Inflation Inflated: Part 1 and 2 – The Consumer and Business Outlook

Host 1:
Welcome to Insight Exchange, presented by L.E.K. Consulting, a global strategy consultancy that helps business leaders seize competitive advantage and amplify growth. Insight Exchange is our forum dedicated to the free, open, and unbiased exchange of the insights and ideas that are driving business into the future. We exchange insights with the brightest minds of the day, the most daring innovators and the doers who are right now rebuilding the world around us.

Emile Santos:
As US inflation in 2022 climbed to its highest levels in more than four decades, and consumer sentiment plummeted to a near all-time low, L.E.K. set out to discover how consumers and businesses were responding. We ended up conducting two surveys, one with over 2,500 consumers and another with more than 300 consumer focused business leaders across 16 consumer subcategories. These businesses covered B2B, B2C and D2C go to market strategies. In this episode, we'll discuss a couple of things. First, how are consumer businesses responding to inflation? Secondly, what businesses are prioritizing in the face, as inflation pressures continue? And third, nuances across subcategories as we think about how consumers and business leaders are reacting and prioritizing or pulling back their spend. My name is Emile Santos and I'm a partner in L.E.K.'s consumer practice, focusing on automotive and mobility, as well as consumer health. Today, I'm joined by my two partners, Rob Haslehurst and Claire Davies, to provide some insights on these topics. Rob, Claire, could you introduce yourselves?

Rob Haslehurst:
Thanks, Emile. This is Rob Haslehurst speaking. I am a partner also in L.E.K.'s consumer sector, with a focus on automotive, on the home and on entertainment, and do a lot of work around consumer led growth strategy and working with businesses in that space to help them grow.

Claire Davies:
And hey everyone, my name's Claire Davies. I'm a partner in the consumer team here at L.E.K. as well, based out of LA. And I spend my time primarily focused on the food and beverage side of the consumer landscape, but also spend time in beauty, personal care and direct to consumer businesses as well.

Emile Santos:
Excellent. Well, first I wanted to dive into how badly consumer business leaders are feeling the impact of inflation. Rob, when you look at the studies that came out or the results from the survey, what are some of the key messages that came out?

Rob Haslehurst:
Yeah, well it'll come as no surprise that this is a top of mind topic for business leaders. We've really seen inflation at both the wholesale and the retail level, in upper single digits for months on end now, and we've been hearing about it in the news, we've been seeing consumers react to it. And even with some of the pullback over the last few months in headline monthly numbers, inflation remains absolutely at historical highs and the actions of the Fed to try to contain it, are just driving up interest rates, which in turn are putting pressure on businesses in other ways, which is still ultimately driven by this inflationary environment.

So when we did the survey, 90% of the businesses that we heard from said that they were experiencing material inflationary impact to their business and that really is true across sectors of the consumer economy. I think particularly food and beverage businesses were feeling a very high level of impact, as actually were automotive leaders. Although the impact there was variable, depending on where they were in the cycle. Some of the more discretionary durables in health and wellness products were sort of seeing the least impact from inflation, but still some level of materiality, it really is affecting everybody.

Claire Davies:
Yeah, that's true. And just chiming in from a food and beverage perspective, Rob, I mean, that makes tons of sense. We look at the food at home inflation data that we've seen come out, and the last 15 straight months, up to the end of 2022, we were seeing increases in inflation, and the food at home inflation was also outstripping the food away from home. But the food and beverage sector has been massively impacted from inflation, I mean, they've been hit on all sides. They've been hit by the things that other sectors have had to deal with. So the rising labor costs, the energy prices, the supply chain snarls, the incredible overseas freight prices that we've seen, and then you've seen things like Ukraine also impact supply of a lot of commodity foods, but on top of that, they've also had to deal with the closer to home impacts.

So the droughts that we've seen in the US, the avian bird flu and all of these things have really impacted across the food and beverage landscape, but the commodities in particular, which you have as your staples in your kitchen, you have as ingredients into other foods. So things like eggs, dairy, fruit and produce, bakery, cereals, et cetera, have really impacted. So you can see how the consumer is feeling the burn as well on the business side.

Emile Santos:
Yeah, Claire, that perfect storm dynamic that you're talking about, I think it was also true on the auto [inaudible 00:05:16] and the work that we've done, and it's pretty interesting. Often auto is a category that acts a little bit more like non-discretionary spend, but the price increases last year were really severe on two fronts. First, was just the incredible growth in fuel prices that I think we all felt at the pump, and in some ways that'd resulted in outsized perception of the cost impact. But that came hand in hand with a confluence of microchip shortages, supply chain disruptions, and really some of the widest asymmetry we've seen between new and used vehicle inventory and demand, which was just led to really a rollercoaster of new and used vehicle pricing with extreme inflation, combined with low sales as well, which I thought was very interesting. Claire, we'd love to hear a little bit about how these sector reactions at a business level, relate to the impact that consumers are feeling when we get their feedback.

Claire Davies:
Yeah. And when we compare the two surveys that we did, the trends are already similar. So consumers are seeing the biggest impact from inflation across those non-discretionary frequently bought everyday kind of categories. And the top two categories impacted are food and beverage and gas and auto parts and upgrades, so that auto space. I think over 55% of respondents reported material impacts of inflation in these two categories. But I think what is interesting in that study is also the nuance around the differences in the demographics of the consumers that we surveyed. So we looked at from age and also income levels, and you see some interesting trends there. So across most of the categories, the impact of inflation was proportional to an individual's income level, but there were a few exceptions. So things like restaurants, home improvement and rent were three that kind of seemed to be impacting groups more uniformly, but there are generational differences as well.

It was interesting, while everyone is clearly feeling the pressure, more than half of Millennials and Gen X's were sort of really feeling it in a bad way and a lot of those are juggling kids, so they've got mortgages, so they're really feeling the pinch, whereas the Gen Z's and the Boomers are slightly less affected. So when you think about it from a business perspective, obviously we've got the category lens that we were just talking about, but you also got to think through which businesses are targeting which consumer demographics, because targeting those ones that are most feeling the pain are probably being disproportionately effective as well.

Emile Santos:
Yeah. So Rob, as you think about some of the feedback that we heard from the business leaders, what are some of the specifics in terms of how inflation is impacting businesses specifically?

Rob Haslehurst:
Yeah. So businesses have really been impacted across their income statement, but it's really the cost of goods sold that we've seen the most significant impact. So 83% of businesses in the survey, were significantly or moderately impacted on the distribution logistics and freight costs. Claire mentioned this earlier, but it's understandable given the cost of overseas freight, the price per container going up from 3,000 to 20,000, as an example, and other elements around shortages in trucking and logistics that really has driven that up across many, many consumer businesses. But it doesn't end there, it kind of started there, but actually almost as many businesses have seen labor costs increase, which is good news to the employee, but from a business perspective, all of those incremental bonuses and wage increases, which reflect labor market tightness and our low unemployment rate, has just added to rising wage pressure. And a lot of those costs are now baked into those businesses income statements going forward, irrespective of what happens to inflation going forward.

The actual underlying costs of raw materials, the sourcing of products was also very significant, almost 80% of our respondents pointed to those. That would include the impacts of sourcing disruption that you talked about in the automotive space, Emile, as well as price rises down the chain that kind of rippled up and went through. And really businesses are having to think about should they be switching suppliers, should they be changing what they use in order to really find stable and affordable supply? Other costs were certainly in there, but really those were the top three in the work we did. And what that's leading to is executives are looking for ways to offset those rising costs. So really reaching for opportunities to both use technology, to redesign models, to change their business needs, to become more efficient, while also at the same time, passing a lot of that price onto consumers.

Claire Davies:
Yeah, that's a good point, Rob. Obviously they're very focused on the cost side, but businesses are laser focused on the revenue side of the equation, particularly around pricing. So how can they pass through the price increases through to consumers? How can they optimize their pricing architecture and balance those margins? How do they make sure, as they push through prices, that their volumes remain stable? And many cases, developing new offers at attractive price points, so thinking about innovation and price pack architecture. But I think it was very clear in the study actually, pricing power is the other big theme really coming out of it. I think we saw almost 70% of respondents feeling that their pricing power had either moderately or significantly impacted them. So they've been focusing on this cost pass through and focusing on how they can use pricing as a lever to offset this continuing inflation.

Rob Haslehurst:
Yep, absolutely. And it's worth coming back and noting or reminding that while all the businesses are feeling it, the extent to which different businesses have the ability to do pricing changes or exposed to particularly large swings in costs, it really does vary by sector in a broad consumer economy. So Emile discussed earlier, the automotive space is a great example. Those supply chain shortages of new vehicles and changes in consumer pattern coming out of COVID, has just put unusual pressure on the supply chain for vehicles, supply chain for parts and that massively rocketed up prices. Now some of that has subsided now, but as you think about the lasting impact on other parts of the supply chain and P&L, you really are seeing a world where that market is fundamentally changed.

On the other hand, some of the non-discretionary categories like pet products or health and wellness and personal care products, they're seeing a little bit less impact overall. They've had the ability, because consumers regard them as so important, those manufacturers have been able to pass on costs, haven't seen big dips in sales as a result of that, and have been able to manage through this inflation to date. Obviously with such extreme numbers though, it's only a matter of time before consumer patterns do change and maybe they trade down into a different brand or other things. So while the consumers are willing to absorb price increases to an extent, businesses have to be very thoughtful around how do they value engineer their products to ensure that they don't have to rely on the consumer constantly putting their hand in their wallet.

Emile Santos:
Yeah, that's a good point, Rob. I think when we looked at that business survey, it suggested that consumers in the non-discretionary categories have been more willing to absorb cost rises or those pass through pricing that Claire mentioned. Claire, how does the feedback from the consumers area reflect that, in comparison to some of the more discretionary areas?

Claire Davies:
Yeah, the findings actually tie rather well across the two. I mean, I mentioned before that consumers are seeing less of the inflationary impact on those non-discretionary items that they purchased, the health and wellness products, the sporting goods, the fitness, et cetera, versus those non-discretionary everyday kind of guys, like food. So that kind of ties between the two surveys, given that those non-discretionary business leaders are seeing less of that impact. But to your question, it's actually interesting, we see sort of four kinds of buckets of behavior depending on the subcategories. So the first of those is suck it up and pay. So rent, utilities, consumers have got less control, so they're just having to pay more for the same. The second though is that non-discretionary items like the food and bevs, the daily household items where we know they're feeling the most pain. And for those where consumers are seeing the higher level of inflation, we're seeing them react differently, they're choosing to trade down.

So as Rob mentioned, there's ways of doing that, lower price brands, private label, cheaper channels like Costco, Walmart, et cetera. And so we're seeing that kind of trade down behavior. Interestingly, pet actually falls into that category, so people still need to buy their pet foods and pet goods, but they're starting to cut down a little bit on the price levels. The third is those discretionary items that we've just been talking about, the electronics, the fitness, the home improvement, travel, et cetera. So the survey are showing that people are continuing to pay, continuing to buy their same brands, they're remaining loyal and they're not trading down to lower price items, but they are instead trading out, should we say. So they're buying a little bit less, but they are absorbing the price increases. And then you've got the other bucket, so the health and wellness, beauty, personal care is kind of spanning that gap, people are reacting differently, a bit of trade down, a bit of buying less, but interesting to see how the different sub-sectors have those different dynamics.

Emile Santos:
Gotcha. So that kind of covers what's been happening if we look at it from the rear view, but we're still in the midst of ongoing pressures and we'd love to hear some of your thoughts around what we can expect out of future behavior from businesses as they face this inflation. Rob, do you want to share some thoughts there?

Rob Haslehurst:
Yeah, sure. So I think when we talk to the executives in this survey, I think what came back was quite similar to what we see around the industry and what we work with, with our clients. So they're leaning pretty heavily into prioritizing initiatives that will help navigate these uncertain waters. We talked a bit about that sort of ability to pass through pricing, so no surprise that actually the first two initiatives we've heard about really tie into pricing. So the first one is as simple as that, passing on prices and just trying to recover and maintain margin. The second one is what I think of as price optimization, so how do you think about the portfolio mix that supports the best possible profitability, but maybe that doesn't involve an active price increase to the consumer.

They're taking action on the cost side though too, and the third and fourth initiatives we heard about was certainly a lot of focus on the opportunities of automation and process redesign to reduce the labor requirement burden and ensure that they don't have exposure to both the cost of that, as well as the risk of key employees not being around and not being able to meet customer needs. And then critically, supply diversification, so the cost that they're paying, how do they keep those down?

Emile Santos:
Got it. Could you double-click a little bit into some of the specifics on each of those four areas that executives were talking about tactically doing from the survey and from the conversations we've had?

Rob Haslehurst:
Sure, absolutely. So on the pricing side, I think what I'd point to here is that analysis and understanding is key. Just a simple margin increase and hold the margin and pass through the same percentage works at times, but doesn't work at others. It's really important that the businesses think through what is their product mix, how do they increase profitability, how do they think about areas where they have a bit more room, versus key price signaling items where they have less ability to move price and need to stay competitive. There's also things that we see businesses doing around using the increases in price coupled with programs to think through customer loyalty, rewards, discounts, to ensure that they're able to get the maximum price, but use this as an opportunity to restructure and take share as well and ensure that they're rewarding and getting the most from their loyal customers.

At the same time, there are things that they're able to do around product re-engineering, around thinking through what is the structure of the product they're selling, are there new SKUs, are new elements that would allow them to meet the same customer need but potentially at a lower price point, or at the same price point but with less cost. I think specifically then that leads you into this kind of pricing architecture point and really it's critical that brands and retailers think about not only just increasing the price, but also recognize the economic pressure on the cost conscious shopper. So what we're actually seeing as well, in addition to increasing price where they can, looking for opportunities to have opening price point products or to participate in a different way. Claire mentioned Costco and Walmart and some of the club and mass channels, does this put pressure on brands to be in places where we're not historically?

They're looking at the sort of architecture of individual product lines and in some cases simplifying, in other cases, creating those opening price products. They're also looking at the broad portfolio and whereas through a lot of the COVID period, a lot of the consumer focus was potentially more on sort of everyday luxury and convenience and willingness to potentially pay a little bit more because of the higher income that they had, not spending in other areas. There's a little bit more focus on how do we develop products that kind of fit the consumer need today, how do we think about portion size, and overlaid on all of that, trends like sustainability, and how do we think about minimizing waste in supply chain and for the consumer? Moving on to the cost side, I think this labor technology and automation piece is really critical. Obviously it doesn't happen overnight, but retailers and consumer products have been working for a long time around thinking through what they can do to evolve their way of going to business, and this has really acted as an accelerant to that.

So activating programs they already had in place, investing in technology, investing in some of the little things around just a process change or a high level piece of off-the-shelf technology to drive a short term change, while also rethinking about the long term and preparedness for the future, as you think about automating and pulling labor out of their processes. That's all happening at a time where it's really important to keep and engage the employee base that we have. Unemployment is still at all-time lows, and so it kind of paradoxically, we're also seeing a lot of companies focus on reducing their turnover, on managing and engaging their teams to both manage cost but also ensure that they're not going through the same sort of people turnover that we saw during 2021 and the sort of hidden costs that come with that. So focusing on their people, focusing on efficiency and building the best with the team they have.

And then moving into the cogs and the sourcing element, really it's to return to best practices, as you think about the supply chain and really spending time not focused just on who can get me the product the quickest and who can get me the most, but thinking through who their vendors are, what their deals with vendors are, how to get better pricing, ensuring that, in some cases, I think you're seeing a willingness to get back into longer term arrangements that maybe fell a little out of favor during the scramble for suppliers in COVID. And just try to diversify and find new suppliers with this sort of shock reminder of some of the fragility of their business, the need to go forward and re-engineer it. And I think that stands to set these businesses up for long-term success, not just around navigating the next few months, but should mean the consumer economy comes out of this in a stronger position than it went in.

Emile Santos:
Got it. So when you think of these thoughts in total, what did we learn about the top strategic priorities for 2023 specifically? It sounds like some of these are for near term impact and others for more long term sustained advantage.

Rob Haslehurst:
Yeah, I think the near term's going to win in that debate, but if you can do both, then certainly businesses would want to do that. So specifically, more than half of the surveyed business leaders have actually already done something on price for 2023. They've already taken at least a price increase or worked on re-engineering it. That said, many of them don't believe they're finished and that still leaves almost half that haven't yet. And so we think that there's significant further room for price engineering, and again, that doesn't necessarily mean increases, that means finding the new place in the market. So that prioritization, that SKU rationalization, really driving the best revenue to cost ratio that.

Some of that supply chain piece is going to be pretty achievable over the course of months rather than years. And so focusing on diversifying supply chain, just ensuring that they're not overpaying for the ... versus competition for the price of the products they're buying. I think some of the technology things we talk about are certainly in the mix and I think a key priority for the CTO's office in many of these businesses. But probably right now with interest rates where they are, there's less willingness to spend on the major capital goods projects and a little bit more focus on the smaller process efficiencies and small tools that can really drive short-term business, while building a plan for that long-term resilience and sustainability.

Emile Santos:
For some of those price increases that you mentioned, what does the future look like for those? Do you guys think they'll stick?

Rob Haslehurst:
Yeah, so most executives we talked to, we asked this question because you would like to think that when a product increases in price and then the raw material decreases, that that's passed through to the consumer. Most of the executives we surveyed said that they're going to try and maintain those price increases even if key supply chain costs fall. And there's a big reason for that. Remember that the costs aren't just about those raw materials, a lot of the price increases that have happened have been supporting cost increases that are likely to stick, things like labor costs, and it's very unusual to go backwards on some of those inputs. At the same time, businesses right now are going to see profit pressure and being able to hold onto some of those price increases is desirable for them as they think about their total cycle and their business and their shareholders.

That said, we live in a competitive capitalist economy and ultimately competitive action is what they're looking for, and no business is going to hold prices in a world where competition is driving consumers away from them. So we don't think that changes. When we look at history, prices rarely go down, we are not expecting a deflationary environment post this shock, but we think that once the pricing pressure is clearly off, and I think you're starting to see early signs of that, then prices are most likely to stick and continue, with competitive pressure reactivating at a new normal, as it reflects the cost base in the business and ultimately the fight for consumers winning out in terms of how businesses think about setting their prices.

Claire Davies:
Yeah. And I'd love to jump in there, just from a consumer perspective, around how they're thinking about it. So I mean, obviously we're in this very uncertain environment where prices just keep going up and when we ask consumers what are they planning to do if prices continue to rise, the areas that they're likely to continue to cut back on are around the whole experiential piece, eating out, gambling, travel, leisure, entertainment. But when we ask what happens when it kind of reverts, well not reverts, but settles down and inflation abates, consumers were very clear that they want to trend back to what they were doing before. So all of their trade down behaviors should return, they'd return to spending on their preferred brands.

So hopefully as we start to see some of this inflationary pressure easing, as we are doing, consumers will start getting a bit more comfortable and hopefully we'll start to see that behavior turning back. But as I mentioned before, a little plug for the report here, you can find it on lek.com, but it's got some really interesting nuances around the different demographics, the generations, income brackets, et cetera, and it's worth a read.

Emile Santos:
Thanks for that plug, Claire. I'll second it in and also suggest that folks [inaudible 00:27:17], a lot of great insights that came out of there on the reports that are lek.com. I guess to quickly summarize the discussion, it seems like there are a couple of key takeaways that we had, some that we might've expected and some that I think are quite interesting. First, inflation has certainly impacted consumer businesses, but it's pretty clear that there are some sectors that have been more insulated than others and the way that consumers and business are behaving in different sub-sectors has also varied. Secondly, I think from the business executive side, I think there's certainly been an effort to maximize prices, but also, I think, importantly, optimizing that price architecture, so that they're not just offsetting costs by passing it through to consumers, but finding the right mix of product and offer and price point for their customers.

I think the third takeaway I had was around some of those non-discretionary products, like food and bev and auto, that have felt the biggest impact as people have been seeing their spend go up week to week. And as a result, some of those pass throughs, consumers are, it sounds like they're often choosing to trade down or in some cases, trade out. On the discretionary side, it feels like inflation, it sounds like it's had a lesser impact on both businesses and consumers, at least in the near term. And consumers seem to be absorbing a lot of those price increases, but perhaps in turn, reducing volume. And I think we'd all expect them to continue cutting back as inflation or if inflation continues. And I guess the last one, in terms of tactics and how to build advantage during this time period, it certainly seems like companies that prioritize or optimize their pricing strategy and execute that considering their consumer and market trends, are going to be really the best position to maintain their price increases once costs stabilize, and could even have opportunities in the near term for further strategic investment.

I wanted to take time just to thank, Rob and Claire, again, for your time. Appreciate all of your insights. Certainly we would like to invite anyone listening here to connect with us more, to learn more about the survey and how businesses are adjusting their go-to-market strategies in the face of the current inflationary environment.

Host 1:
Thank you, our listeners, for joining us today at the Inside Exchange, presented by L.E.K. Consulting. Links to resources mentioned in this podcast can be found in the show notes. Please subscribe or follow for future episodes wherever you listen to your podcasts. Also, we encourage you to submit your suggestions for future insights online at lek.com.