3 c's of Inflation
In this "throwback" post, initially shared in the Professional Pricing Society's Pricing Journal, we learn how important the rules of inflation are in pricing and the successful strategy that sustained over time.
High inflation is one of the main concerns in emerging economies. The conventional pricing approach is not suitable for inflationary environments given the distortion in the traditional business incentives. Under these environments a new framework should be developed in order to assess the new priorities of the pricing policy. This new approach -called the “Inflation’s 3 C”- highlights the key issues that pricing should address, i.e.: Cost, Collections and Communication.
This article develops the key issues that integrate this new framework.
Challenges of Pricing in Emerging Economies: Coping with High Inflation
High inflation is still one of the main concerns in emerging economies. Annual rates in the neighborhood of 10% -and even more for some specific markets- have characterized the pricing situation of many emerging economies for years. This scenario represents high uncertainty for companies doing business at emerging countries.
Prices and their evolution become the centre of the business worries –in many cases- at the expense of losing the focus in the business strategy. This situation entails a particular challenge for the pricing profession. Understanding the new price dynamics becomes a critical issue for the companies’ survival. A new pricing approach together with financial management tools should be implemented in order to cope with this difficult environment.
The conventional pricing approach –valid for low inflation economies- requires some adjustments in order to reflect the new challenges of high inflation environments. While the “4 C” framework is a trusted and important tool to identify the key drivers of pricing in conventional scenarios, i.e.: Cost, Customers, Competitors and Channel, it needs to be redefined when high inflation turns out to be a main concern.
During inflationary times companies try to protect their profits and cash flow transferring the inflationary impact to third parties. These parties are customers, suppliers, and employees. Customers will be affected through selling price adjustments. In the case of suppliers, the company will try to delay the impact of cost increases and extend payment terms as much as possible. Finally in the case of employees, they will be affected if salaries lag behind the inflation rate evolution, reducing their real purchasing power.
Under this environment a new framework should be developed in order to better assess the new priorities of the pricing policy. This new approach -called the “Inflation’s 3 C”- highlights the new set of the key issues that pricing should address i.e.: Cost, Collections and Communication (see figure 1).
This new framework reflects the change in the priorities for the company and the new way of doing business given the distortion of traditional incentives. For example, while during in normal times increasing sales is one of the top priorities of the company, in inflationary times holding large inventories while being very selective in closing sales could be a more profitable strategy. Financial gains (working capital appreciation) can be far more rewarding than classic operational profits under the new set of incentives.
Figure 1: “Inflation’s 3 C”
Key Drivers: “Inflation’s 3 C”
In inflationary environments the company has to keep up with constant cost increases that should be passed through to prices in order to avoid losing profitability and cash flow. Information about costs and its forecasted evolution is vital for the planning and scheduling of the pass-through strategy.
Fluid communication between the pricing professional and key internal departments as Finance & Administration, Purchasing and Human Resources is pivotal under inflationary situations. These departments will be the source of valuable information to make quick decisions under the new price dynamics.
In the case of the Finance & Administration department its contribution is vital to model the forecasted path of the different cost items. This information will allow to make simulations of the forecasted impact in the overall cost structure. The cost simulation model outputs will be a critical raw material for the pricing practitioner to plan the magnitude and timing of the price adjustments.
Fluid communication with the Purchasing department (raw material and services) is also very important as this area is the one that has first hand information from suppliers. Many valuable “off-the-record” inputs about cost evolution –that should be adequately weighted by the pricing professional- can be available even before the detailed cost simulations. This department will source the Finance & Administration department with the necessary information to feed the simulation model. Another critical input from the Purchasing department is the reliability of the raw material deliveries as –mainly in very high inflation contexts- suppliers may constrain or delay the deliveries in order to take advantage of future more favorable pricing conditions. If supply constrains are foreseen the companies pricing situation should be ready to reflect this.
Human Resources is another key department for cost evolution information. This department will be able to forecast the labor cost evolution which could impact both internally (i.e. labor costs of the company) and externally (i.e. labor costs of the suppliers). In the latter case this will let the company anticipate a next round of cost increases once the suppliers recalculate their costs.
In most cases labor costs usually lag behind in the adjustment path of inflationary environments. As a consequence of this lag it is probable that even when raw material inflation starts to decrease, labor cost evolution accelerates in order to catch up with the accumulated inflation rate. The information sourced by Human Resources department will also feed the cost simulation model.
Regarding the methodology to implement the price adjustments the company should always base its pricing on the analysis of the future costs -not of the historical ones- associated with making a sale. The relevant cost is the future cost of replacing the inventory when sales are made. Otherwise, there will be a risk of losing working capital as the revenues generated will not be enough to replace the inventories at the new higher costs.
For example, considering a book seller that is informed that from next month the wholesale price of his books will suffer a 10% increase. If he keeps the retail price unchanged as the new wholesale price has not affected his purchases yet, he will be reducing its financial capacity to replace his inventory as he will be paying a higher price in the next purchase. In this case he will be forced to borrow money or retain a larger portion of the earnings in order to keep the same level of inventory.
To avoid this, he should adjust his retail price as soon as he notices about the increase, in order to reflect the future cost of replacing his inventory.
When high inflation is a persistent phenomenon an automatic price adjustment clause can be an interesting idea to explore. Suppliers and customers could agree on a criterion or index that could serve as a trigger to automatically implement price adjustments. This criterion or index should be as simple and transparent as possible in order to avoid any conflict during its implementation. This system could be very useful to reduce the impact of a constant price negotiation under a persistent inflation situation.
Payment terms are usually reduced during inflationary situations mainly for three reasons: to decrease the exposure of the accounts receivables, to protect the company from the higher risk of past due problems and to avoid charging the customers with the higher cost of financing sales given the higher cost of capital.
Accounts receivables have the same problem that inventories –especially if the company has long payment terms- as there is a risk that the revenues to be collected do not reflect the real “cash” cost of the sale. Unless the prices invoiced already include the cost of capital on the agreed payment term, there is a permanent risk that revenues collected will never be enough to reflect the replacement cost of the goods sold.
Past due problems are very common as some customers are likely to show speculative behaviors trying to delay payments in order to liquidate the burden of accounts receivables exposed to the inflationary erosion. The cost of financing sales also rises as the cost of capital increases to reflect the expected inflation.
The payment term reduction should be usually complemented with stronger incentives in order to increase the opportunity cost for the customers of delaying the payments. A price waterfall analysis could help to break out the entire discounts framework from the invoice price to the pocket price in order to find some opportunities to improve the
collections performance. For example, moving some discounts from commercial purposes (e.g. promotional discounts) to financial purposes (e.g. pay in advance discount or payment in term discount). Focusing the price waterfall items to improving the payment performance can be very helpful under inflationary situations.
The communication strategy is crucial for the price recovery actions success. The communication should not only be directed to customers but also to other stakeholders, as competitors or the government, depending on the particular situation of each market.
Customers should be convinced that the price adjustment is inevitable and equitable for the entire customer base. The price adjustment should be perceived by customers as critical in order to maintain a reliable product supply. Relating the increase to widely known “high-level” cost increases can help to gain credibility and reduce the opposition. Nevertheless -if possible- the company should try to avoid giving too much information to customers about detailed cost increases in order to maintain enough price flexibility. It’s advisable to give only the strictly necessary details about the cost drivers of the price increases. However, in some concentrated markets with few strong customers there’s no other alternative than open book pricing. In that case the company should prepare a detailed spreadsheet communicating the cost impact in each part of the cost structure. Far from desirable, this can be the only way to get a price increase in markets where the demand is very concentrated in a few customers.
Competitors should also receive the message about the price adjustment. Even then, the means and scope should be carefully analyzed in order to avoid behaviors that can be considered illegal in certain markets. The communication -that can be done through an industry council or a press release- should help to spread the idea that is in the best interest of all the players to implement soon a price adjustment in order to maintain the long-term profitability and continue competing at the same price level that before the price increase.
In the case of the government –especially in markets closely screened by governments because of any political or social reason- the message should be directed to communicate the general cost foundations of the price increase. This communication
could also help to refocus the interest of the government control from the suppliers of the market to the supplier’s suppliers.
For many companies –mainly at emerging countries- the price adjustments driven by inflationary environments can be an excellent opportunity to reformulate its pricing policy. Given the uncertainty that surrounds the inflationary situations, all the stakeholders are more wiling to accept price reformulations than in stable situations. This helps to reduce the normal resistance than entails a price adjustment. Following the developed framework the company can turn a problem -as surging inflation- into a real pricing opportunity.
About The Author:
Ariel Baños is an economist with vast experience in pricing at emerging economies. He has developed his expertise at a leading American company operating in the automotive business at emerging countries. Ariel is the founder of Fijaciondeprecios.com the first organization specialized in pricing for Spanish speaking countries. Contact: firstname.lastname@example.org
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Sanguineti, E. and Lazzati S. (2002). “Gerenciar con inflación”. Revista Mercado.