The latest economic news on the Producer (PPI) and Consumer Price Indexes (CPI) has ignited fears of inflation.  In the relay and switch markets prices have been held down by competition as costs continue climb over the past three years.  As manufacturers work on razor thin margins, some of them are deciding to get out of the business while others are ready to raise prices.

The drivers behind these trends will be examined, the outlook for the future discussed, and the potential effects inflation may have on consumers and manufacturers of relays and switches, as well as, the economy.

Material Costs

Prices for copper and silver, which are key ingredients for switches and relays, increased more in 2005 than the years 2003 and 2004 combined.  Two forces -- worldwide demand and speculation -- keep pushing copper, silver, gold, and crude oil prices upward. 

In March of 2005, this column examined rising material costs.  The chart below appeared in that article and has been updated.  The graph shows the indexed total switch market ASP versus raw materials used to produce switches and relays from Q1 2003 through Q1 2006.  Everything to the right of the line drawn through Q1 2005 has occurred since that article appeared.  The metal and oil data was obtained from the New York Mercantile Exchange and resin pricing from Plastics Technology magazine.

Manufactures may not be Able to Avoid Price Increases

The blue line in the graph above shows the Switch Tracks price index for component switches in North America.  Until the second quarter of last year switch prices held steady or went lower while the cost of most raw materials soared.  Of course competitive market pressure is the key reason for this.

As costs rise much quicker than prices, margins decrease and many manufacturers have reduced overhead to be able to work on these margins.  As cost reduction opportunities wane, manufacturing operations begin to near capacity, and material and energy costs continue to go higher, manufacturer profits become exposed to decline.

Most, if not all, manufacturing companies are in business to make a profit.  When high volume low priced business no longer generates an operating profit the value or importance of that business becomes questionable.  Why not raise the price on this type of business?  The obvious fear is losing the business.  However, most senior managers will take lower sales provided total profitability improves.

Automatic “cost down” contracts can become an inextricable burden in this environment of rising material costs.   Auto and appliance manufacturers have required automatic reductions in pricing for component suppliers for many years.  These contracts can be in place for years.  If a manufacturer is unable to realize expected cost reductions combined with unforecasted material cost increases they can be forced to supply products at prices below the cost to manufacture.

What will Happen If Manufacturers Raise Prices?

The first impression is that they will lose business.  This may or may not be the case in the long run.

As any good salesman will point out, price is not the only thing even though it may seem that way.  If a company has product with critical features or performance characteristics it may not be easy to replace them.  Product quality and the ability to deliver the required volume on time and every time is another consideration.  Lower priced competitors may not easily replace a manufacturer, and after all, the incumbent supplier has enjoyed the business for a reason.

If a manufacturer has made the proper decision to raise prices on non-profitable business and then loses it, the company will likely be better off with improved earnings that can be used to grow the business in more profitable ways. 

With fewer manufacturers willing to sell products at the lowest market prices there will be less price pressure.  This should result in upward movement of market prices in these market segments.  If prices move up enough manufacturers that have left the segment may reenter.

Divesting of a Switch Business

Last December ITT Industries decided that their switch business no longer fits with their long-term strategy.  The Cannon/Shadow tact switch product line has long been a part of ITT.  In  2000 ITT decided to increase the breath of their switch products and purchased C&K.  Then additional acquisitions were made to add keypads, dome arrays, and similar products.  Last December they stated that this switch business generated $350 M in revenue per year, arguably making them the largest or one of the largest broad line component switch manufacturers in the world. 

One has to wonder what aspect of the switch business no longer fits the long-term strategy of ITT.  Is it the markets served, sales channels used, technology of the products, prospects for growth, profitability, or something else?

What About the Future

So what does the future hold for commodity prices, the price of switches and relays, and inflation?  If I or anyone else could tell this with certainty they probably would not share the information.  Since I am not certain, here are my thoughts.

Last year and this year when gasoline prices reached $3.00 a gallon there was a noticeable drop in demand.  This made speculators nervous that they would be holding too large a position and this would cause them to sell at loss and future prices for oil dropped.  If a $3.00 per gallon resistance point does not break down, many speculators will leave and this should provide some relief.

A similar situation may be happening with copper, silver, and gold.  Recent inflation fears have folks worried that interest rates will be raised.  This will cause a slow down in economic growth and decrease demand for these metals.  Again, speculators worry that they may hold too large a position to be consumed in the future resulting in unprofitable positions.  If the speculative activity diminishes because of this so will some of the upward price pressure.

Relay and switch prices will rise.  Some of this was seen last year as shown in the graph above.  The upward pressure from material costs needs to be relieved.  Even if commodity prices decline, it will take time for the positive effects to work through to improved margins.  Increasing prices will help speed this up and is more controllable by the manufacturer.

As the cost for goods like relays and switches go up, there will stress on the prices of the goods they go into.  Causing inflation that will reduce consumer buying power and lead to higher interest rates that will continue to slow construction of new homes.  This will have a negative impact on the demand for and production of consumer electronics, brown goods, and white goods.

Corporate spending should hold up, at least for this year, in the face of inflation and higher interest rates.  Corporate profitability over the last three years has created a surplus of cash.  Companies will deploy some of this into productivity improving or growth related capital expenditures.  With cash on hand, the need to borrow and the effect of higher interest rates won’t be felt much here.  How long this spending is maintained will be dependent on profitability.