Cost increases are upending established business rules internationally
Inflation is something that is better known to previous generations of international business managers. Most mid-market leaders in roles today have not seen serious levels of inflation in their working lives. It is a new foe and a dangerous one. To quote former US President, Ronald Reagan: “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man".
Research from Grant Thornton’s International Business Report shows concerns about key cost categories running at or very near record highs around the world. Mid-market businesses across 28 countries monitored report average price increases of 21% for raw materials in the last 12 months, and 20% increases for both energy/utilities and transport costs. Bank/interest costs meanwhile have surged 16% and tax bills have risen by 17%.
These dramatic price hikes upend established business rules and look set to continue for the short to medium term. The World Bank and others are comparing price rises with those of the 1970s, when low economic growth also prevailed. Andrew Webb, chief economist at Grant Thornton Ireland, says “sentiment about inflation shifted rapidly at the start of 2022 from being a transitory, predominantly supply chain and release of pent-up demand issue, to one that has taken a firmer grip. ‘Higher for longer’ now summarises the global inflation context.”
Follow the ‘Essential action plan for managing in inflationary times’
To survive and thrive, mid-market companies around the world must do what they are good at: adapt. To help them, we have drawn on the breadth of experience and market knowledge within Grant Thornton’s network to develop the ‘Essential action plan for managing in inflationary times’. The plan comprises seven actions we believe all mid-market businesses should take now to deal with this threat – or at least consider taking.
Global head of advisory at Grant Thornton International Ltd., Mike Ward, says: “This isn’t a list of everything companies could do, but it is the essential starter actions with maximum impact. The steps will help businesses get through this difficult inflationary period, and make them more resilient to any economic slowdowns, which is a real risk in the aftermath of inflation.”
Peter Bodin, CEO of Grant Thornton International Ltd., comments, “Throughout the pandemic our international network of member firms worked together to help clients tackle the challenges of COVID-19. Now we are mobilising again to collectively help international businesses across our markets deal with inflationary pressures. This action plan represents the very best of our thinking, and our commitment to sustainable, international growth for the mid-market.”
Action 1: Identify and mitigate the risks of inflation for your business
Very few businesses internationally have pre-prepared plans for managing high and prolonged inflation and all businesses should identify the risks and draw up a plan to mitigate them. This isn’t something for one or two key executives to do in a darkened room. Inflation touches all parts of a business, and so “the best plans will include the most points of view,” says Mike.
“And force your senior leadership team to step back and work across the organisation on the bigger picture strategic issues and how to deal with them. You don’t, for example, want the finance group looking at customer profitability in isolation and terminating the wrong customers.”
Once developed, the plan will need to be regularly reviewed to ensure that it evolves in step with the threat. Head of large corporate advisory in Grant Thornton UK, Robert Hannah also stresses the importance of rethinking normal business planning. “In the past, planning used to be relatively easy. Now inflation can erode margins so quickly that accuracy really matters. So, businesses need to plan more frequently, consider a wider range of outcomes and model these well.”
Action 2: Take action to limit external cost increases
This is something we’ve encouraged businesses to consider ever since inflation started to rear its head. Actions here include locking in prices, bulk buying, renegotiating terms with suppliers or changing suppliers. In a high inflation environment these basic countermoves can really make a difference in limiting costs and protecting margins.
Ben Yokell, national sourcing and supply chain transformation leader for Grant Thornton LLP in the US, encourages companies to carefully review supplier contracts and look for opportunities to enhance terms or even take services and goods out to bid. “Many companies only go to market in declining environments but re-evaluating your supply base and third party providers in a rising market can be equally valuable. Inflationary pressures have been driving costs up, but not all suppliers are reacting symmetrically.”
While many companies have been hedging against price increases through bulk buying or advanced ordering, this has put additional pressure on inventory, working capital and storage space requirements. Ben advises companies to “leverage advanced inventory optimisation techniques, industrial engineering, and experienced operations improvement teams/skills to optimise your distribution footprint and return on inventory investment”.
There are also important profit and tax implications associated with bulk buying when it’s done through subsidiaries. Peter Vale, partner for international tax at Grant Thornton Ireland, explains, “If all purchases are routed through a particular subsidiary, then there will be transfer pricing implications to consider. In some cases, depending on the location of the subsidiary and substance ‘on the ground’, this could lead to tax savings in addition to the mitigation of inflation.”
Mike stresses the value of deploying multiple strategies to curtail external costs, rather than relying on just one. And while banging the table and asking for price and term concessions may work for certain types of suppliers, there is increasingly a need to work more collaboratively with suppliers, particularly given the severe stresses that now exist in supply chains.
Action 3: Outsource more activities to lower costs and ameliorate labour shortages
Outsourcing may seem like an old solution to a new problem, but the benefits it offers are now more compelling than ever for international companies looking to both lower costs and address the skills shortage. India has been one of the key global destinations for outsourcing, and Devesh Uniyal, partner - CFO services and business process solutions leader from Grant Thornton in India, explains the costs of service in the outsourcing space compared to in-house teams have declined in the last couple of years.
“Outsourcing partners have invested heavily in automation and developed new service models that can give you immediate access to greater efficiency through shared technology platforms and centres. There’s also been a geographic shift in the location of people working in outsourcing which is positive for costs. Before COVID-19, people used to migrate to expensive tier one cities for work. Now people are going back to tier two and three cities and working from home at a lower cost.”
Fellow partner, Siddharth Talwar, adds: “To complement the benefits of outsourcing, businesses should look at the current design of their processes and explore optimisation opportunities through a range of modern technological tools. A relevant example is a finance function transformation exercise which not only makes processes lean, but also brings in accuracy and efficiency.”
A related strategy that companies are deploying is to relocate operations to lower-cost jurisdictions to help manage wage costs and inflation generally. Peter Vale says Grant Thornton teams are having conversations with a number of companies about relocations but again cautions that this has tax considerations.
“Maybe your R&D is currently in a high-cost jurisdiction, and you are looking at lower-cost alternatives. It's important to consider the tax impact of relocating key activities. In the case of the relocation of value-adding R&D roles, this could lead to the attribution of additional tax profits to that jurisdiction, in particular in a post base erosion and profit shifting environment.”
Action 4: Improve your understanding of the true cost to serve clients
Grant Thornton experts agree that most mid-market companies around the world still don’t accurately and regularly calculate the costs and profits of individual customers that they serve. Yet customer segmentation provides critical information if you are to protect your own profitability by actively managing your customer base during this time.
Even in a developed economy like the US, Chris Smith, principal for business consulting at Grant Thornton LLP in the US, says mid-market companies aren’t doing customer segmentation to the degree necessary. “They do product segmentation, they do account segmentation, but rarely have they put in the programmes and systems to understand their actual customer segments and the profitability of each segment.”
Once the customer segments are clearly defined, the focus should be on understanding the cost to serve each respective segment. He stresses the importance of being clear about what costs are included in these calculations – such as supply chain, sales and marketing, and customer success – and allocating them appropriately to individual customer segments. “This is less about accuracy and more about consistency. I always say there is no perfect formula. What’s important is that you use the same formula year after year so the results are comparable.”
Mike echoes this advice and says agreeing a formula brings challenges, because of the competing interests of different functions. “To avoid a war between functions, we often play an important role in bringing know-how and independence to this exercise, and getting buy-in from all.”
Action 5: Change your pricing strategy so it is more in line with cost increases
Grant Thornton’s unique mid-market insights show just how quick many companies have been to increase prices in the last 12 months. Some 52% of global companies have been increasing prices exactly in line with costs, and another 35% have been increasing prices more than costs.
This is an extraordinary display of pricing power. And it may be tempting for leaders to think they can rely on this in future. “Companies should still look at increasing prices, but they cannot just price their way out of this problem,” says Mike. “The recent price increases have been supported by the particular combination of strong demand and supply shortages. These won’t last forever. Companies need to take a range of different actions to deal with inflation.”
Price increases are rife with risks – notably the loss of customers and competitiveness. Before adjusting prices, Chris advises companies to look at customer experiences (and the implied cost to serve) together with profitability. “You should start by right-sizing the experience for the different segments. If customers are unprofitable, you may decide to scale back the experience to bolster profitability.”
If prices still need to be increased, there are multiple factors to weigh up: existing contractual terms, timing of the increase, nature of historic increases, who the increases should apply to, whether you can link the increases to new features and customers’ willingness to pay. Art and science are needed here, and unless you have pricing capabilities internally, outside advice can be invaluable.
“Too often companies make pricing decisions based upon what’s happening to them. They may increase prices by 7% to offset a 7% cost increase. But if you are going to do a pricing change, don’t do it just to cover how you’ve been impacted. Assess your customers’ willingness to pay and try to get the increase closer to this. You may be surprised by what you can achieve,” says Chris.
How you engage with customers around price increases is also really important. All our leaders stress the importance of open communications, where you explain the pressures and try to work with customers to minimise the issues. Chris also suggests trying to tie increases to new service levels or product features, or even working out what customers already get for free that you could potentially build out and charge them for.
Brad Rolph, national transfer pricing leader for Grant Thornton LLP in Canada and joint global leader, stresses the importance of transfer pricing between related parties also keeping up with costs. “A lot of transfer prices are based on costs, so companies need to track these increases closely and build them into their pricing. Often that doesn’t get done and VAT gets underpaid and custom valuations are wrong. Companies should be reviewing their standard costs more frequently or move to an administratively easier methodology.”
Action 6: Take action to improve capital structure
Not only are input costs increasing, but so too are costs of capital as interest rates rise in order to contain the inflationary pressures. Companies need to optimise their costs of capital, and also look at scaling up or down the level of working capital to meet their needs.
Robert advises businesses to monitor their capital position more closely. In the short-term, if businesses are healthy and have plenty of cash, then they can consider strategies like bulk buying to beat inflation. If the opposite applies, then they may need to look at sourcing additional capital and managing debt. “The earlier capital issues are addressed, the easier it is and the more options there are,” he counsels.
Robert highlights that banks will inevitably become more cautious about lending in this environment. “You may not go to one debt provider and get everything you need. You may need to look at other providers and sources of capital and shop around. Access to finance will change, and so too will the importance of different sources so companies will benefit from getting some advice on other products and advice on structure.”
Action 7: Take steps to improve internal efficiency and costs, and/or reduce waste
There’s only so much you can do to stop higher prices washing through your business, and once they do, the next thing to focus on is internal efficiency. If you can do more with less, and cut down on the wastage, you may be able to offset the higher prices – and lower your environmental impact.
What really drives internal efficiency is technology. Grant Thornton has just published an article exploring how digital can help make mid-market companies more efficient, and where to invest for the biggest gains. Some of the areas we identify are automation, robotics and machine learning. These technologies improve productivity by lowering output costs and allowing companies to deploy human capital more effectively. Data is also really important in understanding true costs (see above), which plays a critical role in informing a company’s decision-making processes.
Deciding how to deploy digital budgets requires meticulous planning, says Xavier Lecaille, global leader of business process solutions at Grant Thornton International Ltd. Companies must evaluate the risks and returns before making significant investments and this is rarely straightforward. “It's not only a technology project, it's a change management project. If you introduce technology in your processes, you need to transform your organisation.”
Waste reduction is often a benefit of greater efficiency, but also deserves separate consideration. Elaine Daly, global head of business consulting at Grant Thornton International Ltd., identifies eight main types of waste including less obvious areas like underutilisation of skills, unnecessary movement of resources and time spent waiting. “Some waste is unavoidable, but most is simply unnoticed or ignored. Addressing it can save your business a lot of money.”
Companies are prioritising the right actions
In our most recent research conducted in May and June, we asked around 5,000 mid-market companies what actions they had taken or were planning to take to meaningfully deal with higher costs and concerns about inflation. The results are shown below.
What’s really encouraging is very few companies are doing nothing and that the mid-market is prioritising what we recommend in our action plan. Six of the top seven actions being taken perfectly align to our plan. So mid-market companies are prioritising the right things. The only recommended action that places outside the top seven actioned areas is ‘Outsourcing more activities to lower costs’, which definitely deserves more consideration by leaders.
Interestingly, what makes it into the mid-market’s top seven but not ours, is ‘focusing on product or service differentiation’. This is something we have recommended in the past Global business pulse for its importance in increasing pricing power and was considered for our list. But this can take time to deliver benefits, compared with the other recommendations.
Leaders need to accelerate progress now
“What is concerning is the fairly low proportion of companies that are taking the actions needed around inflation,” observes Mike. “Even the most popular actions are only being taken by around one-third of all mid-market companies. This is far too low. Companies need to be pulling all these levers now.”
Peter Bodin concludes, “Our essential action plan for managing inflation is a practical and timely tool for any mid-market leader focused on international growth in the current climate. This plan provides a framework for quickly assessing a company's current status and deciding where to focus, in order to protect against inflationary pressures.”