What Is Margin Compression? How to Improve Margins When Inflation Rises

In June 2022, the consumer price index — a measure of consumer price changes in the United States — peaked at 9.1%, reaching its highest rate since the 1980s. The result of these rising prices for goods and services is that all businesses are feeling the effects of inflation.

For most enterprises, inflation increases production costs while revenue stays relatively consistent. When revenue is flat and vendor or supplier costs are up, businesses enter a state of margin compression.

Margin compression can significantly impact an enterprise’s cash flow, jeopardizing its purchasing power, growth investments and even its supplier relationships. However, the solution isn’t as simple as raising prices, improving your sales strategy or reducing costs — factors that your enterprise may have limited control over, especially during an economic downturn. 

What exactly is margin compression and how can your enterprise regain control over its cash flow?

What is margin compression?

Margin compression describes a reduction in gross profit due to higher costs. In other words, the cost of delivering a product or service increases faster than the revenue generated from the product or service, which results in shrinking profit margins.

The cost of goods sold can increase for many reasons, leading to margin compression. In some cases, higher competition in a growing industry may increase costs. Additionally, the business itself can cause margin compression — for example, by using outdated systems or inefficient processes that unnecessarily drive up costs and reduce margins.

During inflationary periods, most businesses, regardless of their industry or internal processes, are impacted by margin compression. When inflation — a measure of increased goods and services costs — exceeds the Federal Reserve’s 2% target, businesses may experience significant margin compression.

How does margin compression impact enterprises?

Margin compression means that an enterprise has less working capital after generating revenue. This negatively impacts:

• Cash flow. Enterprises need consistent cash flow to cover everyday operating expenses such as salaries and marketing. Margin compression may force the business to cut back, leading to layoffs and slower growth.
• Purchasing power. Ideally, an enterprise has enough cash to reinvest in inventory and product development. However, margin compression often forces enterprises to spend more cautiously. High inflation can reduce the business’s purchasing power further as the value of its cash decreases significantly over time.
• Growth and competitive positioning. Enterprises may be left without the cash needed to invest in growth and competitive strategies — such as digital transformation, additional business locations or social, environmental and governance (ESG) initiatives.
• Lending and investment opportunities. Banks and investors use an enterprise’s cash position to evaluate risk. Lower profit margins can affect a business’s ability to access financing opportunities. 

Supply chain relationships. When an enterprise experiences tight margins, its first instinct might be to retain cash longer by extending payment terms with suppliers. However, this can backfire. When suppliers wait extended periods for payment, their cash flow also suffers, which can weaken the entire supply chain.

How can your enterprise improve gross margins?

The obvious solution to margin compression is to raise prices, increase sales or reduce costs to keep revenue in line with higher costs. However, enterprises usually have limited control over these strategies. Raising prices, for example, may drive your business out of the market, especially if competition is tight. During an economic downturn, consumers typically spend more conservatively and are unwilling to pay higher prices. Your business may also find it challenging to reduce expenses by negotiating lower supplier prices.

What enterprises can control, however, are supplier relationships and payment terms. By funding early invoice payments from your balance sheet, your business can gain higher, risk-free returns on your cash while strengthening the supply chain. How?

During inflation, suppliers need to shorten the time it takes to convert inventory and development costs into cash — a metric known as the cash conversion cycle (CCC). While a healthy CCC varies by industry, suppliers generally need to minimize this timeline to sustain cash flow. Otherwise, suppliers may be unable to deliver goods on time and in full to your enterprise, keep prices consistent or support a stable supply chain. 

Your business can offer suppliers early payment in exchange for a discount as a margin compression solution. This not only decreases the cost of goods sold, increasing your profit margins — but it also helps you keep costs stable and avoid supply chain disruptions. 
Fintech companies such as C2FO now offer early payment programs, making it easy for enterprise buyers to implement early payment discounts on terms that benefit both parties. C2FO’s Early Payment program uses dynamic discounting, which allows you to set a target rate of return for early payment and receive a discount at any time before the maturity date. This strategy has been used successfully to increase margins by many global enterprises, including Philips, Macy’s and Air France.

The bottom line

Any enterprise that endures high inflation is likely to experience margin compression. The good news is that your supplier relationships offer a valuable opportunity to lower the cost of goods sold. By paying suppliers early in exchange for a discount, you can build a strong supply chain while maintaining the working capital needed to invest in growth — even during economic uncertainty.

Need to improve margins? Learn more about how to implement an early payment program with C2FO.