Manufacturing demand isn’t the constraint it was. Cost is, and it’s increasingly sorting the sector by size.
September’s UK manufacturing PMI rose to 51.9 from 51.7, extending the current period of expansion to eleven consecutive months. New orders grew for a tenth month and at a faster rate than in August, employment continued to rise and output across the year was running ahead. Taken on its own, the data suggests the manufacturing recovery is becoming established.
The more interesting part of the release sits underneath the headline. Small manufacturers reported sharp falls in both production and new business during September, while medium and large producers continued to grow. At the same time, rates of both input-cost and factory-gate price inflation were higher among SMEs than at larger manufacturers.
Those aren’t two separate findings. They point to the same mechanism. Smaller manufacturers appear to be facing greater cost pressure, passing more of it through into prices and reporting weaker volumes.
Cost is becoming a competitive advantage
When input inflation accelerates, as it did again in September after four months of easing, it does not arrive evenly across the sector. A larger manufacturer is more likely to have purchasing scale, fixed price supply agreements, contracted freight arrangements, greater negotiating power with suppliers and sufficient margin to absorb an increase for a period before having to change its own prices. However, a smaller supplier has fewer options and it either absorbs the cost through margin or goes back to its customer for an increase.
At that point scale stops being simply a margin advantage and starts determining where work is placed. A customer presented with two technically capable suppliers, one of which needs to increase prices while another can hold them, has a straightforward commercial decision to make. That can favour better-capitalised suppliers, whose balance sheets may give them greater capacity to hold prices.
That is an important change in the character of this recovery. When demand is the constraint, businesses compete to win it. When cost becomes the constraint, the ability to absorb that cost becomes a competitive advantage.
There is an alternative explanation worth acknowledging. Smaller manufacturers are not distributed evenly across the sector, and some will have greater exposure to consumer goods, which also contracted in September. Some of the difference may therefore reflect where smaller businesses operate rather than work moving between suppliers.
But that does not explain the whole picture. The same survey shows both input-cost and selling-price inflation running higher among SMEs than at large producers. Whatever contribution sector mix is making to volumes, there is a separate cost and pricing disadvantage associated with size.
Transport provides a useful example. Among the factors manufacturers linked to rising transport costs in September was diesel. Within three days of the survey window closing, the average UK diesel price reached a record 199.18p per litre and subsequently moved above £2 in early October. Whatever manufacturers were reporting about transportation costs during September, the position had further deteriorated by the time the PMI was published.
Diesel is particularly difficult for the mid-market because most manufacturers have little practical ability to hedge and it affects both inbound purchases and outbound finished goods. Freight operators themselves have limited capacity to absorb a sustained increase, so the cost often quickly works its way through supply chains through rates and surcharges.
There is also a more significant question around diesel: availability. The UK’s domestic refining capacity has reduced materially and reliance on imported diesel has increased. A price increase can be absorbed, passed on or argued about; a non-delivery cannot. That deserves treating diesel and transport as a supply-chain resilience issue rather than simply another input cost, and we have commented further on this here.
The composition of September’s growth reinforces the broader point. Investment goods were the strongest-performing category, with production rising at its fastest rate since the end of 2017, while consumer and intermediate goods both contracted. Intermediate goods include many of the components, materials and other inputs that feed production elsewhere in manufacturing, so weakness there matters beyond the businesses immediately reporting it.
Aggregate manufacturing can therefore continue to expand while financial pressure builds further down supply chains. September gives us unusually clear evidence of that divergence: larger manufacturers growing, smaller manufacturers contracting and the smaller businesses experiencing greater inflation at both ends of the P&L.
The international picture points to the same change in the nature of the constraint. US manufacturing remained in expansion during September, with new orders strengthening and backlogs increasing substantially. At the same time, the ISM prices index rose by 6.8 points to 77.9, while customer inventories remained classified as too low for the twenty-fourth consecutive month.
So we now see on both sides of the Atlantic that demand is not necessarily doing all of the rationing. Cost, capacity and availability are becoming the binding constraints, and when those determine how much a business can produce, balance-sheet strength becomes part of operational capability.
This also gives a direct connection with what I wrote after the July manufacturing numbers. At that point, inventories were being reduced while order books continued to strengthen. I described that as a working-capital release with a delayed fuse: reducing stock produces cash once, but if demand remains strong the inventory eventually has to be replaced.
September has started to give us the first proper indication of that next phase. Purchasing volumes increased, but stocks of purchases still contracted and finished-goods inventories reduced again. Supplier delivery times also lengthened at their fastest rate since June, with businesses reporting shipping delays, port congestion and material shortages.
The restock has started, but it isn’t landing quickly enough
That is an expensive position for any business. Cash leaves when the material is purchased, but the operational resilience this expenditure is intended to create only arrives with the stock. Material sitting between supplier and factory has consumed liquidity without yet becoming productive inventory. As supplier lead times extend, that funding requirement increases. Financing additional stock can also be challenging.
This is where the cost and working-capital arguments come together. A smaller manufacturer is already absorbing more input inflation and has less scope to pass it on without losing business. It must now also fund purchasing earlier and potentially for longer as lead times extend. The same balance sheet is being asked to absorb margin pressure, more borrowing costs, and finance the recovery at the same time.
That is why the September split by company size matters more to me than the movement from 51.7 to 51.9.
It also brings me back to what FRP thinks of as the decision economy. Data has become abundant but capital has not. The competitive advantage is not having information that nobody else possesses; it is reading the same information differently and acting decisively on what it implies before the consequence becomes visible in operations or the accounts.
The proximity to the Budget in late October also adds further complication because uncertainty creates a rational reason to wait. Pricing decisions can be postponed, facility discussions delayed, contracts left untouched and decisions around weaker suppliers deferred until there is greater visibility.
But the underlying economics do not wait with them. Input costs continue to accrue, margins continue to move and working-capital requirements continue to develop. Nobody consciously decides to do nothing. They decide there is still time. Six months later, those two decisions can look remarkably similar.
This is why I see restructuring as being about anticipation rather than intervention. By the time working capital or margin becomes the presenting problem, the underlying issue may be a decision that wasn’t taken months earlier.
Three questions manufacturing boards should be asking
For manufacturing boards, there are three questions I would be asking now rather than after the Budget:
- Where is margin actually moving?
Aggregate gross margin may not reveal the answer quickly enough. Look by customer, product and contract. How many recent price increases were accepted in full, and what has happened to enquiry conversion and win rates? - Where is the business effectively financing someone else’s fixed price?
Where selling prices are fixed but energy, materials or freight remain variable, model the remaining contract term against today’s cost base. - Where is financial pressure building below the first tier?
Which critical suppliers are absorbing cost increases? And where are suppliers taking on additional volume without the working capital to fund it?
The headline PMI cannot distinguish between a manufacturer growing because its market is recovering and one losing work because it no longer has the financial capacity to compete on price.
A recovery that sorts by size is not a recovery for everyone in it.
