Deflation – The double-edged sword

Written on September 17, 2010 – 1:39 am | by Ashley Johnson

The HSBC Market Purchasing Manager’s Index (PMI) that surveys 500 companies fell from 57.6 in July to 57.25 in August. Growth in manufacturing has shown signs of slowdown when compared to previous months. The index of new factory orders declined and exports too slipped from 57.4 to 55.5.

A quick look at India’s IIP numbers shows improvement over 2009, but the trend for 2010 shows slowdown around the month of June across almost all major classifications. India’s exports grew by 22.5% in August 2010 while this rate stood at 13.2% in July 2010. IMF’s forecast of slower recovery rate of world economy is only adding to everyone’s anxiety. Is the economic recovery slowing down, causing deflation and dragging us all into double-dip.

A slowdown in the economy, a fall in demand for goods and services can lead to the problem of deflation i.e. fall in prices of goods manufactured, leading to fall in investments, creating idle capacity and further lowering aggregate demand.

Which side the global economy will sit, nobody can predict with precision. The immediate threat is deflation. Deflation can act like a double-edged sword for businesses. On one hand it creates opportunities where prices of expensive technology and other inputs falls, making it the best time for SMEs to invest in such inputs. On the other hand, it increases the vulnerability of company’s earnings as they may not end up getting the same price for their product.

So what can be done to minimize the impact of a possible deflationary situation?

Understand and Plan – Take a good look at the situation where one of the sectors may not be directly hit by inflation/deflation. For instance, technology may be suffering price fall while cement sector may be facing inflation. Plan your course of action to take advantage of the opportunity and manage the threat.
Manage Inventory – Try to reduce inventories and operate as close as possible to the Just-in-Tine (JIT) model. This helps exploit the opportunity created by falling input prices and check fall in top-line.
Invest in Technology – deflation can be the best time to buy technology that helps increase productivity, very effective way of fighting similar threats and reducing variable costs.
Revisit Contracts - If you enter into long term contracts, try to factor in the impact of deflation. A long-term contract during the times of falling prices, may lock you up into high prices times.
Cost reductions – Reduce frills i.e. get rid of ‘Good to have’ things around in the business. Review the operating costs closely, as deflation affects operating margin and profits by impacting wages.
Minimize Exposure to Commodities – They are highly sensitive to price movements, with bleak possibility of fixing prices for clients, they reduce margins instantly. Either get out of commodities based business or diversify into high value products that offer higher margin and are not instantly affected by price fall

Perfect Business!