Inflation: How to raise prices and preserve margins (without losing consumers)

Companies can offset the pressure on their cost base by rethinking products, supply chains, and pricing strategies.

Companies everywhere are facing an unprecedented cost landscape, with labor shortages, supply chain bottlenecks, and soaring commodity and energy prices pushing up input costs and squeezing profit margins.

These inflationary headwinds present challenges for company executives, including whether to pass on higher costs to consumers, even though it could push them to seek out cheaper alternatives or stop buying altogether as recessionary fears rise. In navigating this dilemma, business leaders will need to consider the underlying consumer psychology in order to push through price hikes without sacrificing volume or market share.

At the same time, companies can preserve their profit margins and absorb higher costs by changing the product architecture and by rethinking their supply chain strategy. With US consumer confidence at the lowest level since February 2021, and inflation running at 8.5%, many companies will need to take immediate action to manage the pressure on their cost base.

‘Shrinkflation’: smaller products preserve margins

Pricing is not the only lever that executives can pull. Some firms are practicing ‘shrinkflation’ — reducing the size of their products in the face of soaring costs. This includes many consumer brands such as Unilever, which has dropped the size of its Dove body wash from 24 to 22 ounces in the US but maintained the same recommended retail price (RRP).

Beyond manufacturing, the services sector is also offering less for the same price to protect margins. Hoteliers Hilton and Marriott only make daily housekeeping services available to those who specifically request them, depending on the location. Making these services opt-in reflects labor and materials shortages, which are pushing up costs.

Invest in research and development to shore up supply

Another move companies can make is to invest in research and development (R&D) to reduce their reliance on scarce or costly raw materials and swap out expensive ingredients for cheaper ones. For example, some food and beverage companies, including Unilever, have substituted sunflower oil — which has soared in price because of Russia’s invasion of Ukraine, a top exporter — for more readily available alternatives such as rapeseed.

The question is whether shrinkflation reduces the quality of products and services to a noticeable degree, which would send consumers fleeing. There is a precedent. The mass produced chocolate brands such as Mars and Hershey have in the past lost market share to more premium varieties such as Lindt and Godiva, according to consumer research firm Mintel.

Use advertising to improve market share

The marketing function will play a crucial role in managing consumer expectations. Many companies that have embraced shrinkflation have styled it as a strategy to help tackle obesity or reduce their overall carbon footprint. The food delivery app Just Eat gives customers the option to order smaller portions at some of its partner restaurants to “curb waste”.

There is evidence that consumers are willing to fork out for sustainable products, which for many companies could present an opportunity to swap to more sustainable sourcing. A study from the consultancy Simon-Kucher found 33% of UK consumers would be willing to pay more for sustainable options. Globally, the average premium people would pay for greener alternatives is 25%.

Rethink supply chains to lower the cost base

On top of this, companies will need to reassess their supply chains in order to change prices at a higher frequency. Consumer brands, for instance, tend to agree on longer-term contracts with retailers, which can make it difficult to set rates for products, such as commodities, with volatile prices.

Unilever has faced this pressure with its olive oil brands, and it divested some of these assets over a number of years. Olive oil is one of the most volatile soft commodities, with prices driven by supply. This year, heatwaves have hit production in major exporting nations in western Europe, such as Spain and Italy, which has driven up global prices by 14.2% annually.

One strategy to improve pricing agility is using short-term, flexible contracts that can be adjusted quickly to changes in demand. But this can mean sacrificing resilience. Many companies who already pursued this strategy were caught flat-footed by the supply chain disruptions wrought by the pandemic and shipping bottlenecks that followed as economies reopened.

To shore up supply, it will be important for firms to work with their direct suppliers and the smaller companies they rely on to share information so that everyone can see what is going on in the supply chain. At the same time, companies can leverage technology to quickly identify snags in supply chains, giving them real-time data which they can use to more effectively negotiate with their suppliers on pricing.

How to let your customers know about a price increase

Sometimes, though, it will be necessary to hike prices. This can impact consumers in negative ways, however. While many of the consumer goods giants have passed on higher input costs to retailers, many retailers are fearful of pushing cash-strapped consumers to switch to cheaper alternatives, which could force them into applying discounts. Instead, they absorbed the higher costs or stopped stocking problematic items.

An alternative approach would be to review the portfolio and introduce new products with different prices. It is difficult for consumers to stomach paying more for the same items, but the psychology is different when it comes to new products, even if they’re similar. If you charge more for more, you establish a new point of reference and customers can be more easily persuaded to stay loyal.

Telecoms companies have this strategy down to an art form, frequently changing their price structure and packages on mobile phone contracts in order to maximize profitability.

Ultimately, it is the strength of the brand that will enable businesses to pass on their higher costs to customers. In the business-to-business (B2B) space, companies need to stress their value proposition and get that across to their customers through marketing.

Many technology companies, for instance, say their software can improve business productivity, helping companies who face higher wage bills in tight labor markets. If you can demonstrate value, you can justifiably raise your prices.

Inflation becoming entrenched in economy

These strategies will become even more important in the years ahead as inflation becomes more entrenched because of the impact of changes to global supply chains. The three-decade era of globalization pushed companies to offshore production to low-cost nations — notably China — which has kept the cost of consumer durables in the West low.

Now, globalization risks going into reverse because of the geopolitical fallout from Russia’s invasion of Ukraine along with disruption to global supply chains caused by COVID-19. Onshoring is now a major focus for companies, which is likely to drive up costs and turn global trade from a deflationary force into an inflationary one.

Pricing strategies are likely to remain a major focus for executives, with tough conditions ahead given the macroeconomic uncertainty. There are proactive steps they can take now to manage the inflationary challenges, whether by getting consumers to stomach price increases or offsetting input costs throughout the supply chain.