Healthcare, Energy And Commodity Cost
A hands-on approach from senior leaders and careful strategic planning can help mitigate risks from market forces and global uncertainties in a host of areas.
While uncertainties exist in any given year, 2012 is especially challenging. In the U.S., a presidential election cycle will likely delay hard decisions on government expenditures and taxes. Meanwhile, the European debt crisis, instability in the Middle East and China’s actions on everything from regulation to economic growth directly affect the prospects of many midsized American businesses.
With these issues in mind, senior executives will have their hands full devising ways to grow market share and increase margins while controlling costs. Let’s take a closer look at the cost drivers…
Without question, healthcare is the single most expensive labor cost outside of base compensation. While it is a valuable benefit for attracting and retaining good workers, the cost of that benefit has skyrocketed in the past decade. In fact, according to a recent study by the actuarial and healthcare consulting firm Milliman Inc., the average cost of coverage for a family of four rose from $9,235 in 2002 to $19,393 in 2011. While the Milliman study found that companies faced an average premium increase of 7.3 percent from 2010 to 2011, the research also found that employers were passing along a greater share of those costs to workers.
Despite cost increases that have consistently outpaced inflation in recent years, healthcare premium hikes are expected to be more restrained in 2012. Forecasts by benefits consulting firm Mercer suggest an average premium increase of 5.4 percent this year, which would be the lowest rate hike since 1997.
The level of rage—or happiness—with energy pricing has always been strongly correlated with the cost of fuel sources most vital to a given business. When viewed through that lens, companies that rely heavily on gasoline and diesel fuel face the most immediate price volatility.
According to the U.S. Energy Information Administration (EIA), the average pump price for regular gasoline was $3.83 per gallon in mid-March of this year. On average, that’s a one-year increase of 26 cents per gallon. Similarly, the cost of diesel fuel is also up to about $4.12 per gallon, an average increase of 22 cents per gallon since March 2011. Increased demand (particularly in China) and reduced domestic refining capacity have helped drive price increases. However, the key wild card is the potential for adverse political events in the oil-rich Middle East. For example, the EIA notes that 20 percent of the world’s crude oil supply travels through the Strait of Hormuz. If tensions among Iran, Israel and the U.S. escalate to military action, shipping through this waterway could be blocked, sending crude oil prices to unprecedented levels.
On the other hand, an unusually warm U.S. winter season has led to excess inventories of natural gas, which has put downward pressure on market prices. Natural gas spot prices averaged $2.24 per MMBtu at the Henry Hub in mid-March, down approximately 50 percent from January 2011, and the lowest base price since 2002. In its near-term forecast, the EIA expects natural gas prices to rally modestly, with Henry Hub spot prices averaging $3.17 per MMBtu in 2012 and $3.96 per MMBtu in 2013.
The drop in natural gas pricing also helps reduce the cost of electric power generation. The EIA reports the price of natural gas delivered to electric generators averaged about $3.30 per MMBtu in February, the lowest price in a decade. In addition, EIA projects a three percent decline in the average delivered fuel price for coal-fired electric plants this year. Due to these trends, average U.S. electricity prices are forecasted to rise by just 0.4 percent in 2012 and drop by 0.9 percent in 2013. In contrast, electricity rose by an average annual rate of 2.6 percent over the past five years.
In the wake of an 11 percentage-point drop in overall truckload rates in 2009, the industry gained back most of that ground with modest pricing gains over the next two years. According to a forecast by trucking business intelligence provider TruckGauge.com, truckload rates are expected to rise by nearly six percent this year, followed by projected increases of 7.3 percent in 2013 and 8.6 percent in 2014. In the near term, the biggest risk to pricing is a spike in fuel costs, which could force trucking firms to raise rates or add to existing surcharges. Further down the road, the projections for truckload pricing hinge on stable fuel prices, continued economic recovery and the increased cost of new federal safety regulations.
Meanwhile, less-than-truckload (LTL) rates will most likely continue rising in 2012, primarily because excess capacity has been wrung out of the marketplace. Late last year, Logistics Management magazine reported that major LTL carriers posted general rate increases between 5.9 and 6.9 percent. For 2012, the magazine said additional increases are possible, with cost swings dependent on geography, routes, customers and specific carriers.
A hot topic that directly affects high-tech manufacturers is the availability of rare-earth minerals, which are vital to many automotive, lighting and consumer electronics products. The U.S., in concert with Japan and the European Union, recently asked the World Trade Organization to facilitate a dispute over China’s export limits on these materials. While that nation currently supplies about 95 percent of rare earths, it only exported half of its 30,000-ton quota in 2011, due in part to weak semiconductor demand. In the short term, business leaders can expect pricing to be soft, with some market observers forecasting that rare earth prices could drop back to 2009 levels.
Steps to Help Manage Cost Pressures
While the effect of these (and other) costs will touch businesses in different ways, there are some key steps companies can take to help mitigate risks from market forces. To be successful, these steps require a hands-on approach from senior leaders and careful thought in devising both short- and long-term strategies. A sampling of these steps includes:
Improving workforce development and succession planning. Most companies can gain quick, low-cost wins from specific training activities. Training programs that focus on better initial product quality, faster resolution of field problems, and a higher level of service send a strong message about a customer-centered culture. This approach can combine both monetary and non-cash recognition incentives, all tied to clearly defined performance metrics. At the same time, manufacturing and distribution executives should consider ways to foster an employer of choice environment, which can help improve both recruiting and retention. However, this step toward higher workplace engagement will succeed only if senior leaders take time to be visible, involve production and professional workers in strategic business decisions, and ensure that promotion and pay decisions are firmly rooted in performance.
In the long term, most companies can gain competitive advantage by building succession planning and leadership development programs. According to a recent Korn/Ferry global survey, only 35 percent of companies have a formal CEO succession plan. That challenge may be even more pronounced in manufacturing, where investments in so-called soft skills may not be viewed as mission-critical. To address the issue, consider taking inventory of the core leadership skills needed to succeed at each level of management, and tap internal or third-party resources to design training curricula that meets those needs. To be most effective, leadership training and metrics should also be built into regular performance reviews.
Rethinking healthcare benefit options. While this year’s expected 5.4-percent cost increase in healthcare plans is the lowest in over a decade, business leaders can take additional steps to manage short-term expenses. This may include offering high-deductible health plans with employee savings options, changing the employer contribution for coverage on lower-paid workers, or mandating higher premium costs for smokers. Additionally, informal interviews with clients suggest many manufacturing and distribution companies will manage costs by asking workers to bear an even greater share of out-of-pocket expenses this year.
As a longer-term play, many companies are exploring self-insured options to better manage their total healthcare expenses. While a successful self-insured plan is highly dependent on the health experience of a given workplace, the concept is drawing increased interest from smaller companies, many with as few as 100 workers. With key pieces of federal healthcare reform scheduled to kick in by 2014, it’s a smart idea for business leaders to review a full range of healthcare coverage choices with qualified accounting and healthcare resources.
Enhancing continuous improvement programs. There is a strong correlation between corporate financial performance and the presence of disciplined continuous improvement programs. For example, data collected in the “Summer 2011 McGladrey Manufacturing and Distribution Monitor” revealed that nearly 70 percent of companies with a strong culture of continuous improvement were “thriving and growing.” Just 41 percent of businesses with little or no process improvement culture could make the same claim.
As a quick improvement measure, many companies can increase capacity and reduce labor, material and other costs by simply redesigning production space to a more efficient layout. Longer-term, the use of Lean, Six Sigma and other process improvement methodologies can cut costs and improve efficiency. In addition, business leaders should explore other innovative steps, such as best practice information exchanges with non-competitor companies, which can often yield fresh continuous improvement ideas that can be applied across industry boundaries.
Gaining leverage from vendor relationships. In feedback from Monitor surveys and face-to-face encounters at McGladrey’s 2011 Manufacturing and Distribution Summit, many senior leaders indicated they have no specific approaches to leverage vendor competition or relationships. While that can be an expensive oversight, the steps to correct it are fairly straightforward.
To begin, companies should conduct a detailed spend analysis, which will show direct and indirect costs while uncovering potential savings opportunities. At the same time, it’s wise to begin regular vendor assessments, which can serve as ongoing checkpoints for quality, consistency, price and service levels. Armed with these findings, senior purchasing managers are in a much stronger position to drive attractive business agreements with current providers, while weeding out others who consistently underperform.
Longer-term, companies can employ sophisticated forecasting tools to help them monitor commodity prices and other vendor costs. This provides a useful baseline of real-time marketplace data, which can be used to help hold down price increases from outside suppliers. In addition, the use of a demand pull system for key inventory categories can help establish tighter controls of materials in stock.
Managing transportation costs. As a short-term step, companies can often save money by going paperless, consolidating more orders in fewer shipments, or restructuring payment terms and incentives. At a more strategic level, significant cost and time savings can often be found in a route planning and optimization strategy, which makes the most efficient use of every pickup or delivery mile. For companies with international sourcing or production operations, it is worth calculating the true total landed cost of those functions, with particular emphasis on how it affects the cost of goods sold.
Turning sustainability into a business asset. When it comes to green or sustainability programs, business leaders are often conflicted about perceived tradeoffs of cost and value. However, a strategic, well-designed sustainability initiative can enhance employee engagement, efficiency and business development.
Consider the results of a dedicated sustainability program at Johnson Controls, a Wisconsin-based technology and industrial systems company. Johnson started reporting on various environmental metrics in 2002, and the company boosted its credentials six years later by establishing a global environmental sustainability council. In 2009, Johnson introduced an environmental scorecard, which measured annual performance on reducing carbon output, improving supply-chain sustainability and increasing revenue from sustainable products and services. For its achievements, Johnson earned the top spot on Corporate Responsibility Magazine’s 2011 “100 Best Corporate Citizens” list, which ranks performance in environmental responsibility, climate change, employee relations and other key areas. Due in part to its sustainability initiatives, Johnson’s employee-engagement scores rose from 56 percent in 2007 to 71 percent in 2010.
From 2009 to 2010, Johnson increased its green collar workforce—those devoted to energy-efficiency projects—by 65 percent. Over the next five years, the company forecasts that this investment will result in as many as 17,000 new hires, all of whom will be brought on board to support the company’s energy-efficient product lines. iBi