Inflation is back
Inflation is back in a big way. Per February 2022, the annual inflation rate reached 7.9 percent in the US. We have to expect inflation to stay. We may even fall back to the 1970s, which were characterized by stagflation (= stagnation + inflation). At that time, the oil crises in 1973 and 1978 were the triggers. Today, there are several causes for inflation: COVID-19 and the accompanying explosion in money supply, the disruptions in global supply chains, and the Ukraine crisis. All of these factors are affecting the prices for energy, raw materials, and food.
The inflation traffic light is on deep red. For pricing executives, all the warning signals should be ringing. In the current economic situation, one can make catastrophic pricing mistakes, but there are also opportunities to escape relatively unscathed if one gets it right. In the following, I try to dig deeper and present some considerations that go beyond the usual superficial statements about price and inflation. It requires a deep understanding of the relationships between price and inflation to be able to take the right measures.
Inflation in 50 years
Inflation is nothing new. We have observed inflationary tendencies in many countries, at least since the gold standard was abandoned in 1971. Central banks generally aim for an annual inflation rate of around 2 percent. Figure 1 shows the development of consumer prices in the United States from 1971 to 2021.
Figure 1: Consumer Price Index USA 1971-2021
In this 50-year-period, the consumer price index rose from 40.5 to 271.4. If the value for 1971 is set at 100, the index stands at 670.1 in 2021. That is an increase of 6.7 times and corresponds to an average annual inflation rate of 3.87 percent, which is much higher than the intended rate of 2 percent. This resulted, as the lower curve shows, in a dramatic decline of the dollar´s value of 85.1 percent. In other words, $100 today only have the purchasing power of $14.90 in 1971. Over the half century, the cumulative effect of inflation has led to a massive devaluation of the dollar by more than 80 percent.
The trend shown in Figure 1 for the United States is typical for most highly developed nations. In Germany, the price index increased over the 50 years by a factor of 3.51, which means a loss in value of the Euro and its predecessor, the Deutsche Mark, of 71.5 percent. One exception is Japan, where prices only increased by a factor of 2.6 since 1971; they have actually decreased since 1995. The topic of inflation is and will remain highly relevant for price management.
Varying Inflation Rates and Net Market Position
Looking at inflation rates for an overall economy hides the fact that inflation affects individual industries and companies in very different ways. Over a 10-year-period, the telecommunications sector in Germany achieved a nominal increase in revenue of 5 percent (over the entire period, not annually). Adjusted for inflation, however, the sector experienced a decline of 10 percent in real terms thanks to sharp decreases in telecommunication prices. This came despite numerous innovations and significantly better performance. The telecommunications industry was not even able to increase prices at the rate of inflation. In contrast, the German automobile industry showed a nominal growth of 30 percent and a real growth of 11 percent over the same period. Based on its improved performance, car manufacturers were able to raise their prices by more than the rate of inflation. In the Global Pricing Study conducted by Simon-Kucher & Partners, for which 3,904 managers around the world were surveyed, roughly one third of the respondents said they had raised prices below the rate of inflation, one third at the rate, and one third above the rate. That means that individual companies and industries are affected very differently by inflation. Some gain advantages from inflationary tendencies, while others must accept price declines in real terms.
Inflation has effects on selling prices as well as on procurement prices, i.e., costs. How the difference between selling costs and procurement costs develops over time is decisive for the profit situation. This difference, which one refers to as the “net position,” “is an indicator of the extent to which a company can pass on the price increases it faces and the extent to which it must absorb them.” We assume for the following analysis that the company must accept the trend in procurement prices. How the net position evolves will then obviously depend on any change of the price-response function and the resulting pricing power of the company, as we see in the following.
We assume linear cost and price-response functions. The procurement and the consumption of the inputs take place within the same period. We assume that the variable unit costs increase from in period 0 to in period 1 and that the price-response function in period 0 is:
It changes in period 1 to:
where w is the rate of change of the maximum price, because . The maximum price measures customers’ willingness to pay.
We characterize the change of the price-response function as inflation-neutral, if is equal to the rate of the cost increase . The equation then applies to all prices. After we plug that into (1) we get:
In other words, if the maximum price increases at the same rate that costs do, the sales volume does not change.
If the optimal price also rises at that rate, as does the nominal profit . The “real” or inflation-adjusted profit remains unchanged.
The trend in costs and volume is not inflation-neutral if the price increase rate deviates from the cost increase rate r. If , i.e., the variable unit costs rise at a faster rate than the maximum price, it follows that:
- The optimal price increases percentagewise less than the costs.
- The rate of increase in the nominal profit can be weaker, stronger, or identical to that of costs.
- The real, i.e., inflation adjusted, profit declines.
When the opposite conclusions apply. In that situation, the company may harvest unexpected profits (e.g., in the chemical industry or aviation, when the oil price declines). But this situation is mostly temporary.
We illustrate this relationship with a numerical example, where , and . The optimal prices as well as the nominal and real profits are shown in Figure 2.
||Cost increase r (percent)
|Maximum price increase (percent)
Figure 2: Effects of different rates of increase for costs and maximum price on optimal prices and profits (top figure optimal price, middle figure nominal profit, bottom figure real profit)
We call particular attention to the cases where , as well as where , . In these cases, the nominal profit increases but the real profit declines. The example shows that passing on cost increases to customers in a schematic manner is dangerous.
The most important insights are:
- When passing on cost increases in the form of higher prices, one must be aware of whether and how the price-response function shifts over time.
- The optimal price increase will correspond to the rate of the cost increase only when the maximum price, i.e., customers’ willingness to pay, also grows at the same rate. In that case, the real profit remains the same. In all other cases the optimal price grows at a different rate than the costs.
Phantom profit: nominal vs. real
Inflation involves a problem that is little considered and not well understood: namely, the emergence of phantom profits. When prices and costs rise proportionally, nominal profits also rise. But this higher nominal profit is not worth more than the profit before inflation. If one adjusts the nominal profit for inflation, one gets the so-called real profit. In periods of relatively low inflation, as between 1990 and 2020, the difference between nominal and real profit is small. That was much different in the 1970s. The annual inflation rate was above 6 percent in eight years between 1971 and 1982. And today we are again seeing inflation rates of the same magnitude.
Let’s assume that a company has a revenue of $100 million and an after-tax profit of $10 million. The company’s machinery, which cost $50 million to purchase, is depreciated over five years and then replaced all at once. The annual depreciation is thus $10 million. The business remains steady over the five-year period, i.e., the nominal revenue and profit remained unchanged from year to year at $100 million and $10 million respectively. What is the effect of an annual inflation rate of 5 percent, which means that the machinery becomes five percent more expensive every year? Replacing the machinery after five years would not cost $50 million but rather $63.8 million. This difference of $13.8 million is a “phantom profit.”
One can also express this in another way. The profit declines every year by 5 percent in real terms. In the fifth year, the company earns a real profit of only $7.8 million on a nominal profit of $10 million. The company would have had to increase its tax-reducing level of depreciation by a total of $13.8 million to offset the effects of inflation and maintain the same level of purchasing power in real terms. But the tax basis for depreciation is solely the original purchase costs, and the total amount of depreciation cannot exceed them.
Taxes are levied against nominal profit. The phantom profits are therefore subject to taxation, even though they do not contribute to an increase in real value. In times of high inflation, companies should strive to protect their real profit and not get blinded by the allure of phantom profits. This means that you must use current procurement costs and not historical costs for your pricing.
Tactical Considerations on Price and Inflation
In my work, I have observed in various studies that a high inflation rate leads to a higher price elasticity. A pure orientation on the cost side can therefore lead to dangerous missteps. For countries with extremely high inflation rates, such as Brazil, this process gets turned on its head. One study even found a price elasticity of close to zero. The explanation for this surprising finding lies in the reference or anchor prices. When the inflation rate is extremely high, prices frequently change and buyers lose their reference basis. Such findings underscore the importance of vigilance on the sales side. Measuring changes in the price-response function, however, poses significant problems. One could consider making rolling adjustments to the parameters by examining the price-response function against the latest data at regular intervals.
There is another aspect of price management in an inflationary environment which warrants attention. When all suppliers in a market are affected by the same cost increase, the probability is high that all will follow if one supplier raises prices. Under such circumstances, it can be optimal to pass through the cost increase in full. That applies when the total sales volume in the market is price-inelastic and market shares depend on price.
In March 2022, the hard discounter Aldi, which is somehow accepted as a price leader, announced price increases for many products. I expect that other retailers will follow.
Adjustable price clauses in B2B markets can automate the required price changes to some degree and thus lessen the resistance of customers. But one should be careful here as well. Shapiro reports on a manufacturer who linked product prices to the price of copper because its products contained a large amount of the metal. But since the other costs and the willingness to pay developed differently from the copper price, prices became more and more inadequate over time.
One should keep the following tactical recommendations in mind when adjusting prices vis-à-vis inflation:
- Set clear objectives for price increases: this should happen top-down.
- Break the price objectives down by customer segments, product segments, and channels.
- Pursue the price increase objectives by implementing concrete measures: raise list prices, change the discount system, change payment terms, introduce surcharges, etc.
- Prepare the pricing measures with proper communication:
- develop high‐level communication/announcements by the CEO, e.g., through interviews
- communicate internally to sales
- prepare convincing arguments for customers
- review contracts
- use adjustable price clauses or indexing
- Implement the price increase measures:
- plan all the details, e.g., sequencing, target customers
- closely monitor the implementation; adjust measures if necessary
- watch the competition carefully
- perhaps offer the sales team an incentive based on price increase realization
- Monitor precisely: compare the implemented price increase vs. original objectives in as close to real-time as possible.
The greatest risk posed by inflationary developments is to implement the necessary price increases either too late or not at all. It is hard to catch up after missing these opportunities.
Against the specter of inflation: 10 commandments
1. React quickly, because inflation is here to stay.
2. Pay attention to the inflation rate in your market, not to the general rate.
3. Price increases are made easier by inflation.
4. Inflation reveals how strong your pricing power is. If it is weak, you need to improve your pricing power through innovation, branding, etc.
5. You must deeply understand your customers. On one hand, they are trying to find bargains; on the other hand, they are confused by the wave of price increases.
6. Don’t wait until all competitors have increased prices. Rather, act earlier.
7. Do not raise your prices below the inflation rate, but rather slightly above it.
8. Whether you can fully pass on cost increases depends on the behavior of your competitors. Full pass-through is often difficult.
9. Jumping over price barriers, such as $10, is easier in inflation.
10. Stay on the ball. If inflation continues, don’t chase it. Rather, adjust your prices at short intervals.
- https://www.bls.gov/cpi/, called up on March 14, 2022. ↑
- https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913-. ↑
- The 10-year period between 2000 and 2010. ↑
- Simon-Kucher & Partners, Inflation – Secure Your Profits, Bonn 2011. ↑
- Simon-Kucher, & Partners, Global Pricing Study, Bonn 2011. ↑
- Willi Koll, Inflation und Rentabilität, Wiesbaden: Gabler 1979. ↑
- Hermann Simon and Martin Fassnacht, Price Management, New York: Springer 2019. ↑
- Hermann Simon, True Profit! No Company ever Went Broke Turning a Profit, New York: Springer Nature 2021. ↑
- Benson P. Shapiro and Barbara B. Jackson, Industrial Pricing to Meet Customer Needs. Harvard Business Review, 1978 (6), 119–127. ↑
- Hermann Simon, On the Future of Pricing, International Business & Economics Studies, 2022, Vol. 4, No. 1, 8-10. ↑