At present, the huge inflationary pressure on the cost base of almost every food producer has not yet been further digested downstream in the supply chain. Will consumers, food retailers or food service operators ultimately pay the bill? Or will the problem be pushed back into the chain?
According to Rabobank’s chief macroeconomist, inflation is not necessarily a bad thing—as long as everyone expects and calculates the same inflation rate, that is. Well, the current food cost inflation is not modeled, and it is unprecedented. Except for possible depreciation, almost every cost line in the income statement is facing upward pressure. Whether it is agricultural products, packaging, transportation, energy, or personnel costs, there have been substantial price increases. It cannot be alleviated in the short term. Part of the cost increases even have a structural nature, as supply chains are shifting from ‘just in time’ to ‘just in case.’
The exact magnitude of cost inflation is difficult to measure. Supplies are usually included in the contract, so the actual contract price and contract renewal time vary from company to company. In addition, the cost inflation experienced by a company depends on the type of product it produces, the raw materials used, and the source of the product. A bakery company will face more problems with gasoline prices, a beer company will monitor the prices of glass and aluminum more closely, and nut traders will have to deal with a 822% increase in container prices from Asia. Therefore, instead of focusing on the cost itself, we have asked many suppliers across Europe how much they need to raise prices to food retailers and catering service operators to make up for their explosive cost base. Answers range from 0% to 30% or more. On average, suppliers look to retailers and food service companies about 9% to 10% higher prices (PPI) to deal with the inflated costs.
One thing is certain, given the average operating profit margin of food production, not many producers can absorb the rising cost in their own operations. Many manufacturers make it very clear that subsidizing their products is not an option, so negotiations this fall will be difficult. Whatever you do, don’t blink first
The obvious next question is: What will the food retailer do? Given the operating leverage in its business model, it is in the best interest of the supermarket organization to avoid any price increase-theoretically. Food retailers across Europe are active in a highly competitive market. Taking the lead in increasing consumer prices can damage the reputation of retailers, and if competition lasts long enough, it can also damage sales and market share. In addition, the profit margin of food retailers is not enough to absorb the 10% higher cost of goods sold. This will be a matter of closely monitoring competition, timing any consumer prices hikes carefully (preferably later than competitors), and weighing how much of the cost inflation can be absorbed without aggravating the stock market, shareholders, or co-op members. History provides ambivalent clues as to how supermarkets have dealt with previous inflation peaks.
Looking back some 20 years, we have seen the cost base[i] and producer prices in the EU-27 peak before, in 2007/08 and 2010/11 In the first cost rally, food retailers benefited from a favorable economic climate – just ahead of the financial crisis – and clearly decided to pass most of the inflation on to the consumer (CPI) with a limited delay. In 2010/11, the financial crisis and associated tax increases took a toll on consumers’ wallets, and, consequently, food retailers were much more cautious in how much and when they raised the prices on their shelves. Whether the economic climate in today’s market reflects 2007/08 more or the broader inflation experienced outside food more closely resembles the 2010/11 consumer is the million-dollar question.
In order to calculate an index representing the cost inflation of food producers, we have constructed a cost base of a nonexistent, average food company that uses the FAO food stuff index as agricultural raw materials (40% of costs), the Eurostat energy index representing transport, production, and packaging (30% of costs), and the Eurostat labor cost index for all staff-related costs in production, sales, marketing and administration (30% of costs).
The worst for consumers has yet to come
Given that neither food producers nor food retailers are able or willing to fully absorb cost price increases, consumers may face higher food prices sometime in the first few months of 2022, although not necessarily one-off. Food retailers may choose to increase consumer prices in stages so as not to upset consumers.
The good news for most consumers is that they have ways to avoid inflation in their budgets by buying cheaper products or cheaper channels: buy ground beef instead of steak and choose private-label products instead of brands. Shopping at discounted prices instead of full-service supermarkets or having dinner at QSR stores instead of fast food restaurants.
To make matters more complicated, this reduction in consumer transactions may trigger a substantial change in demand, and both food manufacturers and food retailers need to reflect this in their decision-making on how to deal with the unprecedented inflationary pressure.