For most of my business life, and probably most of yours, there has been one constant: inflation. Things always cost more tomorrow than today, more next year than last year. Because of this, wages and salaries were always rising too, slowly in some years, or rapidly in others. Getting price increases to offset inflation in costs has been the typical problem—but not lately. Price increases are rare and price decreases are common.
As you wait anxiously for signs of a recovery, your concern must be to arrest the decline of prices (and to reduce costs to match the decline). Otherwise, profitability—or what’s left of it—will suffer.
Most people understand inflation. It occurs when more money is created than there is tangible value to support it. With the massive government spending surge and money supply growth in the past year or two, inflation should be a concern. Right now, it isn’t, which is surprising.
The reason that inflation remains tamed is that there is too much idle capacity, chasing an too little demand. When the rate of inflation keeps dropping, as it has lately, that is called disinflation. It is troubling at times, but also manageable if costs can be reduced. Disinflation is not to be confused with deflation.
Deflation is a different and more dangerous phenomenon than disinflation. It has rarely been seen (except in theory) in the past few decades. Japan suffered from deflation and it literally crippled the Japanese economy. Deflation is when the rate of inflation goes negative—less money will buy more value—and buyers wait to buy, expecting that the longer they wait, the lower the price goes.
At least one of the causes of deflation is massive global over-capacity, which drives prices down as sellers try to fuel demand with price concessions. Another cause can be adequate capacity combined with a collapse in demand. This cause feeds on itself. With inflation expected, there is a motivation to buy before prices go higher. When facing deflation, the assumption that prices will be lower in the future causes postponed buying and fuels the collapse in demand.
The most apt example of deflation in the U.S. is in new home construction in formerly “hot” markets like Florida and California—where declines in demand reached 75-90 percent. A tremendous amount of construction capacity was built during the boom years. Much of it has disappeared as many companies failed but too much still remains. This overhang of capacity leads contractors to bid lower and lower prices, until there is no profitability left for anyone. Unscrupulous contractors will then start to cut corners on quality.
Buyers realize that this condition exists and hold off on commitments, expecting falling prices from contractors and raw material suppliers. Desperate for enough business to “stay in business” these contractors and suppliers oblige, lowering prices again and again. This further damages the viability of the industry.
There are a few positive causes for deflation—like greatly increased productivity. Walmart flexed its buying muscle and employed much improved supply chain management to lower the cost of goods again and again. Buying “more (goods) for less (money)” became commonplace. New technology can also be a positive reason for deflation—consider how the explosion of networked computers/communications devices drove down the cost of telephone and cell phone calls. But always, there is always a “price/value floor”—somewhere.
A Vicious Cycle—Until the “Floor” Is Reached
What happens as industries start to fuel the deflationary cycle is instructive. A deflationary spiral can lead to recessions and worse—collapses of whole industries or even entire economies. This is why Federal Central Banks are so afraid of deflation. It simply doesn’t respond to traditional monetary policy solutions. As demand falls, prices decline. Producers chase sales with lower prices and the postponed buying decision is reinforced. More buyers wait longer and buy cheaper, keeping the spiral going, until the “floor”—a price at which no one can supply and survive—is reached.
What Can You Do?
Since most readers cannot influence such things as Fed monetary policy, or global trade policies, let’s focus on what you can do.
- Manage the part of the business you control better, reacting to changes faster and more intelligently. The first step is to understand and recognize the nature of the problem fully.
- Develop early warning systems to detect the onset of a deflationary cycle, gathering information from the marketplace and sharing it rapidly within the company. Anticipate shifts carefully, stay flexible and shop hard/buy sharp.
- Use Cost-Impact-Analysis, which breaks down the components of costs to identify the impact of changes in the cost of labor, the expense elements in overhead, fluctuations in commodity prices, changes in productivity or external factors (e.g., transportation costs). Once expected changes in costs are quantified, strategies can be developed to deal with them before the impact is felt.
- Make material substitutions, which can reduce commodity cost influences; shift sourcing to lower-cost countries/suppliers. Eliminate waste or change your supply chain to remove non-value-added costs.
- Find productivity improvements—one of the most powerful tools—using Lean principles, Six-Sigma® and many other approaches.
- Resort to “old-fashioned” Value Analysis—developed at GE in the 1950s—useful in making the cost-value tradeoffs and maximizing value at a given cost/price level.
All of these are effective approaches to managing in a deflationary cycle. None of them will stop deflation per se, but enough companies acting similarly will slow its spiral. Governmental policies must address it through macro-economic influences such as monetary and trade policy, etc. These are usually outside the control of most managers/executives.
Just Say “No!”
However, selling based on value and not price, and not resorting to irrational pricing (below cost) or price wars, can also help arrest deflation. Sometimes, you just have to say “No, I cannot sell you at that price.”
If/when the buyers begin to sense that prices have reached the “floor”—the level at which value can no longer be sustained at any lower price—they will stop waiting to buy. It is then that deflation has been contained. Then innovation can begin to gain traction, creating new, more valuable products or services, for which buyers will be willing to pay higher prices.
Managing during disinflation is hard; managing during deflation is much harder. Managing in a deflationary environment turns all the things you learned for years upside down.
Albert Einstein admonished us: “The world we have created today has problems which cannot be solved by thinking the way we thought when we created them.” Only if you manage differently, use new tools, gain new insights and then act fast, can you stem the tide of deflation and minimize its damaging effects.
Thanks for this informative post, John.
I now understand deflation.
I have no problem pricing my products based on their value.
It’s not always about price.
The Franchise King