Inflation is the media buzzword of the moment with news stories nearly every day about how the cost of living is increasing.
It is not just hype though, prices are rising in all categories driven by pandemic shockwaves which has driven surges in consumer demand disrupting the demand and supply equilibrium. The patterns many businesses used to underpin their business dynamics are not compatible with the erratic surges in demand. At the same time disruption in the supply chain caused by shipping and port capacity and fragmented manufacturing across the globe caused by lockdown and labour supply is pushing prices up.
These issues are likely to persist and provide a challenge for businesses for some time to come.
On 1 April there will be further pressure on costs when increases in the national minimum wage (6.6% for the main rate) and social care levy (1.25%) are introduced.
For a business paying 100 hours of wages per week at the current minimum wage of £8.91 their weekly wage costs will increase by £71 to £962. This is an increase of around 8%.
It’s vital that in this inflationary environment pricing is top of the agenda for all business owners and managers. Constant upward changes in costs can quickly erode margins and it is important that prices are adjusted to maintain profits.
An important margin to watch is gross profit margin. This is an expression of how much profit you make from every one pound (£1) of sales after deducting direct costs.
An easy way to address increases in costs and reducing margins is to increase prices with an across the board rate. Simply calculate the average increase in costs and then increase prices to maintain the same margin.
A hospitality business uses 100 hour of labour per week and makes 85p of gross profit per £1 of sale before labour costs. Weekly sales are £2,500 per week and gross profits are around £1,234 (49% gross profit margin)
Costs are expected to increase by 5%. Adding to this the wage cost and direct cost increases the gross profit will reduce to around £1,144 (46% gross profit margin).
An increase of prices of 7% would result in the pre increase margin in of 49% being achieved.
Don’t forget your fixed costs too. This year we are likely to see increases in many overheads as service businesses see increases in their costs and pass them on. Some costs such as rent and lease costs might not increase but others like energy etc. are likely to. Large increase in overhead costs can be a problem.
In the example above if overheads before cost increases were £400 per week the net profits would be £834. An increase in overheads of 15% to £460 means that sales need to increase by £122 to compensate. This could be achieved though a price increase of just under 5%.
For most businesses there will be capacity to absorb the extra work required to deal with extra sales but in if the increase in sales required is large it will be necessary to think of the impact extra wages would have on pricing decisions.
I’ll lose customers
Will customers accept your price increases? This is a worry of many business owners face with rising costs. In some respects this question is academic. Unless you are going to shelter your customers from price increases by absorbing higher costs you need to increase your prices.
Three tips to help retain customers
- Price checking competitors is a way of keeping on top of what choices customers may have and making sure your prices are still competitive.
- Adding something your customer will value but doesn’t cost you anything is another way around this. Adding to the customer experience often doesn’t cost anything.
- Showing community spirit or your CSR credentials can help bind customers to you if you can show how your values align but beware of developing fake programs just to buy customer loyalty.
If price increases may have a negative impact on one customer group who buy a particular product consider whether you can price certain products that are sold to customer groups that are highly price sensitive differently.
Stock
To build resilience to further supply chain shocks and shelter the company against volatile price changes businesses could invest in higher quantities of stock. This would have the benefit of being able to provide a more consistent supply to customers and would enable them to price more effectively against known prices but would mean more working capital (cash) is needed to make the upfront investment. There is also a risk that sudden demand shocks could leave the business with stock that it can’t sell and that stock imported with high shipping costs could be expensive VS stock brought in when shipping rates start to fall. If considering this, careful planning needs to be done on demand and funding to ensure the obvious risks are mitigated.
Pricing is going to be a key success factor in 2022 and business owners need to be proactive in their evaluation of whether cost increases need to be passed on to customers and quick to implement any changes.
If you would like help understanding the impact of cost increases on your business please contact me.