Inflation like all risk is a double edge sword. Its negative nature will upset the apple cart and pose uncomfortable challenges for SME managers that have grown accustomed to the status quo.
It will force managers to reconsider their well conceived business plans and perhaps more closely scrutinize this quarters P&L or the company balance sheet. It will present serious challenges for businesses supply chain and client relationships. It may raise the eyebrows of your shareholders and credit providers perhaps provoking some pointed questions concerning your management skills and the validity of your business model.
That said inflation does have an upside. Like all risk factors it has the potential to create opportunities. Inflation will drastically alter market conditions. It will reveal inefficiencies that nimble SME can actively engage and manage to turn those market conditions to their advantage. The key operative words are management, intentionality and active engagement.
Inflation is a silent killer. It stalks all SME threatening to gobble up product margins, revenue opportunities and bottom line profits. It diminishes customer buying power and may threaten the solvency of large customers and suppliers. It drives up the cost of capital, making credit more expensive while it forces state and local governments to raise taxes and fees.
The inflation bogey man lurks in the profit and loss statements of all businesses with SME being particularly vulnerable to its effect. Inflation dramatically shows itself on the expense side of the ledger in the increases for basic materials, energy, delivery services, T&E, administrative expenses and employee benefits. Inflation also affects the income side of the profit loss statement. It erodes the buying power of your customers and threatens collection of receivables by extending days outstanding, increased write offs or the sale of uncollected debt for pennies on the dollar.
SME profitability is particularly sensitive to the effects of inflation because of economies of scale, concentration of risk factors and lack of pricing power.
Many SME lack pricing power. Pricing power suggests that if price of a product rises to a certain level demand for that product will not diminish. For a SME to have pricing power it must offer value add product to dependent buyers. Its product or service cannot be easily replicated or widely available from other sources.
While pricing power escapes most SME numerous factors inhibit their ability to become low cost producers. They deliver product or service differentiation to their customers by other means then low price. Inflation erodes consumer purchasing power driving buyers to seek low cost producers. In this environment SME may suffer when buyers trade down to low cost providers. Key customers may compel SME to lower prices to be more in line with lower cost producers. This is a major threat to SME.
SME tend to have greater risk concentration in their business model. Heightened risk concentrations are most pronounced in small businesses due to a limited product line, geographical risk, market cyclicality and in client and supply chain relationships. Consider a small manufacturer of finished steel products for the home construction industry. Generally, manufactures profitability is highly correlated to the price it pays for basic commodities and has an extremely high concentration of supply chain and product risk. Small businesses may not be able to recover or adjust its product prices to cover increased commodity prices due to existing contractual agreements with customers or its lack of pricing power. The abatement of market demand due to a recession may provoke larger customers to demand price concessions by threatening to move their business to lower cost producers. The pressure on this small manufacturer is compounded by a spike of smaller account losses and moribund demand due to weak cyclical market conditions in its target market.
It’s almost a perfect storm of negative business conditions. Small businesses managers need to understand how inflation touches all aspects of their business and must manage its impact to maintain profitability and sustainable growth.
Managing Inflation Risk with a WIN Campaign
SME can meet the challenge of inflation head on by implementing a Whip Inflation Now (WIN) program that engages the numerous risks inflation poses. In deference to our former President Gerald Ford, business managers can initiate WIN Programs and actions to temper the impact of inflation and to seize opportunities that rapidly changing market conditions create. Small businesses must be extra vigilant and proactive in managing all classes of business risks.
Some small businesses will cave into the demands of their large accounts to cut prices to prevent them from going to a lower cost provider. This is very dangerous for small businesses and can result in “death by a thousand cuts.” Managers should not wait for their largest account to approach them seeking price concessions. Now is the perfect time to go on the offensive and alter the value proposition that only your firm can uniquely deliver to key accounts. Remember your largest accounts are experiencing the negative effects of inflation as well. Go to them and propose a WIN Campaign.
A company’s WIN Campaign can offer a joint marketing program using advanced web enabled technologies. Your WIN Campaign can implement an expanded training and support program tied to a business development program or supply chain rationalization. You may suggest a partnership to develop a new product or put in place a customer loyalty program. Your job is to create a unique value proposition that adds value to your product and convey it to your customer so they cannot commoditize your product. Together you and your clients can WIN the fight against inflation and turn it into a business development initiative. Your clients will appreciate the fact that you are thinking about their business success.
Another common knee jerk reaction to fight rising business costs is to reduce expenses by cutting expenditures on areas that do not support the mission critical functions of the business. Capital is allocated to maintain funding to support sales, production and product delivery. This is coupled with a lean administrative management structure and this model is seen as a recipe for economic survival. Being good stewards of corporate capital is essential during these times. Capital leakage is always a threat to business profitability and needs to be even more diligently managed during times of economic duress. But this strategy is a subsistence survival strategy. It is based on investing the barest minimum of capital to address fluctuating market conditions. This strategy may limit small businesses ability to literally capitalize on opportunities that changing market conditions present.
Cutting expenses for marketing is usually another budget casualty when businesses look to cut costs. This will reduce your current expense line for this quarter and will certainly help bottom line profitability; but skipping this year’s trade show will not help you to locate that new customer who is looking for a supplier because his current provider is struggling with product quality issues. Cutting this expense won’t provide you with the critical insights you need to stay competitive and ahead of new market entrants that are attending trade shows. Who by the way are also aggressively courting your largest account to get just a tiny slice of your business to demonstrate their “superior value proposition.”
Employee benefits and training is another area that is often the focus of budgetary cutbacks. Many SME need to closely consider the gains they will realize by cutting back on benefits offered to its employees. Cutting benefits could increase employee turnover. Training and hiring new employees are an expensive proposition for SME. The loss of key employees can potentially devastate a small business. Expertise, intellectual capital and critical business intelligence leaves the organization when a key employee walks out the door. This is doubly true if some key employees leave the firm and walk some major client relationships out the door with them.
SME can also try to employ risk transfer strategies. Insurance purchases may help in some areas but to fight inflation small businesses can use financial instruments (capital permitting) to hedge against rising prices. The purchase of TIPs, FX forward contracts, commodity or energy futures can help to offset the negative effects of key inflation business threats. As the price of oil rose this summer a modest equity position in oil or other energy company would have helped to offset the increase in energy expenses.
Thankfully adverse economic conditions will force SME to take an honest look at their product lines and business model. Economic adversity provides an opportunity for management to make hard decisions concerning product lines. This is an ideal time to focus and fund the development of products that offer the greatest potential for long term profitability and sustainable growth.
Inflation is a significant problem for small businesses but it is a problem that can be managed. Changing economic conditions alter the landscape for all businesses that accelerate and starkly reveal market inefficiencies. These inefficiencies create market anomalies and opportunities that astute small business owners and managers can capitalize on through an intentional practice of a risk management and opportunity discovery program.
Sum2’s objective is to assist clients to implement corporate sound practices that enhance profitability and sustainable growth. Sum2’s offers a wide stable of risk management apps for SME. The Macroeconomic Risk Assessment App helps managers review macroeconomic and event risks to better manage its potential effect on their business. Sum2 offers a Macroeconomic Risk App and can be downloaded from Google Play or by visiting www.sum2.com or by calling us at 973.287.7535.
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