An entrepreneur and investor. Co-founder at USEReady† attending Owner/President Management – Leadership Program at Harvard Business School
The consumer price index (CPI) and inflation have risen sharply in recent years. As a result, companies around the world are struggling to control costs and their margins, especially as the prices of labour, materials, energy and rent are rising rapidly.
To survive in this economic environment, companies need to understand the impact of shifts in costs on their business. Using this information, they can then apply a range of strategies to limit cost increases and protect their margins.
How do changes in costs affect a company’s margins?
As interest rates rise, borrowing rates also rise. This means that it will become more expensive for companies to access capital in the short and long term. In addition, credit requirements are tightening in the current economic climate. This creates barriers to access to capital for small and medium-sized businesses that may not always be able to meet these stringent requirements. Valuation compression also affects companies’ ability to raise debt in public markets.
Another way cost increases affect companies’ margins is through shifts in labor costs. According to the United States Department of Labor Statistics, there were: 11.5 million vacancies available in the United States in March, along with: 1.9 million applications for unemployment insurance† This indicates that there were six job openings available for every unemployed person in March.
In today’s global economy, there is an increasing demand for goods and services. Many companies are struggling to meet this demand while making a profit, especially as they try to rebuild after the economic impact of the Covid-19 pandemic. As a result, many employers are willing to pay higher wages to ensure that they are adequately staffed and trained.
However, this shift in employment practice has unintended consequences. Many people who are currently employed feel that they are underpaid compared to recent hires or that they are limited in their current positions, so they seek new opportunities in what is called the great layoff†
In addition, many people who have recently been employed are more willing to change jobs in a short time to take advantage of an increase in wages in various industries. This creates a vicious cycle of wage inflation, which poses challenges for companies with limited resources.
Supply chains also play a major role in determining costs and margins. The pandemic and other global events have created many problems in the supply chain, especially in the energy, oil and agricultural markets. A question many stakeholders are asking is whether they should invest more in local production than in global production. On the one hand, investing in local production can help a country and its companies survive the current supply chain problems. However, it was already expensive for companies in North America to produce goods on a large scale. With rising labor costs, production is now becoming even more expensive.
Ongoing supply chain issues have also prompted companies to consider their production and inventory cycles. There is a movement to redefine just-in-time supply chains. Some companies have chosen it produce more than current demand requires. In some cases, companies have also hired more workers than necessary. In this situation, companies have to manage large inventories that affect margins.
Market volatility also affects cost margins. In a matter of weeks, the price of nickel shifted from just $10,000 a pound to over $20,000 a pound to about $12,000 a pound. Similarly, the price of crude oil has fluctuated between $90 and $125 within a few weeks. Similar market volatility is occurring in all sectors, including the food and agriculture industry, the commodity industry, and the specialized skills labor market. Preparing for and hedging against such volatility is expensive and puts significant pressure on a company’s margins.
How companies can manage rising costs
In today’s market, it is extremely difficult to navigate cost pressures. However, companies are constantly innovating, developing greater awareness of their costs and finding ways to control their costs and improve profitability. Proactivity is key in these situations, as it allows you to streamline operations and manage your financial controls. In general, managing predictable margins is just as important if not more important than generating revenue. Below is a list of principles businesses should consider when managing rising costs:
• Communicate with your customers about price increases and possible risks. Get creative and explore new pricing models (e.g. value-based, outcome-based pricing models) to increase margins.
• Liquidity in the event of unforeseen circumstances. Options such as lines of credit, asset-based loans, private equity capital, selling non-strategic parts of your business, and convertible debt are all options and should be considered.
• Use perks 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, promotion and further education of your staff. Encourage employee referrals and invest in employee benefits so you can retain top talent.
• Use flexibility in today’s changing market. Being open to paying higher fees for contractors rather than doing all the tasks in-house can save you unforeseen costs, especially if your business is new.
• Find a balance between profitability and growth. Focus on budgeting areas of investment and continuously tracking your return on investment.
Innovation and automation are key to cost control in today’s economic environment. Keep in mind, however, that in the short term, investments in innovation will drive up costs. However, it can be beneficial in the long run.
Rising inflation and increased market volatility are not short-term problems. Companies must regularly focus on controlling costs, prices and their margins to survive in today’s economy. If companies 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.