How business operations can respond to price increases: A CEO guide

The aftershocks of the COVID-19 pandemic continue to rock the global economy. Following the shutdowns of 2020 and the supply chain challenges of 2021, another wave of disruptions is now breaking over businesses around world: rising input prices.

Wherever you look, the prices of essential materials, products, and services are shooting up at rates unseen in a decade or more. The London Metal Exchange Index of six key industrial metals has doubled since the middle of the pandemic, reaching a height last seen in 2011. In Europe, spot natural-gas prices ended 2021 more than 12 times their prepandemic level. In the run up to the end-of-year holiday season, maritime container freight rates were seven times higher than in 2019.

Inflation is among the top three concerns of senior decision makers globally, surpassing COVID-19.

Consumers are already feeling the impact of those price hikes. The US consumer price index grew by 7.5 percent between January 2021 and January 2022. In Germany and the United Kingdom, the equivalent figures were 4.9 percent and 5.4 percent, respectively. That’s adding to upward pressure on wages. Private-sector labor costs in the United States increased by 4.4 percent last year. In the leisure and hospitality sector, where staff shortages have been particularly acute, labor costs went up by 8 percent. Central banks around the world are putting plans in motion to keep potential inflation under control. In December, for example, the US Federal Reserve said that it would end its policy of bond purchases and increase interest rates as many as three times during 2022.

It’s little wonder that prices have also climbed the senior-management agenda. By October 2021, a regular McKinsey survey of senior business leaders showed that inflation had joined supply chain disruption as one of the biggest perceived risks to growth, supplanting COVID-19 for the first time since the onset of the pandemic (Exhibit 1).

What’s in the driving seat?

Why are prices shooting up? Like most things that matter, there’s no simple answer. Rebounding demand is one obvious driver. After months of suppressed activity during the pandemic, businesses and consumers have been making up for lost time over the past year. Constrained supply is another. Plenty of industries acted fast to curtail production and cancel orders with suppliers early in the crisis. Car production in Europe dropped by more than 23 percent in 2020, for example. But that action left companies short of finished goods and critical components as the recovery began. In the first nine months of 2021, car sales in Europe bounced back, increasing 8 percent, but production rose by only 3.1 percent.

Other commentators worry that there is simply too much cash chasing too few goods and services. Government support measures have pushed money supply in major economies to an all-time high. In the United States, for example, the M2 measure of money supply grew by more than 27 percent in the year to February 2021, a record increase.

And then there are “events.” In March last year, the 400-meter container ship Ever Given became wedged between the banks of the Suez Canal, blocking one of the world’s major shipping routes for six days and compounding the many challenges already facing the maritime sector. In Europe this winter, energy prices have reached record highs, driven by geopolitical tension, as well as by the diversion of liquified natural gas cargoes to customers in Asia and Latin America.

The interaction of macro and micro factors is affecting different categories of goods and services in different ways. That means that the picture of price increases across economies and sectors is extremely varied. In the agricultural sector, the price of maize and wheat last year increased by 44.1 and 31.3 percent, respectively. Meat and dairy prices grew much more slowly, gaining 12.7 and 16.9 percent, respectively, while rice fell by 4 percent.

Geography matters too, especially for products that are costly or difficult to transport between regions. As energy-intensive European industries wrestle with unprecedented costs, natural-gas prices in the United States are still about where they have been for the past decade, for example.

When will it end?

At a macroeconomic level, policy makers are divided between those who believe that today’s high prices are transitory and those who foresee a more sustained period of inflation, accelerated by a wage-price spiral that could drive up costs even for those companies (often in service sectors) that so far have escaped the impact of higher goods prices. Central banks are responding to the challenge at different rates, with some raising interest rates and cutting back on pandemic-era bond purchases, while others keep policies steady.

Moreover, the complex mix of drivers that has led prices to rise in varied and unexpected ways also makes future trends for specific materials, products, or services extremely difficult to predict. In some categories, the key question faced by buyers today is when price stability and availability return to “normal” levels. That’s likely to be true of the semiconductor sector, where prices have always been highly cyclical and adding production capacity requires multibillion-dollar investments in new manufacturing facilities.

In others, further pressures could keep pushing prices up. For example, the transition from fossil fuels may mean that next-normal energy prices are higher for decades to come. It will also change the market dynamics for a host of materials required for batteries, electric motors, and generating equipment for renewable power.

Why the old tools aren’t enough

That uncertainty is creating extremely challenging conditions for organizations and exposing the limits of the two conventional responses to cost increases: pricing and procurement strategy. Pricing isn’t providing the answer, because even if contractual arrangements allow it, and customers are willing and able to pay more, those increases do not always cover all the additional input costs. The result is thinner margins, lower sales volumes, or both.

In the automotive sector, for example, suppliers with contracts that index to the raw-material cost of their products are busy negotiating higher prices with carmaker customers. But carmakers may not be able to pass those higher costs onto their end consumers. Facing rising costs elsewhere, car buyers may have little choice but to select smaller, simpler—and, for carmakers, less profitable—models, or defer purchases altogether.

High costs can threaten the viability of entire businesses, squeezed by rising wholesale costs, insufficient or ineffective hedging strategies, and in some instances, regulatory pressures as well. And while governments have occasionally intervened to provide relief in sectors deemed critical, that option is not realistic for most companies.

Procurement departments, meanwhile, can do a lot in response to price rises, but there are limits to what they can achieve on their own. Conventional procurement approaches include the pursuit of economies of scale through volume purchasing agreements, or long-term contracts in which suppliers accept lower margins in return for demand security. In today’s conditions, the former approach carries less weight with suppliers that already face more demand than they can fulfil. And if high input costs are transient, the latter risks leaving the purchaser in an uncompetitive position when prices fall. In addition, continuing shortages of critical parts and materials are putting pressure on procurement functions to prioritize supply security over cost in the short to medium term.

The role of business operations

We believe that companies can rethink their response to cost increases. They must go beyond conventional commercial levers and take a more holistic approach, one that addresses opportunities to control costs and to reduce the impact of volatility across the organization’s full spectrum of activities. That perspective will encompass far-reaching changes to the way products are designed and manufactured, as well as to the structure of the end-to-end value chain.

Business operations bear the brunt of cost increases because they are where the money is spent: on labor, energy, materials, and logistics services, for example. But operations also offer the opportunity to change a company’s exposure to those costs. And smart decisions on the way value chains are designed, built, and run can have a transformative impact on the organization’s cost base.

Few of the levers we outline below are new, but our conversations with executives indicate that they are significantly underutilized today, for two principal reasons. First, making them work requires coordinated action across the entire organization. And second, some of the most powerful responses to rising and volatile prices call for structural changes to supply chains, production footprints, and even entire business models—all of which fall beyond the remit of operational leaders at most companies. As we’ve argued before, that’s why business operations need to be right at the top of the CEO agenda.

Some of the most powerful responses to rising and volatile prices call for structural changes to supply chains, production footprints, and even entire business models.

Building the business operations cost resilience playbook

Tackling the impact of cost increases across business operations requires a portfolio of solutions. To assist in the design and implementation of such an effort, it can be useful to think about three main “blocks” of activity across short-, medium-, and long-term horizons (Exhibit 2).

There are three horizons of actions for organizations to address cost resilience.

Short-term actions (next one to two months)

The first step for any organization is to ensure that it has a comprehensive understanding of the real underlying costs of the products and services it buys. A major automotive company, for example, has created a dashboard that tracks the price evolution of key raw materials and other inputs in its supply chain. Using data from cleansheet studies and product teardowns, it creates a granular, component-by-component view of the likely impact of rising prices on real supplier costs.

Data from such dashboards help companies to conduct fact-based negotiations with their suppliers, guarding against excessive price increases and ensuring that the impact of rising prices is shared fairly among supply chain participants. Leaders can also use that information to inform pricing decisions and procurement strategy, secure short-term supply of critical items, and identify opportunities to rapidly reduce costs through quick changes to product design or specification.

Medium-term actions (next six to 12 months)

Companies can also double down on efforts to keep in-house costs under control. Improving efficiency, quality, and productivity in business operations allows companies to produce more value with the same labor, materials, and energy inputs. That can be achieved through a combination of “analog” approaches, such as lean, and digital ones, such as Fourth Industrial Revolution technologies.

Companies in the World Economic Forum Global Lighthouse Network continue to show how new technologies can deliver step-change improvements in manufacturing and supply chain operations. One manufacturer of electric-vehicle batteries and components, for example, has redesigned its entire production system to take advantage of advances in AI and advanced analytics. That has helped it increase labor productivity by 75 percent while reducing the occurrence of manufacturing defects by 80 percent. A major high-tech company has more than quadrupled labor productivity by using “lights out,” fully automated manufacturing and warehouse operations at facilities in Southeast Asia.

The pioneers of the Fourth Industrial Revolution have learned that human capabilities are critical for the success of new digital technologies. One global consumer goods company, for instance, has established a digital academy to upskill managers and frontline team leaders across its business operations. In its first year, the academy trained more than 150 people in digital skills using a combination of go-and-see visits, immersive boot camps, and e-learning modules. Graduates of the academy have implemented around 20 different digital, automation, and analytics approaches at nine sites in the company’s manufacturing network, boosting productivity and throughput by more than 20 percent. Digital skills training is now being rolled out to more than 3,000 staff across the organization.

Companies can also take coordinated action to further protect the wider value chain from volatility. Sourcing critical inputs from multiple suppliers in different regions can improve both supply chain resilience and price stability. Redesigning or reformulating products to reduce reliance on scare or high-cost inputs also helps. In the food and beverage sector, some companies have adapted both their recipes and their production systems so that they can switch between different combinations of ingredients according to their relative price and availability.

Longer-term actions (next two to three years)

Over the longer term, companies may want to pursue structural changes to both their value chains and their business models. That process begins with a reevaluation of make-versus-buy and near-versus offshoring decisions. Rapidly rising wage rates in some historically low-cost regions are already driving a shift in global sourcing to newer emerging regions. Some companies are seeking to reduce the number of intermediaries in their supply chains, bypassing distributors and midtier suppliers to purchase directly from the original producers of materials or components. Others have put plans to outsource more of their logistics operations on hold, preferring to stick with the price and service stability offered by their in-house operations.

As well as changing the structure of their value chains, companies may want to reevaluate their position within it. That could involve a return to vertical integration in some sectors as securing a reliable supply of critical inputs becomes more challenging. Food and beverage companies have made strategic investments in ingredient producers for some years, for example. Now carmakers are adopting the same approach, with investments in primary producers of lithium and other key inputs for electric vehicles. As part of their net-zero transition plans, truck and construction equipment makers in Europe are striking long-term deals with producers of “green steel,” manufactured using hydrogen from renewable sources rather than using fossil fuels.

Navigating the price storm

Coordinating these short-, medium-, and long-term initiatives can be the biggest challenge in an organization’s response to rising or volatile costs. And since decisions made in one part of the value chain can have effects that ripple out across the business, effective cost management requires a truly cross-functional perspective.

One way of doing this is through the establishment of a “business operations cost control tower.” This control tower acts as a central repository for cost data and analysis expertise, and it writes the organization’s playbook of mitigation strategies.

The control tower can also serve as a catalyst for cross-functional collaboration. It should be staffed by senior representatives from procurement, manufacturing, supply chain, finance, and commercial functions, who will work together to identify, quantify, prioritize, and implement the most promising levers.

Win either way

If inflation is here for the medium term, companies that adapt their business operations quickly and decisively to reduce their exposure to rising costs will be in the best possible position to maintain margins and growth.

But what if most of today’s sharp price hikes do turn out to be transitory? That’s the real power of the operations-focused approach. Almost without exception, the levers that help an organization respond to rising costs also equip it with the tools and capabilities it needs to thrive when prices fall. Accurate cost models, for example, give procurement teams the tools they need to ensure that the organization captures its fair share of savings from suppliers when their input costs fall. And advanced digital operations provide a platform for the continuous improvement of cost, quality, and flexibility regardless of changes in the price and availability of labor, energy, or other inputs.

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