With US inflation rates rising rapidly small and large manufacturers alike are being affected by inflationary pressures in much the same way, although small manufacturers will undoubtedly feel the sting of rising inflation more deeply than their larger counterparts. These pressures are being further exacerbated by:
- The speculation around a possible recession hitting between now and Q4 of 2023
- All-time record low small business expectations being reported
- The lowest consumer economic expectations being reported since 1980
Knowing that a recession may be coming does not tell us when, why, or how it may occur. However, paired with dropping small business and consumer confidence, a looming recession is only going to worsen the effects of rising inflation rates on US manufacturers.
Regardless of size, inflation will take its toll on manufacturers through cost increases, contract constraints, labor shifts, and input issues, which in turn will affect inventory and capital purchases.
The Pressures of Rising Inflation
Costs are rising faster than prices, which is affecting companies across all verticals, but is really hampering industries with tighter margins. For manufacturers, their pricing structure will determine how strongly they feel the effects of rising inflation. Manufacturers using cost-based pricing will likely be disproportionately affected because as their costs increase, they likely will not be able to increase their prices enough to fully offset these rising costs. As a result, their margins will shrink unless they can find a way to reduce the costs of their raw materials or other inputs. Manufacturers in this position will need to rely on their financial leadership to guide their pricing decisions to ensure they are protecting their slimming margins without pricing themselves out of the market.
Alternatively, depending on the product, manufacturers may be able to reduce the amount of their offerings while keeping prices the same. For packaged goods, we have already begun to see shrinkflation occurring to compensate for manufacturers’ rising costs, and this is likely to continue for the foreseeable future.
With the CPI (Consumer Price Index) above 9% and the PPI (Producer Price Index) above 11% right now, the costs for producers are higher than the costs for consumers. With this, large manufacturers are likely in a better position than smaller or medium-sized manufacturers because they may have contractual obligations with their suppliers that are providing some cost certainty. However, these contracts will not last forever, and when they come up for renewal, manufacturers should prepare themselves for the price shock that is coming. Before this happens, manufacturers must ensure that they have the right leadership team in place to represent their interests in contract negotiations.
Components manufacturers (and other small manufactures that are supplying large manufacturers) are in the most precarious position because they are likely selling at a locked in price. They typically do not have the leverage to negotiate long-term contracts because they are often used as a Tier 2 or Tier 3 supplier instead of a primary supplier. Additionally, these types of manufacturers are more likely to be labor-heavy processes because they are not producing at a large enough scale to justify using costly automation. For these types of manufacturers, the large manufacturers that are working with them may decide to let them break their contracts or renegotiate their contracts to keep them afloat. However, when there is no potential for renegotiation, it will be up to their CEOs and CFOs to work in tandem to determine how they will pursue cost-savings measures to avoid going under.
Manufacturers that are more capital intensive instead of labor intensive and have a value-add component to their manufacturing processes will be the least affected by rising inflation. Rising labor costs across the board (even if wage increases are not necessarily real wage gains for unskilled labor roles) have made the labor used in manufacturing even more costly. As a result, the case has been made for offshoring manufacturing operations in recent years by experienced financial leadership seeking to gain access to a less expensive labor force. Additionally, taking labor out of the manufacturing process altogether in favor of automation and digitization has become more important than ever because as inflation increases, manufacturers must reduce spend in other areas where costs are increasing also.
The costs of fuel sources such as petroleum, diesel, and natural gas have skyrocketed alongside inflationary increases on materials, putting additional pressure on manufacturers that rely heavily on these inputs for their processes. Manufacturers are inextricably tied to these inputs because there is no easy way (and in some cases, no way at all) to remove them from their processes quickly or cheaply, meaning that as these costs increase manufacturers must take the cost hikes on the nose. Better budgeting and reforecasting, process management, and capacity planning by accounting and finance teams can help manufacturers to get the most out of these expenses to improve their bottom line.
Strategic Planning Responses
As inflation continues to trend upward, some manufacturers may opt to buy more inventory in an attempt to reduce future costs (hedging their bets that inventory costs will continue to rise). However, this is the biggest mistake a manufacturer can make because there is no guarantee that inventory costs will continue to rise. Buying inventory before it is needed is a huge gamble that can spell disaster even if costs do rise because doing so ties up cash that could likely be better used in other areas of the business to drive ongoing revenue. It is also a poor cash flow management decision for a leadership team to buy excess inventory because it can go bad before it is used due to spoilage, deterioration, damage, theft, or obsolescence.
Manufacturers dealing with inflation will need to ask themselves the million-dollar question, “Do we delay capital purchases?” The answer to this question will vary not only from one manufacturer to another but also possibly from one expense to another. Unfortunately, there is not a single correct answer to this tricky question. When there is uncertainty about what is coming next, the risk trajectory is different than during times of relative stability when analyzing how a capital expense can contribute to the company’s bottom line. A thorough analysis will need to be done for each capital expense to determine whether its cost today justifies its production tomorrow, taking into consideration the company’s current cash position and projected future position as well. This is one area where a CFO is indispensable because a strong leader will have the financial acumen to conduct this kind of analysis and develop a shrewd strategic plan.
Is your leadership team equipped to handle the kinds of challenges that inflationary pressures put on manufacturing operations? If you need to hire a CFO or would benefit from bringing in a consulting CFO to provide the kinds of insights that can make a difference during times of financial uncertainty, please reach out to us. Contact us today to find out more about how we help manufacturers not only weather the storm, but also thrive in tumultuous times.