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Inflation’s Demise: The Impact on Business Informa

Written By: Nelson M. Nones CPIM
Published On: June 29 2000

Nelson M. Nones CPIM is the Director of Global Marketing for CIM Vision International, Inc. (www.cimvision.com)

Overview

Inflation occurs when an abundance of money exists in relation to goods. This creates artificial demand as consumers accelerate their purchases to avoid future price increases. Suppliers, competing to meet this demand, confront temporary capacity shortages that they alleviate by shifting resources to higher-margin goods and raising the prices of lower-margin goods. In addition, they accelerate purchases of material to avert shortages and avoid future price increases. These actions create additional demand for goods, perpetuating the inflationary cycle.

Today's ERP systems originated from Material Requirements Planning (MRP) and Manufacturing Resources Planning (MRP-II) techniques developed in the 1970s and early 1980s. They focus on improving the accuracy, speed and visibility of short- to medium-term resource planning and allocation decisions, thereby improving management's ability to confidently make profitable commercial decisions. They also focus on minimizing operating costs, and maximizing short- to medium-term revenues, through improved coordination and execution of daily sales, engineering, procurement, production, logistics, maintenance and accounting activities. In short, they are designed to maximize profits by timing business events so exactly that productive resources are committed as late as possible, but never too late to miss profitable sales opportunities.

These are very important business problems during inflationary times, because one or two avoidable, critical resource shortages could mean a missed sale and reduced ability to recover fixed costs. For example, accidental over-commitment of a bottleneck work-center or shipping vessel may delay the arrival of finished goods and cause upstream work-centers to shut down until the backlog is cleared. The cost of underutilized upstream capacity is still incurred, even if production or shipping delays cause lost or delayed revenues.

Prices stabilize or fall when an abundance of goods exists in relation to money. This artificially reduces demand as consumers postpone their purchases in anticipation of even lower prices. Suppliers, challenged to recover their fixed costs, now have excess capacity. They respond by cutting the prices of goods, especially their high-margin products, in order to stimulate sales. In addition, they decelerate their own purchases of material to use-up existing stocks, and await future price decreases. These actions further postpone the demand for goods, setting the stage for a deflationary cycle.

At this writing, Asia and other developing regions are slowly recovering from an acute recession and strong deflationary pressure, while other regions (notably, the United States) continue to enjoy robust growth and modest inflation. This disequilibrium has created a combination of inflationary as well as deflationary pressures throughout the world. For instance, demand for goods remains strong in the United States because buyers there still have inflationary expectations. Asian suppliers have cut prices in order to boost export sales and utilize excess capacity.

If, as many believe, the world is in transition from inflation to price stability or perhaps deflation, how will business priorities be affected before, during, and after the transition? How will changes in business priorities affect ERP system requirements?

Trading

Just-in-time (JIT) principles became standard business practice during inflationary times. In essence, repetitive purchasing and JIT delivery are tactics for hedging against price increases while minimizing inventory-carrying costs. Buyers negotiate fixed-price repetitive-supply contracts that are fulfilled and paid for over the life of the contract through periodic shipments timed to meet the actual need for goods.

Price stability makes such hedging unnecessary, and deflation makes it highly unprofitable. But buyers will be under even greater pressure to keep inventories low, since the value of inventories remains the same or depreciates in relation to cash. As a result, buyers will insist upon immediate delivery of small quantities whenever they can, at spot prices, although some suppliers will succeed in selling large quantities for immediate delivery by offering "temporary" price reductions, especially during the transitional period. For all these reasons, discrete (order-based) procurement and fulfillment systems can be expected to regain popularity lost to repetitive (schedule-based) systems during inflationary times.

At the same time, buyers and sellers can be expected to monitor competitive spot prices more vigilantly than before. The growing popularity of reverse auctions, data warehousing and data mining testify to the increasing demand for such market intelligence. Demand will increase rapidly for powerful search engines and business-to-business electronic commerce technology to solicit and extract the right information at top speed.

The importance of forecasting systems for short- to medium-term planning is likely to diminish. During inflationary times, suppliers used forecasts, customer orders and future repetitive schedule commitments to anticipate capacity as well as material shortages. Forecast accuracy is critical to the proper timing of business events when capacity shortages exist, but becomes irrelevant when unused capacity is abundant.

Inflation made it profitable for suppliers to be selective about what they sold, and to whom. When persistent capacity shortages exist, profits are maximized by discontinuing low-margin products and rewarding high-margin customers. Performance measures such as Economic Value-Add (EVA), employed in sophisticated sales, product profitability and customer profitability reporting systems, evolved to address this requirement. Suppliers are likely to abandon these tactics when confronted with excess capacity, the sooner the better, and "hunt" instead for as many new customers as they can.

Demand will grow for data warehousing, search engines, opportunity management (OMS), customer relationship management (CRM) and collaborative electronic commerce systems to help the sales force identify and qualify new customers fast. Improved sales incentive, sales engineering and product configuration tools will also be needed to find and close new customer business faster than the competition.

During inflationary periods, non-interest-bearing money owed by trade debtors should be collected as soon as possible in order to maximize its purchasing power, and non-interest-bearing money owed to trade creditors should be paid out as late as possible. In between, this money can be invested in short-term financial instruments or commodities bearing relatively high rates of return, since inflation goes hand-in-hand with higher interest rates and commodity values. Over time, many sophisticated remittance processing, money-management and hedging tools have evolved to meet this requirement.

In periods of steady or declining prices, there is no particular incentive to collect any more money from solvent trade debtors than is needed to meet current obligations. The relative benefits of sophisticated remittance processing, money-management and hedging tools are further diminished on account of the lower interest rates typically associated with price stability. But demand for improved credit management tools and up-to-date creditworthiness data is likely to increase, because of the risk that more customers will be in financial difficulties. Strong demand for sophisticated financial hedging tools can also be expected during the transition, because of arbitrage and currency instability caused by inter-regional disequilibria.

Logistics

Demand for logistics systems grew rapidly during inflationary times, in support of JIT business practices. These systems cut shipping costs and minimize in-transit inventory investment by coordinating available shipping capacity with production schedules and procurement requirements, improving management's visibility of current shipping schedules and freight rates, and automatically raising and tracking the necessary paperwork. The value of all these benefits is likely to increase during periods of steady or falling prices.

Persistent excess capacity rewards suppliers who can deliver goods faster than the competition, on short notice. Earlier, it was demonstrated that buyers would insist upon immediate delivery of small quantities, at spot prices inclusive of freight, instead of negotiating long-term repetitive supply contracts. In markets characterized by steady or declining prices, a supplier who is able to deliver the goods exactly when they are needed will win the sale at today's spot price that in no event will be lower, and perhaps will be higher, than tomorrow's.

The supplier's ability to honor such commitments profitably, however, requires immediate knowledge of material availability, production status, shipping schedules, best available freight rates and available shipping capacities. Thus, in addition to conventional supply-chain management (SCM) systems, suppliers are likely to demand collaborative electronic commerce systems to help locate the best available means of transportation, carriers and rates. They will also require improved manufacturing execution (MES) and warehouse management (WMS) systems to get an up-to-the-minute picture of their internal production and logistics operations, and to further reduce inventory investment.

As prices stabilize or fall, suppliers will face increasing pressure to minimize logistics costs. This is best done through a combination of advance planning and solicitation of competitive spot-market bids for shipping services. Thus, demand for logistics planning and cost accounting systems can be expected to remain strong.

Overhead Cost Control

Overhead costs are distorted immediately, and dramatically, by surplus capacity. Labor-intensive producers can adjust fairly rapidly through labor-force reductions, but capital-intensive producers cannot. Liquidating properties or fixed assets can eliminate the cost of persistent surplus capacity, but the assets may be difficult or impossible to sell. Manufacturers can be expected to implement a variety of short- to medium-term accounting tactics and longer-term financial tactics in order to minimize the adverse consequences.

Tactical accounting changes can be anticipated in the areas of fixed asset accounting, overhead cost allocation and inventory valuation. Possible financial tactics include restructuring of operations to minimize fixed costs, asset liquidation and, worst case, asset write-offs.

Fixed overhead costs are typically governed by original acquisition costs and pre-determined amortization schedules. The periodic amortization cost thus accrued is divided by production volumes to determine overhead costs per unit. Excess capacity drives these costs up as ever-smaller production volumes absorb constant amortization costs. In markets experiencing falling prices, real overhead costs will constantly increase over the long run because deflation increases the purchasing power of the original investment.

Businesses tend to amortize their fixed assets as rapidly as allowed during periods of inflation and high capacity utilization. This minimizes short-term tax liabilities by reducing pre-tax profits, and reflects the tendency of equipment to wear-out faster the more it is used. But businesses competing in markets characterized by stable or falling prices can be expected to lengthen the amortization schedules of their existing fixed assets as much as allowed, because equipment is not being utilized as much and because there are smaller pre-tax profits to shelter. This tactic has the salutary effect of reducing overhead cost per unit, reducing cost of sales, boosting short-term profits and strengthening the balance sheet, thereby improving apparent business performance. Many of today's fixed asset accounting and cost-allocation systems, however, lack the flexibility to implement such changes quickly. Strong demand for flexible replacement systems can therefore be anticipated.

Related inventory valuations and the resulting cost of sales per unit will be affected, too. During inflationary periods, businesses tend to maximize cost of sales as much as allowed, chiefly to minimize pre-tax profits and the value-added tax base. In the future, however, financial controllers will be pressured to change their inventory valuation methods by whatever means necessary, and allowable, to minimize cost of sales, in order to further boost short-term profits and strengthen the balance sheet. As with fixed assets, many of today's inventory management systems lack such flexibility. Replacement systems will be needed to the extent that surplus inventories are being cleared in the short- to medium-term, and to whatever extent a minimum inventory investment is required to operate the business over the long run.

During inflationary times, automation of plant, warehouse and office operations became an important tactic for minimizing ever-increasing labor costs. Capital resources could be substituted for labor, and written-off in constant, periodic amounts that declined in real value over time as inflation eroded the purchasing power of money.

This approach is unnecessary during periods of price stability, and downright unprofitable during a deflation, because the purchasing power of money will stay the same or increase over time while the cost of labor stays the same or declines. Further, replacing fixed assets with variable labor resources gives manufacturers far greater ability to control operating costs in the short- to medium-term. Thus, it is probable that labor's proportion of total operating cost will increase, even if the total labor-force is smaller than before. This trend would likely accelerate as existing fixed assets are retired, liquidated or written-off. As a result, steady or declining demand for plant, warehouse and engineering automation systems can be anticipated. This includes robotic, programmable logic controller (PLC), automated storage and retrieval (ASRS), computer-assisted design (CAD), computer-assisted manufacturing (CAM), statistical process control (SPC) and integrated laboratory management (LMS) systems.

Were a prolonged worldwide deflation to occur, demand may shrink so much that suppliers are forced to shut down parts of their operations, or shutter entire facilities. Attempts will be made to sell the idle properties and equipment for the best-possible price, with attendant capital losses written-off immediately.

Sale of assets is most likely to occur while inflation is subsiding, and before the onset of widespread deflationary pressure, because the assets will appear cheap to investors who continue to have long-term inflationary expectations. Liquidations and write-offs will have an immediate, and beneficial, effect on cost of sales, to the extent that periodic amortization costs are significantly reduced in relation to production volumes.

These tactics would not require any significant changes to existing business information system capabilities, but the number of general business systems in-use can be expected to decline as operations are scaled back and facilities closed. These include functions such as general ledger, accounts payable, accounts receivable, inventory control, production control and cost accounting.

Reduction of overhead costs at remaining operations is likely to be a key priority, as well. Older general business systems tend to incur relatively high operating and maintenance costs. Meanwhile, information technology costs have fallen dramatically. As a result, some manufacturers will replace their older general business systems with newer, less-expensive versions, especially if doing so will enable the other tactical changes described in this article to be implemented faster. But many older business systems have already been replaced to address recent Y2K concerns, so the ongoing need for replacement systems is likely to be limited, at best.

Labor Cost Control

During periods of persistent surplus capacity, manufacturers can be expected to reduce their variable labor costs as much as possible. This may be done through elimination of overtime, shift reductions, work-hour reductions, temporary or permanent pay cuts, temporary or permanent layoffs, and reduction of employee benefits. Further, operations may be scaled back or eliminated at high-cost union shops, as well as within high-cost or restrictive labor markets such Germany and labor markets characterized by low unemployment such as the United States.

These effects will be moderated by substitution of variable labor for fixed assets in the drive to control overhead costs, as previously demonstrated. In doing so, however, manufacturers are likely to accelerate the redeployment of productive capacity from high-cost, capital-intensive locales such as the United States to low-cost, labor-intensive regions such as Asia or Central and South America.

These actions may have adverse and increasing social effects, as dramatized by recent protests in Seattle and Washington, D.C. against the International Monetary Fund and World Trade Organization. Worker demands for improved economic security may lead to renewal of isolationist policies in some locales, which would effectively reverse the economic liberalization and globalization trends of recent years.

Business models designed to optimize performance in the previous climate of unrestricted free trade will have to be adjusted to take account of the artificial incentives and penalties created by any new government regulations. This is likely to create new demand for localized regulatory compliance systems that address taxes, duties, tariffs, prohibited goods and foreign exchange controls. At the same time, reduced demand can be expected for general business and supply-chain management systems designed to integrate the unrestricted operations of multinational enterprises.

Business Planning and Improvement

A variety of tools and techniques evolved during inflationary times to improve productivity and maximize profits. These include material requirements planning integrated with capacity requirements planning (MRP-II), advanced planning and scheduling (APS), activity-based costing (ABC) and total quality management (TQM). All of these techniques address business problems created by limited capacities. MRP-II and APS tools are designed to maximize the utilization of existing capacity through improved coordination of individual production and procurement activities, without necessarily improving efficiencies or yields. ABC and TQM are essentially diagnostic tools for identifying the root-causes of inefficiencies and defects, and enable management to monitor the effectiveness of corrective actions. Used together, these tools allow management to wring maximum productivity from its existing capital investment, before additional long-term capacity investments are considered.

In a period characterized by stable or falling prices, fewer new long-term capacity investments will be considered. Instead, gradual disinvestment of existing capacity may occur. Before disinvestment, there will be little or no real benefit from using capacity requirements planning, APS, ABC or TQM tools except to improve the coordination and efficiencies of a smaller labor force. But even in so far as labor utilization is concerned, greater business benefits will accrue from short- to medium-term adjustments to the number of resources employed, rather than continuous long-term improvement of labor efficiencies.

Materials management is likely to remain a top priority, for reasons demonstrated earlier. After clearing excess stock, suppliers will be under intense pressure to keep inventories to an absolute minimum, since their value will remain the same or depreciate relative to cash in the event of a deflation. Expanded use of discrete (order-based) master scheduling (MPS), material requirements planning (MRP), manufacturing execution (MES) and warehouse management (WMS) tools can be expected in order to properly schedule and manage materials in small quantities, on a JIT basis. Continued deployment of quality assurance and control tools for the purpose of improving finished product yields and minimizing waste can also be expected.

Summary

Manufacturers' business priorities will change significantly if a worldwide transition from inflation to price stability or deflation occurs. Many new priorities will be the opposite of those followed during inflationary times. This will have a major impact on market requirements for enterprise systems. The most likely impacts are listed below.

Significant decreases in marketplace demand can be expected for:

  • Repetitive purchasing, order-entry and release management systems

  • Sales forecasting systems

  • Capacity requirements planning (CRP) and advanced planning and scheduling (APS) systems

Some reductions in new marketplace demand can be expected for:

  • Industrial automation devices and systems (robotic equipment, programmable logic controllers, computer-integrated laboratory instrumentation)

  • Warehouse management and automated storage and retrieval (ASRS) systems

  • Computer-assisted design and manufacturing (CAD/CAM) systems

  • Statistical process control (SPC) systems

  • General business systems (general ledger, accounts payable, accounts receivable, inventory control, production control and cost-accounting)

  • Sales analysis systems

  • Advanced remittance processing and money-management systems

  • Activity-based costing systems

  • Global supply-chain management systems

Some new marketplace demand can be expected for:

  • Interactive inventory-control systems

  • Interactive pricing and promotional systems

  • Logistics planning, execution and cost-accounting systems

  • Flexible inventory valuation systems

  • Localized regulatory compliance systems

  • Quality assurance and control systems

Significant new marketplace demand can be expected for:

  • Discrete (order-based) purchasing and customer order-entry systems

  • Interactive electronic commerce (Internet) technology for product catalogues, price lists, reverse auctions, collaborative purchasing, customer order acceptance and payment, shipping schedules, shipping rates and shipping capacities

  • Data-warehousing and data-mining engines for competitor prices, prospective customers and customer creditworthiness

  • Sales engineering and product configuration systems

  • Opportunity management, customer relationship management, sales force automation and commissioning systems

  • Flexible fixed asset accounting systems

  • Flexible overhead cost allocation systems

  • Order-based master scheduling (MPS), material requirements planning (MRP), manufacturing execution (MES) and warehouse management (WMS) systems

About the Author

Nelson M. Nones CPIM is the Director of Global Marketing for CIM Vision International, Inc. in Long Beach, California, USA. Mr. Nones has over 25 years' professional and managerial experience as both a developer and implementer of Manufacturing Execution (MES), Warehouse Management (WMS), Enterprise Resources Planning (ERP), logistics, Manufacturing Resources Planning (MRP-II) and general business accounting software. He has lived and worked in the United States, Asia and Europe, pursued advanced studies in Economics and Geography, and was a market research consultant for the first 8 years of his career. He was Certified in Production and Inventory Management (CPIM) in 1986 by the American Production and Inventory Control Society.

You can contact Mr. Nones through the CIM Vision website:

www.cimvision.com

 
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