If your starting margin is 20% and inflation in your cost base runs at 5% then, by the end of year 4, your margin is down to 2.5%.
If your starting margin is 20% and inflation in your cost base runs at 10% then you will have a negative margin by the middle of year 3.
To put that in context: in August, the ECB’s eurozone HICP (Harmonised Index of Consumer Prices) was at 9.1%, and the UK’s RPI (All Items) was 8.6%.
If your sales contracts are not negotiated then, for future contracts, you need to add the right to adjust pricing for inflation. The important thing here is to have a single date, across all contracts, on which the price is increased. If you tie the adjustment to the anniversary date of each contract, then (given multiple contracts) you are creating an administrative headache for yourself.
If your existing contracts don’t allow you to adjust prices for inflation, you will need to find a way to retrofit that right (and there are ways).
If your contracts are negotiated then you will have fewer (but higher value) contracts and so the administration of the price adjustment is not that big an issue. However, what is important here is that, when you make the original proposal to the customer, you clearly signal that your prices are inflation-linked.
If you don’t, then you can be sure that the customer’s procurement department will see this as an additional discount. In a recent negotiation that I was involved in, the procurement department of a large US company argued for no-inflation linking because “we are looking for price protection”. “That’s strange”, we replied “so are we”.
Clear indication (at the proposal stage) of inflation-linking is part of the Sales-Side Set Up. The Sales-Side Set Up is a technique by which sellers protect themselves from contract erosion at the negotiation stage: I will be looking at this in more detail in subsequent posts.
Choosing the right index to which to link your prices is obviously a key issue. We are doing some research on this and plan to report back in the next few weeks.