Coping with Cost Inflation: Part 1

We all know the power of price increases as a cash flow lever. Pricing is ultimately a function of what the market will bear, and not dictated by cost. Yet covering a company’s costs is an important input to pricing decisions, and current trends provide a very favorable environment for price increases for companies that can execute well.

Below we outline some challenges and related actions. While these approaches are fundamental, don’t write them off as too basic. We continue to see companies with professional investors and managers that do not execute effectively on these fundamentals.

Cost Inflation Challenges

Many portfolio companies are suffering severe profit pressures from rising costs of materials, energy, and other purchases. Cost inflation is a two-headed monster:

1. Big recent problem: Rising, often volatile costs for materials and energy

Companies using steel have been socked with increases of ~40% in the last year. Aluminum, copper and other non-ferrous metals saw their bigger increases earlier, rising 84% in two years. Companies buying chemicals, plastics, and other materials derived from oil have seen costs rise over 20% in the same time. The impact on a mid-market plastic products manufacturer we recently worked with is that materials have jumped to consuming over 40% of their revenue dollars – an unprofitable level. Companies have also faced spikes in the cost of electric power, heating, and cooling for their buildings and production processes. Finally, rising fuel prices have driven transportation costs significantly higher.

Even with recent softening, materials and energy are very visible inflation culprits… and have seen dramatic changes in recent years. But we can’t overlook the cumulative impact of annually rising cost factors.

1. Big ongoing problem: Employee benefit costs – for medical insurance especially – have been rising for years and just keep on going.

When you add the increased cost of health care insurance or self-insurance to normal pay increases and to payroll tax increases, cost per employee at many companies is rising 7 to 12% per year. Depending on the company’s percentage of operating costs tied to headcount, operating costs may be climbing at 3 to 8% per year before any offsets.

Broad-Based Price Actions

For multiple reasons, we are not huge fans of across-the-board price increases (we’ll speak to that next time). However, big increases in material costs sometimes warrant broad price increases or surcharges.

Below are some approaches that we’ve been using with good results. We hope these will provide some background insights that will help private equity boards to identify whether management is doing all it can to maximize yield.

1. Minimize lag times. One of our client companies, a manufacturer with large steel purchases, used to eat two months of input cost increases before new sell prices became effective. We helped plug this margin leak by fixing internal metrics, policies, and processes. Some companies have customer contracts that hinder rapid price changes, but too often the lag is self-inflicted because internal processes aren’t set up to execute increases quickly. The best companies measure lag times and can discuss in detail with their boards how they manage these.
2. Plan for success. Formula One crews don’t do pit stops casually—they choreograph the process, take out all waste, and prepare in advance. This is “Lean management” applied to price increases. Too many marketing and sales organizations do not coordinate effectively with sourcing to anticipate cost increases. Also, we see many businesses where the sales quotation process is woefully sequestered from real-time cost change information, leading to under-pricing and also poor contract terms. Check with the CEO, CFO, or VP of marketing to see if they have planned in advance for executing the next price increase.
3. Measure actual realization of price increases. Most organizations have places where price can leak, and have people who are incented to exploit those vulnerabilities. We frequently see:
   • Effective dates of increase pushed out
   • Discounts altered to lessen the impact of a change in list prices
   • Increases waived on high volume items
   • Credit memos granted after the transaction to negate some or all of the increase

   Policies, processes, incentives, information tools, and training all affect price realization and need to be audited to find margin leaks. Most organizations have diffused decision authority and multiple functions involved in price action (marketing, sales, general managers, finance, IT). Check to see that the CEO and CFO understand who has responsibility for price increases, and whether they have reviewed their incentives.

4. Manage the details. There are lots of implementation details to get right in order for actual transaction prices to reflect intended prices. One manufacturing client had announced two price increases in 2008, with meager results. The senior management team had many beliefs about how the field sales force handled price increases, what the realization rates were, and what the reasons were for lack of market acceptance. When we reviewed the details, almost all of senior management’s perceptions were wrong. They had little insight into the actual behavior, incentives, processes, and skill sets of the sales force. Middle management had been too steeped in the company culture to realize they could be performing better. By measuring the right things and managing the details, our client has executed a third price increase with broad market acceptance. Senior management should be able to demonstrate to the board a command of price increase details.
5. Have the right incentives. This is almost axiomatic with private equity investors for the most senior managers. Yet, we still see otherwise good companies compensating sales people on revenue or on gross margin, neither of which provides much incentive to collect higher prices. Also, incentive plans designed in other circumstances may not be fit for inflationary and recessionary environments. The board should check with management to see if it’s time to update sales compensation.
6. Communicate the rationale to customers. Too many companies rely just on a direct sales force to carry the message to customers, yet they don’t provide the information or tools to help sales people communicate effectively nor use other communication vehicles to reach customers with the message. We observe much lower customer resistance to well-communicated price increases and surcharges. Communication goes both ways—don’t assume you know what customers are thinking. One manufacturing client had hesitated to change its freight terms to reflect current realities because of its own internal beliefs about “standard practice in our industry.” When we talked to major customers, we found that there was no single standard practice for freight charges (there were actually four different norms). Moreover, purchasing managers told us they couldn’t believe that more of their suppliers hadn’t come to them yet with changes given how dramatically freight costs had increased. We helped revise freight terms, generating a large and quick cash flow gain. Ask management to review their customer communications related to price.Many companies now have an urgency to take across-the-board pricing actions. The steps above can help with planning. Our next inflation piece will discuss taking more targeted actions on price and terms to mitigate cost inflation.