Last week the June CPI and PPI were published. With a CPI of 9.1% in June, the CPI is once again at a 40 year high. Consumers are confronted with spending more for energy, a 41.6% year over year increase, and food, a 10.4% increase. With wages rising, but at a lower rate that costs have increased, consumers are altering their buying habits to respond to less cash flow.
The June PPI was 11.3%, with energy reporting a 54.4% increase, transportation & warehousing increasing 23.0%, and food increasing 12.7%. This means businesses are seeing expenses increase month over month and year over year, and financial performance continues to be stressed in margins, EBITDA, and the ability to service debt.
With these levels of CPI and PPI year over year increases, consumer confidence and business confidence are both suffering. The Organization for Economic Cooperation and Development (“OECD”) is a forum where 37 democratic governments share information to promote sustainable growth. The group publishes a Consumer Confidence Index (“CCI”) and Business Confidence Index (“BCI”) for the combined 37 governments, and for each separate country.
A CCI above 100 indicates consumer confidence is positive. Values below 100 indicate consumers are less likely to spend, as they are concerned about their future economic situation. The overall CCI for June is below 97, and the US CCI for June is below 96.
A BCI above 100 indicates businesses have optimism for future performance, with a BCI below 100 indicating pessimism for the outlook for the business and the economy. The BCI for all governments for June is just above 100. In the US the BCI for June is at 100 and trending down.
Businesses and consumers are experiencing cost increases that are not offset by wage or revenue growth. Outlooks are becoming more negative, and businesses and consumers are struggling with how to navigate this economic environment. Consumers have already changed buyer habits, which in turn impacts businesses providing the goods and services to consumers.
What can a company do to respond to these trends?
First, paralysis and fear are not an option. This is a difficult situation. There is no doubt of that. But the way to deal with the uncertainty of the situation and the stress created is to analyze, manage and adapt.
That leads us to analyze, manage and adapt. How does a business do that? The tools a business uses today are tools that most owners and managers have not had to employ in the recent past. Two thirds of the US population has not experienced inflation at this level and is not used to using all these tools to improve performance.
Here are several key approaches for successful management in this environment:
Price volume variance analysis. Because the per unit prices are changing, it is imperative that volume and price both be considered. For example, fixed and variable operating costs need to be evaluated based on current volumes and prices – not historical levels. A business could make the wrong decision on pricing or expense management if per unit activity is not considered. Often we use a “common size income statement” as the initial basis for this review. We might consider revenue and expenses per board foot, per pound, per bushel, or per some other unit of measure that is specific to the business.
Customer profitability. The contracts governing the customer relationship need to be reviewed for potential price increases, or for potential renegotiation at the next opportunity. Understanding the unique customer requirements and the costs associated with providing the product or service will help a business focus on the clients that are the most reliably profitable. A contract summary matrix is the basis for this analysis. Then identifying the unique customer requirements is key. For example, if customer A requires mixed boxes of product and pays the same as a customer that accepts boxes of the same product, the costs to handle and mix the product must be attributed to the profitability of customer A.
Product profitability. The need to evaluate product and project profitability is critical. Emphasizing the more profitable products could shift the break-even performance of the business toward improved performance. The mix between various products that are produced from the same raw materials will also need to be evaluated. For example, chicken processors often say they wish they could purchase a bird with 20 wings to maximize profits.
Expenses in categories that are experiencing the highest price change need to be evaluated. If transportation and warehousing are up 23.0% and the business being analyzed has only experienced a 10.0% increase, it is important to know why the increased costs have not yet been experienced. On the other hand, if the business experienced a 35.0% increase that is also critical to expense analysis. For categories such as energy, it may be time to employ an expert in utility cost management and negotiation with alternative energy providers.
Expenses in categories that rely on providers who rely on transportation and warehousing, energy, or food need to be evaluated for price increases and potential further increases. For example, if a supplier is providing an energy intensive material to the business being evaluated, and the cost of the material has not increased at the level of energy increases, it may be time to consider the impact of further price increases.
Alternative supplier analysis. Businesses that rely on one or two key suppliers are at greater risk of price increases and service disruptions. The emphasis on analysis of alternative suppliers will need to be intensified.
Labor costs must be evaluated in terms of base pay, overtime, commissions, and other incentives paid to employees. Turnover costs must be considered. Remote work versus in person work requirements need to be evaluated on a person by person, department by department basis. With labor costs increasing, automation may be a better alternative than it would have been in prior years.
Interest rates. The cost of money is increasing and should be expected to increase further. Fixed charge coverage ratios need to be reforecast based on current EBITDA performance and current interest rate expenses.
Financial analysis often separates the winners from the losers, but in an economic period such as the one we are experiencing in 2022, financial analysis is not a luxury. It is a requirement.
Using a third party to evaluate these key performance metrics may increase the likelihood of success. A third party may be able to prepare the detailed analysis the company is unable to direct resources toward preparing itself. A third party should have fewer preconceived ideas and would be able to look at the data with a clear eye. This is a time to ask questions – tough questions – about customers, suppliers, and staffing and consider creative alternatives.
Analyze, manage, and adapt!