How
CFOs Can Solve The Inflation Puzzle
By Jim DeLoach, Former Andersen Partner and currently a
Managing Director at Protiviti
As
concerns over the rise of economic inflation escalate, a stark reality emerges:
There are legions of executives—even board members—who have never had to cope
with persistent inflation. A rare environment of this kind presents a unique
opportunity for leading CFOs to elevate scenario planning activities and other
next-generation finance capabilities with the objective of contributing an
enterprise-wide solution to a puzzling challenge with numerous moving pieces.
While
it’s tempting to harken back to the 1970s and early 1980s for insights on
responding to soaring prices, that would be a mistake. The current
environment—and the role of the CFO—fundamentally differ from what they were
four decades ago. The types of consumer demand shifts, supply chain disruptions,
tight labor markets, demographic makeup and other factors driving inflation
higher in today’s markets did not exist in 1982. Nor did a 100-year pandemic
event with its various complications and aftereffects. These differences in the
dynamic are contributing not only to inflation, but also to volatility and
unpredictability.
Business
moves at a much faster pace today given the global, interconnected and
data-driven manner in which companies operate. Corporate finance groups have
access to powerful systems, brilliant algorithms and vast pools of data to
sharpen their forecasts and scenario planning. Finance leaders rely on these
resources to shape corporate strategy around technology investments, supply
chain resilience, talent management and even organizational culture, in
addition to more traditional matters such as product costs and below-the-line
expenses and the ability to absorb or pass those along to customers.
CFOs
will need to deploy all of the next-generation approaches and tools in their
quivers to address the multifaceted challenges that inflation poses to their
organizations, regardless of industry. Examples of key challenges include:
- Working capital management pressures:
High prices raise pressing questions concerning working
capital: How much inventory are we willing to carry as warehousing
costs increase? What’s our breaking point? What’s our exposure to rising
interest rates? How do we balance working capital management requirements
with the need to satisfy customer demand? What’s the optimum cash position
needed to support operations and take advantage of discount opportunities
given the deterioration in purchasing power?
- Trading partners’ credit risks:
Customers and suppliers grapple with the same
inflationary pressures and working capital management challenges, which
can create a drag on their profitability. Moreover, these issues can
impede a customer’s ability to pay and a supplier’s ability to deliver.
- Pricing strategy: Businesses
have the option to pass along higher costs of manufacturing and talent to
customers by raising prices. This response can work well—until it doesn’t.
When prices become too high, customers reduce purchasing activity, eating
into profit margins. Or they may choose to take their business elsewhere.
CFOs face a tall task in pinpointing the breaking point in price
increases. Also, there is the challenge of aligning sales management with
pricing strategy and concessions, not to mention keeping the strategy
current with changing inflation rates.
- Workforce risks:
Inflation is an equal opportunity risk in that it affects everything with
a value assigned to it, from the purchasing power of monetary assets to
the cost of commodities and raw materials to defined benefit plan
performance to the cost of talent. When annual compensation increases 3-5%
but inflation hovers at 7-8%, employees are effectively experiencing a pay
cut—this is less than optimal during a long-term talent crunch which has
given substantial leverage to employees.
- Procurement strategy:
Persistent inflation necessitates different approaches in negotiating
pricing with suppliers. For example, proposed price increases should be
traced back to specific inputs (including labor) and raw materials,
product design should be evaluated to optimize cost builds, and price
negotiation strategies should vary depending on whether long-term
purchasing contracts are indexed to inflation. If hedging strategies are
in play, they should be coordinated enterprisewide.
CFOs
should play a decisive role in addressing these and other challenges and how
they affect their organization’s overall strategy and its interrelated enabling
components, including product strategy, marketing strategy, human capital
management strategy, and so on. If the finance group, for example, forecasts
that a product price increase ultimately could erode profit margins by 10-15%,
should marketing investments be reduced by a similar amount, should the product
pricing remain at current levels, should procurement revisit price negotiation
strategies, or should a different lever or combination of levers be pulled?
Making
these strategic determinations requires CFOs and their teams to lean on their
data, predictive analytics and advanced technology tools to craft dynamic plans
and contingencies that can be adapted to volatile economic swings while
maintaining the organization’s overall strategy. (I’ve written in Forbes about
the building blocks of these plans, which include next-generation
forecasting, advanced
analytics and emerging
technology tools.)
A
plan of action
To
equip their organizations to address the quandaries sparked by inflationary
pressures, CFOs should:
- Get the data: Finance
groups need access to ever-expanding collections of data sets from
organizational partners, suppliers and customers. This diverse data
generates real-time insights on the availability and cost of raw
materials, suppliers’ pricing decisions, fluctuating logistics costs,
soaring labor costs, and more. Granular, data-driven insights are
especially critical during inflationary periods when the costs of similar
materials, products and skills fluctuate in uneven and unexpected ways.
- Elevate scenario planning: The
data and business indicators finance groups obtain ultimately fuel
scenario planning and stress-testing (e.g., projecting those breaking
points where price increases reduce demand). CFOs need to leverage this
information to identify the factors most sensitive to inflationary
pressures and then run those drivers through various scenarios to assess
implications to the business plan and analyze mitigation options. If
oil prices jump another 20 percent next quarter, what does that mean for
our shipping costs and how should we respond?
- Find (and keep) finance talent:
Optimizing the data, predictive analytics and technology tools required to
generate—and continually regenerate—forecasts, robust scenario plans, and
effective stress tests requires a next-generation finance mindset. Finance
analysts need proficiency with cutting-edge tools and techniques, comfort
with getting information quicker (and from further afield), and
interpersonal dexterity in managing the expectations of an expanding group
of internal customers and external partners. Needless to say, that
requires the right talent.
- Communicate and collaborate: Sustaining
working capital requirements amid rising interest rates and price
gyrations requires constant communication with accounts receivable teams
and treasury partners. Sales and supply chain leaders are similarly
crucial partners to optimize sales and preserve margins. Boards need to be
kept abreast of changing plans, and the investment community’s appetite
for information, along with often-exacting expectations, need to be
managed. CFOs also should consider deepening their collaboration with
appropriate external technology providers and talent sourcing partners who
play an increasingly important role in supporting their initiatives to
manage the organization’s inflation-related challenges.
The
CFO’s role in the organization’s response to the current inflationary cycle and
its resulting uncertainties boils down to communication, collaboration and—just
as important—coordination. Finance groups possess the data, tools and expertise
required to produce and analyze the data, indicators and information that
combine to form an accurate picture of the risks inflation poses. As those
scenarios and forecasts are generated and continually regenerated based on new,
real-time inputs, finance should coordinate responses requiring behavioral
shifts from leaders throughout the business.
It's
time for CFOs to call on their inner enigmatologist to coordinate how all of
the pieces of the organization’s inflation risks and responses should click
into place. CFOs should accept nothing less than an effective, sustainable enterprise-wide
solution. Their internal and external customers will do no less, as well.
Check out Jim’s website.