An entrepreneur and investor. Co-founder at USEReady. attending Owner/President Management – Leadership Program at Harvard Business School
Over the past few years, the consumer price index (CPI) and inflation have increased significantly. As a result, businesses around the world are struggling to manage costs and their margins, especially as the price of labor, materials, energy and rent are rapidly increasing.
In order to survive in this economic environment, businesses must develop an understanding of how shifts in costs impact their business. Using this information, they can then adopt a range of strategies to mitigate cost increases and protect their margins.
How do changes in costs impact a business’s margins?
As interest rates increase, lending rates also increase. This means that it becomes more expensive for businesses to access capital in both the short and long term. In addition, in the current economic environment, lending requirements are becoming more stringent. This creates barriers to accessing capital for small and midsized businesses that may not always be able to meet these strict requirements. Valuation compression is also impacting businesses’ ability to raise debt in the public markets.
Another way that cost increases are impacting businesses’ margins is via shifts in labor costs. According to the U.S. Department of Labor Statistics, there were 11.5 million job positions available in the United States in March, along with 1.9 million unemployment insurance claims. This indicates that there were six positions available in March for every unemployed individual.
In the current global economy, there is an increasing demand for goods and services. Many companies are scrambling to meet this demand and turn a profit simultaneously, particularly as they try to rebuild after the economic fallout of the Covid-19 pandemic. Because of this, many employers are willing to pay higher wages in order to ensure they have a sufficiently staffed and skilled workforce.
However, this shift within employment practices is causing unintended consequences. Many currently employed individuals feel as if they are being underpaid compared to recent hires or are limited in their current roles, so they are seeking new opportunities in what is being called the Great Resignation.
In addition, many individuals who have recently been employed are more willing to change their jobs within a short time period in order to take advantage of a rise in wages across several industries. This is creating a vicious cycle of wage inflation, which presents challenges for resource-strapped businesses.
Supply chains also play a big role in determining cost and margins. The pandemic and other global events have created many supply chain issues, particularly in the energy, oil and agricultural markets. One question many stakeholders are asking is whether to invest more in local production compared to global production. On one hand, investing in local production can help a country and its businesses survive current supply chain issues. However, for businesses in North America, engaging in large-scale production of goods was already expensive. With rising labor costs, production is now even more expensive.
Continuous supply chain issues have also prompted businesses to consider their production and inventory cycles. There is a movement to redefine just-in-time supply chains. Some businesses have opted to produce more than the current demand requires. In some instances, businesses have also hired more labor than needed. In this situation, businesses are having to manage large inventories impacting margins.
Market volatility influences cost margins as well. In a matter of weeks, the price of nickel shifted from just $10,000 per pound to over $20,000 per pound to about $12,000 per pound. Similarly, the price of crude oil has oscillated between $90 and $125 within a few weeks. Across industries, including in the food and agriculture industries, commodity industry and specialized skill labor market, comparable market volatility is taking place. Preparing for and hedging against such volatility is expensive, and it puts significant strain on a company’s margins.
How Businesses Can Manage Rising Costs
In today’s market, it is extremely hard to navigate cost pressures. However, businesses are continuously innovating, developing greater awareness of their costs and finding ways to manage their costs and improve profitability. In these situations, proactivity is key, as it will allow you to streamline operations and manage your financial controls. Overall, managing predictable margins is as important as, if not more important than, generating sales. Below is a list of principles businesses should consider when trying to manage rising costs:
• Communicate with your customers about price increases and potential risks. Be creative and explore new pricing models (e.g., value-based, outcome-based pricing models) to increase margins.
• Liquidity for unforeseen circumstances. Options such as credit lines, asset-based lending, capital from private equity, selling nonstrategic parts of your business and convertible debt are all options and must be considered.
• Use benefits and other strategies to retain talent. When hiring new employees, focus on hiring a mix of employees (e.g., senior and junior employees, local and remote employees). Invest in cross-training, promoting and upskilling your staff. Encourage employee referrals, and invest in employee benefits so that you can retain top talent.
• Use flexibility in today’s changing market. If you are open to paying higher for contractors rather than performing all tasks in-house, you can save unforeseen costs, particularly if your business is new.
• Strike a balance between profitability and growth. Focus on budgeting for investment areas and tracking your return on investment on an ongoing basis.
Innovation and automation are key to managing costs in the current economic environment. However, be aware that in the short term, investments in innovation will inflate costs. In the long term, however, it can prove useful.
Rising inflation and increased market volatility are not short-term problems. Businesses must focus on managing costs, pricing and their margins on a regular basis in order to survive in today’s economy. If businesses are able to develop a concrete understanding of their cost profile and introduce innovation into their business models—as well as communicate, hire and operate more effectively—they will be able to remain competitive.