Saturday September 10, 2022

Restructuring Advisory Partner Ian Corfield, and Directors Justin Matthews and Richard Sanfourche explore how to pass on the cost of inflationary rises whilst mitigating the risks.

Right now, it feels as though wherever you look businesses in broadcast interviews and press articles are expressing their fears about today’s inflationary pressures. A regular theme is how they cannot pass on price increases because, as so many put it, “my customers won’t stand for it”.

In some cases, this attitude is clearly appropriate. Tom Strainer of CAMRA recently pointed out how some pubs are facing energy price rises of 500% to 600%. As quoted in the Daily Star, he said: “How much would 500% be on a £5 pint – you’re talking ridiculous amounts of money, 15 or 20 quid for a pint. What you can say with surety is you can’t possibly pass on these energy increases and you can’t increase the pint by 500%.”

Of course, he is correct when it comes to the beer price – but this is an extreme example. At the risk of being brutally frank, in many cases putting a blanket ban on passing on the costs is an attitude with some very real associated dangers associated. In many cases, it’s a recipe for some business distress; in others, it may even be a direct cause of actual business failure.

It’s ignoring a very important reality: if your business does not in some way pass on the cost increases that it’s having to bear, possibly through open and honest communication across the supply chain, its margins will shrink or even disappear altogether. In some cases, that shrinkage will prove terminal.

Assessing your customer leverage

So how can business owners pass on the price increases they’re experiencing without damaging customer relationships or even losing them altogether?

The answer, of course, is not straightforward. It not only depends on which sector you operate in; it’s also dependent to a great degree on the amount of leverage you have over your customers. For example, if your business represents a critical link in a manufacturing supply chain where you are the sole supplier of an essential component or service, customers will often have little choice other than to comply with whatever increase you request.

But if you’re the supplier of a largely commoditised product or service that you’ve sold in the past on the basis of aggressive pricing, your room for manoeuvre will be significantly restricted.

The nature and base value of your product or service is also an essential consideration. For example, if you produce a £5 microchip that is an essential component of a £50,000 vehicle, even doubling its price probably won’t be a deal-breaker. However, trying to do the same with an item that represents 50% (or even 5%) of the vehicle’s end value would almost certainly be doomed to failure.

Similarly, if you’re in a sector like construction, where fixed-price contracts tend to be the norm, you’ll find it difficult to pass on any cost increases landed on you by your suppliers. And if you operate a care home, the likelihood is that your biggest customer will be a cash-strapped local authority. This obviously restricts your choices, with one possible solution being to increase the proportion of private patients you care for.

Creating positive points of difference

None of this is to say that businesses don’t have the potential to compete harder by creating leverage in different ways. Providing excellent service, mining-specific areas of expertise or delivering outstanding product quality can all be powerful means of adding value to your customer relationships. They all make it harder for customers to risk rocking the boat with a point-blank refusal to pay more.

But you shouldn’t take it for granted that this will always be the case. Companies will often be prepared to accept a bit of pain to support a trusted partner through a difficult period, but if that period starts to look as though it may become extended they’ll sooner or later start to wonder if they couldn’t do better by switching suppliers. We are seeing this in action in the food-manufacturing sector. The sheds are accepting new input prices, albeit often on a ratchet arrangement involving future clawback and the requirement to be treated as a priority customer.

One strategy that continues to be successful is that of providing a specific service enhancement in exchange for a price increase – perhaps through accelerated delivery times or improved packaging. Get this right, and you are delivering a form of added value that is directly associated with your product. This can mean that this additional value becomes permanently engrained in your product, making it attractive over the longer term.

Another possible approach is that of changing the product rather than its price. If you provide branded foods, for example, you might be able to avoid overt price increases by simply charging the same for less – something known as ‘shrinkflation’, as practised by chocolate manufacturers everywhere.

Or you might be able to find ways of reducing your costs of production, perhaps by buying cheaper materials, enabling you to maintain your own headline pricing for the medium term.

However, in a prolonged period of inflation, even these approaches will eventually run out of traction and prices will need to shift upwards too. This is particularly the case in sectors like manufacturing, where long supply changes mean the inflationary impact is compounded all along the line, forcing the end customer to pay for the sum total of increases that have been implemented at many points in the chain.

Strategic organisational change

These are some of the reasons why adopting organisational change and rationalising your costs to lock in your margin at a more strategic level is a good approach. Achieving this correctly means that even if you have to increase your prices (and this is inevitable, with even McDonalds famously increasing the price of its cheeseburger after 14 years) you’ll be able to do so at an acceptable level that matches the realistic expectations of your customers.

This is where zero-based budgeting can be extremely useful, if not essential. This involves starting from scratch in every accounting period to build costings from the ground up, rather than simply tinkering with those inherited from last year. It’s fresh thinking, related entirely to the current reality. And a similar approach to manufacturing can also be powerful: do things really have to be made that way just because they have in the past?

In this context, a ‘strategic’ understanding means one that is based on the real costs of running your business alongside an accurate analysis of where you can reduce them. That’s not to say just looking at the costs of power, rent and production processes as well as staffing levels – although these certainly should be among your considerations. It goes much further. For example, get to understand your customers in depth, and what it is about your business and its products that they value most. Where is the business making most of its money? Then consider redeploying budget from underperforming areas to invest in those in-demand products, services and other touchpoints. Look at the areas that are underperforming; should you shut them down? Or would others be able to realise value from them if you sold them on?

And what can you do to streamline your operations and become more agile in the long term? Can you shrink the business by dropping less profitable lines or areas to focus on those most resilient, core products and services that drive the best returns? What opportunities are there for new efficiencies based on automation? Could you defray your costs by joining a buying group?

Are there customer or supplier relationships that are beyond salvaging that you should exit at the earliest opportunity?

When considering questions like these and many others, ensure that you are using accurate, up-to-date data on which to base all your decision-making. Consider using a rolling 13-week cashflow forecast so you can continually monitor and manage money in and out of the business.

And above all, ensure that you embed this more strategic approach, always supported by the accurate analysis of the best available data, as an essential part of business as usual. That way, it will become a permanent driver of continuous improvement.

At FRP, we have considerable experience of implementing successful change programmes, enabling businesses in all sectors to rationalise their costs and improve margins while maintaining positive customer relationships.

With costs on the rise, early action is advisable to ensure the best possible outcome – over the short and the longer terms.