Tuesday, November 23, 2010

As Costs Spike, Will Companies Raise Prices?

Prices of commodities like cotton, wheat, corn, gasoline, copper, and oil are skyrocketing. The reasons vary but in general there is growing demand for them in developing nations and traders are betting on a falling dollar and rising commodity prices. The combination of real demand exceeding supply and massive trading bets is pushing up prices in dollar terms. 

The problem facing companies that use these commodities in their products is whether to pass those cost increases on to their customers. If they do, they risk losing sales to competitors who decide to eat the cost increases and keep their prices where they are to attract cash-starved American customers in a weak economy.

The problem is that if these companies do not raise prices, they will disappoint investors when they report lower than expected profits. So companies are struggling with how best to respond. Their choices could sink the economy into stagflation on steroids.

Evidence of commodities price spikes is compelling, even as general inflation statistics -- the October CPI was up 0.6%, the lowest rate in 53 years -- suggest prices are flat in the U.S.. And a huge factor in that rise in commodity prices has been demand from China. Food inflation there is soaring at 10%, according to Bloomberg, so China is raising interest rates in an effort to put the brakes on those price increase.

How Can General Inflation Be Low When So Many Commodity Prices Are Spiking?

Meanwhile, the price increases in many commodities have been much greater than the general level of U.S. inflation. Bloomberg Businessweek reports the following examples:
  • Raw materials prices. The Thomson Reuters/Jefferies CRB Index of 19 raw materials has risen 15.3% percent in the past five months, led by agriculture commodities. However, in the last 10 days, that index has lost 6.6% as investors anticipate slower economic growth in China;
  • Corn futures for March delivery spiked 56% from June 30 to a Nov. 4 peak of $6.04 per bushel. Between then and Nov. 22, those corn futures have slipped 12.3%;
  • Wheat futures climbed 28.3% since June 2010;
  • Sugar prices skyrocketed 60% during that time;
  • Cotton futures for March delivery rose 51.6%;
  • Crude oil inched up 5.2%; and
  • Copper prices increased 26.4%.
Not all companies are choosing to eat those cost increases. Those with strong brand recognition -- General Mills (GIS) and Crocs (CROX) shoes -- will raise prices in 2011, according to analysts.

Clothing and footwear makers are not going to be able to pass the rising costs of raw materials on to their customers. That's because of a decade-long trend of declining prices due to greater rivalry among competitors and the opening of new retail channels leading to aggressive price cuts. Between 1998 and 2008, clothing and footwear prices fell 10% and 4% respectively, according to Bloomberg Businessweek. And that trend is not likely to reverse in the middle of a moribund economy.

Different clothing suppliers are dealing with the rising costs of raw materials -- like rayon and cotton -- differently. Some -- such as V.F. Corp. (VFC), Nike (NKE), Polo Ralph Lauren (RL), and Phillips-Van Heusen (PVH) -- refuse to pay their suppliers the full rise in their costs.

Although the rayon costs have risen due to higher oil prices (rayon is derived from oil), these retailers are going to shift their product mix to favor the higher margin rayon-based apparel instead of selling pure cotton items -- whose costs have risen much more. Meanwhile, retailers that source for their own labels -- like Gap (GPS) and J.C. Penney (JCP) -- are likely to pay their Chinese suppliers as much as 30% more as a result of rising cotton costs.

Food makers are trying to avoid price increases by selling lower quality products that cost less. For example, in the beef industry, there is a shift to less expensive cuts like flank steaks, skirt steaks, and top sirloin which costs $2 per pound at wholesale and retails between $5.99 and $6.99, reports Bloomberg Businessweek.

How Long Can Companies Hold The Line On Prices?

Only a few companies -- those with unique value to customers -- will be able to raise their prices to keep their margins. The rest will probably engage in a combination of accepting lower margins and trying to cut their other costs to keep their margins from slipping. Those cost cuts could mean throwing more people out of work which would slow down consumer demand and cut into sales growth.

But the real issue is whether these companies will ultimately be forced to raise their prices in order to boost their earnings enough to meet Wall Street's expectations. The only way those price increases will stick is if all competitors follow. And in most industries there is too much rivalry for that to happen.

Perhaps the most common response will be to offer a broader array of lower quality products that carry the same prices as the higher quality ones did before those commodity price spikes. This will create the illusion in the minds of consumers that they are not paying more.

Alternatively, companies could raise prices across the board and companies could cut staff to maintain their margins. This would create a world in which the smaller number of people with jobs would be paying higher prices while the growing number of unemployed would suffer a further economic squeeze.


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