What retailers need to know about inflation: Part 2

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Source: The Conversation.

This is the second instalment of a two-part series from James Taylor and the Particular Audience team discussing what retailers need to know about inflation. You can read the first instalment here

Still reeling and/or thriving from direct and indirect effects of COVID-19, certain retailers are facing significant margin squeezes from increased costs. 

The question now for retailers is: how much can they lift prices without losing sales? Passing costs on to consumers is always a difficult call even when your competitors are also facing margin squeezes. Some retailers can afford to lift prices more than others, but it depends on what you’re selling and how price sensitive your customers are. 

In this article we evaluate what inflation means for various retail categories and how to prepare for a future online.

What this means for retail in inflation

The past couple of years has brought about new challenges, with rising inflation being the next. Over the next few paragraphs we explore how we expect different categories to fare in an era of high inflation — then propose tech and data solutions that can prepare retailers for the future.

Pharmaceutical

As pharmaceuticals are necessity goods, consumers will buy them regardless of higher prices. Post pandemic, the demand for pharmaceutical drugs has been higher, so we anticipate that the total demand and total spending of consumers in this vertical will remain unchanged. 

Fast moving consumer goods (FMCG)

Fast-moving consumer goods will continue to be sold despite rising inflation and have great price elasticity. Commodities prices will continue to rise as some resources become more scarce (cooking oil, tea, cocoa etc) both in production and supply chains. With the outbreak of the pandemic, consumers were quick to hoard FMCG, this anticipation of supply shortages ironically was the cause of some supply shortages. We are still experiencing shocks to the supply chain and we anticipate FMCG will continue to generate higher revenue as prices increase. 

Alcohol

Alcohol is often described as a ‘recession proof’ product, and this holds true amid rising prices during inflationary periods. With demand being inelastic, suppliers and retailers benefit from passing on the higher percentage of costs to buyers.  

Books

Books are unlikely to be affected, since how much a book ‘should’ cost isn’t obvious. In an ideally competitive industry, it would be costs plus normal profit margins. The rapid growth of e-book sales complicates the analysis further. However, costs have certainly been coming down on the production front thanks to technology, although they may well have gone up on the marketing front.

Electronics

In 2022 electronics retailers will contend with rising material and labour costs as manufacturers hike prices to minimise the damage done to their bottom lines by various disruptions to the global supply chain, commodity prices etc. Retailers will have to raise prices to sufficiently cover these costs, or risk having margins squeezed.  

Increasingly, electronics are marketed and treated as necessities rather than luxuries (as they were in the 20th century). With consumers becoming more dependent on these products we begin to see price inelastic demand, and even if items such as laptops and phones begin to take up a bigger proportion of disposable income, higher prices from the retailers will not deter consumers from upgrading and purchasing new electronics, especially if there is a clear need to buy (for example, if your laptop breaks down you’ll replace it as quickly as you can because your work and personal life depend on it).

There are however luxury, non-necessity items. So where phones and laptops will likely be fine, sound technology for example may struggle somewhat. 

White goods

When white goods purchases make up a higher portion of income, consumers aim to make more savvy choices and hold back spending until a good deal or a discount appears. Whilst there is currently a general trend of increased prices (resulting in higher revenue per transaction for retailers) consumers don’t tend to hoard white goods and electronics from anxiety around supply shortages. Overall, delay of consumption reduces the growth of revenue and profits for white goods retailers. 

That said, many items are necessities so there is some support here.

Price checking is already rife in this category, and we imagine it will only increase. Short of a race to the bottom, intelligent incentive programs will be pivotal to win in this retail category.

Automotive

Both new and used cars are becoming more expensive. The rising price of new cars has been partly attributed to a shortage of semiconductors used in the manufacturing process, as well as a backlog from the closure of factories during the pandemic. The cost of used cars is currently higher than at any other time this century. Cox Automotive reports that as of December 2021, the average retail price for a used vehicle in the United States is now a new record of more than US$28,000 ($37,000). Given that many people are still working from home, or reducing travel, it’s likely that used car prices will continue to rise as consumers opt for used cars instead of new ones. 

It’s even more pronounced in countries that don’t make their own cars any more, like Australia.

Rising oil prices can have a big impact on the buying behaviour of consumers when it comes to cars. The historical oil crisis of the 70s (which resulted in massive inflation and unprecedented gas prices) made small fuel efficient cars popular, and chief among these were the Volkswagen Beetle and the AMC Pacer. The market competition between these two cars gave consumers more options and helped to keep prices lower. 

Unfortunately, in 2022 the auto industry is still battling supply chain complications, meaning dealerships are still experiencing shortages and consumers have less choice. However, with oil prices rising once again, there has been an uptick in demand for electric vehicles such as the Tesla Model 3, with EV car sales increasing by 76.3% in 2021 in the UK alone. Australia recorded 20,665 EV sales in 2021, a significant increase from the 6,900 sold in 2020, which means electric cars now make up 1.95% of the new car market. In the US, EV sales were 735,000 in 2021, up from 375,000 in 2020 reaching 4.4 % share (up from 2.3 % in 2020). 

Luxury goods

Brand loyalty plays a huge role in customer retention, as long as brands deliver products that meet expectations of quality, exclusivity and remain true to the legacy and heritage of a luxury brand, customers will continue to buy irrespective of price rises. The rich stay rich (or at least aspirational) after all!

The pricing power of luxury brands is clear in the rises we’ve already seen during the pandemic. For example, LVMH increased prices on the Louis Vuitton brand roughly 5% across the board in 2020 without negatively impacting sales volume. 

Although there will be a fall in demand from low to middle income consumers, higher income consumers are unlikely to change their spending behaviour in the luxury vertical. Due to the strong emotional attachment luxury brands enjoy, we anticipate a general growth in revenue in this vertical. 

Beauty 

The rising cost of raw materials used in beauty products (chief among these being palm oil which has soared 82% in two years due to Indonesian labour shortages), as well as transport, labour and energy costs have resulted in a “once-in-two-decade” backdrop for price hikes according to Unilever’s CEO Alan Jope. 

Nevertheless, as lockdowns and social distancing restrictions continue to lift, consumers will be spending more time outside the house and we anticipate that demand for beauty products will rise irrespective of price hikes. 

This could already be seen in 2021 as restrictions eased in certain countries, with the UK seeing a 2.6% increase in beauty product sales by the end of the year. Skincare brands saw the highest growth, which indicates the demand for ‘self care’ items established during the pandemic is still surging. 

To balance the costs of rising prices for consumers, some retailers will opt for periodic flash discounts, savings on shipping, and opportunities to earn loyalty points and commissions when they shop more often and/or refer new customers. Retailers will attempt to limit price rises for drugstore cosmetics as they aim to shift large quantities of inventory quickly. 

Luxury items might perform well despite price increases due to the strong consumer loyalty to these brands, however current data from Particular Audience clients suggests that items considered luxury in beauty and pharma are actually suffering vs lower cost substitutes, suggesting a converse luxury effect in this vertical.

Furniture and homewares

Heavy goods, often made overseas, have been most impacted by supply chain bottlenecks, labor shortages and now the ramping cost of raw materials. The average wait time for a new sofa can be months not weeks.

Consumer demand will vary depending on their circumstance, the luxury segment is again likely protected. The more accessible tiers are already adjusting prices upward, notably IKEA raised prices 9% on supply chain woes alone, that was prior to the outbreak of war and energy price shocks.

Efficient inventory allocation is going to be key in maximising margins during this time, at Particular Audience we have a ‘Data Science as a Service’ team that specialises in exactly this. Nike is an example of a brand/retailer that has already brought this in house with its acquisition of predictive analytics and demand sensing business Celect in 2019 — great timing for the company.

Fashion

The business model of the apparel industry relies heavily on moving volume. Fashion retailers aim to sell as much as possible as swiftly as possible, shifting their inventory quickly to avoid mounting storage costs.

Although the price of clothing and footwear in the US has risen recently, with prices up 5% over the course of 2021, US fashion prices are ultimately down 7.9% from 30 years ago thanks largely to the rise of fast fashion. Items like jeans and t-shirts actually cost less on average than they did in the 80s, and fashion has seen a steady deflation since that time with companies cutting costs and avoiding raising prices by moving manufacturing overseas. 

Bargain prices have resulted in Americans buying five times more clothing than they did in 1980, and the enormous demand for clothing has only increased with digital transformation and the rise of e-commerce, as well as influencer marketing and impulse discovery, which has helped many retailers weather the pandemic storm and closure of brick-and-mortar stores. 

This decrease in price to the consumer has meant that retailers need to hit higher volume to make the same money. Those that have succeeded are giant businesses today, just look at Zara owner Inditex for proof.

With ongoing supply chain issues such as factory shutdowns, surging raw material prices (such as that of cotton) and shipping goods by air freight (a process more expensive than ocean shipping) cost pressure is increasing. The question is whether costs can be passed onto consumers used to low consideration impulse purchases. We think not, since this is a market predicated on low costs.

We anticipate that retailers will attempt to limit price hikes to retain sales but disappearing margins mean they need to take action fast.

Shein is the leader in the pack with their massive offering, made on demand low waste(!?) business model. For other retailers, this level of demand led production is difficult to replicate. In the following sections we outline some more achievable strategies for fashion retailers to protect themselves, which include selecting performance and/or usage priced tech vendors, margin accretive CRO strategies that look beyond topline uplift, and new ways to monetise traffic outside of physical item sales (such as Retail Media to capitalise on clicks, and digital merchandise strategies).

The inflationary environment we’re moving into may also present a market opportunity for retailers of sustainable, high quality and ethically manufactured apparel as the movement for ‘slow’ fashion gains popularity among certain consumers. If consumers have less disposable income, they could make more considered choices, meaning quality and ethical considerations may inform their buying behaviour, prompting them to invest in fewer, better quality items. 

Competition matters

For retailers in general, the obvious risk is that rising prices will eat into profits or even lead to losses. If you own a corner store, for example, and the cost of a loaf of bread goes up by 10%, that increase is going to be passed on to customers in one way or another. You may lose sales if people perceive they can get a better deal elsewhere, or if they simply can’t afford your product any more.

But as long as you can pass on the cost increases to customers, then profits should be protected — right? Not necessarily. Most retailers are working with relatively thin margins (after marketing) — often less than 10%. A 10% increase in costs might not be so easy to pass on to customers.

The more competitive a retailer’s vertical, and the less necessary the product being sold, the worse a retailer will fare during inflationary periods. This would be even more pronounced in a stagflation scenario, which would prompt a follow up article to this one.

If a retailer’s inventory is a total necessity, is not a high consideration purchase, and that retailer is part of a duopoly or monopoly then it will do relatively well as it is most able to raise its own prices. Retailers are going to see their cost bases go up — even Visa and Mastercard are increasing their take.

Consumers get stung by inflation and they become worse off, which poses a demand risk to retail.

The good news is that retail is relatively inefficient as a whole, thus has a lot to gain from honing in on that inefficiency, mining untapped value in data and optimising operations to counter the forces of inflation and potential drops in consumer demand.

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