November 30, 2021

Deciliiter.ne

Breaking News Breaf

Price increases: whether or not to pass it on to customers?



While the price of raw materials and components has literally soared since the start of the year, like the barrel of Brent which is close to 80 dollars, many companies are wondering whether they should not postpone this increase downstream, on their customers. To answer this delicate question, five factors must be taken into account.

First, the structure of the market. If the latter is very competitive, margins are low and companies have no choice but to pass the full cost increase through the price. Conversely, on a concentrated market, the company will absorb part of the increase and only pass on a fraction of it to its customers.

Input weight

Second, whether or not the increase in costs is symmetrical is taken into account. If the companies in a sector have the same production technologies, they are all affected in the same way: in this case, a repercussion on the customers will be easier to implement since all the actors will have the same incentive to do so. . Conversely, if a company is more affected than its competitors by rising costs, it risks losing customers if it decides to increase its prices. We are thinking of a sector such as air transport in which low cost players and incumbent companies operate, which do not have the same degree of exposure to the price of oil. Paradoxically, an increase in the price of oil will affect low cost more, since kerosene can represent up to 35% of their variable cost. To postpone, alone, the increase would risk encouraging low cost customers to turn to historical competitors.

Third, the weight of the input in the cost of production plays a decisive role: if its weight is limited, the rise in price could be absorbed by squeezing margins. But conversely, we can consider that the low weight of the input will encourage the company to increase its price, since the increase will be limited for customers.

Relational capital

Fourth, the company must take into account the downstream structure of its customers : when the latter are few and large, they have strong negotiating power, likely to prevent any repercussion of the additional cost. We think, for example, of large customers in the computer industry or mass distribution.

Fifth, businesses need to consider whether the increase in the price of inputs is permanent or transient. If it is transient, it may be rational not to pass on the increase, at least in the short term: renegotiating contracts with customers is costly in terms of time and possible penalties, so-called “menu costs”. In addition, changing contracts along the way can undermine relationship capital and the trust built with customers. In this regard, it is not certain that all price increases today are of the same nature: in the case of energy, it is likely that the price increase is sustainable and structural, which is not not necessarily the case for semiconductors, whose prices are historically very cyclical and depend on production capacities.

Ultimately, the question of whether the cost increase is passed on to the price is the result of a multifactorial assessment, which depends on the nature of the shock and the industry.

THE AUTHOR: Emmanuel Combe is vice-president of the Autorité de la concurrence and university professor at Skema Business School