In a recent newsletter
, I wrote about the importance of understanding product or service cost when dealing with supply chain problems and inflation. Today, I dive into product costs amid
(If you are in a service business, this applies to you as well since the framework is similar.)
Today, businesses are facing three systemic issues affecting product cost.
#1. Product Shortages
Today’s shortages are mostly a result of manufacturing shutdowns from Covid, changes in consumer demand because of Covid, and increases in business inventory levels that have occurred as a result.
For example, early in the pandemic, demand for food products sold in restaurants dropped while demand for similar food sold in grocery stores increased. In the short term, there wasn’t enough consumer product packaging line capacity to handle this increase in demand on the grocery store side, even though there may have been ample supply of the underlying food. Worse, production capacity was reduced for many products from Covid shutdowns due to workers sick with Covid.
Walmart and other big box retailers then loaded up on products, which in turn overloaded supply chains, causing bottlenecks — effectively decreasing the supply of transportation. These supply chain shortages resulted in much higher transportation costs, leading to product cost increases.
Hopefully, as lockdowns end and the demand spikes work their way through the system, these shortages will dissipate.
#2. Labor Shortages
There is a labor shortage in the United States, causing wages and benefit expenses to increase as companies compete for scarce workers. This reduction in the size of the workforce has occurred for two primary reasons.
First, because the percentage of working age people that are working has declined. Second, because the size of the working age population overall has decreased, as Boomers retire and are replaced by Zoomers (the generation after the Millennials) who represent a smaller population.
Wages and benefit expenses will keep increasing until a new equilibrium is reached. Typically, this type of adjustment takes considerable time to emerge.
#3. Monetary Inflation
The United States and many other parts of the world are experiencing Monetary inflation. This happens when the money supply increases without a corresponding increase in the quantity of goods and services. With more money chasing a stable supply, the
level of prices increases, not just the price of some items. Milton Friedman demonstrated this phenomenon long ago and was awarded the Nobel Prize in Economics for his work.
How much has the money supply (technically, “M2”) grown? Before Covid, the monthly year over year increase was in the 3.8% to 7.0% range. But from May 2020 to March 2021, that same measure jumped a whopping 24%! Since March 2021, M2 has been increasing in the 12.3% to 14.2% range — 2X the pre-Covid rate. So, Monetary inflation will be here for the indefinite future.
All Costs Need to Be Considered
One thing that has changed since the outset of Covid is that more than just material costs are increasing. Today, when looking at changes in product cost, actual and projected, all costs must be considered.
I break out costs into three buckets: variable, controllable fixed, and committed fixed:
#1. Variable costs are just that, they vary with the volume sold.
#2. Controllable fixed costs are costs that don’t vary with volume in the near term, but can be changed, at least somewhat. For example, in manufacturing, hourly factory labor often varies with the volume produced: hours worked goes up or down. Supervisors are salaried, however, so their costs don’t vary with volume. But… the number of supervisors can be changed by management, as can the type or cost per person.
#3. Committed fixed costs don’t vary with volume and management can’t change them in the near term (if at all). Examples include depreciation, rent, and many insurance costs. Often, when looking at product costs and how they might change, fixed costs, particularly committed fixed costs, are ignored or assumed to be constant. No more.
What to Do
Overall, assume that just about all costs will increase at the annual rate of monetary inflation and that compensation costs will increase faster than that.
Easier said than done, I know. Most economists can’t predict inflation worth beans and it’s too soon to predict how fast compensation costs will increase. But inflation isn’t returning to the 2% level anytime soon and the salary increases of last year and this quarter aren’t likely to suddenly end. One way to look at how much salary and wage costs might go up is to assume that employees this year will recover the inflation from last year.
A few tips…
Anticipate volume changes. Most businesses look at product costs on a per unit basis. If volume increases, fixed costs per unit goes down and vice versa. During Covid, many businesses experienced volume swings in both directions, so don’t overlook these potential changes.
Also, many variable costs can change on a per unit basis if the volume goes above or below a certain range. For example, a manufacturing client of mine uses a lot of natural gas and electricity in its production process — gas and electricity usage vary with volume. But pre-Covid, my clients signed multiyear contracts at low prices. Great! But, there is a minimum volume requirement and an upper cap on volume covered by the contract. So, if there is a big drop in volume, these costs become fixed costs; too big of an increase in volume and the unit cost jumps to higher market prices.
Many committed fixed costs are not inflation-proof. Take rent. Typically, certain cost increases are passed through to the tenant. Property and casualty insurance costs move a bit differently. The costs the insurance covers go up with inflation. All things being equal, insurance premiums will go up with inflation, too.
Keep computer systems up to date, particularly those used to get product cost. For example, a client of mine that I helped sell did not keep its Bills of Material (BOMs) up to date. This surfaced in the working capital adjustment review process and all sorts of inventory discrepancies were found. BOMS weren’t current so the automatic reduction in raw material inventories was incorrect — the wrong materials were reduced. If those errors weren’t fixed and the BOM was used as a basis for product cost, product cost would be wrong as would any increases in product cost.
Track unit volume, not just sales dollars and have a standardized unit of measure across products. This is needed to be able to turn changes in dollar cost to changes in unit cost. Unit cost is what matters for our purposes. For example, when I worked for Kraft Foods, we tracked pound/pints. At Budget Rent A Car, we tracked daily billed revenue days. My manufacturing client tracks cubic feet sold. The same logic works for service businesses, it’s just that there are no (or few) raw materials.
Inflation is here for the foreseeable future and compensation costs will continue to rise even faster. When tracking and projecting product costs, realize that all costs will be increasing, and that people costs will rise at an even faster rate.