Managing the inflation curve

Inflation is back and, like it or not, it’s here to stay. What businesses do next is critical to surviving through the most challenging economic outlook in a generation.

Double-digit inflation. Unheard of in the lifetime of most of the professionals who work with me at Interpath. At 10.1% in July 2022, it’s not been since the early 1980s that the Consumer Prices Index (or a historical proxy) hit such dizzying levels. It’s also one of the highest rates of many of our trading partners, running above levels seen across much, though not all, of the Eurozone, as well as the US, Japan and Switzerland.

And the outlook isn’t much better. Analysts at Citi are indicating inflation could hit 18 or 19% by January 2023 as the energy price cap jumps twice. Goldman Sachs are suggesting perhaps 22%. Frankly, who knows? And whilst the Bank of England continues to suggest that the inflation is transitory in nature, the risk of inflation becoming baked into the UK’s medium-term economic landscape is looking increasingly likely.

Given the almost-blanket media coverage of the cost-of-living crisis this summer, clearly none of this is breaking news. Yet the real-world impact this is already having on consumers - and by consequence on businesses - across the country remains hard to understate. As I write this in early September, ONS data showed 1 in 7 businesses with more than ten employees were already on variable energy rates for energy. A further 10% of businesses report their current fixed rates expiring by the end of 2022.

Business owners are now facing ever-strengthening headwinds buffeting their P&L, barely a year after the COVID-19 pandemic landed a few choice blows on their balance sheets. Exhausted directors may well feel like they’ve gone the full twelve rounds already and be half-tempted, at the sight of a rematch against yet another invisible foe, to throw in the towel now.

But there are things businesses can do right now to place themselves in the best position possible. None of these things are revolutionary and none can magic away energy prices jumping 50% or more. They do, however, provide some initial steps that businesses large and small can undertake right now to prepare for uncertain times ahead.

Get a grip of the business

Now really is the time to do a thorough review of your operations. Lift the covers up and take a critical look at what actually generates returns and what doesn’t. Get a firm hand on what your financing position is, what your lending covenants are and the timing of those assessments. Undertake sensitivity analysis on your P&L, developing some realistic worst-case scenarios and how they might play out in your business.

Make cash your priority

P&L and balance sheets are important but, ultimately, it’s liquidity that financial directors should be keeping an eye on over the winter. Where they’re not running one already, businesses should be preparing a detailed thirteen-week short-term cash flow forecast (STCFF), identifying where there may be cash pinch points and taking action ahead of time to address these.

For many, STCFF’s can seem time-consuming and an unproductive use of time for a stretched Finance department. However, in our experience, a STCFF is invaluable for businesses working through difficult times. If undertaken robustly, a STCFF can provide management and stakeholders with comfort that the business has the headroom in place to continue without disruption if and when something goes wrong e.g., a late-paying customer, or an unexpected outlay that can’t be deferred.

Once set up, the drumbeat of regularly refreshing it can be relatively straightforward, and allows directors to effectively model different scenarios for input/output costs, and price adjustments.

Find the wins where you can

Many performance athletes look at the relentless pursuit of marginal gains – that a few small adjustments to, say, the aerodynamic profile of a cycle helmet or handlebars, can add up to make a meaningful difference to the lap time.

The same principles can be applied in a commercial environment, where even the leanest of business models can usually find operational efficiencies somewhere within their processes.

At this stage, it’s likely that a lot of the larger low-hanging fruit when it comes to cost savings have been picked already. Yet the approach used by Olympic medallists can be equally applied to maximise business performance. Can certain operations be consolidated, reduced in frequency, moved digitally, outsourced (or insourced) to reduce costs or improve control? Can product lines be reduced, or the total number of inputs slimmed down to minimise waste and benefit from scale economies? None of these, in themselves, are a silver bullet when it comes to finding cost savings. but when added together can help build the headroom necessary to absorb unexpected performance dips.

Value chain renegotiation

It’s evident that businesses are UK still trying to absorb cost pressures as best they can, with recent ONS data shows Output Producer Price Index (PPI) or ‘factory gate prices’ running well below Input PPI.

Although the delta between the two PPI is unprecedented, it’s only the acceleration of a trend seen during much of the past decade (see below). Though there are many underlying reasons for this, at a macro level it’s indicative of a very lean operating environment for many UK businesses. In short, when a shock like this comes along, there’s very little margin left to squeeze.

Some businesses are fortunate and may have a contractual mechanism in place to increase prices in line with general inflation or some other suitable measure/formula. Others may not be, including those at the end of the chain. Yet it can be daunting engaging in pricing negotiations with a key customer or supplier, especially if they are responsible for a large chunk of business and have alternatives within relatively easy reach.

Our view is that most customers are generally supportive of their suppliers in the current trading environment and are open to negotiations on price. What is critical for suppliers, however, is being able to be clear and articulate about how specific cost pressures have impacted their operation. If a business can point to cost X increasing by a certain amount and how that tracks through to the overall product cost, the customer is likely to be far more receptive to ‘sharing the pain’ than placing an arbitrary 10 or 15% increase across-the-board.

There may also be value in many cases of an independent third party to act as an ‘honest broker’ in these negotiations. They can help both sides work towards a settlement that provides the supplier with the uplift necessary to continue trading whilst providing the customer and its stakeholder with the comfort that the price increase agreed is fair and proportionate.

Seek advice early

Leaving the envelopes in the drawer unopened is never the best approach. The earlier businesses can identify an issue coming down the road, the more options there are to successfully navigate the situation.

At Interpath, our team have supported businesses through various challenging economic spells. We’ve helped businesses sustainably reduce costs – avoiding false economies where cuts in expenditure in one area reappear somewhere else. We’ve also helped businesses review the core performance aspects of their business – getting a handle on cash, reviewing their lending position and taking steps to make sustainable changes that really make a difference.

We can also support businesses not facing immediate stress or distress to consolidate their position and prepare for growth opportunities as the economic landscape stabilises, or act as that ‘honest broker’ in discussions with suppliers and customers.

There’s no magic wand in the fight against rising costs – it’s going to be bruising. But a few simple steps, taken in good time, can make a material impact on business performance in the months ahead.