Recent spikes in the cost of raw materials have been nibbling at the margins of many manufacturers. Rapidly growing demand from emerging economic powerhouses China and India has outstripped supply for many materials. While in recent months prices seem to have plateaued, raw material supply continues to be strained and supply chain bottlenecks resulting in price increases can be expected to reoccur in the future.
How can manufacturers address the rising costs of raw materials?
The most logical and “elegant” response would be to pass the costs on to the customer by raising prices. Often, though, competitive pressures may not allow a company to pass on all or a part of its cost increases. The vendor is then forced to absorb all or part of the costs or take other measures (see below). Alarm bells should go off if rising costs of materials lead to a gradual deterioration of a manufacturer’s margins over a three to five year period.
If a company feels that it gets unfavorable prices or it is not guaranteed a prompt supply because of its lack of purchasing power, it could try to increase its power at the negotiation table by adding bulk, i.e. by merging with another company or being bought by a bigger user of the same kind of raw material. If the merger partner/buyer is a manufacturer of complementary products in complementary markets, additional benefits could be reaped from the alliance.
As an alternative, a company may want to drop its lower margin products from the mix by selling some product lines. This is usually a very difficult decision that many managers delay –sometimes until it is too late. Selling or retiring product lines often leads to underutilized capacity which in turn leads to the flawed conclusion that even though these product lines are not profitable, their continued production would contribute to cover the costs of machinery and equipment. This kind of thinking, while pervasive, is very dangerous as it tends to sidestep necessary structural measures. In other cases, manufacturers are reluctant to give up some product lines because they feel the customer wants to choose from a complete range of products (one-stop-shopping). In these cases, arrangements with low-cost manufacturers may be the solution.
What manufacturers should not do
It usually does not make sense to shift production to a low-cost country if the margins are falling as a result of higher costs of materials. Raw materials are commodities and have similar prices in all countries of the world. A shift of production to countries with a low cost of labor only makes sense if the portion of the labor costs is a high percentage of total costs. If costs of labor are average or low in terms of total costs, the company would not gain very much by transplanting its operation. On the contrary, it would have to add new costs of logistics, communication, etc.
Sometimes companies resort to an “all-out” effort to push up sales. The thinking is that higher sales of lower margin products would restore profits to previous levels; another mistaken conclusion. While profits may reach previous levels in absolute terms, the margins continue to deteriorate, structural measures are not taken, and the company continues its decline.
What can GGI do for companies with deteriorating margins?
- GGI can help you sell low-margin product lines/subsidiaries.
- GGI can find companies with high-margin products/product lines that would be interested in merging with you or being bought by you.
- GGI can find buyers/partners with greater purchasing power and other synergies.