With the U.S. consumer price index up 5% for the year ending June 30 and unemployment currently at 5.7%, many retailers have found themselves in a tough situation, locked between rising product costs and a limited ability to raise their prices. Even cost-savvy market leaders such as Costco are having a difficult time. But Wharton faculty say that handled carefully, the current inflationary period may actually be a business opportunity for some retailers, especially if they make selective changes in inventory management, pricing and promotions.

That new thinking can begin with inventory. According to Gérard Cachon, a professor of operations and information management, from the 1990s to 2005, minimizing inventory was seen as a key to success. “The whole mindset has been, ‘Let’s get rid of it.'” But that was when most prices were stable or declining. Today, he says, it’s not as clear that this is the best strategy. In fact, some retailers may want to start holding much more inventory than they did in the past as a way to hedge against future price increases. “Of course … it’s a little risky to hold inventory that might [lose value], especially perishable goods and fashion-oriented goods… but to the extent [retailers] know that prices will be rising over time, they will start to try to hold more inventory.”

Cachon also suggests that contracts with suppliers include some agreement on how to handle future price increases. For example, include fuel-cost adjustments “so that both sides are sharing the risk.” Company buyers, he says, can also look for more local products to cut down on transportation costs. “What I expect is that sourcing from farther away becomes less attractive … because the extra transportation costs are now going to swamp” price advantages for many distant suppliers. As energy costs continue to rise, retail chains’ distribution plans are likely to be driven by fuel efficiency rather than labor or location of physical assets. “I suspect that some retailers will start to consolidate their network, closing marginal stores because they’re too expensive to supply given their [low] profitability,” Cachon says.

In addition, operations and marketing departments will need to work much more closely to successfully navigate the new environment. “There’sa lot of volatility right now, and with a lot of volatility … a retailer who typically runs with very small profit margins can go from making money to losing money pretty quickly,” Cachon says. Ensuring that the company stays profitable “is going to require some experimentation and probably a lot of coordination between the two groups.”

The current volatility has shaken some major value-oriented retailers, who typically do well in hard times, says Wharton marketing professor David Reibstein. “For the Wal-Marts of the world, inflation is actually something pretty good, because so many customers are trying to figure out, ‘How do I save money during these inflationary times?’ And that takes them more and more to the value-based retailers. The Costcos and Wal-Marts and Dollar stores should be thriving during such periods.”

Squeezed by Lower Demand

However, this particular environment presents some peculiar difficulties. “The problem is not only that there are inflationary pressures, but that aggregate demand is going down,” says Wharton marketing professor Leonard Lodish. “That’s why you see retailers like Boscov’s and Mervyn’s in trouble, because they may still be marking up their goods but there’s not enough demand to keep the stores full.” Both of those regional department stores recently filed for Chapter 11 bankruptcy protection.

Retailers typically try to pass through their costs by adding their margin to the supplier’s higher price. By itself, such cost-plus pricing can be a profitable strategy in an inflationary time if consumers have accepted the idea that prices are rising in a given category, such as baked goods, Lodish says. A price hike to keep up with inflation may actually create more profit for the retailer, he adds. How? An item sold for $2 at wholesale nets 20 cents for a retailer who sells at a 10% markup. But a $2.10 wholesale item nets a retailer 21 cents at the same markup. If the retailer’s overall costs — such as labor, shipping, marketing and other products — remain static, that extra penny of margin can flow to the bottom line.

But with rising product costs and consumers worried about their jobs, marking up the price of goods becomes a delicate business. “The smart way for the retailer to do it is to … raise prices a little bit here, a little bit there over time so that the consumer doesn’t have one big sticker-shock,” says Wharton marketing professor Stephen Hoch. “In order to do that, the retailer has to absorb some of the pain in the short run and eventually pass it on down. And frankly, the manufacturers are trying to absorb pain too because … they don’t want to be the one that’s raising prices when their competitors aren’t.”

How much exactly is “a little bit?” In the past, most retailers have not known how to quantify the point at which price increases start cutting into demand. Now, business scholars are trying to work out more robust models to determine how much a price should be increased; among them is Wharton marketing professor Omar Besbes.

He cites one study which found that a good way to gauge the market is to test several different prices at once, ideally in different stores, and see how consumers respond. “This is a way to hedge against future changes in the market,” Besbes says, by enabling the retailer to develop a model to test how consumers will react to future price increases.

Hoch suggests that retailers try to promote sales in a product area in which prices have not increased. At the moment, prices of electronics and clothing have not risen, but food and energy have. For grocers, he says, “a prime choice … is to emphasize their private-label goods. It’s their ace in the hole.” Grocers typically put more emphasis on their store brands during an inflationary period as a way to offer the customer a better deal without cutting into their own margins, he explained. At the same time, pushing the private label keeps the pressure on manufacturers of nationally branded goods to keep their own price increases in check.

Retailers can try also to cut prices in an important category as a way to boost market share, as Costco does by selling gas at a relatively low price. Others have cut prices as an opportunity for running promotions or special sales, recognizing that with their customers facing an inflationary crunch, “it might be an opportune time to run some deep discounts as a way to try to capture some volume,” says Reibstein.

Even specialty retailers who can’t make shifts between products quite so easily may find they can reposition their products to an extent. One example that Lodish admires: auto dealers who pitch the notion that now is a good time to buy a big vehicle because the discount will save customers more than enough money to compensate for the extra fuel costs over four or five years. “It’s crafting and putting the best face on the value statement that you’re making,” he says.

Other strategies for succeeding in an inflationary environment may require some counter-intuitive thinking. While companies typically slash sales and marketing budgets during tough times, some studies have suggested that they would do better to turn up the advertising volume, says Reibstein. “Those that do not cut back tend to have much bigger returns for their marketing spend [in economic downturns] than during times of prosperity,” Reibstein notes. “And that’s a real surprise, because you would think during prosperity, people have money to spend and you’re more likely to get a return for any of your marketing investment… Most marketing spending has an impact basis — that is, how much you’re spending relative to your competition.” So, if the competition is buying less advertising, the merchants who spend more get a greater share of exposure. “Companies with enough cash to boost spending on marketing can use a bad time as a period in which to focus on gaining more market share.”

Hoch warns that retailers shouldn’t overlook the other aspects of their business, particularly service. “Retailers need to go out of their way to provide friendly customer service because everybody’s going to be out there screaming value,” he says.

As complex as some of these adjustments might seem, Cachon is confident that retailers will adapt more quickly than in previous inflationary periods, such as during the 1970s oil shocks. He says retailers now have much more information because of bar coding and other technologies that allow them to track their goods from suppliers to the checkout line. “Retailers are much more flexible and agile than they used to be. This [economic slowdown] is not something that I would expect to spiral out of control. … There will be some new winners among the retailers who can adjust quickly.”