Price Deflation can make it feel like you're running a lot harder just to keep up with last year.

In the weird and wacky world of electrical products pricing, electrical distributors are seeing a new threat to their profits: deflation. In a deflationary economy, according to the Institute of Certified Financial Planners, Denver, Colo., the prices of goods and services decline, and there are too many goods on the market chasing too few dollars.

This is happening in the electrical market today, but it probably sounds a bit crazy to electrical distributors, reps and manufacturers who grew up in a business world where inflation consistently nudged product costs up. To cover these increases, manufacturers charged distributors more for their products and distributors in turn raised their prices to end users to cover these price hikes.

"The Electrical Price Index," published each month by Electrical Marketing newsletter, EW's sister publication, shows that indeed, prices for a diverse basket of electrical products have dropped. This index, composed of 28 electrical product groups, is down 1.8% since last December. At press time, the product categories with the biggest decreases over the past year were as follows: building wire and cable (-14.9%); nonmetallic conduit (-3.9%); power wire and cable (-3.6%); and ballasts (-3.4%).

Deflation reigns supreme today in many electrical product categories for several reasons:

There's a surplus of product on the market because manufacturers are cranking out more products than the market now demands;

Production improvements on the factory floor allow manufacturers to build or assemble more products at lower costs than they could in the past;

And manufacturers in Asia and other economically depressed areas around the globe are slashing prices just to keep their factories open and to take in whatever meager profits they can pocket.

What do these macroeconomic trends mean to electrical distributors? Several distributors have noticed that in the past year or two they have had to sell more products to keep pace with the same sales volume, and that while the manufacturers' costs of many products that they sell are going down, so too are the prices they can charge in the marketplace. Distributors are also being squeezed by the fact that fixed costs such as labor, utilities and warehousing space remain steady or are increasing.

Says Steve Helle, vice president, Capitol Light & Supply, Inc. (CLS), Hartford, Conn., "Let's not kid ourselves. In this industry, a lot of the products we sell cost us a whole lot less than they did last year: steel, PVC, copper, ballasts, fixtures, fittings, the list goes on and on. On a unit-to-unit basis, we're stressing our operations because we've got to sell 20% more units to do the same gross-margin dollars. That's assuming the gross margin stays the same. If you just held your gross-profit margins, you have to handle some percentage more units.

"That has made it a struggle to grow our business as fast as we'd like to grow it, and as we have grown it in the last couple of years. So it's taxing some of our operational systems. I think we're in for a bumpy ride over the next six months. I'm not suggesting we're in recession, but we're going to have to scratch and claw to make the same amount of dough, and really scratch and claw to make more net income."

While the New York metropolitan market continues to flourish, Greg Griswold, vice president and general manager of Kennedy Electrical Supply Corp., Jamaica, N.Y. says profit levels continue to shrink, in part because of deflation. "That's the residual of some people having a couple of bad years and beating the crap out of everything, but you're also seeing some deflationary trends," he says. "Pipe has gone down a little bit, wire's all over the place, and people just assume that prices on materials should be going down because of what's been going on in the world.

"That's been tough, because people costs are not going down, and utility prices are not going down. My typical costs as a business are increasing, and I'm having to handle more, physically, to get to the same profit level. That drives my costs up.

"Net-income-wise, we don't expect (next year) to be as good a year as this year or as last year even, but we expect to do more volume. That's kind of scary. Everybody assumes you sold 10% more than you did last year so you must be doing better. Not necessarily the case. Unfortunately, if we didn't sell 10% more, we'd be a lot worse off. It keeps shrinking and shrinking, and it's a very difficult situation."

CLS's Helle says for years electrical distributors almost routinely updated their prices to cover manufacturers' pricing increases, but that's no longer the case. "Deflation is a costly thing. For the last 20 years, every year every electrical distributor updated his pricing to the new price increases. You know what? They're not there. If people really look at the units that they're moving now to do the same gross dollars, they're going to see that lots of stuff that they're buying in the electrical world is a whole lot less than it was last year."

While deflation of a few percent over the past few years is driving some electrical distributors crazy, they should be glad they aren't distributors of electronic components, where prices of computer-related products are in a free-fall. Adam Fein, president, Pembroke Consulting, Inc., Philadelphia, Pa., says of all distribution-based businesses, the electronics industry best exemplifies the perils of deflation, and can serve as a benchmark for other distributors struggling to understand this issue.

"The prices of things like D-RAM semiconductor chips are going through the floor. You have this weird problem where the products you are selling are going down in price, but the costs of labor, or building a warehouse or renting a truck are stable or flat. You are buying your inputs in one market and selling them in another, and you are having these incredible margin swings."

Robert Lush is professor of marketing and accounting at the University of Oklahoma, and is on the board of directors of an Oklahoma-based distributor of computer memory chips and boards. That company saw prices of its core products drop 80%-95% over the last 30 months. "This company went from $40 million in sales to $22 million, but shipped about six times as much product," he says. To bring back some of the lost sales, he says that distributor started an assembly operation where it does some light manufacturing of products that it has sold for years. Adam Fein believes offering a new service like this is one of the best ways a distributor can beat deflation.

"While goods go down in price, historically, services rarely go down in price," he says. "There is really not much service deflation. Many of these distributors in these deflationary environments shift their product mix into more service-based types of activities, where they actually get paid a fee for the service. They have to lower their cost and understand their cost well enough to unbundle their margin and to offer it on an a la carte basis."

Deflation is one of the main reasons that the electronics industry, already much more consolidated than the electrical business, is seeing another wave of mergers and acquisitions. It could conceivably happen in the electrical industry, too. "The deflationary environment favors lower-cost producers," says Adam Fein. "There has been dramatic consolidation in the electronics market in the past 20 years, but it has accelerated in the last two to three years as this margin squeeze accelerated. You just can't afford to have any fat anymore."

There's no easy fix for deflation, but Robert Lush, professor of marketing and accounting, University of Oklahoma, and Adam Fein, president, Pembroke Consulting, Inc., Philadelphia, Pa., suggest the following:

Improve your company's productivity. No mystery here, but for distributors who have already focused on this, there may be no more fat left.Get paid for value-added services. It's tough to convince customers to pay for a service you used to provide for free, but it has worked for some distributors.

Diversify into other product or market areas. If your core market is under assault from deflation, consider moving into some new niches that aren't. Get into the acquisition game. You can spread more of your fixed costs across the additional sales volume.

Check your inventory accounting methods. FIFO (First-In, First-Out) inventory accounting works best during inflation, while LIFO (Last-In, First Out) will help in deflationary times, says Fein.