Managing inflation: Is the tail wagging the dog?

Many companies, while struggling with a comprehensive digital roadmap, are deploying digital technologies more rapidly to meet the challenges of supply chain disruptions and demand/supply volatility especially with the unintended consequence of inflation. Senior executives require guidance to prioritize technology solutions and actionable digital capabilities to manage inflationary trends. The best practices, we suggest, must focus on managing margin compression, typical within inflationary environments.

Inflation and the threat of recession are now prompting management to fine-tune constraint-based planning and execution. Inflation is now a business constraint to be factored into strategic planning and tactical day-to-day execution.

From bullwhip effect to tail wagging the dog

During the disruption created by COVID-19, many companies underwent crises driven by the magnitude of business constraints: demand volatility, cross channel contention (e.g., institutional distribution with low demand versus consumer direct and store retail distribution with high demand), supply shortages, labor shortages, vendor capacity constraints, operating cash flow disruptions, “oh my!”. Many of the decisions thought to address the challenges from a macro-economic and sustainability perspective have resulted in unintended consequences (e.g., energy shortages, increased transportation cost, and business closures) across market ecosystems.

Inflation and the possible consequence of recession are now surfacing as new disruptive factors to the business and especially supply chain. Traditionally, supply chain managers have focused their attention on demand; however, reductions in supply and its sources are looming as even more threatening than demand changes to the supply chain. History has proven inflation can erode margins quickly. Rising supply and transportation/logistics costs are forcing companies to enforce higher sales prices to maintain margins.

Although some companies have the pricing power to offset input cost increases, others may be limited by their customers’ price sensitivity and competition. Higher prices coupled with demand contraction dampen margin recovery, and typically force customers to find alternative options. Unfortunately, as companies seek options, they find global reductions in supply sources are eliminating options faster than companies can find them.

While we have traditionally had to overcome the bullwhip effect, it may be that we are now experiencing the tail wagging the dog effect. Responses to inflation and supply/sources reduction need to be managed proactively to minimize lost sales and market share erosion.

Pragmatic practices respond to disruption

Now that inflation has become a top-of-mind topic and business disruptor, the question is what can we do about it?  Depending on your industry, prices and costs will be rising at different rates potentially squeezing margins irreparably. Senior managers are realizing it is in their best interest to maximize the power of digital transformation and platforms following these practices.

•Improve forecasting accuracy via price-elasticity-of-demand analytics

Use your digital technologies to identify price sensitivity and fine-tune the sales forecast using advanced predictive analytics. It is critical that your digital strategy enables progress toward cognitive analytics maturity.
Price elasticity of demand looks at the expected sales volume increase/decrease associated with a change in price. Analysis of your historical data allows you to assess the average price sensitivity of your product offerings. The analysis can be as simple as a linear regression analysis on Excel, or as sophisticated as a multivariate non-linear regression exercise, managed by the native predictive analytics engine of your digital enterprise applications platform (ERP) core. Regardless of how you analyze the data, the end-result is much improved forecast accuracy driving higher sales order fulfillment (revenue) and increased margins.

•Improve margin by aligning sales team reward systems

Many companies choose to incentivize the sales force based exclusively on sales volume. In an inflationary environment, a better practice is to reward sales of higher margin products or incentives based on a percent of gross/net margin. Providing the sales force with real-time updates on pricing and available-to-promise capability, enabled by your digital applications, provide a great opportunity to add value.

Most companies use standard or activity-based costing. A better practice is to monitor the gross margin variance to plan, by breaking it out into its three components: price variance, volume variance, and mix variance. Monitoring gross margin variances provides the feedback required to stay on plan.

•Improve margin by optimizing product offerings to align with the good, better, best concept

In the seminal book “Priceless: the Myth of Fair Value” by William Poundstone, the author provides case studies which prove that tiered product offerings are effective at driving top and bottom lines. The tiers would target the correct positioning quadrants and optimize pricing.

The opportunity cost of losing sales due to price sensitivity is very high. However, by using advanced digital analytics to analyze your market’s customer-product market segmentation, you’ll be more knowledgeable on the appropriate product-price combination for each customer segment. With mature digital technologies and fueled by internet consumer demographics/behavior/location data, companies can segment markets of the moment corelating common consumer and product attributes and online behavior for dynamic demand analysis and marketing initiatives. The ultimate objective is to provide product offerings with pricing that aligns with the concept of good, better, best.

•Improve margin and customer loyalty by minimizing backorders with fair-share-distribution models

It is well-documented that inflation expectations tend to lead customers to drive above-average demand. This is because they expect to minimize the impact of future price increases. But one large above average order from one large customer can lead to stockouts that can have a long-term customer loyalty impact to the rest of your customer base. Exacerbating this challenge is that supply availability, reliability, and sources are economic and regulatory causality of supply variation versus demand causality.

Non-demand causality of supply variability and “long tail” variabilities impact production and distribution inventory planning uncertainty as much as more than demand variability. At the same time, delays and amplification of demand variability/signals backward to supply that trigger the bullwhip effect are experienced as time delays and amplification of supply signals that trigger the tail wagging the dog to meet the demand. Currently, the solution companies have adopted is to use fair-share order allocation, based on historical sales demand by customer-product combinations.

While analyzing and implementing solutions based on fair-share distribution models is a current practice that minimizes the risks of losing customer loyalty as amplified supply shortages creep their way through the supply chain, there may be no supply fair share to allocate. A longer term solution will be adoption of ecosystem commerce, supply network management, ERP4 (ecosystem resource planning) and growing shared services business models.

•Improve margin with supply network/ecosystem constraint-based simulations (digital twin)

Emerging and growing digital core solutions (ERP) and ecosystem commerce platforms (ECP) are accelerating the requirements for companies to deploy cloud-based applications and enterprise-wide digital transformation including digital twins to provide real-time visibility and capability to run constraint-based planning simulation runs. When coupled with ecosystem monitoring and visibility variance from plan alerts are generated to support proactive risk mitigation, resilience and response to demand and supply variability. Almost all digital enterprise application solutions provide the ability to issue real-time alerts to enable companies to manage and respond to unplanned supply disruptions with adequate lead time. Building upon the power of advances in predictive and soon prescriptive analytics, companies can advance their digital maturity based on data abundance/availability, artificial intelligence and machine learning.

What it all means

During the disruption created by COVID-19, many companies underwent crises driven by the magnitude of business constraints: demand volatility, supply labor shortages, vendor capacity constraints, operating cash flow disruptions, etc. Macroeconomic and geopolitical decisions were made resulting in unintended consequences with global market and supply network ecosystem implications and disruptive risks.
Inflation has now surfaced as an immediate new disruptive factor to the business. History has proven inflation can erode margins quickly impacting market supply and behavior. Some analysts suggest that if recession in not already here, it soon will be. Due to chronic inflation expectations, we now have additional variables to manage. The current inflationary trend provides another opportunity for business to maximize the capabilities of digital transformation programs. Will we soon experience the irresistible force of demand meeting the immovable object of supply? More importantly, will you be prepared?

Serge Ratmiroff is a delivery partner,  with Tata Consultancy Services (TCS) and can be reached at [email protected]. Rich Sherman is a senior fellow, Supply Chain Centre of Excellence, with Tata Consultancy Services (TCS) and can be reached at [email protected].

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