Rising inflation hurts margins

Raw material costs have been rising due to high inflation caused by post-COVID-19 supply chain constraints.

This has posed a challenge to consumer goods companies—for whom input cost is a major expenditure—as they strive to ensure their revenue and profits are not significantly impacted. The choices before them are not easy. Passing on the rising cost of goods to end-consumers could result in loss of revenue and market share, while absorbing it would erode margins.  

Revenue growth management (RGM) provides the tools and techniques needed to tackle inflation. This is especially applicable for consumer packaged goods (CPG) companies as pricing is an important revenue and a profitability lever for the industry. CPG companies have the flexibility to tweak the prices of products. Price increases are far more effective compared to cost optimization in protecting the bottom line. However, consumers are extremely sensitive to price changes and can easily switch between different CPG products. This is where RGM tools come in. They provide business leaders of consumer goods companies with a surgeon’s scalpel to effect price increases in a calibrated manner and deal with inflationary pressures to protect top line and bottom line amid growing business volatility.

Companies faced with the highest level of inflation in decades

CPG companies are witnessing the highest level of inflation in several decades due to the pandemic-induced supply-chain constraints as well as higher prices of energy, raw material, packaging, and freight.

A leading US-based manufacturer of personal care products, for example, has witnessed the cost of raw materials like polymer resin increase by 30%. Similarly, the CEO of a leading food company remarked that they have seen an increase of half-a-billion dollars in input costs within a year. Initially, companies took a wait-and-watch approach hoping the supply chain kinks would even out and ease inflationary pressures. But, it seems, inflation is here to stay for some time. 

The big question, therefore, confronting every CPG company is how to deal with it. Cost-cutting measures alone are not adequate to offset the increase in cost of goods (COGS). Price increases are also called for, and CPG leaders like P&G and Nestle have already announced price increases. However, increasing prices can be tricky. If it is not done in the right way, companies could lose revenue and market share. Some products can take price rises without significantly impacting sales, whereas other price-sensitive products cannot take a price rise without losing consumers. Revenue growth management techniques and tools can be used by CPG companies to navigate complex pricing decisions in a calibrated way and minimize the impact to the top line and bottom line. 

Cost-cutting measures alone are not enough, price increases are also required for CPG companies to tackle the increase in costs of goods (COGS). 

Let us look at how three CPG companies are adopting different approaches to tackle inflation and the lessons and inferences we can draw from their strategies. The first CPG company is a leading food company and a category leader. Their products, targeted at the health-conscious consumers, are in the premium price range, and, therefore, the pricing is significantly higher than competition. They are doing very well in revenue growth but are facing a difficult choice due to inflationary pressures that have increased the cost of goods. They can either increase prices to protect the bottom line or absorb the costs and take a hit on the bottom line. As their prices were already high, the company feared losing market share if they increased the prices further and, hence, decided to absorb the higher COGS. So, while the company managed to protect its top line, its bottom line, however, took a beating and the company ended up in losses.   

The second company is in the home and personal care segment. Their major raw materials are palm oil and crude oil, the prices of which had jumped over 100%. The CPG company passed on a part of the higher raw material costs to consumers by increasing the prices of products. On the other hand, the competition took a more measured approach by increasing prices in small increments and for selective stock keeping units (SKUs). As a result, the CPG company lost market share and struggled to recover it. This company did the exact opposite of the first one and, yet, ended up on the losing side. Is there a better way to respond?  Could these two companies have done anything different to protect their top line and bottom line? 

Yes, another approach is possible, like the one adopted by the third company, which took a more calibrated approach to price increases. Neither did it simply pass on the higher input costs, nor did it absorb the burden. Instead, it examined products based on price sensitivity. It left intact the prices of products more sensitive to price change and selectively increased the prices of those that are less sensitive. Typically, products with greater stickiness due to health or other specialized benefits are less price sensitive. As a result, the company was able to offset at least a part of the increase in COGS without losing sales or market share. 

The company used another smart strategy. Instead of a product-based response, it took a portfolio-based approach by looking at the basket of products in the category and at their different pack sizes. With a portfolio-based approach, there was more room to play around with price increases and protect the overall category revenue. 

CPG leaders straddle the category pyramid with products in the value, core, and premium segments. They also have a wide variety of pack sizes to cater to various occasions and consumer segments. Price optimization techniques across the portfolio of different products and pack sizes maximize the overall outcomes of revenue and profitability. The idea is to manage the entire category in a holistic fashion and not just a particular product.  

Price optimization techniques applied across the portfolio of different products—for value, core, and premium segments and in various pack sizes for different consumer segments—maximize revenue and profitability.

Another approach is to do a deep dive into the margin waterfall chart and analyze how the increase in COGS can be countered by effective price mix and holistic margin management techniques. US-based global CPG player General Mills, through effective revenue growth management techniques, enhanced the price mix by 5%. By using holistic margin management, they removed non-value-added costs from a customer's perspective and reinvested the savings in value-creating opportunities. As an example, the company stopped using different lid colors for yoghurt varieties and stuck to just one, saving two million for the brand annually. 

Advanced AI-ML techniques help fight inflation

So, what did we learn from these three CPG companies? The trick is to avoid an either-or approach and use a both-and approach.

The solution is not to just absorb the price increase or completely pass it on to end-consumers. Both need to be done, but in a calibrated way. The big question then is: how to take a calibrated approach, how do you figure out where prices can be increased and where they need to be untouched? The answer lies in using revenue growth management techniques and tools that can help measure the price sensitivity analysis of various products of a CPG manufacturer and of competition based on elasticity and cross-elasticity. Price-sensitive products are highly elastic and price-insensitive products are inelastic. Advanced statistical and AI-ML techniques like log linear regression and deep learning can be used to compute elasticity and cross-elasticity. RGM tools like price simulators can help evaluate the impact of price increase on sales. 

But not all companies or brands have the power to increase prices. Strong brands with loyal customers have good pricing power and can take price increases without significantly losing sales. It takes many years to build a strong brand that commands customer loyalty. Legendary investor Warren Buffet famously said: “The single-most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business.”

Not all companies or brands can increase prices at will. But strong brands with loyal customers have good pricing power to effect price increases without losing sales significantly. 

The next approach is portfolio-based pricing as opposed to taking pricing decisions for individual products. A portfolio approach takes into consideration a basket of products and pack sizes, providing the flexibility to make pricing decisions in holistic way that benefits the entire category. It considers the inter-play and cross-impact between various products in the portfolio and optimizes the revenue and profit outcomes across the portfolio as opposed to a single product.  

Portfolio pricing uses the cross elasticities within the basket of products to analyze the cross impact of changing the price of one product on the other products in the portfolio. The model maximizes the overall category revenue and profit as opposed to simplistic approaches that look at products individually and maximize the outcome. Other techniques like shrinkflation are especially suited to price-point-based products. Here, the CPG companies keep the price of the product intact but reduce the quantity per unit to offset the higher COGS. A leading Home and personal care product company uses this approach for its price point pack. Reduction in quantity of the pack reduces volume growth but protects margins and unit sales.  Advanced RGM solutions provide what if scenario analysis that helps in decision making for use cases like price sensitivity analysis, portfolio pricing and shrinkflation and margin waterfall analysis.