Surviving in the modern competitive landscape is difficult enough, and turning a healthy profit is an even greater achievement. But perhaps the most aggravating of factors is economic turmoil.
Some businesses have demonstrated that they can navigate multi-faceted economic change, whereas other groups have faced bankruptcy because of a single macroeconomic shift. What distinguishes the former from the latter, and how can businesses broadly protect themselves against different economic changes?
In this article, we’ll explain how the leadership of large and small organisations can position themselves to be able to deal with common economic headwinds. We’ll explain what factors make a company more agile, dynamic and able to avoid an economic crisis triggering an internal financial crisis.
Types of economic change
In this article we’ll summarise the textbook game plan for dealing with each of the following economic events in turn:
- Economic recession
- Increases in the cost of input materials
- National wage increases
- Changes to the strength of the domestic currency
1. Economic recession
The Bank of England considers the country to be in a recession when it has two consecutive quarters (i.e. six months) of negative growth.
A recession is indicative of reduced consumer confidence, which leads to lower consumer spending, which leads to shrinking corporate profits, which can lead to large-scale redundancies which feedback into the vicious cycle.
Naturally, the industry and sector a company is situated in will have a tremendous influence over whether a recession would hit hard or barely touch a business. A water company will hardly notice a recession because all consumers will prioritise the payment of utility bills as these are core essentials. A supercar showroom, on the other hand, may find that all of their business dries up for an extended period.
A universal precaution that businesses can take to protect themselves from the worst of a recession is to constrain their overhead base to incremental increases over time. Companies that invest in huge upgrades, or rapid growth of outlets/offices are those most prone to having huge obligations relative to the size of their turnover. If the optimistic growth projections aren’t met, the creditors may have to apply to the courts to bring in an administrator after seeking advice from reputable law firms, such as Bates Wells & Braithwaite.
2. Increases in the cost of input materials
Manufacturing businesses rely on a simple equation = Sales price less the cost to produce each item, less an allocation of central overhead costs = profit per unit sold.
When you unpack this formula, it will be clear that change to any of these three inputs (sales price, direct cost, overheads) will impact the profitability of a business.
However, the element most out of a companies control will be input costs. Surging commodity prices can lead to the cost of some raw materials or input components rising by double-digit percentage points in a single year. For example, Bloomberg reported in September 2021 that the price of Silicon, a relatively abundant commodity used to produce computer processors, had skyrocketed by 300%. This might sound like a mind-boggling increase, but even the simplest economics books hold the answer in the shape of a supply/demand curve.
Companies can protect themselves from short term price shocks by using derivative contracts to fix the price of future supplies months or even years into the future. These are known as ‘forwards’ as they represent a forward purchase order for physical delivery. Alternatively, a company can use futures derivatives that don’t result in a physical settlement but provide a gain or loss. This can be designed to compensate a producer for increases or reductions in the price of an input commodity.
Derivatives are complex financial instruments and are usually only traded by sophisticated treasury teams within large corporate groups.
3. National wage increases
For many organisations, particularly service organisations, labour is the key ‘input’ to deliver the product or service. Therefore when wages are rising at pace, this can threaten the bottom-line viability of a product.
Businesses compete across international borders, and therefore companies may be particularly frustrated when increases in their labour costs are not being enjoyed equally by competitors based in other countries.
Businesses can protect themselves against nation-specific surges in labour costs by diversifying their manufacturing bases across the world. In this way, the overall group can absorb regional issues.
Service providers who serve customers in a local area (e.g. a restaurant) don’t have the same options on the table. Instead, these businesses could turn to the only real alternative to labour: machines.
As wages have risen in wealthy and developing countries, it is natural that businesses look for ways to supplement a labour force with equipment, machines or even fully automated robots to maximise the level of production for each pound or dollar spent on wages.
4. Changes to the strength of the domestic currency
Import and export businesses (such as car manufacturers) are extremely sensitive to changes in the strength of their domestic currency relative to their import or export markets.
For example, when the value of Pound Sterling rises against the Euro, this spells bad news for British car sales. This means that European customers must exchange more of their Euros in order to meet the same sales price in Pound Sterling. Sales prices, when stated in Euros, will appear to rise, despite the UK manufacturer seeing no windfall as a result of the apparently higher transaction value.
Companies can mitigate foreign currency fluctuations by using derivatives to hedge against movements in the currency. If a British company can reliably forecast their future sales in Euros, they can agree on a GBP: EUR exchange rate today which will apply in each future month. This provides the company with security over the GBP value of those sales, even if the exchange rate was volatile.
5. How to increase corporate resilience in preparation
The common theme in each of the scenarios above may have begun to appear. Resilience isn’t about entrenchment. Ultimately, economic resilience demands flexibility and creativity.
As a boat riding giant waves, you want to be able to soar over the crest and sail down to the trough while remaining on the surface. You don’t want to stubbornly and bravely submarine into the wave.
It’s about arming your executive team with the ability to spot a warning signal and take action to turn the dials to mitigate early and effectively, to avoid more serious actions needing to be taken on the brink. It’s about bringing aboard the right expert, be they legal, financial or strategy, to ensure that you’ve considered all the key economic scenarios.