Whether it’s tariffs, trade wars, or post-pandemic inflation caused by kink-ridden supply chains and what many experts believe to be excess money printing, inflation is an insidious drag on businesses’ operations. When it comes to energy’s contribution to inflation, the U.S. Energy Information Administration (EIA) reports that crude and natural gas prices in 2022 have increased on an annualized and weekly basis. Looking at the snapshot of 7/21/2022, WTI crude on the futures market was $96.35 a barrel. This was up more than $26 compared to 12 months ago, and $0.57 higher than a week earlier. For the same time frame, natural gas futures were $7.932/MMBtu, an increase of $3.973 from 12 months ago and an increase of $1.332 from a week earlier.
When it comes to businesses using any type of commodity, they’re faced with the question of how to raise retail prices when their prices increase. Many business owners are hesitant to increase prices on their goods and services as they fear it will drive away customers. But in light of increasing input prices, not implementing price increases correctly will impact a business’s earnings and profitability.
As McKinsey & Company explains, there are many considerations for why businesses have had trouble with mitigating costs in light of rising input costs. It’s important to monitor raw material costs with a fine-tooth comb. Businesses that bury costs of commodities, labor, or tariffs under general accounting categories hide spikes in input costs due to factoring in ancillary costs. If volatile input or uncontrollable factors, however, like tariffs can be monitored independently and in real time, businesses are more likely to be able to increase prices – and do so more gradually. With this in mind, McKinsey & Company highlights four practices that businesses can implement to combat pressure from input costs and pushback from customers who question the reason for price increases.
1. Create a Database of Dynamic Costs
By looking at historical records going back as far as 36 months, businesses can determine trends and keep track of increases or decreases in input materials to share with the sales and customer service departments, who can then communicate with customers. Along with looking at how contracts are written and if there are escalator clauses that permit conditions to adjust for increases in input materials, taking steps to accurately measure the impact of raw material costs can be helpful for price increase considerations.
A business could look at costs by department. If a plating department at a manufacturing company plates 50,000 pieces of metal a month, incurs $200,000 of direct material costs, and has $50,000 in labor and overhead costs, that can be broken down into a per unit cost of $4 for materials and $1 of labor and overhead costs. If the per unit cost of materials fluctuates, investigation can occur through the supply chain from the supplier to the price of futures contracts to see if prices can be negotiated or must be increased for customers.
2. Mind the Economy
Businesses are advised to keep an eye on current economic conditions. This is how companies can set a dynamic pricing strategy. Building on the first step, it’s advised to index prices to those of commodities to reduce the lag time between when companies experience changes in costs for their input materials and when retail prices reflect the true cost to the company. Be it fuel, wood, coffee, or metals, understanding how the price of commodities fluctuates in real-time is essential to determine when and how to adjust prices for retail customers. It can also help businesses determine how competitors are adjusting their pricing to customers, how far prices could increase, and how to augment the delivery of goods or services to stay competitive and profitable.
In addition to escalation clauses, companies adapting to changing input material prices could consider introducing shorter-term contracts, looking for more competitive suppliers, and/or substituting different but equal quality/performance materials.
3. Coaching Staff to Educate and Explain Price Fluctuations
Continual evaluations for sales teams are imperative. Supervisors must see what accounts have (and have not) been informed of price increases. They should focus on what accounts have accepted price increases (and what level of price increases have been accepted). They also should look at what accounts are likely to accept price increases and what accounts are not likely to accept price increases. Businesses also must factor in the business cycle for the sales process and how each account is performing relative to its price increase targets due to cyclical increases in input commodity prices and interest rates for financing availability. Ongoing coaching should be implemented to identify major issues and ways to resolve them. Anticipating and preparing sales representatives for customer questions through role-playing can help better prepare employees to explain why price increases are a part of doing business.
4. Managing Performance
Businesses must play the long game after products or services have been priced accordingly to commodity and input prices. Since inflation follows the economic cycle, upside and downside pricing dynamics can catch companies off guard. Consistently updated product or service pricing systems and prepared sales teams can lead to more profitable margins and hopefully the ability to weather volatile and long-term price spikes.
Much like the price of commodities and labor fluctuate based on dynamic market conditions, finding ways to adapt one’s business practices can increase the chances of surviving and thriving in a challenging economy.
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