Fighting inflation? Strategies to justify cost recovery
Since the beginning of 2021, labor, raw material, logistics, and utilities costs have skyrocketed, heavily outpacing customary inflation rates. Companies used to be able to absorb the increases through cost-cutting measures and efficiency gains; today, however, the strategies manufacturers used to deploy to dull the impact of inflation are no longer enough.
Today, however, the strategies manufacturers used to deploy to dull the impact of inflation are no longer enough.
Whether your company is on the supplier or customer side, you’re pressed — to justify cost increases if the former, and to determine if costs are reasonable if the latter. For both customer and supplier, it takes hard data coupled with margin intelligence to mitigate inflationary cost increases. We share road-tested strategies to address increases in four common areas.
1. Justifying increases in material costs
When negotiating with your supply base or your customers, candid, fact-based discussions with supporting data are important. Both help maintain transparency and show that due diligence was done to pass on the lowest cost increase possible.
When companies realize their cost increases surpass their contractual agreements, the first instinct often is to pass them on directly to customers. But without an understanding of which specific parts or customers are impacted, it’s extremely difficult to negotiate. Before initiating a discussion about a cost increase, you’ll want to determine:
- Which parts are impacted.
- Customer share of price change (if the part is made for multiple customers.)
- If customer and supplier material recovery mechanisms are synchronized.
To help build a business case around the data, consider these actions:
- Monitor your purchase price variances. If you’re using standard costs, tracking purchase price variances upon receipt of goods is critical to understanding when and where changes occur. When passing costs on to the customer, detailed records of invoices are key to making the business case for an increase.
- Review parts tied to material agreements. This can be used to align on commodity cost increase. Understanding raw material indices and any triggers for increases are crucial to timely discussions with customers and suppliers. That said, in this inflationary environment, the indices often have not kept up with specific purchased parts. Customer recovery agreements may not match up with supplier recovery agreements, or vice versa, so a deep understanding of those recovery mechanisms is essential to knowing what your true costs are.
- Review parts not tied to material agreements. Most customers and suppliers are open to tying raw material costs to indices that are balanced and fair. If the commodity price goes up, so does the finished product price to the customer, rather than evaluating this as a lump sum.
Pricing can be adjusted monthly, quarterly, semiannually, or annually. As you might imagine, semiannually and annually are the least desirable — when possible, you want to avoid lagging debits and credits on the balance sheet.
And keep in mind that customers will want to see, if not require, justification when reviewing cost increases not tied to a market index.
Keep in mind that customers will want to see, if not require, justification when reviewing cost increases not tied to a market index.
2. Justifying increases in labor costs
According to the National Association of Manufacturers, manufacturing lost nearly 1.4 million workers during the pandemic and, as of Q2 2021, had only recovered 63% of the sector’s pre-COVID-19 workforce. That translates to a dearth of skilled labor, causing additional downtime and inefficiency across industries. Add training costs and the intangible damage to your customer relationships for not meeting due dates, and the costs add up quickly. These labor impacts are three-fold:
- Wage increases: Employers are paying 20 to 25% higher wages than pre-pandemic to keep good employees. With companies typically budgeting 3% year over year for wage increases, this should be an obvious area to review and extract statistics to bolster a case for cost recovery.
- Labor shortages: To fill the void, contract labor or creative shift planning with premiums will increase overall labor cost.
- Labor efficiency loss: The influx of contract labor and new, inexperienced employees can cause a serious drop in productivity. Where a skilled worker might be able to complete a specific task in 30 seconds, it might take two inexperienced individuals more than double that amount of time to complete the same task.
If you’re trying to justify labor increases presented by a supplier, or you’re presenting price increases to a customer:
- Understand which processes are impacted. Not all manufacturing is created equal, and assuming one job may have the same cost impact as another is a recipe for failure.
- Separate wage increases from efficiency losses. This shows customers a high level of business acumen, builds trust in the integrity of the data, and quantifies the two-fold impact of labor shortages.
- Highlight the cost differences between direct labor and contract labor. Fringes and other costs are often lost in this comparison, so presenting an accurate calculation of labor cost helps both parties realize the crunch of the labor shortage.
3. Justifying increases in freight, logistics, and warehousing costs
Freight and logistics have seen severe increases since the pandemic began. Given the shutdown of major ports and highways in China, port congestion in the United States and Europe, and labor shortages in warehousing and all modes of transportation, getting parts on time and on budget is nearly impossible. Throw in Russia’s invasion of Ukraine and its impact on fuel prices, and freight and logistics bottlenecks get even more complex.
Consider the following factors when justifying freight increases:
- Freight cost by SKU: Knowing how freight costs impact products at the parts number level will make negotiations easier. No one wants to pay for another customer’s freight or expediting fees, so knowing how to allocate freight costs to individual parts helps you assure customers they’re not subsidizing their competitors.
- Warehousing: One often overlooked cost is storage. With lead times exceeding 52 weeks for some products, companies must stock more inventory to eliminate work stoppages. The need for space to store those parts, and the labor and equipment to move them around, must be accounted for in the piece price.
The impact per piece is crucial to quantifying increases, with the best-case scenario being a schedule by part, based on actual invoices. However, time and detail of cost data are two constraints that may drive the decision to use standard costing as a baseline or assign freight as a percent of material. Regardless, having a firm understanding of product- and customer-specific freight and logistics costs from the balance sheet only adds to the confidence in your data.
4. Justifying increases in utilities costs
Utilities are a headwind for the U.S. economy. The United States spent 4.8% of its GDP on energy in 2020 and is on pace to spend 13% this year — a record. And according to the U.S. Chamber of Commerce, Europe is seeing the same issue and spending over 9% of its GDP on energy, the highest share since 1981. Rising natural gas prices in the United States are negatively impacting energy-intensive manufacturing processes, forcing interest groups to petition Congress for “policies that will unleash the potential of inexpensive and efficient American energy” (Wisconsin Manufacturers and Commerce association).
Just as with freight, logistics, and warehousing, knowing the utility cost per SKU helps identify which products are consuming the most gas, water, and electricity. Oftentimes, companies know anecdotally which products are high-utility consumers, but customers typically don’t want to deal in anecdotes; they want facts and figures. Having the information available at the parts number level helps accomplish that and strengthen the case for cost increases.
Proper cost allocation methodologies — that also are sustainable, flexible, and appropriate for your particular business — are especially critical today. In our inflationary environment, cost and margin data are your superpower for maximizing cost recovery while protecting your invaluable customer relationships.