UK: THE LONG, SLOW GRIND TO PROFITS. - Companies are now finding themselves in a piggy-in-the middle position with no control over the cost of raw materials and no prospect of passing them to increasingly hike-resistant customers.

by David Smith.
Last Updated: 31 Aug 2010

Companies are now finding themselves in a piggy-in-the middle position with no control over the cost of raw materials and no prospect of passing them to increasingly hike-resistant customers.

Charles Miller Smith, chief executive of ICI, recently announced plans to seek out and implement cost savings within the chemicals giant of £400 million a year. These efficiency improvements were not to be achieved through job cuts or plant closures but, said Smith, 'by improving operational performance in areas like purchasing, supply chain management and manufacturing excellence'.

Nothing unusual in this you may think; companies are constantly trying to achieve efficiency gains and, indeed, would soon fall by the wayside if they did not. But Smith was quite explicit about the reasons behind the cost-saving drive: ICI had been achieving too low a rate of return on its assets (15% against a target of 20%), and there was little prospect of lifting that rate through higher prices.

Indeed, the outlook for the bulk chemicals market, in the light of some softening of world industrial demand, was for weaker prices, and there was little that ICI, even as a major player, could do about it. The ICI task, therefore, has to be to approach the problem from the other side, by benchmarking itself against the best competitors in each of its businesses and achieving efficiency levels on a par with, or better than, its rivals. Only thus could the rate of return be lifted to achieve the company's targets.

The chemicals business, sensitive as it is to global economic trends, and unable to do much about them, might be considered a special case. But is it? Consider Merrydown, the drinks group, famous for its ciders. Although operating on a much smaller scale, its problems are identical to those of ICI. According to Richard Purdey, Merrydown's chairman, the cider price war that the company has been caught up in is a 'vicious' one which shows no sign of easing. Post-duty cider prices have retreated to their levels of 10 years ago and, in spite of cost cuts amounting to £1.5 million in the financial year which ended on 31 March, Merrydown still made a pre-tax loss of £2.7 million. And, in the absence of any indications that the pressure on prices may be easing, cost-cutting seems to be the only way forward.

No business needs to be reminded that it is tough out there. But these examples from opposite ends of the industrial spectrum are symptomatic of a wider generality. We are, it seems, in an environment where it is only possible to make money by constantly pruning, cost-cutting and introducing far-reaching efficiency savings. Even then, if the competitive environment is tough enough, such measures may not be enough. The days of easy profits, often floating on a tide of rising inflation, are long gone. Making money has become a grinding process.

At the heart of it lies an old business truism - that the customer is king. And not only is the modern-day customer positively regal but he, or she, is more price-sensitive than at any time in recent corporate history.

Businesses find themselves in an uncomfortable, piggy-in-the-middle situation. Powerless to exert control over their raw material costs, which themselves often reflect macroeconomic factors such as the pound's performance on the foreign exchanges, they are also unable to pass these higher costs on.

The CBI has been monitoring trends in industrial costs and prices for 40 years. Earlier this year its reports caused mild alarm at the Treasury and the Bank of England. Industry's costs were rising, it said, and in time-honoured way these rising costs would be passed on to customers in the form of higher prices. It was a semi-official inflation alert. But then a curious thing happened. Industry's costs, both for raw materials and labour, continued to climb. In fact in its latest quarterly survey they showed their strongest rise for four-and-a-half years. At that time inflation was in double figures. Firms, however, which had earlier been gung-ho about their ability to pass these cost increases on to customers, were now much more cautious. Price expectations eased back, as managers accepted that they would not be able to force through higher prices, and the Chancellor of the Exchequer was able to breathe a sigh of relief. Managers, of course, were left with the task of rebuilding margins in some other way, most probably by following the ICI/Merrydown cost-saving route.

'The squeeze on margins is likely to continue,' says Andrew Buxton, chairman of Barclays and head of the CBI's economic situation committee. 'Prices are rising more slowly even though cost pressures due to higher raw material prices have continued to mount. Competition is fierce in both home and overseas markets.' Sudhir Junankar, the CBI economist whose task it is to condense the raw information from industry and turn it into the organisation's industrial trends surveys, notices several forces at work. 'In general, the closer you are to the consumer market, the more difficult it is to raise prices,' he says. 'But the pressure on margins does not begin and end with retailers. They, in turn, are putting the squeeze on their suppliers, and the effect is felt right back along the supply chain.' He also maintains that the pressure is more intense than at the comparable stage in earlier cycles, but then so too is the response of companies. 'Cost-cutting and cost-control has become a continuous process, a way of life,' he says. 'But firms have become better at it. By responding to the toughness of the pricing environment companies have managed to improve their profitability in difficult conditions.' But why is it so hard to force through price increases now, and is this the permanent situation facing industry? David Buck of the Chartered Institute of Purchasing and Supply (CIPS) which, like the CBI has been reporting a squeeze on margins for virtually the entire period of Britain's post-1992 industrial upturn, says there is no doubt that there has been a fundamental change in behaviour. 'The '80s were different, and in many ways a lot easier,' he says. 'The '90s are all about being lean, mean and ready to rationalise. The interesting question is whether it was the 1980s that was the exceptional decade and we have merely returned to normality.' On a practical level, Buck detects a growing awareness among buyers about what products and services should cost, and an unwillingness to accept higher prices. 'Buyers are much more knowledgeable and aware,' he says. 'They know, more than ever, what is going on in the marketplace, usually as much as the suppliers themselves, and they are highly resistant to higher prices.' A large part of the explanation for this, of course, rests with the fact that inflation generally has been consistently lower than at any time in the past 30 years. Even in the 1980s, a decade in which the Thatcher Government was given credit for bringing inflation to heel, the annual increase in prices averaged 8%. During this recovery, in contrast, inflation has averaged between 2% and 3%, a huge difference. The result is that buyers, their own incomes and budgets constrained, are unwilling to accept higher prices without challenge. The phenomenon known by economists as the 'money illusion', whereby real price changes can be achieved under the camouflage of a general rise in the price level, has been dealt a decisive blow. The Government, having set out to eradicate the mentality of the annual pay round, may also have succeeded in eliminating the annual, or twice-yearly, uprating of list prices.

'We are in a different, and difficult environment as regards inflation,' says Doug McWilliams of the Centre for Economics and Business Research (CEBR). 'That means a lower average rate of inflation or, for many firms, no increase at all in their final prices. The result of this is a process which starts in the consumer market and is working its way right back to raw materials, and it is more obvious in Britain than elsewhere. The problem is that firms are often in no position to influence their raw material prices - there has been a shift in the terms of trade in favour of primary commodity producers. In this environment firms either have to reduce the cost of labour or increase its productivity.' The other side of this, suggests Buck, is that firms could be storing up problems for the future. 'Cost-saving is of course essential but I sometimes wonder whether industry is becoming a little too anorexic,' he says. 'Companies are restructuring and rationalising so much that they are getting, or will get, skill shortages.' This danger aside, tight control of labour costs provides part of the answer to a current conundrum. Although the pressure on margins is real, it would be highly misleading to say there has been no recovery in profitability. An analysis by Michael Saunders of Salomon Brothers shows that gross trading profits as a share of national income, having peaked at 18.4% in the late 1980s, slumped to 11.5% at their lowest point in the recession (in the early part of 1992). But by the beginning of this year, the share of profits in gross domestic product had made up most of the lost ground, rising to 16.3%.

Tight control over labour costs, both in staff numbers and in extracting higher output from available personnel, referred to by McWilliams, is one important factor in this. The dog that has yet to bark in the current recovery is a decisive upturn in wage settlements, in spite of a falling official unemployment total. The danger for firms was that the effects of rising raw material costs would be compounded by an upturn in labour costs, a double whammy. This has not happened, allowing firms to breathe a collective sigh of relief and rebuild profitability in a tough competitive environment.

But even this would not have been possible without two other factors identified by the Bank of England in its annual assessment of company profitability and finance, published in August. Although it noted some slippage in company profits in the early months of this year, it too was struck by the general recovery in profitability, measured by the pre-tax rate of return on capital employed, since the recession's low point, against a backdrop of pressure on domestic margins.

The two factors emphasised by the Bank were, firstly, an increase in capital productivity, itself a side-effect of firms' often-criticised unwillingness to boost spending significantly on new plant and machinery. By extracting rising output from their existing capital stock - allowing capacity utilisation to rise - managers are automatically engineering an increase in the rate of return on capital. Eventually, of course, capacity ceilings are reached and the process becomes no longer tenable. However, capacity utilisation has yet to reach the levels of the late 1980s.

The second factor identified by the Bank is that, while domestic margins have been squeezed, export margins rose strongly in the wake of sterling's departure from the European exchange rate mechanism three years ago, and have continued to improve. The rise in export margins has continued this year in response to a further decline for sterling against the D-mark and other European currencies - in the first three months of the year export prices rose by 7% on the previous quarter, something that few, if any, businesses could have come close to achieving in the domestic market. And, in fact, this rise in overseas margins has been a double blessing. Without it, the pressure on domestic margins would have been sufficient to constrain severely any overall improvement in business profitability. Healthy export margins, which contrast so starkly with the tightly price-constrained domestic environment have, in addition, persuaded companies to divert resources into export markets, with clear benefits for their profitability and the health of the economy.

This shows up in wide differences between the 'haves' and 'have-nots' when it comes to profit. Sectors with a strong export component will, according to estimates by UBS, all show healthy profits increases this year, with increases of 31% for engineering, 40% for vehicles and components and 25% for general manufacturing. In contrast, those reliant on the domestic market are struggling, with household goods manufacturers set for a 3% profits decline, distributors down 18% and general retailers 4%.

Not everyone, however, can divert into export markets. And, sooner or later, the prospect of easier profits in overseas markets will end. Sterling cannot decline indefinitely, and many of the price-constraining factors that apply in Britain are present, and becoming more so, overseas.

The solution to making money in price-constrained markets, apart from tough cost controls, has to lie with product and process innovation. It is still clear that even parsimonious consumers and professional buyers are prepared to pay premium prices for new and innovative products. Even for some consumer electronic products, prices have stuck more than would have been expected from previous experience. Think of camcorders, where miniaturisation has kept prices high, or home cinema, which attracts a fat premium over conventional televisions. Even compact discs, which initially attracted huge consumer price-resistance, have in general maintained their prices. As for process innovation, this can open up a whole new range of cost reductions.

Nor is the outlook for margins necessarily bleak, even if price prospects are dull. The CEBR's McWilliams believes that the current pricing environment is here to stay, but he also thinks that industry in Britain, and in Europe generally, is on the brink of a revolution in costs that will allow a sharp increase in profitability, even if prices are constrained. 'The world is moving into a period where the trend will be towards higher profitability rather than lower profitability. Education and skills levels in the newly industrialised countries of the Far East and India are improving sharply, and labour in Britain and Europe will have to respond to survive. Labour costs will fall and what this will produce is an improvement in profitability on something like the scale that we saw in Victorian England.' He may be right, although an enduring fall in labour costs implies a squeeze on wages that will serve to reinforce the reluctance, and for that matter the ability, of consumers to accept higher prices. One firm's redundancy programme is another's lost sales.

And there is a gloomier way of looking at the present set of circumstances. It is that, in this new era of tightly constrained prices, businesses have survived thanks to three factors: a one-off one - the devaluation of sterling; a temporary one - the tilt in the balance of the labour market in their favour; and an unsustainable one - the eking out of additional production from existing capital stock. As these diminish in importance, making money will become even harder. Nor are there any obvious hiding places; the impetus to grind down prices is as strong in, say, auditing fees and bank charges, as it is in manufacturing.

The solution then, becomes rather more drastic. Areas of business that were viable during a period of generally rising prices are no longer so. Rationalisation becomes a permanent strategy. And the apparent economic nirvana of stable prices is harder and harder to equate with vigorous business expansion.

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