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Inflation: limit the impact by fixing and locking in costs

Friday August 12, 2022

Restructuring Advisory Partner Ian Corfield, and Directors Justin Matthews and Richard Sanfourche cover the options on to fix costs and lock them in to get ahead of rising prices.

In another article in our series on how to survive, and perhaps even thrive, during a period of high inflation we discuss how most effectively to pass on the costs of doing business to your clients and customers.

In other words, we look at how to operate the business relationship from the supplier perspective.

But that’s only half the story, most suppliers are customers too. So here the spotlight is on being the customer. When prices are rising fast, how do you take control of the costs of the goods and services you buy? How do you fix a cost and lock it in?

Whatever your business, you need to enter into a hedging agreement with the mindset that you’re protecting yourself against a downside risk. Ian CorfieldRestructuring Advisory Partner

The headline answer that most accountants and business consultants would probably give to this question is that you should at least consider ‘hedging.’

This is a word used in various phrases that range widely in terms of sophistication, from ‘hedge your bets’ at the lower end to ‘bear put spread hedging’ in the more sophisticated environment of the financial markets.

Spread the risk

But essentially, hedging is always about making an educated compromise that ensures your risk remains manageable within tolerable boundaries. In finance, this can mean taking two different positions with an inverse relationship, meaning that if one should fall, the other is likely to rise. In business, hedging most often means agreeing a price today for a purchase to be made at some point in the weeks or months to come.

The idea is that hedging of this sort reduces risk by providing visibility and control over future spending. Examples might range from a housebuilder buying sand or cement in advance at a set price, to a manufacturer buying steel, or a restaurant buying meat, milk or butter (which is a major stress point right now).

But, whatever your business, you need to enter into a hedging agreement with the mindset that you’re protecting yourself against a downside risk; specifically, against the cost of the materials in question going up over that period. You do not, therefore, decide to hedge with a view of actively seeking an upside benefit – although, of course, under the right conditions this can occur.

You also have to accept that hedging is likely to be a costly strategy that will tie up your cash for the entire term of the agreement. Look at it as an insurance premium: nobody challenges the need to spend money on protecting a house or a car. Furthermore, you must also go in with the understanding that if there is a downward shift in pricing during the period, however unlikely that might be, you will be lumbered with having to pay a premium.

Better the devil you know…

All that said, in business the devil you know is almost always the best one. And hedging can pay off spectacularly well if everything goes in the right direction. For example, a manufacturer of farming equipment who stockpiles steel at the right moment can gain the double benefit of low-cost materials allied with the rising value of the end product.

So, while a hedge doesn’t 100% guarantee that you will save money you will know where you stand when it comes to the crunch. And that’s an extremely important advantage during an inflationary period, particularly as it can help support your credit profile when seeking to finance existing and new business relationships.

Consider your contracts

Another major consideration to bear in mind is the nature of the existing contracts you have in place with your suppliers. These might have been initially drawn up in very different economic circumstances, and may no longer suit your needs in a new environment. As a result, some might be exposing your business unnecessarily to the risk of rising costs or other harmful impacts

While few contracts allow suppliers free rein when it comes to pricing, many will include terms that allow certain cost-increases to be passed on to the customer, particularly those relating to raw materials with a market price. Contracts may also include provisions that allow prices to be raised at set intervals, although when inflation is rampant, this approach can expose suppliers to increased costs that they are unable to pass on. The same, of course, is true of entirely fixed-price contracts.

It’s therefore essential that you have a clear understanding of whether, when and how your supplier contracts allow prices to change. If you don’t already have this insight, you should make gaining it a priority. And be prepared for the process to be complex, particularly if your business has many contracts in place that are based on a wide variety of formats. Fortunately, we’re seeing tech solutions emerge that enable rapid analysis across a wide range of different formats.

For a contract to work to everybody’s benefit, it usually needs to balance the needs of both parties. So even if it appears to be strongly in favour of your business as the customer, it’s possible that it will not remain beneficial over the long term. Without some form of negotiation and resolution, a supplier may be forced to take action, such as resigning your business or even withdrawing from the market. In the case of a specialist supplier, particularly one whose quality adds value to your offer, an outcome of this sort could prove damaging to your prospects.

Once you fully understand the precise terms of your contracts, you’re well positioned if necessary to discuss or even renegotiate the terms of the contract to ensure a continuation of a relationship – ideally on mutually beneficial terms and with a shared recognition that this may be a temporary arrangement that can revert to normal once the crisis is over. Be aware of the potential downside too: a supplier or customer may use the new pricing structure to their advantage later. For example, a supermarket may demand primacy of supply in exchange for a cost increase, meaning the supplier will lose other customers. And it might not stop there, with the now dominant customer demanding even better terms down the line in the knowledge that the supplier has no room for manoeuvre. So if the desired outcome proves to be difficult or even impossible, you may be forced to consider looking for a new customer or supplier you can work with on terms that are acceptable to both sides.

A new competitive environment

Another major impact of the current economic ‘shock’, leading to increased costs of transport, is the greater time it is taking for goods and materials to be distributed across the world. This in turn is leading to a significant change in the way that businesses compete: with more companies seeking to fix prices through hedging, and a reduced opportunity to justify higher prices through fast delivery, the concept of ‘time-based competition’ (TBC) is losing its dominance after three decades.

This has the potential to cause issues for many companies, particularly in relation to their working-capital needs, at a jittery time for the capital markets. In addition, those businesses that use speed of manufacture and delivery as a primary differentiator have little need for storage facilities, meaning they are ill-equipped to stockpile materials or components. They can, of course, hire space from others, but doing so will add to their costs. Or they could barter within the supply chain, gaining storage in return for privileged pricing (although this would affect margin).

So fixing a price and then locking it in can be very challenging for businesses. While supermarkets are past masters at it in their dealings with suppliers, this is due in no small part to the typically unbalanced nature of their supplier relationships, in which they are much the dominant partner.

However, there is much that companies of all sizes can do to deflect some of the most damaging impact of rising materials and component prices.

Related team

Ian Corfield

Ian Corfield

  • Partner
  • Restructuring Advisory
  • London

Richard Sanfourche

Richard Sanfourche

  • Director
  • Financial Advisory
  • London

Justin Matthews

Justin Matthews

  • Director
  • Financial Advisory
  • London