What is inflation?
This word has consumed headline news for over a year now across the globe. While it’s easy to associate inflation with price increases for items such as eggs or the price for an evening stay at a hotel, the underlying drivers can be a bit more complicated. Inflation, or the rate at which prices for goods and services ride, can be attributed to three primary drivers:
- Demand-pull: Increase in money supply (M2) and credit which stimulates the overall demand for goods and services. The demand increases more rapidly than the economy’s production capacity. This is basic supply and demand economics.
- Cost-push: This often kicks in when demand-pull inflation is going strong. Costs for raw materials increase and the business must in turn raise their prices regardless of demand. Think of this as a restaurant charging you more for your favorite dish due to the increased price of poultry – the costs are pushed downstream when margins cannot be maintained.
- Built-in: When demand-pull and cost-push inflation occurs the expectation amongst employees is a salary or pay raise. To keep margins elevated, businesses then raise prices to accommodate higher wages for their workforce. This is realized annually whether you’re a corporate employee at a multi-billion-dollar company or an hourly employee at the local coffee shop.
Getting paid more due to built-in inflation sounds great, right?! Only if the cost of living around you is less relative to your wage increase; otherwise, you may still be losing money each year relatively speaking. Unfortunately, as shown in the data provided by statistica, inflation has been beating wages for some time.
Pricing during inflation
Given that we experienced a period where trillions of dollars were funneled into the economy as stimulus during the COVID-19 pandemic, it’s only fitting that a combination of the above inflation drivers kicked into overdrive. This presented both a risk and an opportunity for service organizations with respect to pricing strategies.
- Risks: If prices are left unchecked, increase costs in a cost-push inflationary environment could squeeze margins. Additionally, if prices are raised too high too fast consumers may push back and demand/customer loyalty could dissipate.
- Opportunities: Less profitable prices can be re-negotiated leading to increased profitability in the long run. Pricing strategies can evolve, such as incorporating customer-differentiated pricing models.
Regardless of the types and number of changes made during an inflationary period for parts pricing, agility and data are keys to success!
How is inflation reduced?
To quote Sir Isaac Newton, “For every action in nature there is an equal and opposite reaction.” The reaction to inflation is identified by what is called quantitative tightening and the change in interest rates:
- Quantitative tightening: To supply the market with supportive monetary policies, the central banks increase their balance sheet via quantitative easing with treasuries, bonds, mortgage-backed securities, etc. Quantitative tightening is the inverse action by which the central banks decrease their balance sheets by selling the collateral (treasuries, bonds, etc.) or letting them mature and removing them from their cash balance. In other words, the bank account takes on deposits and has withdrawals just like yours and mine, just with a lot more money and transactions are forced by leaders.
- Interest rates: Central banks have the ability to increase or decrease interest rates which result in restricting or loosening the ability for interbank lending. The easiest comparison to everyday life is when interest rates are cheap for mortgages, people tend to want to buy new homes or refinance their current mortgages. When interest rates rise, demand drops as an inverse correlation.
The tools above have been put into play during the course of 2022 and continue to be used as 2023 is underway. The hope of central banks is that through these tools, inflation will come down but not at the expense of causing a recession. The process of inflation being reduced is known as deflation and has completely different implications for how service organizations will approach running their business.
What are the challenges during deflation?
Deflation – or a decline in prices for goods and services – is typically associated with a contraction of the money supply and credit in the economy. Prices declining means everything is great! Not so fast, let’s take a look at some of the challenges and opportunities that take place during this period:
- Cost of capital increases due to quantitative tightening, which impacts both purchasing power and inventory management.
- Demand destruction may occur as a result of money and credit being removed from the economy.
- Business investment may stagnate over time as companies focus on the preservation of capital on balance sheets.
- Purchasing power rises over time, and even more so when currency exchange rates normalize on a global scale.
Excluding the resurgence of purchasing power within the currency, it’s very apparent that the challenges above can create quite a headache for the service leader who owns the responsibility of the organization’s P&L.
The Bullwhip effect
To make matters more challenging for manufacturing companies and supply chain leaders, the past several years have been a textbook example of what is known as the bullwhip effect for some manufacturers and service organizations. This is a scenario in which small changes in demand at the consumer end of the supply chain become amplified when moving up the supply chain from retail to the manufacturing end. Manufacturers are often left holding significant inventory (or the proverbial bag) at the end of this sequence, which may or may not coincide with slowing demand. Carrying excess inventory in any situation is not looked highly upon; however, in today’s environment when the cost of capital is so high and the technology landscape is moving so quickly, the risks are amplified.
Companies often run campaigns or discount programs to move the excessive inventory but must balance this carefully to not destroy profitability. In a perfect world, lowering prices leads to a direct correlation with increasing demand and allows inventory to be reduced in line with company goals. This is also known as Price Elasticity of Demand. While some view this ratio as a means to increase total demand for a product, it’s Syncron’s view that demand doesn’t actually increase or decrease, but rather is shifted forward and backward in time. Additionally, demand may be shifted from finished goods sales at the OEM to the aftermarket in the event discounts are appealing enough for consumers to continue the operation of existing assets. Using another physics example, Syncron’s view on Price Elasticity of Demand is very similar to the Law of Conservation of Energy where energy can neither be created nor destroyed – only converted from one form of energy to another.
While not specific to aftermarket sales, a well-known example of this in recent months is Tesla. The car manufacturer dropped prices up to 20% for certain models to start 2023. The individuals who jumped on this deal and purchased vehicles were likely already interested in purchasing an Electric Vehicle. This move by Tesla shifted the timing of demand up in line with the discount offering window.
Pricing during deflation
While the challenges associated with deflation can often be ominous from a top-line growth perspective near term, it does present an opportunity to increase customer base and brand loyalty. During deflation, companies really have two options:
- Reduce pricing and profitability in order to pass on savings to customers, by which the increase in customer base may offset the drop in top-line revenue.
- Maintain or increase pricing to grow top-line revenue and margins, resulting in no savings for customers and risk of churn.
Assuming companies elect to go with option 1 (fingers crossed as a consumer), they can’t just blindly reduce their prices in a race to $0. There are three questions that need to be addressed in order to develop a comprehensive strategy:
- When do I need to start lowering prices?
- How much do I need to lower prices?
- For which customers and products do I need to lower prices?
With consumer expectations increasing at a significant rate, it’s critical that data be available on a consistent basis to support these questions as part of an ongoing business review. As we all know from the past several years, market sentiment and economic conditions can pivot on a dime. The importance of data and technology cannot be overstated as a means to driving a successful pricing strategy in aftermarket parts organizations.
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