Effects of inflation in distribution & manufacture industry

Effects of inflation in distribution & manufacture industry

I have mentioned the effects of inflation from different perspectives in previous articles, the most recent being “4 distribution trends to consider for your 2022 Business Plan”. The annual inflation rate for the United States is 6.2% for the 12 months ended October 2021, the highest since November 1990 and the trend seems to indicate that it will not get better any time soon. For this reason, in this article, I will explain in detail what inflation is, why it happens, its impact on businesses, and most importantly, how to plan to deal with it.

What is inflation?

Inflation is a phenomenon characterized by the general rise in prices for both producers and consumers, for some time. When the general price level rises, each dollar buys fewer goods and services; consequently, inflation reflects a reduction in purchasing power per dollar.

Is inflation good or bad?

Inflation is not inherently good or bad. If companies are not prepared, inflation could be a bad thing, forcing businesses to raise their prices before their prepared competitors, leading to a loss of customers. For others, it could be a benefit, spurring activity in their industry that would otherwise occur elsewhere, if prices were lower. Another variable to rate inflation is its level: a little might be desirable, while too much could grind consumer spending to a halt and send the economy into a downward spiral. The Federal Reserve considers that around 2% is the level of inflation necessary to stimulate production and create jobs without significantly affecting consumers.

Economy cycles and effects of inflation
Economy cycles

Cycles of inflation and deflation are common in the business cycle of any country. This is illustrated in the graphic below. Cycles of expansion tend to be inflationary while the cycles of contraction are deflationary.

The effects of inflation on the distribution business

The effects of inflation affect all companies, but distribution companies have added pressures due to the nature of their operation. Let’s take a look at some of the effects of inflation on distributors and manufacturers.

  1. Decrease in customer purchases: with less purchasing power and less money in the bank, consumers tend to buy less. Fewer consumers buy, less profit for companies.
  2. Increased inventory costs: When replacement inventory costs more than the inventory you just sold, it can lead to an inventory shortage and a reduction in gross profit.
  3. Increased cost of service: every time a price changes, the distribution company must change the price tag of its products in the store.
  4. Increased transportation costs: During inflationary cycles, the cost of fuel and truck maintenance increases, putting more pressure on gross profit.
  5. Wage factor: The lag between employee wages and the inflation rate affects productivity and increases personnel turnover. This leads to decreased throughput, delayed deliveries, and lower invoicing.
  6. Reduced borrowing and investment capacity.

Causes of inflation

There are two main drivers of inflation, namely, demand-pull and cost-push inflation. Let’s take a look at each of them.

Demand-pull inflation.

It occurs when the demand for goods exceeds the supply; therefore this inflation has to do with the production of goods and services. When this happens people are willing to pay more to get the products, so companies will respond by pushing up prices. Some of the reasons that trigger this inflation are:

  • Excess money supply: This occurs when the government prints too much money. It is done to pay off the debts. The oversupply of money is the main driver of hyperinflation. It can also occur if the Fed puts too much credit in the banking system.
  • Growing economy: During the expansion phase of a business cycle, people feel confident to spend more.
  • Discretionary Government Policies: Government spending and policies might drive up demand without an increase in production, which will generate unmet demands that trigger an inflationary cycle. For example, when the government reduces taxes, consumers have more income to spend on goods and services. Another example is tax breaks for mortgage interest or energy-efficient vehicles; they would increase the purchase of homes and electric cars, respectively.

Cost-push inflation.

This occurs when there is an increase in the cost of production or imported goods. Some of the factors that have this effect are:

  • Production Cartels: This happens when a group of producers of basic goods is organized to control prices and markets. For example, OPEC (Organization of Petroleum Companies) had strict control over the prices of all petroleum derivatives, in addition to the reality of the business cycle.
  • Wage rises: Wage inflation occurs when workers have enough leverage to force through wage increases. Companies then pass higher costs on to consumers.
  • Natural Disasters: Natural disasters cause inflation by disrupting supply. The recent pandemic is an excellent example of this factor. So are the 911 terrorist attacks or the collapse of the banking system in 2008.
  • Government Regulation and Taxation: Government policies can be a driver for both types of inflation. For example, the rise of custom duties on Chinese goods, regardless of the logic behind them, had an inflationary effect.
  • Exchange rates: Changes in the value of money in a country affect the cost of imports from that country. China has been a traditional example of this; by manipulating the RMB rate (plus export incentives) they have managed to keep their export prices below other countries.

How to plan to cope with the effects of inflation?

The purpose of the previous section was to explain to you that many factors could trigger inflation cycles and most of them are beyond the reach of the business owner. However, knowing the symptoms of inflation and the impact they might have on your operation, you can devise action plans to mitigate the effects and, sometimes, even take advantage of them. Let’s highlight some of them.

  1. Cost control actions:
    • Increase productivity: One way to combat inflation without hiking prices is to figure out how to maintain the same levels of productivity with less staff. This is particularly useful when inflation is driven by labor costs. Implementing productivity bonuses is another way to counteract salary pressure.
    • Reduce material costs: Finding efficiencies wherever you can is a good thing. For example, if you can get the necessary materials at a reduced cost from a different supplier, that could offset the effects of inflation. But be careful with this, there is a big difference between going cheaper and less expensive.
    • Smaller product presentation:  In reality, most consumers do not take a look at the wording on the packages of the products they are purchasing. Therefore, a common practice among manufacturers to deal with cost increases is to decrease the content of the product in the package. There are two ways to do it: keep the same box or bag and simply change the quantity on the labels, or make a smaller bag. Either way, the consumer will end up paying more per unit.
    • Implement new technology: There are two ways that technology can help reduce production and warehousing costs. One is to add automation or robots to production. The other is by implementing a software system that provides total control of your operation and avoids human errors.
  2. Controlled price increase: You can delay the price increase as long as possible with cost control actions, but raising prices is inevitable in an inflationary environment. With proper ERP, manufacturing software, and warehouse management systems you have all the variables to decide when, how, and by what proportion to raise prices and do so in a way that positions you better than your competitors.
  3. Avoid the “borrowing trap” during expansion cycles: Early in the inflation cycle, banks are actively expanding their loan portfolio as the government´s easy money policies kick the economy into overdrive. During this artificial “boom” many distributors succumb to the lure of easy money. The rationale is that with the loan they can purchase more inventory that will be sold at higher prices and generate excess cash flow; so, the cost of repaying the loan will be less than the value of the contracted loan. However, with inflation, demand will eventually decline. If the amount loaned did not match the increase in income, the financial health of your company will be affected. Be smart about how many loans you get!.

I hope this article has been helpful. By knowing how the economic cycle works and monitoring the triggers that lead to an inflationary cycle, you can mitigate the effects of inflation in your business and make the best with the recommendations we have made in previous articles. I will continue to publish information related to Warehouse Management, distribution practices and trends, and the general economy. If you are interested in this article or want to learn more about Laceup Solutions, register to keep you updated on future articles.

You can also watch at this video that complements the information in this article.

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