The Oxford English Dictionary defines survival, “as the state of continuing to live or exist, often despite difficulty or danger.” Many manufacturers in the quarters to come may find themselves in a survival state given a combination of sector dependent inflation/deflation, inventory challenges, employment woes, supply chain disruptions and declining consumer demand. And those lucky ones which do emerge partially or fully unscathed would do well to prepare for the worst even if they emerge among the best.
Surviving — let alone thriving — in this climate will be easier said than done. And it will require looking beyond the headlines. For example, it would be easy to read a popular business newspaper, magazine, or online journal in June of this year, and believe that we were still living through unbridled economic inflation across what we buy and what we sell. But nothing could be further from the truth — in fact, a lot of the manufacturing sector is more deflationary than inflationary as we go to press.
Managing Unwanted Inventory amidst Shrinking Demand
While energy, ingredient, and food prices continue to rise, many metals are coming significantly off their highs as companies begin to burn off larger and larger inventories and as consumer demand for certain items begins to dwindle (and as housing starts decline). A related theme is that an increasing number of companies across retail and manufacturing are getting stuck with unwanted inventories in consumer goods and other areas.
For this reason, it is incredibly important that manufacturers pay close attention to consumer spending, which is perhaps the only crystal economic ball we have at the moment. Why? Over time, consumer spending must drive manufacturing output. There is only so much inventory for finished products that manufacturers, wholesalers, and retailers can hold.
At the moment, economic data suggests appliance manufacturers (large and small) are showing signs of posting year-over-year declines, particularly in the home goods and heavy appliances area (the latter of which is also likely to be further impacted by declines in new housing starts and a real estate slowdown attributable primarily to rising interest rates).
The Economist suggests that even the companies which are best at forecasting demand are having challenges. Specifically, “Some big American retailers, notably Walmart, have reported large increases in stocks. In part, this is the result of errors in forecasting demand. But it also reflects an increase in the desired level of inventories. As just-in-time production gives way to just-in-case stockpiling, the scope for greater volatility in GDP, and in corporate earnings, is increasing.”
Navigating Inflation and Fixed Pricing
Perhaps the largest challenge in this environment outside of inventory levels is that in a variety of industries — such as appliances, HVAC equipment, and drills — inflation is already priced into 2H 2022 numbers, even if demand is falling. That is because many companies lock in the specific pricing that they must sell a given product at even if their own cost structure remains variable.
The challenge is that we now have a situation where inflation is already priced into certain products even if we are entering into a deflationary cycle for certain commodities. This will result in, you guessed it: someone (or multiple parties) in the supply chain holding high priced inventory as market conditions change. Granted, we have consumer inflation continuing to rise as the dog days of summer begin (e.g., energy and food). But manufacturers are going to find themselves selling high priced inventory because they took on price increases from last year but now those commodity prices have begun to fall.
Still, for some, inventory may not be synonymous with the four-letter curse words that it once was. As The Economist observes, “For some, the very notion of inventory is changing. No longer the corporate devil on the balance sheet, it is proving “a form of insurance against unexpected delays. And though insurance is costly, company bosses seem willing to pay for more of it. The trade-off between efficiency and self-insurance, between just-in-time and just-in-case, has shifted markedly towards the latter. And larger inventories imply greater scope for inventory cycles in the future.”
One tactic that some companies might take to hedge the benefits (and cost) of holding inventory are bank and non-bank inventory finance products which come in the form of asset-based lending (since inventory is an asset). One such product that an increasing number of banks are offering are revolving lines of credit based on the amount of goods in accounts receivable and inventory based on the borrower’s balance sheet. These are loans secured by the underlying assets, including inventory. Like a line of credit, these funds are available to borrow from and are then typically repaid as inventory turns.
Inventory is not necessarily a rising price asset (even if it is one which you can borrow against). For this reason, we are currently guiding manufacturers to burn off inventory, particularly if they are carrying 6-9 months or more. On the other hand, many manufacturers continue to point to very healthy backlogs, but ISM data suggests these backlogs are falling. After these backlogs are burned off, manufacturers will be in the same spot as the rest of the economy — waiting for visible demand signals, one way or the other.
3 Guidelines to follow during Inflation and Supply Chain Troubles
There are three pieces of inflation and supply chain guidance that we are giving to our clients during this rocky time of uncertainty. First, as noted, “do not add to the pile.” The inventory pile that is. Some companies we know of have 11 months of inventory. Get inventory levels back down to historical norms.
Second, make sure you have at least three supply sources for everything you buy. This will make you more resilient overall regardless of what the economy or geopolitics throws at us. Even if it costs you a bit more from not gaining economies of scale with a single or dual source supply situation (but note: if you have more than three suppliers for a given category, you may have too many!).
And third, automate every job function you can with technology and have your team focused on higher value-add areas. At present, we can’t hire fast enough. But if you need to do the same job with a team that has 20% fewer FTEs after layoffs during the second half of 2022 (hypothetical — but maybe not), how would you do it? Related to this point: start looking at cost cutting and belt tightening. If you can put in place hiring freezes by improving productivity, you could very well find yourself holding onto your best employees while your competitors have to jettison experienced staff.
How Manufacturers can Prepare for the Future
Of course, there are additional tactics that we recommend as well specific to contract negotiation tactics. To this point, ensure that your supply contracts (and ideally customer contracts, too, if possible) are tied to price indexes at least for next year. As you get ready for fall negotiations, attempt to lock in as little as upside and downside contract risk as possible — float it. Opting to have contracts adjusted on a monthly basis will help smooth pricing variability as markets (and demand) flow and ebb.
Manufacturers have much to lose and little to gain from the unique economy we have unfolding in front of our eyes. While the 2H 2022 economy may be interesting to future economic students, the more boring we can make it for our businesses, the better. And to channel mundane rather than exciting, the best arrow in our management quiver may very well be preparation and planning.
