<p>Imagine the chief executive of a manufacturing company walking into the Monday morning review meeting with two pieces of bad news. The procurement head reports that energy, freight and imported raw materials have all jumped. Then the sales head explains that the company cannot raise prices because cheaper Chinese products are lurking in the market and customers are threatening to switch suppliers. The chief executive is, consequently, confronted with an awkward question. What does a company do when its costs are rising but its prices cannot? For several years, businesses have tended to think about inflation in a fairly uncomplicated manner. Costs rise, companies increase prices, customers whinge for a while and life moves on. That logic is now becoming wobbly. </p><p>This is particularly relevant for Indian companies. India imports most of the oil it consumes and any sustained disruption in the Middle East eventually travels through the economy. Even companies that import infrequently are affected because their suppliers, transporters or customers may depend on imported energy or materials. No business is entirely insulated from a large increase in the cost of moving and producing things. At the same time, Chinese factories continue to produce on a scale that few countries can match. When domestic demand in China is insufficient to absorb this output, more goods find their way abroad. The prices can be particularly competitive and Indian buyers understandably find them alluring. Consequently, a domestic producer may see its cost base rise just as its customers demand a price reduction. </p><p>One side argues that cheap imports are always harmful because they damage domestic manufacturing. The other claims that cheap imports are beneficial because they lower costs for consumers and downstream industries. Both arguments contain some truth, but neither is binding. Protecting a chemical producer, for example, may preserve domestic capacity, but it may also raise the costs of pharmaceutical, agricultural or engineering companies that use the chemical. Economic policy therefore has to choose between opposing interests and those choices will never please everybody. </p><p>For companies, however, the question now is not whether government policy is correct. It is how management should respond. The answer begins with a better understanding of where profits are actually made. Many companies know their average margin, but do not know enough about the profitability of individual products, customers or regions. When costs rise unevenly and pricing power weakens, averages become deceptive. The traditional response to margin pressure is to cut costs across the organisation. That is a folly. Smart firms will distinguish between expenditure that supports yesterday’s habits and expenditure that protects tomorrow’s competitiveness. They may streamline product ranges, alter specifications or withdraw from customers who are expensive to serve. They may also need to invest more in automation and product development. </p><p>Pricing will require greater judgement. Companies frequently speak of pricing power as though it were a permanent attribute of a strong brand. In reality, pricing power changes by product and circumstance. A company may be able to raise prices in a specialised category where switching costs are high, but not in a standard product exposed to imports. Management must therefore abandon broad price increases and use a more selective approach, supported by better data and an understanding of customer behaviour. The chief executive’s task is not merely to predict oil prices, exchange rates or interest rates. It is to understand how these contradictory forces pass through the company’s own profit and loss account. That requires finance, production and supply chains to work together. </p>
<p>Imagine the chief executive of a manufacturing company walking into the Monday morning review meeting with two pieces of bad news. The procurement head reports that energy, freight and imported raw materials have all jumped. Then the sales head explains that the company cannot raise prices because cheaper Chinese products are lurking in the market and customers are threatening to switch suppliers. The chief executive is, consequently, confronted with an awkward question. What does a company do when its costs are rising but its prices cannot? For several years, businesses have tended to think about inflation in a fairly uncomplicated manner. Costs rise, companies increase prices, customers whinge for a while and life moves on. That logic is now becoming wobbly. </p><p>This is particularly relevant for Indian companies. India imports most of the oil it consumes and any sustained disruption in the Middle East eventually travels through the economy. Even companies that import infrequently are affected because their suppliers, transporters or customers may depend on imported energy or materials. No business is entirely insulated from a large increase in the cost of moving and producing things. At the same time, Chinese factories continue to produce on a scale that few countries can match. When domestic demand in China is insufficient to absorb this output, more goods find their way abroad. The prices can be particularly competitive and Indian buyers understandably find them alluring. Consequently, a domestic producer may see its cost base rise just as its customers demand a price reduction. </p><p>One side argues that cheap imports are always harmful because they damage domestic manufacturing. The other claims that cheap imports are beneficial because they lower costs for consumers and downstream industries. Both arguments contain some truth, but neither is binding. Protecting a chemical producer, for example, may preserve domestic capacity, but it may also raise the costs of pharmaceutical, agricultural or engineering companies that use the chemical. Economic policy therefore has to choose between opposing interests and those choices will never please everybody. </p><p>For companies, however, the question now is not whether government policy is correct. It is how management should respond. The answer begins with a better understanding of where profits are actually made. Many companies know their average margin, but do not know enough about the profitability of individual products, customers or regions. When costs rise unevenly and pricing power weakens, averages become deceptive. The traditional response to margin pressure is to cut costs across the organisation. That is a folly. Smart firms will distinguish between expenditure that supports yesterday’s habits and expenditure that protects tomorrow’s competitiveness. They may streamline product ranges, alter specifications or withdraw from customers who are expensive to serve. They may also need to invest more in automation and product development. </p><p>Pricing will require greater judgement. Companies frequently speak of pricing power as though it were a permanent attribute of a strong brand. In reality, pricing power changes by product and circumstance. A company may be able to raise prices in a specialised category where switching costs are high, but not in a standard product exposed to imports. Management must therefore abandon broad price increases and use a more selective approach, supported by better data and an understanding of customer behaviour. The chief executive’s task is not merely to predict oil prices, exchange rates or interest rates. It is to understand how these contradictory forces pass through the company’s own profit and loss account. That requires finance, production and supply chains to work together. </p>
