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Demand pull and cost push: Two sides of the inflation coin

A nonfactor for decades, inflation is now parsed into demand pull and cost push

Pricing analysts across the tech industry will have to take a new look at the mix of inflationary pressures, sort those pressures by cost push and demand pull, and adjust their own business muscle memory for both short- and long-term instability stemming from rising energy costs, destabilized supply chains and increased component demand.

 

To excel at textbook economic analysis, you are told to look at one variable, “all other being equal,” or ceteris paribus. But the real world never works that way. The real world becomes particularly alarming for economists when their textbook explanations are not borne out by what is happening.

 

Such a situation occurred in the late 1970s. Inflation (and unemployment) increased from 7.5% to 10.4% from Jimmy Carter’s presidency to Ronald Reagan’s presidency, and then chair of the U.S. Federal Reserve Paul Volcker began raising interest rates to choke off inflation. The term “stagflation” was coined to explain the inexplicable. As we seek to understand inflation today, we have a better parsing of the multiple factors that can drive inflation.

Demand pull inflation: The classic definition

Demand pull inflation is classic 20th century thinking. It loosely corresponds to “too many dollars chasing too few goods.” Traditional Keynesian economic thinking asserts that this situation means the economy is overheating. It asserts the solution is for central banks to raise interest rates to slow demand and bring it in line with current supply. Low unemployment is expected to be a compatible condition to this kind of economic overheating, and with the slowdown, labor market pressure will likewise abate.

Cost push inflation: A fancier definition for resource scarcity (and potentially disruption)

Cost push drove the high inflationary cycle of the 1970s. Oil price shocks, driven by OPEC production decisions, triggered choke points across the entire economy. Companies had little recourse but to pass along price increases, or to “push” the costs onto the consumers at a time when unemployment was high.

The current blend of demand pull and cost push

Today demand pull influences are seen more on the consumer side, with record-high savings during the pandemic shutdown, plus consumer purchases and housing prices spiking due to various government relief payments. Similarly, unemployment remains low, and certain skilled positions, especially acute in the tech sector, remain hard to fill.

 

Textbook moves to raise interest rates to slow the economy are being deployed to cool this economic overheating. Whether it results in a soft or hard landing of the economy on more stable ground remains open to, at times, contentious debate, given cost push inflation is also rampant.

 

Cost push is readily apparent in any purchases of basic staples. Energy and food are about as basic as it gets, and there are no simple solutions to those issues. Energy is a heavily regulated industry, with public support for moving away from fossil fuels mounting, especially among younger individuals. Food prices are being hit by both the energy cost increases and the supply chain disruptions resulting from the conflict in Ukraine. Neither fuel nor food disruptions are likely to abate soon, and the food issues around wheat and the attendant products manufactured from wheat are likely to worsen before they improve.

 

If that news is not dire enough, energy supply chain constraints do not appear to be a short-term blip on the way to resuming normal productive capacity. A Grid News article lays out in great detail the supply chain constraints — rising demand, conversion of refinery capacity to renewable diesel, and shuttering of older domestic refinery capacity during the pandemic —impacting the refinery segment.

 

Further, expansion of U.S. refinery capacity is unlikely given regulatory and environmental risk, as well as a fundamental shift in financial outlook. The article expects gas prices to rise over the summer, which is a normal occurrence, but the article is not optimistic about an increase in refining capacity in the U.S. due to cost, environmental regulation, and long-term industry outlook as public sentiment grows for green alternatives.

What does this mean for the technology industry?

Within the tech sector multiple inflationary influences apply pressure. Rising energy costs will often be remediated with temporary surcharges. Amazon indicated in the company’s last earnings call that it was considering such measures. This surcharge can work for finished goods; however, component shortages triggering demand pull inflationary pressures similarly have a blend of cost considerations.

 

Some cost spikes will work themselves out as supply chains react to pandemic-induced disruptions. Other cost spikes will persist until productive capacity increases, given how many more finished goods outside of the technology space itself consume embedded components in smart devices.

 

For infrastructure manufacturers, this means year-to-year price declines in the “faster, better, cheaper” trendline, predicated on Moore’s law for decades, should at least temporarily flatten out. TBR analysis of the silicon shortages suggests these challenges will be ameliorated in the next two to three fiscal quarters.

 

The other pressure and risk consideration will be the impact on long-term pricing agreements for managed services and “as a Service” subscriptions. A backlog of recurring revenue priced with lower inflation forecasts will likely apply margin pressure to developing “as a Service” revenue streams of pure play companies and independent operating units within multiline businesses. Pricing adjustments may be baked into new agreements and renewals moving forward, but the runoff of booked contractual commitments could impact profit margins. Noncurrent bookings will be a telling indicator.

 

Services firms basing project fees on billable hours should be reasonably well insulated given hourly rates can change in real time to adjust for rising labor and fringe expenses.

 

As stated, pricing analysts will have to take a new look at the mix of inflationary pressures, sort those pressures by cost push and demand pull, and adjust their own business muscle memory for both short- and long-term instability rising energy costs, destabilized supply chains, and increased component demand brings to bear on their respective market segments and the monitoring of their commercial offers.

Inflation, cybersecurity and taxes: PwC’s update from Dubai

What happens in Dubai … well, happens everywhere

On March 1, PwC Dubai hosted a LinkedIn webcast, “Transforming Our Region,” featuring commentary by Stephen Anderson, PwC Middle East markets leader; Richard Boxshall, PwC chief economist for the region; and Hanan Abboud, a partner in PwC’s International Tax & M&A practice. This latest episode of the webcast series, which started in the summer of 2020, included three main themes, two of which likely resonate strongly outside the Middle East region.

Global inflation can be a drag, but regionally not so bad

First, Anderson and Boxshall noted recent regional economic growth and an overall positive picture, particularly as the pandemic begins to wane, but cautioned about inflation as a damper in the near term, with a critical caveat: Many of the global inflationary pressures and trends have been more muted in the Middle East, particularly within the economies of Saudi Arabia and the United Arab Emirates (UAE). Boxshall reported that inflation has been relatively low and well managed locally, at around 2% for the region, but varies widely across countries.

Like elsewhere, energy prices and supply chain snafus drive most of the inflationary concerns and effects in the Middle East, but high oil prices act as a double-edged sword for some of the most important regional economies, as more money flows into government coffers while demand is put at risk of being suppressed in the long run. Overall, PwC reported on the cautious sentiment in the region as the business leaders it surveyed see inflation elsewhere and hope for sustained smart economic stewardship to keep inflation low in the region.

Cybersecurity tops concerns

Investment and innovation comprised a second regional trend with global echoes, primarily because of the main concern about what could hold back growth: cybersecurity risks. According to Anderson, cybersecurity generated more worry among Middle East business leaders than geopolitical tensions or lingering pandemic-related healthcare risks. Notably, PwC’s survey did not factor in Russia’s invasion of Ukraine, which could bring geopolitics to the forefront. In TBR’s view, consultancies like PwC that can address clients’ cybersecurity concerns in concert with offerings around innovation, transformation and sustainability will continue to outpace cyber-centric or niche vendors as client leaders increasingly appreciate the business value of integrating cybersecurity into enterprisewide strategy.

Joining the global movement toward 15% tax rate

The last development PwC highlighted will have the greatest near-term effect in the UAE but bodes well for global economic growth and regional good governance. Anderson and his colleagues noted that the UAE became the first country in the region to announce plans to adhere to Organization for Economic Co-operation and Development (OECD) guidelines by instituting a 15% minimum corporate tax rate. With the country planning to implement the 15% tax rate effective June 1, 2023, and the local business corporate tax rate capped at 9%, PwC acknowledged plenty of unknowns and expects plenty of exemptions. But overall UAE is continuing its decades-long efforts to keep the country economically attractive and closely intertwined with the global economy.

Advising clients on adjustments to the new 15% tax rate, to include navigating free-trade-zone rules, will provide near-term opportunities in the UAE and longer-term revenues as other regional governments adopt similar tax structures. For PwC, a new UAE tax regime aligns perfectly with PwC’s The New Equation strategy and emphasis on trust, transparency and global interconnectedness. As TBR noted in November, “Globally, PwC partners were leaning into the trust and leadership components of The New Equation and finding clients receptive to, and even welcoming of, PwC’s efforts to ‘peek around the corner’ at trends, challenges and opportunities on the near and far horizons.”

Don’t bet against the Emirates

In TBR’s estimates, PwC’s 2021 management consulting revenues in the Middle East topped $670 million, roughly one-third of the firm’s APAC revenues but growing faster than any other PwC region. Inflation spikes and cybersecurity strikes may slow that growth, but a more likely scenario is that the UAE, the Kingdom of Saudi Arabia and other regional economies will maintain their rapid growth as their booming talent pools and friendly tax and corporate governance structures continue to draw investments and continue to create opportunities for consultancies like PwC. I served in Dubai, UAE, as a foreign service officer for the State Department in the late 1990s and know it’s a fool’s bet to think the UAE won’t, eventually and sometimes in surprising ways, do exactly what they say they’re going to do.

As inflation rears, will it throw off SaaS and ITO operating models

Who today has experienced a long-term economic inflationary period?

Inflation is very much in the U.S. news as it reaches 40-year highs. This means a person has to be near the end of their professional careers to have experienced the previous inflationary period. One of the authors dimly recalls his economics professors trying to parse what, at the time, was called stagflation, which impacted the United States in the 1970s. Oil price shocks drove up prices, while unemployment remained high. Inflation previously had been explained as too many dollars chasing too few goods and was generally assigned to economies overheating because of very low unemployment rates.

Today economists seek to assess economic fundamentals to predict whether this inflationary spike will be temporary or persistent. Factors suggesting a short-term spike revolve around the well-publicized supply chain disruptions coupled with record savings levels during the pandemic when discretionary spending on things like travel and restaurant meals was greatly hindered and retail spending shifted from in-store shopping to e-commerce.

On the other hand, some economists point to persistent government deficits due to pumping money into the economy. Given various regulatory and economic uncertainties, that money has been sitting on the sidelines. Further stock market run-ups in valuation have been attributed to investor money seeking higher returns that can be achieved in traditional savings and bond ownership because of low interest rates on these conservative investment instruments.

Partisans will selectively mention these factors to explain away or criticize the current economic climate. Businesses, on the other hand, have a recently dormant financial risk rearing its ugly head that can dramatically impact long-term financial forecasting.

So what are the technology company business models where inflation has near term impact?

Transaction-based businesses in  the IT industry will be able to follow traditional methods of passing costs on to the customer. But, for those business units working from Anything as a Service (XaaS) subscription models, ITO contracts and infrastructure managed service agreements, the near-term impact could be more acute.

Cloud-enabled SaaS models are a relatively new phenomenon as Industry 4.0 gains momentum. Proponents of these business models also assert that legacy business model metrics and analysis do not apply given the majority of selling expenses are recognized in the first fiscal quarter of multiyear agreements while the revenue is then recognized ratably over the contract term. As such, the financial spokespeople for these business models lean heavily on relatively new business metrics — annual recurring revenue (ARR), net dollar revenue retention and lifetime customer value — that chart a forecast course for when operating profits will materialize.

ITO contracts have had a somewhat longer evolution, starting as multiyear deals where vendors could reap greater profits as operating costs declined due to the increased automation of the overall monitoring and maintenance. These contracts then moved to shorter-term durations and, more recently, have stipulated cost decreases over time such that any operating costs savings created by the vendor are passed along, or at least shared with, the customer. The ITO market has likewise seen a shift or rebranding of these customer offers into infrastructure managed services to pivot the contract model to be more in line with SaaS constructs.

When inflation was last a top-of-mind economic consideration, most IT was on premises and operated by company personnel. TBR seriously doubts strategic scenario planning for these new subscription consumption models prior to perhaps late 2020 anticipated the current inflationary levels and their potential operating impact.

What is the immediate inflationary risk to XaaS and ITO business models?

SaaS models take several years to generate profit in what is variously described as the flywheel effect or the force multiplier effect. Increased labor and utility costs beyond forecast and tethered to long-term contracts will add several percentage points of operating costs to these models. In this sense, the newer the SaaS operating model the less risk it will have to cost structure as it has less renewed revenue. TBR expects the more mature the SaaS model, and greater amount of accrued or committed revenue, the more adverse the bottom-line operating impact.

The ITO market, on the other hand, has shown persistent declines, resulting in consolidations and divestments to profitably manage eroding streams traditional ITO vendors seek to convert into managed services agreements. The inflation impact on costing will amplify the need to infuse these business practices with more automated capabilities or increased low-cost (typically offshore) labor as offsets. Still, the operating profit declines in this space will likely worsen unless vendors seek to negotiate incremental cost increases that customers may or may not be willing to accept based on their own issues with cost containment.

What go-forward tactics are in the technology vendor toolbox to mitigate inflationary impact?

Inflation is not new, but the operating models prevalent now were not around when we last experienced it. Business strategists still have a blend of initiatives they can embrace to preserve their operating models and their customer relationships:

  1. Market education: Transparent declarations on the cost impacts to the vendor business and any suggestions of sharing the burden with customers can preserve customer loyalty.
  2. Customer research in existing brand perception. The XaaS Pricing team has a very good blog outlining the Van Westendorp Price Sensitivity Meter and its applicability setting B2B SaaS pricing strategy. That research methodology can assist vendors in level setting where they stand with customers on the value perception and give pricing strategists a line of sight into how much room they have within their brand perception for implementing price increases.
  3. New contract language for price increases: The historic quiet period on inflation, coupled with the innate reality within technology of “faster, better, cheaper,” has customers expecting price reductions for IT that will require true customer education around inflation as an offset to those prevailing market expectations. This will not help with the inflationary impacts on the existing contracts that must be honored, but can establish a new go-forward pricing model that can take into account a business risk largely dormant for the better part of 40 years.

Inflation as a business risk will persist for the foreseeable future. TBR will be assessing it closely as public companies report their earnings and release their financial filing documents.