Show how inflation and a firm's competitive standing shape sales and cost forecasts
The idea
A company's competitive position decides how much of any change in costs it keeps. Porter's five forces are the threat of new entrants, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers and rivalry among existing competitors. Where these forces are weak, a firm has pricing power: it can pass input cost inflation through to customers and protect its margin, and in deflation it may hold prices while costs fall. Where they are strong, the reverse holds, and inflation squeezes margins while deflation is competed away. Forecasting under inflation therefore means projecting prices and volumes separately, since sales growth is (1 + price change)(1 + volume change) minus 1 and higher prices may cost volume, and projecting each cost line at its own inflation rate rather than assuming the margin simply holds.
A practice question
Which of the following is one of Porter's five forces?
- The level of interest ratesWhy not: A macroeconomic variable. It affects all industries rather than describing industry structure.
- The quality of managementWhy not: A company-specific trait, not one of the forces shaping an industry.
- The bargaining power of suppliers — correct
The five forces are the threat of new entrants, the threat of substitutes, buyer power, supplier power and rivalry among competitors.
A harder one
A firm has sales of 1,000 and cost of goods sold of 600. Input costs rise 10%, volumes are flat and it can raise prices by only 4%. Forecast gross profit is:
- 440Why not: Includes the 4% price increase but not the 10% rise in costs.
- 380 — correct
- 340Why not: Includes the 10% rise in costs but not the 4% price increase.
Sales = 1,000 x 1.04 = 1,040. COGS = 600 x 1.10 = 660. Gross profit = 1,040 - 660 = 380, down from 400.
The hardest tier
Input costs across an industry fall sharply. Which company is most likely to keep the saving as a higher margin?
- One with few substitutes and weak buyers — correct
- One facing many close rivals for shareWhy not: Intense rivalry means competitors cut prices to win share, passing the saving to customers.
- One in a market with low entry barriersWhy not: Easy entry invites newcomers to undercut prices, competing the saving away.
In deflation, only firms with pricing power can hold prices as costs fall. Weak buyer power and few substitutes are the conditions that allow it.
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