Inflation will continue to be a permanent and deep-rooted component of the global economy, not a temporary spike. We are currently experiencing what can be figuratively described as a “cocaine-injected” economy. This injection is being driven by several key factors, including geopolitical turmoil and the machinations of powerful monopolies, causing rising costs. Companies need to clearly and explicitly build this into their five-year plans.
First, let's understand the “why” that every business must think about, plan for, and prepare for cost increases over the next five years. Take an example of a business that has determined that costs will rise at about 7% per year. If calculated linearly, the cumulative increase in costs over five years is 35%, but if compounded, it is over 40%. The question then becomes, what should we do now to address this very likely future reality? Productivity initiatives? New product launches? Can we price to maintain margins? How do we manage cash flow? Productivity lessons are born, new product ideas, new structures, new sourcing methods, rethinking capital allocation.
Now think about the possible outcomes: If you anticipate a 7 percent increase, take action, and the actual increase in costs is 4 percent, that's good news and puts you in a better position. If the increase is 9 percent, that's bad news, but it still puts you in a much better position than companies that didn't prepare for the increase.
The reasons for this action-oriented preparedness are clear: we live in an era of rising costs driven by extraordinary forces. First, there are clear signs that defense spending has accelerated globally, increasing from approximately $750 billion in 2000 to $2.4 trillion and will continue to rise. This includes a significant increase in the United States from $320 billion in 2000 to $876 billion in 2022, as well as increased defense capabilities by other nations. Increased defense spending, driven by ongoing conflicts and geopolitical tensions, directly stimulates various sectors of the economy, especially those where defense equipment and materiel are produced and supplied.
Second, the US shift to a new industrial policy aimed at reducing dependence on China has led to huge subsidies for the creation of domestic industries. This policy covers critical sectors such as semiconductors and other infrastructure, benefiting not only the US but also its allies. Investment flows to these sectors amount to nearly $1 trillion and will probably increase as tensions continue. This pattern is mirrored not only in China but also in the EU and other countries.
On the private side, with generous government assistance, large investments are being made in new factories such as the TSMC facility in Arizona. According to census data, these investments will total more than $210 billion in 2023 alone, more than three times the annual growth rate of the 2010s, creating ripple effects throughout the economy and increasing the impact on inflation. Demographic changes and labor shortages will continue to put upward pressure on wages. Large, ongoing investments in technology and automation upgrades will also continue to contribute. Under President Trump, the introduction of tariffs will be another driver of rising input costs.
The reality of inflation
Most people understand that the Consumer Price Index (CPI) does not fully reflect the inflation that consumers actually experience. A trip to McDonald's or Wendy's, where many low-income consumers take their families, highlights what we all know: real inflation is higher than the CPI. The costs of food and energy, which make up a large portion of daily spending, are rising at rates that the CPI measure does not fully capture.
But for businesses, the pressures are even more underestimated and underunderstood. Take insurance costs, particularly employee health care costs. Insurance costs are the biggest driver of long-term cost growth for U.S. businesses, with costs per employee rising 5.2% in 2023 alone (see chart below left). The same is true for employer Social Security contributions.
The risk of additional costs is growing across global supply chains where prices and supplies of key commodities such as energy and rare earth elements are controlled by authoritarian regimes. This control of supply and prices extends to critical resources needed across industries, from pharmaceuticals to technology, with cascading effects on all businesses. Prices and supplies are further exacerbated by piracy and drought conditions in the Panama Canal.
Energy prices remain high and continue to impact sectors across the economy, from aluminum production to data centers, which is another major cost driver: According to the U.S. Bureau of Labor Statistics, the average cost per kilowatt-hour has risen from $0.084 in 2000 to $0.173 in 2024, and with rising consumption over the next decade, this price is unlikely to come down.
Rising wages and shifting economic demands are accelerating the move toward automation and digitization. This investment is essential, but it also brings inflationary pressures, especially as more technology is delivered “as a service.” For example, remember when Microsoft's ubiquitous Office products were available for under $600 in a one-time purchase? Today, Office costs can exceed $22 per user per month with automatic updates, excluding the latest AI upgrades. Adding additional features can push the cost well over $50 per user per month. It's unlikely that such costs will decrease in the coming years.
Where to see and what to do
It is essential that boards and management teams incorporate these insights into strategic five-year plans, which include mapping the impact of each factor on operations and preparing for continued cost increases through productivity and efficiency innovations.
First, the board should hear from the CEO/CFO about external cost drivers for the industry and business, such as rising interest costs. Looking back over the past five years, what patterns have you seen? Second, the board should ask how these drivers will be addressed in the next five-year plan. If past patterns persist, what will be the impact on future costs and profitability? And third, what steps will management be taking this year to prepare for these changes? If cost increases are lower than expected, congratulations! Shareholders will be ecstatic, but there will be more positive surprises than negatives. Other areas for management to address include:
• Detailed analysis of cost structure
This phenomenon of hidden cost growth makes it imperative for companies to pay more attention and focus on key input sources. This includes identifying every element of cost, from raw materials, labor, and energy to logistics, IT, and digitalization efforts. Understanding where your costs come from is the first step in managing them. For example, if a large portion of your costs are tied to commodities that are sensitive to geopolitical tensions, consider hedging strategies against price fluctuations.
• Communication and transparency
Keep the lines of communication open with all stakeholders. Internally, make sure people understand what's coming so they're acclimatized and prepared for the new environment. This message also carries over to investor calls to ensure the company's credibility isn't lost when something unexpected happens.
• Supply chain resilience
Rising prices in situations where supply chain availability is controlled by dictators or affected by natural phenomena such as drought or piracy in the Panama Canal puts companies under immense pressure.
• Manage your balance sheet
In an environment of great uncertainty, rising costs, and cash-eating inflation, it's important to be careful with your leverage ratios. Excessive short-term debt could be fatal.
• Employee training and retention
This is the toughest job. HR has to develop new ideas on compensation, talent retention and putting the right people in the right jobs with the right mindset.
The strategies outlined here require a proactive, flexible management approach. Companies that anticipate change and adapt quickly to the new realities of a high-cost environment will not only survive, but thrive, turning challenges into opportunities for growth and innovation.
