The price rises that started after the COVID-19 outbreak have turned out to be more than a one-off shock. Energy, agriculture, and minerals markets all face disruptions ranging from Russia’s invasion of Ukraine to climate change that are driving inflation worldwide. Consumer price indices in the United States are expected to increase around 8.6% in 2022 from an average of 1.5% to 2% between 2010 and 2020. For the euro area, economists project that increases in the harmonized Index of Consumer Prices (HICP) will ease slightly but remain at unusually high levels, declining from an average of 8.1% in 2022 to 5.5% in 2023 and 2.3% in 2024 (versus an annual average increase of 1% to 1.5% between 2010 and 2020). While some countries like Latin America are used to inflationary spikes, geographies with historically low inflation rates are even more at risk, with only a few chief executives having faced the challenge of leading a company through peaks like today’s.
Over the longer term, “greenflation” from the relatively high price of renewables and “climateflation” from the economic impact of increasingly frequent severe weather events could stoke inflation even further. The price of carbon dioxide emissions, meanwhile, is also rising sharply due to tougher regulations and bolder pledges by companies to reduce or eliminate greenhouse-gas emissions. The forecasted 2030 price of 1 ton of CO2 has increased by more than 200% in the last two years.
In this environment, every inflation uptick is paid for and the cost of inaction is considerable. One of our clients, an international B2B service player, is facing inflation with a high wage increase across its main geographies, reaching a 6% rise on average. Even considering pricing pass-through of 50%, not taking incremental pricing actions would result in a monthly loss of 8M€ and an operating margin decrease of 3.9 percentage points. For another international client operating in food and facilities management markets, keeping the same cost structure and pass-through policies (greater than 70% average pass-through) in this higher-inflation environment would put at risk 80% of the margin by 2025.
While the new inflation is a source of risk and uncertainty, it also provides an opportunity for business leaders. To seize it, c-suite officers need to think beyond the implications for short-term profitability and consider how they can adapt their operating models and differentiate their companies. First responses are no longer sufficient; it is time for more radical actions.
A first step is to build an in-depth understanding of the impacts of inflation along the entire value chain and address questions such as: Which customers pose the greatest risk? What are the current and forecasted impacts on each cost line? Which contracts contain cost adjustments? Having established the specific challenges presented by inflation, companies should deploy a comprehensive playbook to overcome them based on four pillars.
When inflation increases, companies often first react by raising prices to defend their margins. So the first question is how to calculate price hikes to respond quickly. Instead of setting the same price increases across the board, companies should implement differentiated increases tailored to each customer and contract. To do that, the first step is to understand what the current and expectable impact of inflation is. This requires tools that provide margin visibility at a granular level, by account and by product or service, enabling a proper understanding of cost drivers (including forecasts) and refreshed at a high frequency — such as monthly — given the uncertainty driven by inflation. Based on this granular understanding, renegotiation campaigns need to be launched quickly considering factors such as pricing power, the level of commoditization or scarcity of each product and service, and each client’s potential switching cost or risk of churn. This level of data granularity also enabled the world’s largest food manufacturer to adopt a “cut the tail” inflation strategy in the second quarter of 2022, trimming underperforming SKUs to counter inflationary headwinds. The objective was to hedge against the current rise in inputs prices and supply-chain pressures, aiming for a positive effect on other portfolio products.
Companies should prepare these renegotiation discussions with clients; an initial move can be a public announcement of price increases. And sales teams need to change the nature of discussions with their clients. They should be prepared to answer questions on pricing changes and start win-win discussions on partnerships, making clear that they might lower their prices — or moderate their price rises — depending on future inflation. More radical actions than price increases could include deprioritizing delivery or exiting a contract. One major high-tech player has developed non-standard repricing levers that pass through the price increases of some of the components it buys and extend to possible contract termination.
The current inflation is also an opportunity to make long-term changes to pricing practices. When economic conditions are volatile, companies need to adjust their prices more frequently than at annual reviews. That’s why in parallel of the renegotiation campaigns, companies need to review contract clauses, introducing more price pass-through formulas and aligning terms and conditions to allow future price increases or renegotiations at a higher frequency. Companies also need to equip teams with agile pricing solution, guidelines, and tooling. And they need to set up a solid governance, coordinating pricing, sales, and procurement teams to address complex, volatile environments.
Addressing suppliers’ price increases
Many suppliers are facing component and commodity price increases themselves and will need to raise their own prices. Companies’ responses will depend on their leverage as customers. Where a company is in a strong position, it can use a traditional negotiation toolkit: build and train a team, then carry out negotiations. If a company is in a relatively weak position, it might be better to look for alternative sources. This will require coordination with its pricing and sales team to set a target price and cost range, as well as launching a search for other suppliers.
Avoiding shortages and breaks in the supply chain
Companies in industries exposed to supply chain disruption might have to address component shortages by rethinking their supply chains. One option is to turn their relationship with a supplier into a more open and collaborative partnership. This can include coordinated actions, such as sharing information on inventory and costs or using open-book contracts. These arrangements can strengthen the relationship and help better anticipate potential shortages.
In the most critical cases, product portfolios can be adjusted, and products redesigned to avoid blockages — designed to cost, for example, to take account of price increases or component shortages. Some heavy-industry companies, such as vehicle manufacturers, have had to find new supply sources through innovative solutions, for example the recycling or reuse of components and the gray market. Another measure has been the adaptation of product portfolios through design-to-cost production.
Two major trends are having an impact on the way companies manage employees. First, inflation is pushing up salaries across the board. Second, many industries are suffering from a growing shortage of workers, increasing the bargaining power of talented employees. The labor squeeze is particularly challenging in people-intensive industries, such as catering and facility management, where services are provided on-site, and postal and parcels delivery.
As well as better compensation, staff are seeking more favorable terms in employers’ wider value propositions. One company we are acquainted with has worked extensively on its value proposition to reposition itself as an employer of choice. It has redesigned its mobility programs and implemented best practices for everyday work, for example ensuring that employees do not suffer mental health problems and providing exoskeletons to reduce physical stress. It has also realigned its career development process in a way that optimizes each employee’s career path. And it has spread diversity, equity, and inclusion best practices throughout the company.
Unsurprisingly, employees think stimulating work and a fair and competitive base salary are the most important factors in their employment packages, according to an Oliver Wyman study conducted on the more than 1,500 employees of a European high-tech company with offices in several countries. In the current inflationary environment, companies might need to revise salaries more than once a year to address employees’ concerns over their standards of living. However, employers should also consider alternatives to standard salary increases. In some cases, one-off bonuses or stock awards might be more appropriate.
To make their businesses attractive to talent over the longer term, companies will need to create a distinctive experience. This implies paying attention to aspects of working conditions that concern employees, including the provision of healthcare and childcare. Work-life balance can be adjusted through a four-day workweek or by giving unions a greater voice in working hours and pay. Companies can also offer training or support for education and development — such as covering the cost of a master’s degree — as well as providing extra childcare to facilitate these activities.
New Tools And A Committee To Thrive Despite Inflation
Though inflation might traditionally be a focus for a CFO, the new environment means that a company’s entire senior leadership will need to consider its impacts. One way to do this is to set up a transversal steering committee involving functions including finance, sales and marketing, products, procurement, and human resources. This committee will use advanced tools to analyze the specific impacts inflation is having on the company now — and the impacts it is likely to have in the future, with the objective to get ahead of events rather than reacting to them. These should include enhanced data to make informed strategic decisions rapidly, including transparent price-tracking processes, predictions of future inflation, and a standard way of calculating inflation exposure. One large European biscuit manufacturer anticipated an upcoming peak in paper costs and quickly implemented a double-sourcing strategy for corrugated boxes paper, reducing the inflation impact (10% cost increase versus 30% for the market in the same period).
CEOs need to get ready for whatever the future brings, whether this be spiraling inflation or a relatively quick return to price stability. Above all, they have an opportunity to reinvent their business model. To seize that opportunity, CEOs could start today by asking themselves and senior leaders the following questions:
- What are the precise inflation impacts on margin, by geography, and by product line? What are the forecasts and related impact evolution?
- What is the pass-through level and, most important, its pace? What are the levers to improve it?
- Are current organization, governance, and monitoring— targets, KPIs, incentives, tools, and so on — optimal to lead the company through inflation spikes?
This article was made possible with the support and insights from Hugues Havrin, Bruno Despujol and Simon Eymery.