Inflation force and Retailers’ position

With the US consumer price index up 5% for the year ending June 30, and unemployment currently at 5.7%, many retailers have found themselves in a tough situation, locked between rising product costs and a limited ability to raise their prices.

Even cost-savvy market leaders such as Costco are having a difficult time. But Wharton faculty say that handled carefully, the current inflationary period may actually be a business opportunity for some retailers, especially if they make selective changes in inventory management, pricing and promotions.

That new thinking can begin with inventory. From the 1990s to 2005, minimising inventory was seen as a key to success. The whole mindset has been, Lets get rid of it. But that was when most prices were stable or declining.

Today, its not as clear that this is the best strategy. In fact, some retailers may want to start holding much more inventory than they did in the past as a way to hedge against future price increases. Of course, it is a little risky to hold inventory that might lose value, especially perishable goods and fashion-oriented goods. But to the extent retailers know that prices will be rising over time, they will start trying to hold more inventory.

Contracts with suppliers include some agreement on how to handle future price increases. For example, include fuel-cost adjustments so that both sides are sharing the risk. Company buyers can also look for more local products to cut down on transportation costs.

What I expect is that sourcing from farther away becomes less attractive, because the extra transportation costs are now going to swamp price advantages for many distant suppliers. As energy costs continue to rise, retail chains distribution plans are likely to be driven by fuel efficiency rather than labor or location of physical assets. Some retailers will start to consolidate their network, closing marginal stores as they are too expensive to supply given their low profitability.

In addition, operations and marketing departments will need to work much more closely to successfully navigate the new environment. There is a lot of volatility right now, and with a lot of volatility a retailer who typically runs with very small profit margins can go from making money to losing money pretty quickly. Ensuring that the company stays profitable is going to require some experimentation and probably a lot of coordination between the two groups.

The current volatility has shaken some major value-oriented retailers, who typically do well in hard times. For the Wal-Marts of the world, inflation is actually something pretty good, because so many customers are trying to figure out, how do I save money during these inflationary times? And that takes them more and more to the value-based retailers. The Costcos and Wal-Marts and Dollar stores should be thriving during such periods.

However, this particular environment presents some peculiar difficulties. The problem is not only that there are inflationary pressures, but that aggregate demand is going down. That is why you see retailers like Boscos and Mervyns in trouble, because they may still be marking up their goods but there is not enough demand to keep the stores full. Both of those regional department stores recently filed for Chapter 11 bankruptcy protection.

Retailers typically try to pass through their costs by adding their margin to the suppliers higher price. By itself, such cost-plus-pricing can be a profitable strategy in an inflationary time if consumers have accepted the idea that prices are rising in a given category, such as baked goods.