Why Companies Should Prepare for Inflation

Why Companies Should Prepare for Inflation

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Why Companies Should Prepare for Inflation

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    Preparing for Inflation

    What can companies do to protect themselves against the adverse effects of inflation and be among the inflation winners in their industry? The previous analysis suggests a four-step program.

    Assess the risks. Companies should start now to develop a detailed understanding of their potential exposure under alternative inflation scenarios. It’s critical to recognize the key sources of exposure for each line of business in the portfolio and the specific areas of weakness. This will allow senior management to identify the most effective measures for inflation protection and to develop a winning inflation strategy.

    Know your real costs and prices. We have already mentioned money illusion—the propensity to mistake price increases for real gains that tricks managers into paying less attention to real growth and productivity improvement. Inflation winners avoid this trap by tracking inflation-adjusted financial indicators that reflect the real performance of their businesses. What’s more, they provide real-time internal cost and price data and a high level of transparency on competitive pricing to allow decision makers to react quickly to changing market conditions.

    Protect gross margins. Inflation winners also work hard to defend their gross margins. Doing so can spell the difference between creating and squandering value during inflationary periods. The key to successful margin protection in times of inflation lies in superior pricing strategies and processes. This requires close coordination between the sales and procurement departments in order to identify margin pressure from rising raw-material prices early enough to react. It also requires creative contract design to pass inflation risks on to customers (for example, through index pricing or economic price-adjustment clauses). And it requires internal processes that allow for fast and frequent price adjustments and zero leakage in price realization (as can occur through discounting). Inflation winners will also apply pricing strategies that decrease the price sensitivity of their customers—for instance, by unbundling product and service offerings or by locking in customers at low prices and subsequently up-selling.

    Safeguard investment programs. A final differentiating trait of inflation winners is that they are better able to protect their investment programs. This is of particular relevance for companies with high capex requirements. Inflated costs for replacement or growth investments will put a considerable strain on the liquidity and valuation of such companies. In order to avoid a precarious underinvestment risk and corresponding loss of competitiveness, inflation winners will choose a conservative financial policy with low leverage and sufficient unused borrowing capacity. At the same time, they will reduce their capital requirements as much as possible and increase their asset productivity by such means as outsourcing, sale-and-leaseback contracts, strict net-working-capital optimization, or careful prioritization of planned investment projects.

    These steps are easy to describe—but difficult to do. In a second working paper, we will lay out a comprehensive program for making a company “inflation ready” for the time when the inflationary pressures now on the horizon finally arrive.

    For an overview of different approaches to inflation accounting, see David F. Hawkins, “Inflation Accounting and Analysis,” Harvard Business School Note 100-063, December 1999.