A perfect storm?

The planets are aligning to create a disaster scenario for the toy industry with rising costs, currency fluctuations and other factors piling on the pressure. Simon Birchenough, co-founder and chairman of Worlds Apart, explains why?.
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Most disaster scenarios come about when a number of unrelated events come together and conspire against each other to make a bad situation considerably worse – could it be that such a “Perfect Storm” has been brewing across the entire supply chain of the Toy Sector over the last 12-18 months, and is about to break as we go into 2008?

Consider five apparently unconnected events:

1. Commodity prices. World demand has relentlessly pushed all commodity prices up over the last 12 months, with oil, copper, nickel, iron ore, paper pulp and timber leading the way – over the last 24 months, both oil and steel have doubled in price.

2. Increased labour costs. New social compliance requirements in the Guangdong area have increased the minimum wage, social security contributions and other welfare benefits - there has also been a shortage of migrant workers for the low value-added jobs. Whilst such improvements in the working conditions and pay are well overdue, the combined effect has been an increase of 25-30 per cent in real labour costs over the last two years.

3. Appreciation of the local currency. Since the exchange rate reforms in mid 2005, the local currency, the RMB, has appreciated by over five per cent against the dollar. Since most of the factory costs are settled in RMB from dollar revenues, the impact on margins has been significant - and most observers see an acceleration of this appreciation in the coming months.
(If labour accounts for 20-30 per cent of the total production cost, then the rises in wages and RMB appreciation in the past two years alone have already resulted in an estimated increase of 6-12 per cent in the total production cost.)

4. Removal of Export Tax subsidies. The last 12 months has seen the reduction or removal of a number of significant local subsidies and tax breaks, and in particular the Export VAT Rebate. The HKTDC refers to these events as “the final straw” in a recent report.

5. European safety and environmental improvements.
New legislation to further protect both the consumer and the environment have led to the reduction or removal of phthalates, heavy metals and many other organic compounds. It is difficult to generalise across all toys but the additional cost implications of the combined ROHS, WEEE & phthalate initiatives has been significant and it’s not over yet - the new Part 9 and REACH legislation will go a lot further in requiring the removal of over 2,000 new chemicals from the toy manufacturing process and the new testing protocols will become increasingly expensive.

So why has this not already led to more significant price rises in the high street? There are two key reasons: Those at the front of the supply chain (the factories & vendors) have seen their margins dramatically reduced as they’ve tried to either absorb the increases or unsuccessfully pass them on, but many are now on their knees and factory closures are at an all time high. The weakening dollar has meant that those selling in sterling have seen their buying power in China in 2007 increase by about 10 per cent - this has significantly subsidised the manufacturing cost increases of last year, but is unlikely to continue as factory gate inflation races ahead of any further currency gains.

But also spare a thought for those vendors who run substantial FOB programs, quoted in dollars, who have experienced the same cost increases but without the currency gains to offset against them.

So where is this all going in 2008? Unfortunately, all the signs are that we’re going to see a lot more of the same and our ability to react and do things differently will be key:

In this Brave New World, the biggest challenge for us all will be to change the expectations of the consumer (and we are all consumers…), who only remembers a golden age when less and less bought more and more.

The value proposition must move away from price, and in this respect, marketing excellence will be key – that means many more new and innovative products, at the right price, imaginatively promoted to an increasingly impoverished & selective consumer.

Constructive dialogue with manufacturing and retailing partners is key – entrenched positions will lead to supply shortages and then no one wins. Expect more direct sourcing of commodity style products by retailers – any products without IP, TV advertising or character licenses must now surely be on the “endangered” list.

The fittest will survive, but those poorly run businesses without brands or a good value propositions will find this year one of the toughest in living memory.

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