Profitability is the single most important reason people start businesses. Sustainability, in this case as the ability to maintain your business at a certain level now and into the future, is a direct result of remaining profitable. The threat to any business’s profitability and sustainability, in turn, is runaway and unmanaged costs. A sure case of going out of business is one where costs exceed the price for which a business is able to sell its products or service in a long-term contract.

In the current environment where soaring costs are the natural order of doing business in South Africa, the threat to profitability has never been more eminent.  Domestic companies are threatened from all sides. Rising fuel costs, above-inflation wage increases, increasing electricity costs, soaring administered prices and port charges, high domestic steel prices and a weak currency, among many others, are all pressure points faced by local businesses from a cost point of view.    

For the past 60 years, SEIFSA’s Price and Index Pages (PIPS) solution has provided a credible tailor-made tool to adjust for price escalation in contracts, ensuring fair and equitable relationships between buyers and suppliers involved in a contract.  With PIPS, SEIFSA is positioned to advance the interests of businesses and keep their doors open. Partly, this is achieved through provision of the right information in a central and credible source. It is critical that this type of insights are, as provided by PIPS, timeously accessible, correctly calculated and interpreted. SEIFSA’s PIPS is knowledge driven and its competence and relevance is supported by many success stories. The insights in PIPS have provided businesses the opportunity to buy their companies’ sustainability.

To demonstrate the importance of this offering and the reason a business cannot afford not to keep track and recover input costs increases, we have provided an illustrative example showing the impact an incorrect provision inflation can have on a company.

We assume the following:   

• A R10 million contract that is to be rolled out over a 10-year period.
• The company experiences an input cost inflation rate of 6% annually (that is a weighted average of labour, overheads, electricity, materials, etc).
• For simplicity, we assume that the annual inflation rate remains constant at 6% per annum for all 10 years.
• However, due to an incorrect measurement of the input cost inflation, the company only measures and passes on 4% output inflation to its clients.
• This yields a 2% variance between what the company is paying in input cost inflation and what it is recovering.

The 2% error equates to a cumulative loss of R2.6 million rand after 10 years, which is the equivalent of 26% of the contract value.

This begs the question: In the current environment characterised by very low margins and weak order books, can companies really afford not to pay attention to the risks inflation exposes them to?

Some important points can be made to supplement this exercise and the importance of the point being made:

1. The losses identified through the exercise are not notional costs. They are real costs incurred by the company which, in turn, has an inability to pass them on, thus resulting in margin squeeze.
2. The losses are not only realised at the end of the project (i.e. the cumulative total), but from year one of the contract.
3. The assumptions made in the exercise (i.e. R10 million and a 2% error) can be considered to be fairly conservative. The same losses would be much higher, assuming a bigger contract and a wider error margin.

Importantly, if reversed, the same scenario illustrated above applies to the project cost overruns that would be experienced by a company buying product for large- scale projects and, in turn, threatening the company’s sustainability.
Correct measurement of a company’s input cost basket ensures that the company accurately replicates its inflation curve and ensures its sustainability.