On Management

Dec. 21, 2004
Surviving a deflationary era requires quick reaction to shrinking demand, declining prices .

For most of my business life -- and probably for yours -- the one constant has been inflation. Things cost more tomorrow than today, more next year than last year. However, if we examine the longer view, the current period of prolonged inflation is not normal. Over an extended time frame -- say, a century or more -- much lower inflation, no inflation, or even deflation has been the norm. For many companies, during periods of mild inflation or no inflation it is difficult to secure price increases. In fact, price decreases are more likely. As we enter the new millennium, manufacturers will have to find ways to arrest the decline of prices or to reduce costs if they hope to maintain profit levels. When it costs more to purchase the same value in goods or services, that is inflation. The opposite of inflation is disinflation, which occurs when the opposite happens -- less money buys more value. Beyond disinflation lies the spectre of deflation. Whereas disinflation is characterized by moderately declining prices, deflation implies dramatic price erosion caused by major shifts in the balance of supply and demand. Deflation is a broader and more dangerous phenomenon -- and it seems a more distinct prospect than at any time since the Great Depression. One potential cause of deflation is massive global overcapacity, which drives prices down regardless of monetary policy. Another cause can be a major slump in demand that feeds on itself. When inflation is expected, there is motivation to buy things before prices go higher. But in a deflationary environment, the assumption that prices will be lower in the future causes postponed buying and fuels the collapse in demand. If a deflationary spiral starts, it can trigger recessions -- or, worse, the collapse of entire economies. As demand falls, prices decline as producers chase sales, and the decision to postpone buying is reinforced. Consumers wait longer and buy cheaper, keeping the spiral going. Even monetary policy (increasing the money supply or lowering interest rates) can't break this kind of spiral easily. Most businesspeople have no real influence over such things as monetary policy, but there are things that we can do to lessen the impact of these economic forces. We can do a better job of managing the part of the business that we control. And we can react to changes faster and more intelligently. Several of my clients have expressed concern about continually declining prices and what they ought to be doing about it. One solution is to devise an early-warning system that is responsive to changes in the price of commodities. I call it CIA -- for "cost impact analysis." This CIA allows a company to track commodity prices and exchange rates that are major cost drivers and quantify how the changes will hit its bottom line if left unmanaged. Once the effect of the changes in commodity costs is quantified, strategies can be developed to deal with those changes -- before the impact is felt. The second tool is decades old -- value analysis and cost improvement (VACI). This is a 1950s process that originated at General Electric Co., but has been updated to fit current business conditions. VACI breaks costs down and assigns them to the functional or prestige value provided. This is a complementary approach to CIA, since cost breakdowns are necessary for both analyses. Most businesses benefit in two ways from a CIA-VACI process. First, large cost-saving or cost-avoidance opportunities are usually identified. Second, training in CIA-VACI forever changes the way people think about cost and value, which is a long-lasting benefit. Only if we manage differently, using new tools to gain insights and then acting quickly, can we stem the tide of deflation and its potentially damaging impact. John Mariotti, a former manufacturing CEO, is president of The Enterprise Group (www.shape-shifters.com). He lives in Knoxville. His e-mail address is [email protected].

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