Inflation in Europe reached record heights this fall, with more than half of the 19 eurozone countries seeing double-digit growth in consumer prices. Inflation rates in both Germany and the United Kingdom soared over 10 percent, while in Italy it approached 13 percent, its highest level in four decades.
Across the continent, double-digit inflation has disrupted people’s lives and livelihoods. Street demonstrations and strikes in several countries are just some of the ways that people are protesting cost-of-living increases. And, of course, there’s pain for consumers at the cash register.
Unfortunately, there are no indications that things will improve anytime soon. Although the European Central Bank has raised interest rates to curb inflation, it also predicts that consumer prices will continue to rise. Moreover, devaluation of the euro and the pound against the US dollar has put further pressure on manufacturers and retailers that need to pay their suppliers in US dollars, and several countries are now facing a potential recession.
What’s a retailer to do amid this growing economic pressure? Although many have opted to delay major moves, it’s now clear that companies need to act quickly to adjust for elevated inflation levels while preparing themselves for long-term resiliency.
In this article, we examine the current state of inflation in Europe, take a quick dive into rapidly changing consumer behavior and sentiment, and draw lessons from previous periods of economic volatility. Finally, we describe a holistic approach that can help retailers think about how to simultaneously tackle inflationary challenges and build long-term resilience.
Economic winds of change
With the cost of food going up more than 15 percent, gas prices skyrocketing, and wages increasing by more than 5 percent in the past year, Europe is seeing prices soar at rates not seen since the 1970s. The underlying drivers of current inflation are well documented. The continent is still feeling the effects of the pandemic; the war in Ukraine has exacerbated supply disruptions and resulted in steep price increases in food, fertilizers, and natural gas; labor is hard to find and costs continue to rise.
Companies need to act quickly to adjust for elevated inflation levels while preparing themselves for long-term resiliency.
The outlook does not seem promising. For starters, inflation may not yet have reached its peak. Economists at the International Monetary Fund (IMF) predict that global inflation will remain above 6 percent for at least another year. And 39 percent of economists surveyed by Reuters in August 2022 said they expected inflation to stay high beyond 2023. Economists from central banks, the IMF, and the OECD predict that it will be another year or two before prices stabilize (Exhibit 1).
Also, central banks have raised interest rates, which will further tighten consumers’ ability to spend and retailers’ ability to manage costs. In October 2022, the European Central Bank raised rates by 0.75 percentage points, its third consecutive interest rate hike. These rate hikes lead to less disposable income for households with variable-rate mortgages, car loans, and revolving credit card debt. They also raise the cost of capital, energy, and labor for businesses, putting retailers with higher debt-leverage ratios at particular risk and making capital improvements more costly to finance.
Additionally, consumer confidence in Europe has plummeted, falling to levels even lower than those in the first months of the COVID-19 pandemic (Exhibit 2). In recent months, consumer confidence has even fallen below 92 percent in some eurozone countries. Our latest Europe Consumer Pulse Survey shows that consumers are pessimistic, with 43 percent expressing doubts about economic recovery. Fifty-eight percent of respondents cite inflation as their top worry, overwhelmingly ahead of other concerns such as the war in Ukraine, climate change, or unemployment.
As a result, people are reducing or drawing down on savings. Fifty-five percent of consumers in Europe say they’ve reduced their savings in recent months, and one-third say they’ve dipped into savings to cover living expenses; 80 percent of our Europe Consumer Pulse Survey respondents say they have changed their shopping behavior—for example, by trying private-label brands, switching stores, or shifting from brick-and-mortar to online shopping (Exhibit 3).
Retail resiliency during the last downturn
Amid such economic instability, how can retailers preserve margins and offset for currency volatility? History shows that resilient retailers—those that adopt a through-cycle mindset, as opposed to those that batten down the hatches and dramatically reduce spending—are much more likely to come out stronger from a crisis.
We analyzed aggregate company data of the 80 largest European retailers by market capitalization to see how they performed during the 2008 financial crisis and its aftermath. When we segmented this group into resilient and nonresilient companies—separating out those in the top quartile of TSR—we saw that the companies willing to invest in longer-term growth and market share reaped a longer-term payoff by the time the economy recovered (Exhibit 4). By 2017, the TSR performance gap between resilient and nonresilient retailers was 277 basis points (Exhibit 5).
Resilient retailers built operational and financial optionality during the downturn cycle. Specifically, they moved faster and pushed harder on productivity, which lowered costs while preserving capacity for growth. Second, they made strategic divestments during the downturn that freed up capital for acquisition of distressed and undervalued assets that were core to driving growth. Finally, they saw opportunities to win market share over the medium to long term and continued to invest in transformation and growth. As a result, they outperformed peers through the 2008 downturn and saw significant sales growth during the recovery.
A holistic inflation playbook
Building on these lessons, retailers can adopt a holistic approach to manage the current period of economic uncertainty. To do this, companies can set up a centralized “inflation management office,” bringing in leaders from different functions such as finance, supply chain, HR, commercial, and operations to work in an agile way and unify efforts. By fostering rigorous transparency, this control tower can function as a facilitator for fast and decisive actions—and position retailers for outsize growth following a downturn—by focusing on the following:
- Commercial effectiveness. Retailers can focus on value to consumers by resetting and clearly communicating pricing, promotions, and product assortment decisions.
- Resilience in supply chain and sourcing. Quick fixes aren’t sufficient. Instead, retailers will need to completely overhaul their relationships and network of suppliers.
- Productivity in G&A functions. Retailers can improve efficiency in G&A by running a leaner organization.
Commercial effectiveness requires an orchestrated response that blends a deep understanding of how the market and customers interact; actions to fine-tune pricing, promotions, assortment strategy, and communications; and an operating model that uses data to make forward-looking decisions. When commercial levers are managed well, companies are more likely to preserve and protect their consumer base while minimizing negative impact on the bottom line. Retailers should consider focusing on the following:
- Pricing. Retailers could decide where to invest to create more affordable options and greater price coverage for consumers (for example, through key-value-item pricing, everyday-value pricing, and entry-price-point assortment) and where to gain margins to cater to higher-end customers, such as by developing super-premium and sustainable products. Retailers can also strategically balance investments and price increases across categories to keep prices lower and more competitive. They should regularly track price perception and make the real-time changes required to protect it, since customers’ willingness to pay has been distorted by the rapidly changing economy. Currently, only 15 to 20 percent of retailers have some form of dynamic pricing capabilities.
- Promotions. Companies could review their price-to-promotion mix by category to ensure that investments for specific products and categories are yielding adequate volume and margin. To do this, companies might consider jettisoning complicated multilever promotions and instead streamlining and simplifying them into initiatives that more directly influence prices. For example, retailers can use data science to identify the promotions—typically half of them—that truly create value. Another approach might be to use customer data to offer personalized promotions for loyalty program members.
- Assortment. Retailers could drive more value by ensuring availability of the right mix of products, simplifying choices for consumers, accelerating product rotation at point of sale, and protecting margins by offering more premium offerings. They can invest where the customer is headed, with optimal entry price points for lower-ticket items and higher-margin offerings, all while reducing assortment and duplication in the middle. This will have a strong impact on end-to-end cost efficiency.
- Communication. Retailers could benefit from a strong focus on value in their customer communications. Simple, straightforward marketing campaigns that articulate product benefits in relation to price are critical to earning shoppers’ trust. Companies that ensure their messages are consistent across both online and offline channels and that launch well-integrated campaigns all the way to the point of sale will be more likely to earn trust. For example, grocery chain Lidl Switzerland launched its “Typical Lidl” media campaign this year with a series of humorous ads to educate and update customers on price comparisons and value versus competition.
Resilience in supply chains and sourcing
Nearly three years into the pandemic, supply chain disruptions and distribution network bottlenecks are still affecting product availability. Additionally, the latest round of price increases has created tensions between retailers and consumer-packaged-goods suppliers—in some cases, stopping supply altogether. In July 2022, for example, one company temporarily stopped supplying certain products to Tesco after the two companies could not come to an agreement over pricing. But properly managed and derisked supply chains and sourcing could enable retailers to achieve 5 to 10 percent cost savings. Retailers can focus on the following:
- Sourcing strategy. Retailers can diversify sources of supply to become more resilient. For example, they can consider resetting the countries of origin for their products, increasing nearshoring, or becoming more climate resilient. Some retailers have joined sourcing alliances to partner for growth. A recent study from INSEAD found that buying alliances in the retail sector can help meaningfully lower consumer prices.
- Supply chain automation. By exploring digital solutions and automation in warehouses and stores, retailers can alleviate labor challenges, redeploy employees to higher-value activities, and avoid unnecessary product touches to optimize for greater speed and efficiency. For example, earlier this year, UK grocer Ocado Retail deployed 2,000 robots able to pick two million food items a day in a London fulfillment center. Enhanced analytics can enable companies to make better and faster inventory decisions and create a leaner operating model.
- Fact-based negotiation. Retailers can be more methodical in negotiating with vendors. By understanding the impact of price increases for raw materials on actual cost, companies can have more fact-based discussions with suppliers. Retailers can also use advanced analytics to understand the financial trade-offs of commercial decisions across assortment, price, promotions, and assets in a more granular way, and deploy sophisticated databases to better track supplier capacity. For example, Ocado launched Crunch Grocery Insights, a service that enables a single, shared, real-time view of retail performance between Ocado and more than four hundred suppliers, offering primary sales data, product availability, promotions, and web analytics. This platform enables far richer and data-driven negotiations.
Productivity in G&A functions
With targeted efforts to increase productivity in G&A areas such as procurement and finance, retailers can better navigate inflation. Our analysis shows that companies that activate the following productivity improvement initiatives could achieve a 4 to 5 percent cost reduction:
- Zero-based organization. Many organizations have room for overhead improvements through elimination, outsourcing, reduction, or simplification of both core and noncore operations. Taking a true zero-based organizational approach—starting from first principles—can yield a shift in mindset to prioritize strategic optimums and survival minimums. Companies can create a model to move quickly between these two structures, based on their needs, with the support of technology. To do this, retail leaders can adopt a zero-based budgeting mindset, rethinking budgets based on incentives to keep costs contained.
- Indirect procurement. Procurement should be viewed more expansively, extending far beyond driving down costs and becoming instead a true strategic partner to enhance a company’s operations. Ambitious companies might consider elevating the role of the chief procurement officer to provide more visibility and tighter collaboration with a retailer’s management team.
- Process automation. Instead of leaning into distributed functions and separate teams managing digital and physical retail, companies could consider options like shared services, offshoring, or nearshoring. Retailers could tighten up their processes by viewing customers through an integrated, omnichannel lens, with teams managing commercial processes across channels in tandem. For example, consumer electronics retailer CECONOMY is syncing logistics through new IT systems to improve omnichannel service levels, optimize stock, and improve last-mile costs. This way, the company can quickly redirect capacity and resources to better serve physical and e-commerce consumers simultaneously at optimal service levels based on their individual needs.
With inflation likely to persist for some time, retailers need to prepare a longer-term action plan to offset the negative effects of rising prices while proactively preserving their balance sheets. As in the past, companies that prepare adequately are more likely to come out stronger from the economic downturn. Although responding to inflation won’t be easy, taking a structured and holistic approach can maximize the likelihood of resiliency, growth, and long-term success.