Rising prices and other inflationary pressure could reduce corporate profits by up to 9 percent in 2011 and 2012, according to new research from the Hackett Group, a global strategic business advisory firm. For a typical company with $27.8bn in revenue, Hackett's study estimated that commodity and offshore labor inflation could drive a $150m/year hit to the bottom line.

Hackett's study found new warning signs of inflation on the horizon. According to the study, which polled executives at large global corporations, the recent inflation of commodity prices is likely to increase significantly over the next 12 months, and be accompanied by rising inflation in internal labor costs and external services.

Companies in the study reported that they will pass half of these additional costs onto their buyers but the other half of these costs will need to be absorbed by their organization. In addition, while most companies in the Hackett study say they can effectively anticipate commodity price increases, more than 60 percent say they have not been successful at mitigating these costs. Part of the challenge is that few of today's executives have experienced significant inflation, last seen in 1981, so organizations are having to learn how to best manage inflation challenges all over again.

Companies are already feeling the effect of rising commodity prices, and have seen commodity prices increase by nearly 5 percent over the past year, according to the Hackett study. Key commodities like crude oil and metals have risen dramatically, with some prices more than doubling over the past two years. Commodity price volatility is also a major factor, having increased by nearly 60 percent since before the recent recession, according to Hackett's research.

But in the next 12 months, companies in the Hackett study said they expect the rate of inflation for commodities overall to rise by more than 30 percent, to 6.3 percent per year. At the same time, these companies are expecting the rate of inflation for internal labor to more than triple, rising from 0.7 percent to 2.2 percent, and the rate of inflation for external services spending to increase more than two-fold, from 1.2 percent to 3 percent.

Labor and services cost inflation are in part being driven by a tightening of labor supply markets in India, China and other low-cost labor markets, fueled by increased demand. Most indicators for India and China point to roughly 6 to 10 percent inflation for 2011.

"Inflation has become one of the top issues with our clients," said Hackett chief research officer Michel Janssen. "Strength is returning to the global economy, but the rate of inflation has already increased significantly, and clients are concerned about the impact of further inflation during the coming year. Like the proverbial deer in the headlights, many companies see the approaching danger, but don't know how to get out of the way. There's real potential for all this to have an impact on growth, profitability and consumer prices. It's very tough to keep your promises to Wall Street when you can't accurately forecast or control your expenses."

Hackett's research detailed the problems large companies face mitigating commodity cost increases. Most companies tend to take a fragmented, siloed approach to anticipating and mitigating costs, Hackett found. More advanced companies forecast prices and do some basic hedging by adjusting contract length, purchase volumes, or inventory levels. But few take a truly cross-functional approach, or do the analysis required to understand the impact of commodity cost increases on profitability, use specialized analytics to anticipate future commodity costs, or provide clear direction and policy for making hedging decisions.

Hackett's study also offered recommendations and guidelines for companies to improve their ability to mitigate input cost inflation. Hackett recommended that companies focus on integrated input-cost planning, to forecast and plan for changes in commodity prices, and use robust scenario planning to link supply plans, including pricing, with demand/business plans. An integrated approach to commercial risk management was recommended, to better understand commercial objectives and create a "spend portfolio" that is managed by procurement and finance working together. Finally, Hackett recommends that companies move beyond simple input-cost mitigation, to consider broader cross-functional approaches to cost mitigation, such as changing product designs, financial hedging, or vertical integration such as acquiring a critical niche supplier.

"There's no question that companies are facing a real roller coaster when it comes to input costs in the coming year," said Hackett senior research director Pierre Mitchell. "It's a ride that senior executives would love to get off. But most companies simply don't have the metrics, tools and organizational models in place to make this happen. The looming threat of rising inflation is an opportunity for executives to build a business case for developing new capabilities, and improving cross-functional capabilities."

Source: The Hackett Group