Inflation Is Here to Stay – Businesses Need to Reinforce Their Resilience With Best Practices

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.

Host 2:
Three decades of historically low inflation have left many businesses without the experience or capabilities to navigate the changing economic paradigm. In recent months, gas, wheat, corn, and other essential food ingredients have risen by over 100%. Key manufacturing commodities have fared little better with copper, aluminum, and others experiencing increases of over 60%. Add in demands for wage increases across the globe, and it's hard to imagine any business avoiding today's inflationary pressures. Our latest Pan-European survey measures the response of businesses across sectors to the surge in inflation. We looked at the causes of today's rapidly rising cost, the impact on business, and how winning companies are using key levers to thrive despite the inflationary pressures. We have developed a powerful inflation resilience framework to help guide clients through these most challenging of times.

Aubry Pierre:
Hello everyone. I'm Aubry Pierre, managing director in L.E.K.'s London office. I lead our organization and performance practice in Europe. Thank you for joining me today, Jean-Philippe and Claudio. Would you please take a moment to introduce yourselves?

Jean-Philippe Grosmaitre:
Thank you, Aubry. Hi, I'm Jean-Philippe Grosmaitre. I'm managing director in L.E.K.'s Paris office. Within our organization and performance practice, I invest most of my time thinking about the next challenges of our clients in all kinds of cost optimization from operations to support functions.

Claudio Molinaro:
And hi, I'm Claudio Molinaro. I'm managing directors in L.E.K.s's Paris office. And within our corporate and performance practice, I'm the reference partner relating to sales excellence, including, but not only, pricing strategy.

Aubry Pierre:
Thanks, both. This is going to be a great discussion and I can't wait to jump in. To get started, let's begin with you, Claudio. Could you tell us a bit about the reasons for creating this survey and how it's innovating on the current way to think about inflation resilience?

Claudio Molinaro:
Sure. Thanks, Aubry. To start with, one of our partners, [inaudible 00:02:39], reported during Q2 on the anxiety of the investors' community on the impact of inflation. So leveraging our value creation knowhow, we designed a framework for inflation resilience, regrouping about 40 key levers under the control of each EXCO member, such as the head of sales, the head of operations, the head of talents, and the CFO, to flight inflation in the short, medium, and long term. As you know, at L.E.K., we like to quantify all we do and we like to understand what winners do better than others. Since there was no real consensus on the market about inflation magnitude and resilience levers, we decided to directly ask CEOs and other EXCO members. So we gathered a panel of a thousand companies spread evenly among four countries, the UK, France, Spain, and Germany, around 11 industries to get a sense of how they are impacted by inflation and how they fight it. Our clients are now using the survey results to benchmark their own responses to inflation and resulting financial performance. They can take the survey and compare their actions to peers, as easy and insightful as you will see.

Aubry Pierre:
Wow, Claudio, that's an amazing approach. Jean-Philippe, tell me about the impact of inflation on companies' costs. What are the conclusions and insights from the survey?

Jean-Philippe Grosmaitre:
Well, sure, Aubry. We found that on average inflation impacted companies by 8.3% over the last 12 months and is expected to hit by another 6.7% over the next 12 months, which makes a compounded cost increase of 15.5% over the two years. This is true across the panel we surveyed. We asked each of the companies to assess the impact of inflation on their raw materials, utilities, transport, labor, and other costs, and to provide us for each category with their best estimate of inflation over the last 12 months or the next 12 months. On average, the most impacted costs items were materials at 9.1% and personnel at 7.9% over the last 12 months. But the most important thing is that we found a very high variance within each industry, with maximal values beyond 100% of increase for materials and utilities as it was including energy. There was also some meaningful variance by country, with France 1% below Germany on average over the last 12 months. And Germany may be more anxious about the next 12 months at 7.6%.

Aubry Pierre:
No wonder, given the outlook for energy prices and raw materials. Thanks, Jean-Philippe. Now Claudio, let me ask you how successful firms have been in passing on at least a portion of this inflation into the pricing of their products and services?

Claudio Molinaro:
Sure, Aubry, thanks. In our approach, we thought market power of companies was essential to be successful in passing through inflation. And we asked many questions on levels of client fragmentation, competitor consolidation, barriers to entry such as technological advantages. But in the end, we concentrated on actual price increases as the best proxy for market resilience. What we found was that nearly all the panel had increased prices over the last 12 months, with 10% of companies passing increases of over 10%. 45% of them passed increases above 5%. And 45% of companies between zero and five. This is unusually high; and moreover, nearly 40% of them increase prices twice or more. Now, expectations for the next 12 months are much lower, with only 22% above 5%, against 55% previously. So despite these price increases, business do not on average expect any reduction in demand, which I found very surprising. And overall, businesses made it clear that while price increases did not meet too much resistance over the last 12 months, they expected new price increases to be much more difficult to pass on.

Aubry Pierre:
Very interesting points, Claudio, thanks. This tends to demonstrate that at least some of the companies found ways to protect their margins. Turning to did, Jean-Philippe, did you manage to understand the impact of inflation on profits overall?

Jean-Philippe Grosmaitre:
Of course, Aubry. That was the purpose of the survey. We found key five outcomes. First, on average, companies were expecting to lose 25% of EBITDA over two years, the last 12 months and the next 12 months. And on average, EBITDA could go down from 20 to 15% of revenue on the whole panel. But second, what we have found was that one-third of companies were resilient, capable of increasing prices sufficiently to protect results from inflationary impacts. On the contrary, we found that 20% of company were in crisis mode as they saw their EBITDA drop by more than 10 percentage point of sales, which means on average a drop of 50% of the EBITDA on the same period.

The third aspect we found out was that no sector was immune, but certain sectors were better off, such as energy environment, 50% resilient, and raw materials and packaging, 46% resilient, which have overall those sectors a culture of inflation pass through in their terms and conditions. The fourth outcome was that smaller companies, less than 150 million euros in our panel in sales, were hit harder. Only 21% of them were resilient. And last but at least, as per countries, we found that the rate of companies in crisis were higher by circa 10% in Germany and Spain rather than in France and the UK. In our view, this is partly explained by a better pass through in the UK of inflation into prices and less inflation in France due to governmental [inaudible 00:08:45].

Aubry Pierre:
And Jean-Philippe, in summary, have any companies managed this particularly well?

Jean-Philippe Grosmaitre:
Yes, indeed. About 33% of respondents overcame cost inflation by adjusting their pricing or their cost levels. So we looked into more details on how they manage this, looking for best practices.

Aubry Pierre:
Now okay, very insightful. So it's probably a good time to move away from the numbers and to try and understand what winning companies do to better fight inflations than others. If we look at our inflation resilience framework, it really has four components: commercial excellence, operational resilience, proactive talent management, and tight financial management. Claudio, let's start with commercial excellence. What are the best practices of winning companies in this field?

Claudio Molinaro:
Thanks, Aubry. Commercial excellence is indeed a key enabler of resilience as it focuses on making sales more efficient and pricing correctly adjusted. Typically, this is under the responsibility of the head of sales and marketing. In this field, we have a strong variety of situations differing from sector to sector. Regulated industries in healthcare, for example, have had less flexibility around price management than B2B industrial companies or even retailers. What we did is we measured maturity of each company along seven key levers, preselected amongst the 40 commercial excellence levers we have. The goal was really to give great weight to levers already implemented versus the ones in progress or the ones just envisaged by the companies to see who took action with results. And looking at winners and resilient players, we found that they are better than the panel in targeting specific customer segments and passing discreet price increases to specific customers. Another key lever these best performance have used is to redirect customers towards more profitable products.

In addition, a key learning for me is that the most resilient companies have not engaged in massive sales force reorganization. What they've done is they've focused instead on a limited number of actions, like the ones we said, discrete price increases, product portfolio adjustments, but have been more efficient in execution. This requires a discipline and agile Salesforce management. This was relatively consistent in each industry we looked at. And we have a report per industry giving even more details.

Aubry Pierre:
Interesting. I see commercial excellence as a powerful way to leverage both strategy and operations to play on levers that cost reduction alone just cannot match. Moving on to operational resilience, Jean-Philippe, can you elaborate on some of the insights on what winners are doing better than others?

Jean-Philippe Grosmaitre:
Thanks, Aubry. Operational resilience looks at all that can be done to reduce inflation impacts on cost structure. That's typically under the responsibility of the COO. In this category, we have key improvements such as shortage anticipation, cost reductions, or better cost pricing models in the short term, and alternative sourcing, more flexible production, and CapEx reallocation towards automation, for example, in the midterm. Looking at winners, we found that they are better than the panel in ensuring sourcing flexibility to avoid shortages, that they really focus on optimizing direct labor and reducing overheads. Again, what we took out is that preparation and focus in times of headwinds look to be the keys for better operational resilience, minimizing impacts of inflation, and looking to compensate with other actions what is irresistibly increasing.

Aubry Pierre:
There's so many levers to be considered here. It's interesting to hear what the priorities of the winners were. Thanks, Jean-Philippe. Now, there's another category where inflation looks very high, talent, the cost of labor. Claudio, what's happening here? And how do the winners stand out?

Claudio Molinaro:
Tough question. We were really very surprised by the level of labor inflation. Looking into the details, we found an increase, meaning that recruiting had to be done at a constrained and rising market level. This inflated salaries that were already higher than in previous years. This talent management really looks at all that can be done to reduce inflation impact on labor, which is typically under the responsibility of the Chief Human Resources office. We looked at the maturity of each company along eight key levers, pre-selected among over 30 proactive talent management leaders that we have. And in this category, winners really prioritized work flexibility and new ways of working, to both improve loyalty and engagement on one hand, and on the other hand, reduce office costs. Long term impacts will remain to be seen, but in the short term, this has brought good results.

Another thing, looking at winners and resilient players that we found, is that one of their key successes has been to retain personnel in competencies. This obviously generated salary increases much stronger than in the past and more frequent throughout the year, but not only. Resilient companies have also worked on non-wage benefits and giving purpose to the work they do. Broadly speaking, managers believe the war for talent will remain a top priority on their agenda for the next year, and they will keep a close look on salary negotiations and discrete salary increases. Winners look to do things right, and if the rest is aligned, no wonder that they resist better or even benefit from this new normal.

Aubry Pierre:
Thanks. Last but not least, Jean-Philippe, can you tell us how winners mastered financial management in these kinds of uncertainty?

Jean-Philippe Grosmaitre:
Great question, Aubry. After all, you can only change what you measure well. Tight financial management is in our view a key enabler to fight against inflation, typically under the responsibility of the CFO. In this category, winners were strong in five key areas. First, scenario planning to anticipate and arbitrate priorities. Second, improved cash forecasts and collections for a better analytical tool for a more agile S&OP forecast. And fourth, risk sharing models to be implemented with partners with a new way of contracting. And fifth, reinforcing the business partner role of finance team in the midterm with the business. We measured maturity of each company along eight key levers, preselected amongst 30 proactive talent management levers. So looking at winners, we also found that they are better than the panel in cost pricing model reliability enabling them to make decisions, state of the art cash collections, and monitoring of early warnings relating to inflation.

Maybe one last thing, if I may, Aubry. Most additional levers indicated by companies dealt with using technology and automation to transform the way business is done and increase productivity, reactivity, contributing to better value and cost reduction. When you think about all the untapped source of progress that AI data and analytics will enable in the years to come, you can be confident that resilience will be reinforced thanks to digitalization.

Aubry Pierre:
Thanks so much, Jean-Philippe and Claudio, for telling us about these key insights from our inflation resilience survey. There is so much at stake combining strategy and operational excellence, and I can't wait to see how it continues to evolve. As a reminder, this is L.E.K.'s first piece in a series on inflation resilience, so stay tuned for further insights.

Jean-Philippe Grosmaitre:
I agree, Aubry. This is an area that really is at the forefront of years to come since inflation is here to stay. Thank you again for chatting.

Claudio Molinaro:
Yes, indeed. Thanks, Aubry. We build momentum on this hot topic as we have already been benchmarking dozens of PE-owned companies with our panel of a thousand companies, so definitely stay tuned.

Host 1:
Thank you, our listeners, for joining us today at the Insight 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 podcast. Also, we encourage you to submit your suggestions for future insights online at LEK.com.