Where Do Higher Input Prices End Up?

 | Oct 19, 2011 | 3:00 PM EDT
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With the Bureau of Labor Statistics (BLS) release of its trio of inflation gauges in the past week – Import Price and Export Price Indexes, Producer Price Index (PPI) and Consumer Price Index (CPI), and as earnings season is now underway, a large question I have may finally be answered. Put simply, where are all of those higher input prices going?

We can see the prices of goods as they move along the production chain from raw commodities to store shelves, and huge cost increases exist at the beginning stages of production. By the time products reach consumers, however, pricing pressures seem to have evaporated. It is too simplistic to assume that companies' margins are taking the hit; instead, factors, such as productivity gains and constrained wage increases, could offset these pressures, at least in part.

Consider the following table that illustrates the cost of goods including crude to intermediate goods to finished goods in the PPI. Then look at the price increases when those goods eventually reach consumers, noted in the CPI. The dramatic cost increases taper off by the time they reach the customer, especially when one looks at Core CPI. (I will use the headline PPI data since companies use energy in the manufacturing and transporting of goods.)

Cost of Goods - PPI Crude to Core CPI

Where are those early-stage cost increases going? Well, one reason is that crude goods are only a part of the costs to the end consumer. By the time a given good reaches its final sale, raw materials are a small part of the typical cost of the average good.

What costs make up the rest? Labor is the biggest component, accounting for about 70%, or so, of the total costs of goods and services, on average. This is where I want to draw your attention. Let's explore how companies are able to offset higher input costs to keep final prices lower by keeping unit labor costs under control. In doing so, they might be able to preserve some, or even most, of their profit margins.

Unit labor costs are basically a function of two things: the amount a company pays its workers per hour and how much each worker produces in a given hour. The latter factor is driven by productivity gains -- the higher the productivity gains, the lower the unit labor cost pressures, generally speaking. Companies can pay their workers less or extract more output per work hour to offset the higher input prices.

Note that productivity is not just assembly line workers producing ever more widgets per hour, it's also the barber that buys an accounting software that eliminates his need for a part-time bookkeeper. He's still cutting hair at the same rate, but without the bookkeeper's hours, his output (revenues) per hour increases. That is often what productivity gains are about and the reason why unemployment remains high, while output has recovered more noticeably. Companies turn to technology as a cost-efficient means of increasing sales without increasing staff.

We see this economic data manifested in the Productivity and Costs report and the Real Earnings report, also tabulated by the BLS. For productivity measures, we won't get third-quarter data until after the third-quarter GDP report, as GDP data feed into the productivity measures. Right now, we will work only with second-quarter data.

In the second-quarter GDP data, we see that year-over-year productivity gains were 0.7%. As a result, unit labor costs rose by just 1.9% for the 12 months ending in June. By comparison, the PPI for finished goods surged 7.0%, while the headline CPI advanced 3.4% during this period. Subdued labor costs, due in part to productivity gains, were the buffer between the input costs companies incurred and the prices they charged.

However, the productivity gains in the last quarter are actually less than the long-term average annual productivity gains, which usually post in the area of about 2% or so, historically speaking. When productivity is not growing as fast as companies would like, a company needs to keep hourly wages under control if it wants to maintain its profit margins. As we see from the Real Earnings report, the data for September real earnings (after inflation) decreased by -0.1% in September, as companies increased hourly wages by 0.2%, less than the 0.3% rise in CPI inflation. For the past 12 months, real earnings fell by -1.7%, offsetting part of the increase in companies' input costs.

As mentioned, we do not yet have the third-quarter productivity data to work with. So, as we digest earnings reports in coming weeks, I will look for how companies' margins have fared. Have companies had enough productivity gains and controlled labor costs to maintain profits? Or, are companies finding it harder to offset higher input costs through wage measures alone, if productivity gains disappoint?

From the employees' perspective, too little productivity means companies will be loath to give them raises. If companies experience high productivity gains, employers will have little reason to hire more workers.

Of course, when employers give their workers pay raises, those consumers can then pay higher prices, allowing companies to raise their selling prices to accommodate their higher input prices. That cycle is now broken; there is no wage-price spiral. And that is keeping overall inflation tame, even if it is limiting consumers' buying power.

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