Firms need to start developing inflation mindset now and prepare for this risk

By Boston Consulting Group

Despite near-term deflationary pressures in at least some developed economies, the current economic environment is a perfect breeding ground for inflation. As such, companies face a high mid-term risk of a prolonged period of inflation.

Inflation has a corrosive effect on business performance. It undermines profits even as it causes managers to think their company is doing better than it really is. It encourages underinvestment. It distorts resource allocation. It also depresses market values; stocks generally underperform during inflationary periods.

Ready for inflation?

How well a company is prepared for inflation will depend on having organizational structures and processes in place that support effective decision-making in a turbulent, rapidly changing environment.

Many of the characteristics of an inflation-ready organization may look identical to general best practices. But those practices will be stressed by the demands of an inflationary environment, so it pays to assess these organizational capabilities as part of the overall inflation-exposure exercise.

Three functions, in particular, will be important in developing inflation readiness: pricing, procurement, and finance. An inflation-ready pricing function, for example, will have a strong business-intelligence operation and advanced pricing analytics. The organization should have robust real-time data about market trends and price levels and be able to react quickly to the latest developments.

When it comes to procurement and supply chain management, inflationary periods pose a complex optimization problem. The costs of input factors are rising, while at the same time it’s imperative for inventories to remain low.

To successfully balance the tradeoff, speed and seamless collaboration will be essential. The procurement organization should have the capacity to react quickly to changing input costs based on real-time information. It also has to communicate frequently with the sales organization so that it can increase prices if necessary. Finally, procurement should gather business intelligence on the supply market to identify opportunities for cost reduction, either by renegotiating contracts or by switching suppliers.

The finance and accounting departments also need to be quick, alert, and prepared for inflation. The higher the uncertainty of an inflationary environment, the more serious damage can be done to the quality of a company’s planning.

A company must have the capacity to use multiple time horizons for planning, monitor closely the quality of planning, and adjust the frequency of planning, if necessary. Inflation-ready finance and accounting organizations should use explicit inflation assumptions in their planning, be able to simulate the effects of different inflation scenarios, and adjust their key performance metrics for inflationary distortions.

Inflation protection plan

By the end of its inflation-exposure diagnostic, a company should know how ready the organization is to cope with the resulting challenges. This understanding lays the groundwork for developing a full-fledged inflation protection plan. The precise focus, scope, and degree of urgency of the protection program will vary depending on a company’s specific vulnerabilities and risks. However, every inflation-protection program should have three fundamental characteristics:

Holistic, not fragmented: Because protecting a company from the negative effects of inflation requires close cooperation among many functional units, an effective protection program must take a holistic approach. Businesses should establish a cross-functional task force responsible for developing an integrated, company-wide anti-inflation program.

The specific composition of the task force will depend on the results of the inflation exposure diagnostic. The task force should be responsible not only for developing the inflation protection plan but also for setting up an early warning system to monitor leading indicators and to evaluate continuously the probabilities of alternative inflation scenarios. And should the company confront inflation in its key markets, the task force will direct and oversee the response.

A Mindset, not just a system: Making a company inflation-ready is not just a matter of creating a system. It also requires changing the mindset of the workforce. The vast majority of managers and employees today have not experienced a major period of inflation during their careers. As a result, they will need to rethink their assumptions and adjust their expectations.

For example, the marketing staff will have to switch from a world of annual price increases and a focus on volume to a world of monthly price reviews and a focus on margins. The procurement organization must shift from negotiating for the lowest price to achieving price stability and predictability. In finance, employees will need to develop a stronger focus on the short term. They also must emphasize speed and flexibility in providing cost and profitability data to those making decisions. Only when such inflation-ready perspectives are anchored within an organization’s thinking and processes can a company claim to be truly prepared for inflation.

It is therefore important, throughout the development and deployment of an inflation protection program, to actively communicate the goals and scope of the program to all stakeholders. Frequent internal communication is essential in order to create inflation awareness, develop commitment and support for the inflation protection program, and build the processes and capabilities necessary to adjust to inflation. External communication is also important in order to keep shareholders informed and to demonstrate how the inflation protection program is creating value.

Strategic, not just operational: Finally, a company’s inflation protection program should be strategic, not just operational. Inflation can have a significant impact on corporate and business-unit strategy. The relative importance of different sources of competitive advantage may shift.

For example, low capital requirements and a superior financing strategy can suddenly become key sources of competitive advantage. Such shifts create new opportunities for prepared companies either through better positioning or through superior capabilities. Both corporate decision-makers and business unit executives should rethink their competitive positioning from an inflation perspective and develop strategies to benefit from a more dynamic environment.

Because key success factors and industry structures are subject to change during an inflationary period, a company needs to pursue inflation-specific competitive strategies that take into account its current positioning.

For instance, a cost leader will have a clear advantage; it can afford to wait longer than the competition to raise prices and in this way win market share. However, a market share leader has a much less attractive competitive position; it may be forced to increase prices first, because there is little additional market share to gain from undercutting competitors.

A follower can choose between two attractive strategies: keeping prices stable and winning market share or raising prices under the shield of the market share leader and protecting or even increasing margins.

But inflation-specific strategies are not limited to pricing. For instance, if a company has limited ability to pass on rising costs, small adjustments to its business strategy may not be enough to ensure that it remains competitive. Such a company will have to reinvent its business model to respond to the inflationary threat.

Consider, for example, a situation in which a company's major customers have strong pricing power and are easily able to pass on rising costs to their own customers. Because the company's customers are well protected from the negative impacts of inflation, one effective strategy for the company is to link its prices to those customers' revenues.

The company could do this, for instance, by shifting from selling a product to selling a service (the classic example is GE’s turbine business selling “power by the hour”). This not only reduces inflation exposure but also can create a competitive advantage by offering a superior service. More generally, turbulent inflationary economics call for companies to take an adaptive, dynamic approach to business strategy to overcome the limitations of deterministic methods and keep pace with incessant change.

Preparing for and protecting against inflation is a complex task. It requires significant effort ― and often ― before the immediate need and benefits become clear. Nevertheless, companies need to start developing an inflation mindset now and prepare for this risk. Their decisions today will determine whether they will be the wheat or the chaff when inflation finally arrives on their doorsteps.