Diffuse inflation pressures

Matthew Flynn is a Managing Consultant at Vendigital. He recently shared his insights with Engineering Capacity.

The geopolitical climate has become more volatile in recent times, putting pressure on global supply chains and triggering inflation. For manufacturers, this has led to a build-up of inflationary pressures, all of which need diffusing now.

Cost pressures affecting the price of commodities, energy, transportation and labour are reaching boiling point for manufacturers and many are being forced to pass on price increases at the same time as reducing operating margins. Research conducted recently by the CBI confirms that four-fifths of UK-based manufacturers expect to pass on price increases to their customers in the coming months.

With UK inflation running at a 40-year high, staying one step ahead of cost increases and protecting business viability has become an ongoing concern for many manufacturers. Energy-intensive industries and those that source raw materials or components globally have been particularly badly affected, due to exponential increases in the price of oil and their impact on energy and shipping costs. At the same time, rising demand across many markets is forcing manufacturers to take on the extra strain of ramping up production.

A keen focus on cost management is obviously needed in today’s more volatile trading environment. Businesses should start by taking a close look at their supply chains to understand where cost is coming from. In some instances, it may be necessary to challenge cost understanding. For example, if a manufacturer is currently buying aluminium foil lids and their supplier tells them that 60 per cent of the cost of each lid is due to the use of aluminium, recent cost volatility in this area could justify closer examination. Analysis could find that aluminium actually accounts for just 10 per cent of the total cost of manufacture and this insight could inform cost negotiations. There could also be opportunities to reduce the total cost of manufacture, by switching away from aluminium in favour of another raw material or reusing waste material, while protecting margins for both customer and supplier. Developing a cost modelling tool that allows manufacturers to work collaboratively with their supply base to optimise value is likely to prove a worthwhile investment.

It may also be possible to adapt commercial structures to drive efficiencies and protect margins as far as possible. For example, manufacturers could consider putting in place conversion-based agreements, which provide an incentive to the supplier to reuse material. While cost increases tend to be passed through the value chain quite quickly, what happens when the cost of raw materials or products starts to fall again? Manufacturers should ensure that agreements are linked to market indices so that the benefit of any price fall is felt as quickly as possible.

During times of geopolitical volatility, it is important for manufacturers to keep testing the market to ensure they are getting value for money and avoid getting locked in. For example, buying raw materials or products from certain regions of the world has recently become incredibly costly due to disruption caused by the war in Ukraine. In some cases, new supply chain opportunities are emerging in entirely different geographies. For example, packaging businesses reliant on supplies of high-performance plastics might find that due to higher oil and energy prices, and global supply chain disruption, it is more cost effective to source product from the Middle East. In other regions, labour costs have risen significantly and shifting sourcing arrangements to other countries could prove beneficial. The proportion of material, labour, energy and transportation costs may have changed to such an extent that new geographies offer better sourcing options.

Another lever that manufacturers can use to control their cost base is of course cost engineering. This typically involves modifying the design of a product by reducing or switching out a costly or hard-to-source material, in favour of another. Alternatively, it could involve adapting the manufacturing process to use less material and/or minimise waste. Additionally, revisiting business cases for innovation that suffered an extended payback period may now become more viable given the higher cost base. In many instances, cost engineering can generate opportunities to add value to a product by differentiating it in some way.

When costs are rising and disruption is rife, pricing considerations become more challenging. Manufacturers may be reluctant to pass on cost increases to their customers, but feel they have little choice. This where it may make sense to put in place a dynamic pricing model based on a deep understanding of market conditions. For example, access to reliable market data could help a business to understand the implications of passing on cost, so it can pitch prices at a level that is likely to secure customers’ buy-in. In some cases, prices could be tailored according to how easy or not it might be for a customer to switch supplier.

Market-driven dynamic modelling tools can be used to strengthen supply chain relationships and secure demand. They work by incentivising customers to commit to a specific volume, over a set time period, in exchange for better terms, which could mean a lower price, holding more stock or a shorter lead time. Additionally, manufacturers can limit their risk exposure by purchasing raw materials in bulk. Making sure sales teams have access to these tools and know how to use them, will help to eliminate the go-it-alone approach to customer negotiations, which can undermine business performance.

Diffusing inflationary pressures is a major challenge for manufacturers, but using robust market data to inform sourcing, customer service and pricing decisions can help to improve cost management and drive value.