CFOs Battle Margin Pressures and Production Delays

Robert Hartwig, University of South Carolina

Profits are slimmer for businesses beset by a combination of stalled supply chains and higher commodity prices. Delays in production schedules caused by idled container ships off ports in California, combined with rising commodities prices, are dampening earnings in the retail, construction, and manufacturing industries, among others.

“It’s idiosyncratic by industry, but it’s fair to say that companies dependent on commodities are experiencing a sharp runup in prices and acute margin pressures,” says Robert Hartwig, a professor of finance at the University of South Carolina’s Darla Moore School of Business.

Material shortages and other supply chain deficiencies are a factor, too. As a result, some companies can’t get commodities or finished products in time to satisfy demand, leaving them short of cash flow and revenue forecasts. Witness The Gap, which will lose up to $300 million in fourth-quarter sales due to Vietnam factory closures and port backlogs.

How acute the bottom-line financial pressures are depends on whether the organization can pass on higher input and shipping costs to customers, says Hartwig. Economic data showing higher energy, food, technology, and automotive prices suggests some companies are doing it successfully.

But raising prices is not a long-term solution, especially as wage costs increase.

The August AICPA’s economic survey found that many finance executives expected higher than average salary and benefit costs as the calendar flips to 2022. To improve recruitment and retention in sectors where labor is scarce, 64% of the surveyed executives said their companies were offering better pay.

“The costs to attract and retain labor are growing across most industries, from low-paying sectors like fast food to companies in higher-paying sectors increasing compensation to recruit specific skill-sets,” says Hartwig.

Conserving Cash

What approaches are companies taking? Margin squeezes and parts delays are slowing things down at Polaris, a publicly-traded manufacturer of motorcycles, snowmobiles, boats, and all-terrain vehicles. Despite booming demand for outdoor recreational products during the long and enervating stay-at-home months of the pandemic, supplies are tight. “We expected the constrictions would ease in the second half, which didn’t happen then or in the third quarter either,” says Polaris CFO Bob Mack.

New side-by-sides vehicle models from Polaris.

To keep its U.S. and international factories moving, the company is absorbing an extra $300 million in incremental costs this year, five times normal expenses. The money is going toward expedited shipments, logistics, and higher-priced commodities, says Mack. “Some supplies like steel are three times where they were a year ago… Our retail sales are driven by what we can get into the market at a time of extraordinary demand. We could be having an unbelievable year. It’s very frustrating.”

Companies like Polaris are stockpiling components and parts to offset the continued shipping delays. “We thought the second half would mark the end of shipment delays, but they’re getting worse and may persist through 2022,” says Mack.  A recent report by S&P Global Market Intelligence found that inventories in the S&P 500 are 53% higher than 10-year quarterly averages pre-COVID-19.

Holding more inventory, of course, consumes working capital. “We need to run more efficient production schedules to get vehicles to customers as quickly as possible, but the added inventory chews up cash,” Mack explains.

“We need to run more efficient production schedules to get vehicles to customers as quickly as possible, but the added inventory chews up cash.”
— Bob Mack, CFO, Polaris

Every two weeks, Mack meets with Polaris’ treasurer, corporate controller, and business unit CFOs to talk through the company’s cash position. “We’re looking at the timing of large capital expenditures, for instance, as well as managing cash levels at our foreign subsidiaries to help balance the U.S. borrowings,” he explains.

Polaris raised the price of vehicles and added freight surcharges to compensate for steep price increases in freight shipment and components. It set a mid-single-digit price increase across the board recently, “some of which may be permanent,” says Mack. “We’re looking at our costs [against] what economists are predicting.”

If forecasts suggest higher costs will continue, Mack says that Polaris will take an “aggressive posture” on vehicle prices. Until six months ago, it reviewed prices yearly. Now, out of necessity, Polaris has instituted quarterly price reviews.

Meanwhile, to prioritize delivery of highest-demand vehicle parts, Mack has dispatched supply chain and logistics teams to collaborate with suppliers across the United States and in places like China and Vietnam. A similar partnership approach with U.S. freight forwarders will help ensure trucks are ready at ports to collect and deliver needed components rapidly. “We’re even partnering with some suppliers’ [human resources] organizations to help them recruit labor if and when they have shortages,” Mack says.

Hedging Bets

At Houston-based Trussway Manufacturing, a leading maker of roof trusses and wood floors for multifamily home developers and construction firms, lumber costs “nearly doubled to the highest we’ve ever seen, and steel pricing and availability continues to impact the construction industry,” says John Tunison, Trussway’s CFO. “That’s been tough on our margins.”

Higher input costs present the greatest challenge, particularly the long-duration fixed-price contracting executed by Trussway’s customers — multifamily home developers, general contractors, and framers. “Bank financing is arranged upfront and requires fixed prices for all contractors and suppliers since it takes a long time to build a multifamily development,” Tunison explains.

Trussway employees assemble a roof truss.

Having locked in pricing over a certain period, Trussway cannot change it because the price of lumber, for example, has skyrocketed. To moderate the margin impact, Tunison has implemented hedging strategies involving the execution of forward contracts. He’s also using risk-based pricing models that reflect the uncertain costs of commodities. “We try to figure out our customers’ pain points by way of helping to solve them in ways that address our profitable revenue objectives,” he said.

For example, if a concrete contractor is unavailable, it delays the completion of a multifamily project, “taking a whack at the fixed-price contract with the developer,” Mack explains. “Knowing this, we try to be flexible in our scheduling and pricing to help out the developer.”

Tunison is also trying to conserve Trussway’s own labor expenses, particularly in regions with heated labor competition. “It’s getting harder to compete against companies like Amazon, which is on a hiring spree to populate new distribution centers,” he says. Those centers are often in areas like Fort Worth, Texas, and Fredericksburg, Virginia, where Truss manufacturing sites are located. Then, there is the consistently upward pressure on the costs of insurance and medical and dental benefits for the company’s 1,500 employees. “There’s not much we can do about that,” Mack admits.

Analytics and Efficiencies

To address significant supply chain disruption and cost inflation across Ulta Beauty, finance has several cost-containment strategies in play at the cosmetics and fragrance chain of nearly 1,300 stores.

On the company’s October 19 investor day, it detailed its plans for process enhancements and technology improvements designed to slice off $150 million to $200 million of costs by 2024. It helps that Ulta’s growing e-commerce unit is more profitable with new capabilities like buy online, pick-up in-store, ship from store, and pack and ship efficiencies in distribution centers, said CFO Scott Settersten on the investor day call.

Scott Settersten, CFO, Ulta Beauty

The retailer hopes to also find cost efficiencies in its store footprints. Settersten noted that Ulta has about 500 stores with leases up for renewal over the next three years. “Strong financial performance and high brand awareness make Ulta Beauty a tenant of choice, and we will continue to work with our landlord partners to optimize our store footprint and improve financial outcomes,” he said. In addition, Ulta is “resetting” its corporate overhead and “pausing [its] international aspiration in the near term,” Settersten said.

Because Ulta is a retailer, “we don’t directly control the manufacturer’s cost or pricing, but we can flex our promotional cadence to mitigate some of the rising cost pressures we’re seeing,” Settersten told CFO in mid-November.

Revenue-building promotions are underway in Ulta’s loyalty program, Ultamate Rewards. The program allows the retailer to gather data on its loyalty members’ shopping habits to align promotional offers with their interests and needs. Data analytics allows Ulta to provide early access to new products, special coupons, and loyalty points, Settersten says. Since more than 95% of Ulta’s business is with loyalty program members, the promotions are a compelling investment in increasing sales volume.

Across the company’s supply chain network, the improved analytics offer more accurate forecasts and enhanced insights into inventory in-stock levels and distribution center process efficiencies. For example, says Settersten, Ulta is learning which are its highest-selling goods so it can alert distribution centers to put those goods closer to the people putting together the palettes.

As to the upcoming holiday period, the retailer is confident it has the distribution center and store staffs to handle the surge. But wage pressures across industries have not escaped Settersten’s notice. Ulta has built wage inflation into its 2021 forecast and long-term outlook, at the least to the extent that finance can measure it or anticipate it, he says.

Rising labor costs, as well as recruitment and hiring expenses, won’t abate soon for Ulta Beauty or any other company, says the University of South Carolina’s Hartwig. He says that companies will have to find ways to economize on labor costs through investments in automation and productivity enhancements.

The veteran economist projects a disentanglement of the supply chain next year, helping to ease some of the current margin strains. As for overall inflation in the U.S., Hartwig predicts it will gradually return to more traditional norms, “falling to around 4% by the end of 2022 and decreasing to around 2% in 2023,” he says, assuming declines in the prices of energy futures.

Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.

Cover photo by Mario Tama/Getty Images; Ulta Beauty photo by Frazer Harrison/Getty Images; Polaris, Trussway photos courtesy of the companies.
Darla School of Business, inventory, labor costs, operating margin, Polaris, Trussway, Ulta Beauty