Why costs have fallen, but prices haven’t

Arun Bruce Anirudh Tara | Updated on January 20, 2018 Published on June 07, 2016

Keys to a dream It comes at an inflated price szefei/shutterstock.com

Customers must demand that the benefits percolate down to them. Else, they will continue to be exploited

What if the mid-level sedan you just paid ₹11 lakh for, should have been ₹8 lakh.  Or the 485 L frost-free refrigerator you upgraded to should have been ₹40,000 and not ₹55,000?   

Most raw materials have become cheaper over the last three years.  Crude oil has also become cheaper.  A combined fall of this kind has never happened in recent history. Oil is trading in the $40-50s now, from a high of $100/barrel just a few years ago. Steel which cost as much $550/mt two or three years ago, cost $270/mt for those who imported in January this year.  Iron ore and coking coal — core ingredients of any iron/steel making process — have fallen by more than half over the last three years.  Aluminium is trading at around $1,600/mt from a high of $2,500/mt just a few years ago.

Simply put, it can be up to 50 per cent cheaper to make and move products.

No trickle-down

One would expect that benefits from falling raw material prices would have trickled down to the end consumer.  Sadly, this is not true. So, who really has benefitted from this commodity deflation? The middle men: manufacturing companies and the Government.

Most manufacturing companies have had strong profitability growth recently despite slowing demand growth. Hero MotoCorp declared a 71 per cent growth year on year in profits in the latest quarter whereas Topline grew only by 10 per cent. Asian Paints saw an overall increase in operating profits by 35 per cent in the December quarter; sales in the same period grew only by 13 per cent. Companies have been quite disciplined in not passing on price decreases to customers, locking in improved profits due to lower costs — despite a slowdown in revenue growth.

This is not necessarily wrong. Most of these companies have seen cycles where hard-earned profits have been eroded in just a few quarters, and recouping some of the losses is admittedly healthy over the long term.

The Government has also extracted its pound of flesh in time with the deflation. Excise duty on petrol has been hiked five times since November 2014, with as much as a 133 per cent increase in excise and 7 per cent increase in VAT. Taxes now account for more than 50 per cent of the end consumer price. Taxes on cars have gone up — without as much as a whimper of resistance from consumers.  The Government clearly felt that increased tax revenue in the interest of fiscal consolidation was more important than passing on benefits of lower prices to its consumers. 

So what’s next?

One of three scenarios could unfold:

Scenario 1: An upstart in the manufacturing industry breaks rank. An opportunistic appliance company cuts prices especially in launching new products. Other compatriots follow suit and before we know it, there is a slew of lower cost launches in the market to woo the consumer. Wouldn’t we all love such an upstart!

Scenario 2: Consumers wake up and demand lower inflation. Protests erupt. The Government gives up its fiscal orientation to trade in some of the recent taxes in return for a happier vote bank. It also pushes manufacturers to be less ‘disciplined’ in their pricing and pass on more benefits to the consumer. A dream scenario, companies fall in line, consumers see prices fall!

Scenario 3: Raw material costs firm up sooner than expected.  A global event (revival in Chinese/US demand), or a local event (extension of the current MIP in steel for beyond 6 months) starts driving commodity prices up. Upstarts get cold feet, manufacturers hold on to prices, citing recent uptick in costs.  Consumers hesitate to demand firmly. We end up with a dream scenario for the manufacturers, as they lock in a one-time improvement in profits. Consumers, on the other hand, do not have felt any price softening at all. 

Scenario 3, unfortunately, is starting to unfold as we speak, and is looking more likely than before. Chinese steel companies have started exercising prudence in controlling their output and steel prices world over have firmed up by more than $50 over the last two months. Domestic steel prices have gone up even more by around ₹5,000-7,000 thanks to the MIP. Scenario 1 is also slowly starting to unfold with a few car launches at considerably lower prices than before

Ideally, for a vibrant democracy, Scenario 2 should be gaining ground — with customers demanding their rightful price. Inflation was a big election issue during the last parliamentary elections and it is in our hands yet again to demand lower prices with the same enthusiasm and vigour that made inflation a central agenda in the 2014 elections. Instead of debating issues of nationalism and tolerance which have turned out to be platforms for political parties to unsettle each other, shouldn’t we rather be fighting the real battle —– and who knows we could soon have that 485 L refrigerator at ₹40,000 again

Bruce is partner and director at BCG, where Tara is principal

Published on June 07, 2016

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