Finance: Inflation

Inflation threatens profits
Michel Janssen

Companies expect a significant rise in commodity prices and offshore labor rates, while more than 60 percent say they cannot successfully mitigate inflation, according to research from The Hackett Group, presented here by Michel Janssen and Pierre Mitchel.

 

Rising prices and other inflationary pressures could reduce corporate profits by up to 9 percent in 2011 and 2012, according to a new study from the The Hackett Group, Inc, a global strategic business advisory firm. For a typical Global 1000 company with $27.8 billion in revenue, the study estimated that commodity and offshore labor inflation could drive a $150 million/year hit to the bottom line. 

The Hackett Group's research also found that world-class companies can more than mitigate the effects of inflationary pressures by enhancing their operating platforms to take advantage of productivity improvement opportunities.

The study found new warning signs of inflation on the horizon. Polling executives at large global corporations, it found that the recent inflation of commodity prices is likely to increase significantly over the next 12 months, and be accompanied by rising inflation in internal labor costs and external services.

Companies in the study reported that they will pass half of these additional costs on to their buyers, but the other half will need to be absorbed by their organizations. In addition, while most companies in the study say they can effectively anticipate commodity price increases, more than 60 percent say they have not been successful at mitigating these costs. Part of the strategic sourcing challenge is that few of today’s executives have experienced significant inflation, which was last seen in 1981, so organizations are having to learn how best to manage inflation challenges all over again.

Companies are already feeling the effect of rising commodity prices, seeing them increase by nearly 5 percent over the past year, according to the study. Key commodities like crude oil and metals have risen dramatically, with someprices more than doubling over the past two years. Commodity price volatility is also a major factor, having increased by nearly 60 percent since before the recent recession.

In the next 12 months, companies in the study said they expect the rate of inflation for commodities overall to rise by more than 30 percent, to 6.3 percent per year. At the same time, these companies are expecting the rate of inflation for internal labor to more than triple, rising from 0.7 percent to 2.2 percent, and the rate of inflation for external services spending to increase more than two-fold, from 1.2 percent to 3 percent.

Labor and services cost inflation are in part being driven by a tightening of labor supply markets in India, China, and other low-cost labor markets, fueled by increased demand. Most indicators for India and China point to roughly 6-10 percent inflation for 2011.

“Inflation has become one of the top issues with our clients,” said The Hackett Group Chief Research Officer Michel Janssen. “Strength is returning to the global economy, but the rate of inflation has already increased significantly, and clients are concerned about the impact of further inflation during the coming year. Like the proverbial deer in the headlights, many companies see the approaching danger, but don’t know how to get out of the way. There’s real potential for all this to have an impact on growth, profitability, and consumer prices. It’s very tough to keep your promises to Wall Street when you can’t accurately forecast or control your expenses.”

The research detailed the problems large companies face in cost reduction, and at specifically mitigating commodity cost increases. From a procurement strategy perspective, most companies tend to take a fragmented, siloed approach to anticipating and mitigating costs, the study found. More advanced companies forecast prices and do some basic hedging by adjusting contract length, purchase volumes or inventory levels. But few take a truly cross-functional approach, or do the analysis required to understand the impact of commodity cost increases on profitability, use specialized analytics to anticipate future commodity costs, or provide clear direction and policy for making hedging decisions.

The study also offered recommendations and guidelines for companies to improve their supply chain strategy and their ability to mitigate input cost inflation. The Hackett Group recommended that companies focus on integrated input-cost planning, to forecast and plan for changes in commodity prices, and use robust scenario planning to link supply plans, including pricing, with demand/business plans. An integrated approach to commercial risk management was recommended, to better understand commercial objectives and create a “spend portfolio” that is managed by procurement and finance working together. Finally, the report recommended that companies move beyond simple input-cost mitigation, to consider broader cross-functional approaches to cost mitigation, such as changing product designs, financial hedging, or vertical integration such as acquiring a critical niche supplier.

The research also detailed the operational changes in The Hackett Group’s Operating Platforms or Service Delivery Model and other areas that set world-class companies apart, enabling them to mitigate inflationary effects and other potential pressure against profits.The Group’s 2011 data reveals that world-class companies set themselves apart in several important ways which help them continue to excel in today’s inflationary environment. They deliver services in finance, IT, HR, procurement, and other back office areas at 29-42 percent less cost than the peer group, translating into savings of $314-$446 million for the typical Global 1000 organization. In addition, they have achieved these efficiency advantages while also improving their effectiveness.

“There’s no question that companies are facing a roller-coaster ride when it comes to input costs in the coming year,” said The Hackett Group Senior Research Director Pierre Mitchell. “It’s a ride that senior executives would love to get off, but most companies simply don’t have the metrics, tools, and organizational models in place to make this happen. The threat of rising inflation is an opportunity for executives to build a business case for developing new capabilities, and improving cross-functional capabilities.”

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The Hackett Group isa global strategic business advisory and operations improvement consulting firm, and a leader in best practice advisory, business benchmarking, and transformation consulting services including strategy and operations, working capital management, and globalization advice. Through its REL group, The Hackett Group offers working capital solutions focused on delivering significant cash flow improvements. www.thehackettgroup.com