well as commodity costs.
- There is usually a temporary profit spike early in recoveries when there is a surge in productivity growth and a slowdown in compensation costs, but that doesn’t tend to last as labor costs pick up. Don’t assume that growth rates will be even, and watch for rising labor costs.
- The rule of thumb for developed economies is that labor costs dominate business input costs. While the costs of energy and other raw materials are significant, labor costs are the largest business costs. In the nonfinancial corporate business sector, labor costs are roughly three times more significant than non-labor costs, according to Merrill Lynch. Factor in expected pay raises and hiring costs, looking at the supply and demand for the labor you seek. For startups, this may mean that locking in full-time talent may be less costly now than in the near future, even though labor costs are often your riskiest investment.
- Rising commodity prices will not hit companies as hard as many pundits believe, but some companies may feel the pain of consumer restraint. Watch commodity prices, but know that they don’t necessarily spell inflation. It may be a good time to revisit your supply chain costs and find a more efficient distribution model.
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As shallow and cold as it may sound, there are repercussions beyond the aftershocks, death, and destruction that followed the quake that has so tragically shaken Japan. I hope the rescue continues, more lives can be saved, and the potential nuclear catastrophe can be contained. My heart goes out to Japan, but my mind turns to the economic impact.
When considering the impact of a massive event, it is wise to use multiple levels of analysis (e.g., economic, social, and political perspectives). In this post, we briefly consider the micro-level industries affected, the global macroeconomic effects, and the political or policy repercussions of the quake’s aftermath.
- On a micro level, daily we are hearing about how factory closures in Japan are affecting the global supply chain. “Nearly all automakers, even those with no plants in Japan, could be forced to halt production of some models in the weeks ahead if Japanese suppliers are unable to quickly resume making parts used in their vehicles.” The only two automakers who do not use Japanese parts in their vehicles are Hyundai and BMW, according to the article.
- Merrill Lynch says: “Japan is the world’s fourth-largest exporter, accounting for about 14% of exports of automotive products. It also produces 60% of the silicon used to make semiconductor chips. Japan is a key supplier of advanced components to Asian nations that specialize in the final assembly phase of manufacturing. China depends on Japan for 13% of its imports, largely capital goods, such as machine tools and electronic parts for manufacturing.”
- In terms of oil and interest rates, demand for oil, liquefied natural gas, and coal from Japan is expected to increase to help cover power requirements, which will push global oil demand higher in the near term. A sustained oil spike will lead to a greater chance of oil prices sneaking into core inflation, which would mess with the U.S. Federal Reserve and other central banks’ efforts to keep interest rates low. Caveat: if the economy is badly damaged, Japan’s longer-term energy needs will be depressed; also, around 40% of the country’s energy comes from nuclear power, implying that there may be infrastructure delays that impede a quick expansion of fossil fuel-burning plants to offset nuclear plant closures.
- On a global macroeconomic level, Japan represents 8.7% of global GDP as of 2010, says the IMF. Japan’s impact on global growth and U.S. GDP will be limited, as Japan constitutes less than 5% of U.S. exports and roughly 6% of U.S. imports, according to Merrill Lynch. The macroeconomic affects will be a drag on the global economy, but not an enormous weight.
- In terms of what the nuclear crisis in Japan means for energy policies in other countries, it seems that nuclear power has a future - at least for the moment. But U.S. nuclear regulators are considering a formal review in the wake of Japan’s crisis. Germany has reacted more aggressively, closing seven nuclear reactors built before 1980 for a three-month review of nuclear-plant safety and the country’s broader energy strategy.
I hope everyone takes a few seconds to text the word ASIA to 30333 to make a one-time donation of $5.