In 2022 retailers must understand the mechanics of inflation to stay viable

Five general guidelines retailers should follow to get to grips with high inflation

If retailers are going to get to grips with inflation, they firstly have to understand its mechanics. Only then can they stay viable in this new, high inflation environment, says Andrew Gorecki, Managing Director at Retail Directions.

Decades ago, American economist and statistician, Milton Friedman, used the term ‘inflation party’. He painted a scenario where the government prints more money exceeding the growth in manufacturing and services, everyone has more cash, business speeds up and prices have not taken off as yet. Everyone has a good time. Party time.

Clearly, we have now moved to the next phase – the time of reckoning.

Prices have started to grow rapidly, reaching shocking levels in some areas, such as gasoline and electricity. This will lead to business collapses and growth in unemployment, creating the cocktail for recession. This may make for grim reading, but it cannot be helped. Inflationary cycle always follows the same pattern.

The accelerated inflationary process can be seen globally, with the US facing a 40 year inflation high, UK inflation is also at its highest levels in 40 years, rising to 9.1%, and in Australia, research from global bank Citi forecasts a $60b hit to consumers’ domestic retail spending capacity in FY23. The inflation party has come to an end in most economies around the world.

The implication for retailers

What does this mean for retailers who got used to a relatively low and stable inflation rate between 2% and 3% a year? It means that they must review their business model, so it continues to operate well in this new environment where the value of money diminishes faster.

In the new environment, retailers must take into account higher interest rates, which will increase the cost of capital and borrowings, and the need to re-synchronise the relationship between the cost of goods and retail prices charged to customers.

To provide guidelines for this new environment, let’s consider a simple three-month long business cycle within a retail business that sells fashion goods. The retailer orders an item for $20, it gets delivered in two months and then customers buy it for $50, producing 60% gross margin.

If the cost of goods during these three months goes up by 0.75% (3% annually), as it used to, the replacement stock will cost $20.15 – not a big deal, it just means margin reduction from 60.0% to 59.7%. The retailer could pass this on to consumers, by slightly increasing the retail price, or by absorbing it. Over 12 months, the cost will go up to $20.60, reducing margins to 58.8%. This would require price increases as the financial model of the business would start to squeak.

However, if inflation rate reaches 9% a year, the cost will go up from $20.00, to $20.45 and the margin now will reduce to 59.1% over the three months period and annually to 56.4%. This definitely requires on-going price increases, as the business model won’t be able to cope with such erosion of margins.

If we combine this with the reduced buying power (wages rarely keep up with inflation, people move into higher tax brackets, and non-discretionary costs go up – such as rent, electricity, mortgage repayments etc.), we can expect that the revenue of the business won’t keep up with inflation either.

What can a retailer do when confronted with this changed reality? Here are five general guidelines retailers should take note of:

1) Shorten your price increase cycle but protect your brand positioning

Instead of changing prices rarely, recognise the need to keep your prices in sync with changing costs on a regular basis. In each buying cycle prices need to be revised, to maintain the margin. But do it carefully, taking price points into account and possibly taking some margin hit on products that people usually look at to form an opinion about a retailer’s overall pricing level.

Norman Drieselmann, Chief Executive Officer at Retailability, a South African based group of retail brands, offered key insights on this topic.

Drieselmann said, “The biggest objective in our space has been to ensure our value positioning remains intact in the mind of the consumer. The next step is to evaluate how you can gain market share in this state of chaos in the market. Our approach has always been to focus on key product categories that we are known for in the market, and then drive a value message through both above the line marketing and in store execution to optimise our performance in those very specific categories that competitors will struggle to emulate.”

Drieselmann explained that to ensure key known items were maintained at pre inflation levels, it has, “…necessitated a short-term drop in input margins, but was felt a fair sacrifice to ensure our price perception in the customers mind is maintained. It was noted that despite the input margin pressure in those selected lines, our overall margin through the till was maintained in that department.”

2) Expect reduced profits, even if margins hold

With the top line also under pressure, even if margins hold, the volume of profit can still decline. To counter this, all aspects of the business must be examined, including rent, outgoings and labour to reduce the cost base. Any waste (meaning money spent that is not a genuine expense) must be vigorously eliminated. Simplify your processes and systems. Labour sinks and other areas of business inefficiency that were tolerated in the good times have now become a luxury no business can afford.

In parallel, retailers need to find new ways to boost the top line. Drieselmann discussed that one tactic Retailability had employed over the last 12 months, was to drive multiple deals. Drieselmann explains, “This established the ability to offer better pricing to my peer retailers while ensuring we continued to bank enough gross margin rands (dollars) to drive profit growth.

Drieselmann added, “We noted customers buying items together with friends and family to take advantage of the deals. While slightly eroding margin rate, our experience has shown that the gross margin rands (dollars) grow significantly as basket sizes grow and new customers are brought into our stores.

3) Preserve capital

Part of the high inflation fallout includes rising cost of capital. Hence, it goes without saying that with interest rates growing rapidly, only projects with short term payback should be approved.

Projects need to be short, to minimise the risk of project failure (and capital waste) due to the continually evolving business environment. Ideally, you should be able to get your money back in 12 months. If you can’t, think twice.

More than anything, avoid grandiose schemes, as they could mortally wound the business. Do more testing before you commit business to new markets or product lines.

4) Plan for medium term

Retailers who successfully alter their business model to stay viable in the high-inflation world, will enjoy increased business volume and profitability after about 18 to 24 months, as some of their competitors will be forced to exit the market, failing to adapt to the new environment.

Note that high inflation could stay with us long term, so the focus needs to be not on trying to wait for inflation to go away, but on rearranging the business so it can survive in the medium term and then thrive once some of the competitors disappear.

5) Stay calm

A challenging shift in the business environment usually causes anxiety and could lead to an overreaction. This needs to be avoided – business environment changes and good businesses recognise this as normal and adapt. An easy period in the past was also easy on the competitors, so things won’t be worse going forward (‘we are all in it together’ as many politicians like to say), they will be just different.

This article was first published on the Supply Chain Channel.