Inflation is Eyeing Medtech’s Margins

This column’s audience is managers of medtech supply chain companies, so I try to write about topics that will interest them. But my latest contribution—to borrow a word from the better-read New York Times columnist and Nobel laureate in Economics Paul Krugman—is wonky. Considering the impact of inflation on the supply chain is a discussion of macroeconomics, a topic sure to cure insomnia for many but critical for profitable operations in the coming months and years. The medtech industry will endure inflation better than other manufacturing sectors but profit margins will be stressed by materials and energy cost fluctuations. Higher labor and borrowing costs will prove to be near-permanent features of the next few years. The key to success for supply managers will be to guard margins rather than prices.

For the first time in 50 years the world faces high inflation across all aspects of the global economy. Both consumer and producer prices have seen 8% to 9% increases year-on-year. Many managers will point to even greater rises in materials, energy, and labor since the outbreak of COVID-19. Unlike the oil price shock of the 1970s, the causes of this round of price increases is more complex and nuanced.

Inflation is an imbalance in which demand outruns supply, causing prices to rise. The origin of this bout of high inflation is the pandemic. As economies contracted sharply during the 2020 lockdowns, governments worldwide began issuing relief checks to families and companies to bridge what was hoped would be a temporary absence of work and markets. Much of this money was not spent immediately but saved by recipients until the fast-spreading virus slowed enough for a return to semi-normal consumption. When that time did come, the providers of goods and services were ill-prepared for the sharp uptick in spending.

The manufacturing labor force was disrupted and dispersed. Many experienced employees took advantage of the stimulus and booming stock market to retire rather than return to work. Lockdowns and uneven order patterns (down, then up, then really up) disrupted the cross-Pacific supply chains leading to shortages and global manufacturing delays. Demand was higher than any time in history yet the supply of goods—never that easy to increase on short notice—was below pre-COVID-19 capacity. Hence, inflation.

Two other factors made the situation worse. Low interest rates, a necessity for maintaining the economy during the pandemic, were extended to aid the global recovery. Low rates led to greater consumption as the cost of money hovered near zero. The icing on the inflation cake was the invasion of Ukraine, which reduced Russian oil and gas shipments to Western markets and sharply boosted energy costs.

Does Inflation Matter to Medtech?

All manufacturers are affected by higher costs of labor, materials, and energy. In theory, inflation is most harmful in industries where prices cannot rise with costs. Medtech OEMs have been successful in increasing prices and have permitted their suppliers to increase prices as well. The inflation challenge for medtech is not out-and-out survival. Rather, the dynamic nature of changing prices imperils short-term profitability and long-term stability. In other words, costs are going to bounce around, which makes it hard to price products and projects. In keeping with the teachings of one of the first industrial economists—Alfred Marshall—the time element is the chief difficulty of almost every economic problem. Let’s look at each major cost factor to see how it will transform the management of medtech suppliers in the near (and far) future.

Materials: Slowly Falling Prices

Metal and resin price increases have slowed compared to the previous two years. At this point, the picture diverges. Metals have already seen a slight pullback other than on spot markets. Resins are slowly reacting to oil price changes, which have remained historically high. Momentarily we are in a “turbulent top” phase of the market as supply and demand readjust. Of these two factors, demand is the more important. As the last of the stimulus funds are spent and higher interest rates choke off consumption at the rates we’ve seen for the last two years, the prices of materials will be the warning bells of a slowdown. Watch for uneven declines in material prices over the next two years. Rather than holding excess inventory, medtech managers may wish to leverage smaller buys while keeping a close eye on the materials markets.

Energy: Rising but Poised to Fall

Energy price increases have been obvious to all, be it new electric rates up 30% higher or the $50 tank of gas. But the worst is yet to come. We are only seeing the first impacts of higher energy prices. The Ukraine war and OPEC plus supply management ensures prices will remain high for some time to come. Industry will make changes to decrease energy consumption. New sources of oil and gas will come online as the high price justifies their recovery but the process will take at least a year before any meaningful effect is felt. An alternative scenario is that overmatch of inflation and higher interest rates vs. paychecks will force the economy into a recession. Unpleasant as this may be, a reduction in consumption will force a repricing of energy. Medtech, though not immune to recessions, should be less affected than industries manufacturing discretionary products such as consumer electronics and luxury automobiles. A wise medtech manager may suffer with higher energy costs this winter while hunting for lower, long-term buying options next spring and summer.

Labor: Ratchet Effect and Minor Good News

Medtech suppliers have experienced labor cost increases across the spectrum. Skilled staff, always in short supply, have seen salary increases of 10% to 20% over the last 18 months, though semi- and unskilled workers are enjoying even higher increases on a percentage basis. Benefit costs are also expanding by double digits and have yet to fully show up on corporate budgets.

Modern labor costs are considered “ratcheted” by economists. This means that once they rise, unlike material or energy prices, they are resistant to decreases in times of less demand. Simply put: Most employees will quit if management asks for a pay cut. The last time industrial pay cuts were tried on a broad basis was during the Great Depression. Union membership shot up and rapid movement by workers to any jobs that offered parity with their old wage became a fact of life. Cutting wages is not a strategy to consider.

However, employers can look forward to the return of recent retirees. Rising costs and a throttle on the stock market from higher interest rates will cause skilled employees who left their positions to consider coming back to work.

Capital Expenditure, Interest Rates, and Process Improvement

Following the global lending crisis of 2000-2010, central banks dropped interest rates to low single digits. Capital-intensive industries like manufacturing took advantage of the low rates to replace and expand their capital equipment base. Inflation is a double driver of interest rates. First, it is a component of the quoted interest rate, meaning as inflation increases, interest rates go up by the identical amount. Secondly, to combat inflation central banks raise rates even further to slow demand and return the economy to a more desirable condition. With the cost of money higher, capital expenditures must be more carefully justified. Managers should expect to see less equipment purchased and older equipment being refurbished rather than replaced in marginal cases. A small benefit of higher rates is that manufacturers will expand their re-evaluation of processes as an alternative to replacing marginally effective new equipment. The medtech industry is likely to experience a richer portfolio of approaches to productivity as a pure technology approach becomes more expensive.

Interest rates are likely to remain one to three points higher compared with the last decade and this increase will be in place for at least the next three years, barring a severe recession threat.

Summary

The great challenge of inflation to medtech managers will be defending margins as the volatile components of their costs—materials and energy—reprice in the coming months. Labor increases are unavoidable as are borrowing costs but new approaches to working with retired workers and a focus on processes may ameliorate some of the pain. 

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Tony Freeman is the President of A.S. Freeman Advisors, a merger and acquisitions and strategy advisory firm serving the precision manufacturing and specialty materials industries. He can be reached at [email protected].