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Author: ICAEW Insights
Published: 11 Apr 2022
For anyone under the age of 50, significant cost inflation is probably not something you have had to deal with at work before. As we near the end of the COVID-19 pandemic, with a series of supply chain shortages and conflict-raised commodity prices, we have some new challenges to deal with.
The first issue is understanding what the business’s costs are doing. Businesses need to keep in mind that first-in, first-out systems will tell you what your stock cost when you bought it, not what it is costing you now. They should also note that standard cost systems may need to be rolled up more frequently than in the past and ask themselves: “Does the company have any ability to fix future prices through forward contracts or hedging?”
Setting the pricing is the next challenge to tackle. Businesses require some estimation of what will happen between now and when the goods/services are delivered to the customer. Then it’s a case of deciding where to set your customer pricing against these projected costs. If your customers buy regularly, they will see an increase in pricing, so your communications need to be well thought out.
Businesses will also need to put some thought towards their working capital; as their unit costs and prices increase, all the working capital levels – stock, debtors, creditors – increase, too. Make sure, if the working capital is self-funded, that there is sufficient cash or facilities to support this. If a business is using invoice discounting, they may need to negotiate a higher credit limit. They’ll also need to work out if their credit insurance limits are sufficient for large customers, especially if price increases are inflating their monthly sales.
Wages and salaries are a current concern, especially where media coverage of inflation is fuelling wage expectations. In most areas, unemployment is low and recruitment is difficult, therefore companies should look back at what pay rises they gave in 2021 when inflation was low and bring that into a two-year narrative for their decision making and communications.
If the business can’t afford to raise the pay rate enough, they could offer more hours or overtime to help staff achieve a sufficient increase in take-home pay. They could also undertake efficiency measures to get more return from the wages spend. Companies could also remind their staff of the value of their overall employment offering, including flexibility, pensions and benefits.
Key performance indicators (KPIs) will also need to be revisited: some measures such as earnings before interest, taxes, depreciation and amortisation, and cash are always true, but other leading indicators used as KPIs may lull the business into a false sense of security. Remember that many customers are ordering ahead to try to fix future prices, meaning that current order intake will look strong, as will the order book. However, the business must consider when those orders will turn into sales revenue. The best thing to do is revisit the original KPIs and see if they are still working, or whether they need to be tweaked.
When it comes to navigating the current inflationary environment, there is a string of commercial issues that should be considered. For example, is the business able to buy and finance more stock now to avoid future cost increases? Beware that many current steep cost increases are predicted to level off and then possibly fall, so the business doesn’t want to over-buy at the top of the market.
Also make sure to look beyond the traditional quote validity period to defining what the prices will be when the goods will be delivered. Try to figure out whether there’s an option to be open with customers and work with them to secure their order commitment back-to-back with materials commitments so that the pricing passes through in a predictable way. This transparency should be very well received from buyers as you are both working towards the same solution.
The current situation is far from ‘business as usual’, so businesses need to think carefully about their day-to-day decisions. The way they treat their staff, suppliers and customers today will shape the business success over the next few years. If they can behave fairly through these difficult times, then they should emerge stronger.
Nick Tiley is the founder and director of Cambridge Financial Direction, a specialist accountancy service company.
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