As we begin a new year, there are many opportunities and challenges facing manufacturing and distribution companies. Headwinds that we noted in our 2022 Outlook —supply chain disruption, commodity price increases, skilled labor shortages and shortages in various inventories—have seen overall stabilization. However, spikes in pricing and overall inflation in pricing continues. Volatility, in addition to high energy and commodity prices, continues to disrupt industrial manufacturing and automotive sectors, both of which are large consumers of energy and raw materials. With overall wage inflation affecting all levels of businesses, skilled labor shortages, changes in tax policy, increases in interest rates, new sustainability goals, and a looming recession, companies have a new focus for the year ahead.
The following are the top five areas manufacturing and distribution companies should focus on in 2023.
1. Inflation and rising interest costs
In 2022, rising inflation seemed to be a short-term issue driven by the pandemic. However, the temporary inflation narrative has vanished. We have seen the highest inflation in four decades. Inflation has spanned seven percent to nine percent throughout 2022, and will continue to take a toll on businesses through rising costs, labor constraints, and variable supply chain disruption.
Increased costs have created working capital constraints for a lot of businesses, as most are dependent on working capital lines of credit to fund inventory purchases. Those lines of credit have seen significant increases over the past year as supply chains opened up at the end of 2022 and businesses saw a huge influx in delayed inventory. Overall, inventory levels are becoming exceedingly high and as demand tempers, we should expect to see declining prices as companies need to start turning over their inventories quicker. Companies have had to focus more than ever on cash flow projections to alleviate these burdens and work with their banks/financing institutions to increase the short and long-term borrowing capacities. With all of this, the federal reserve has increased their base interest rate from a quarter of a percent at the beginning of 2022 to four and a half percent at the end of the calendar year, with an expectation of more increases coming in 2023.
Many companies had strong income for 2022, but overall, there is an expectation that 2023 will be more challenging with a looming downturn. With the short-term increase in inventory levels noted above, companies are diligently working to turn those inventories into sales before a potential recession. This situation has caused a bigger need for companies to manage their cash flow projections and also try to manage their overall interest costs. From a tax perspective, interest expense limitations under Section 163(j) will make the cost of financing additional working capital more expensive for businesses. Leveraged businesses should project their 2023 tax posture to determine whether or not they will have their interest expense deductions limited. If their interest expense deduction is limited, they can consider amortizing portions of their line of credit or work to sell through excess inventory to avoid longer carrying costs. Companies should be proactive as banks are already starting to tighten standards and lending capacity.
2. Excess working capital and labor shortages accelerating investments in technology
Many companies rebounded from the pandemic with overall healthy balance sheets to begin 2023. Some companies have used their additional funds to reinvest in their business to prepare for future labor shortage challenges by investing in new enterprise resource planning (ERP) systems. These ERP systems combine financial management software with other core tools such as customer relationship management (CRM), marketing automation platforms (MAP), and inventory management. Customers are also demanding more real-time supply chain information (lead times, quantity on hand) and an expectation of being able to access this information online or through their customer representative.
One of the biggest lessons learned over the past few years is that supply chain visibility is one of the most critical components to success for manufacturers and distributors, and the only way to alleviate that pressure is to have real-time visibility and forecasting ability within your supply chain. Businesses that did not have that ability or relied on certain employees for all of those tasks “offline” know these investments are critical. These investments will not only provide faster real-time reporting and higher quality results and production, but will also minimize a company’s dependence on labor while maximizing their customers’ satisfaction.
3. Improving visibility to profitability at the product level
With the 2023 economic outlook being uncertain, business owners and managers are heavily focusing on profitability. In my experience, most owners and business managers they do not track profitability at the product level due to limitations in their accounting system. Companies will need an enhanced view of profitability by product to assess true gross profit margins. Cost savings such as purchasing power, rebates, incentives, prompt pay discounts, and royalties are difficult to track down to the individual product level. Even supply chain disruptions for certain products have carrying costs that can go unaccounted for at the product profitability level.
A new ERP system could be the fix, however, if a new ERP system is not an immediate priority, companies should review their current systems to evaluate if existing inventory modules are being used effectively. They can also use existing analytical excel tools to assess product profitability. Companies should review their cost allocations more periodically and by various product groups. This will help drive better decision making beyond profitability if certain products are being offered to promote customer demand and retention. This analysis should then extend to true individual customer profitability and a determination if certain customer relationships should be expanded or even reduced.
4. Research and development (R&D) – a significant tax change
Historically, having R&D costs has been beneficial since they can generate a tax credit, while the costs incurred to generate the credit are fully deductible if the reduced credit is claimed. Under the Tax Cuts and Jobs Acts passed in December 2017, a delayed provision was included which affected tax years starting in 2022. The provision requires R&D expenses to be capitalized and amortized over five years (15 years if the activities are performed outside of the United States). The capitalization rules translate to a half year of amortization for 2022.
This tax provision came into effect in 2022 and is already starting to have a ripple effect on many businesses. Most manufacturers spend a considerable amount of their resources on R&D, and a substantial increase in the cost of investment (increase in taxes) would require them to make difficult planning and investment decisions. This comes at a time when most companies are trying to make their processes and products more sustainable, which requires considerable investments. A sizeable reduction in available resources could also present obstacles to businesses’ equipment investments and environmental/sustainability goals.
There has been bipartisan support in Washington for the elimination or deferral of this change to R&D expenses as part of several acts, including the Build Back Better Act. However, no act or change has occurred to date. Although the potential remains for Washington to reverse this provision retroactively for the 2022 and the 2023 tax year, it would be prudent to plan for the compliance under the existing law and for the additional taxable income.
Cybercrime has significantly surged worldwide in the past several years. Manufacturers and distributors are specifically targeted with ransomware attacks through tactics such as spear phishing — the increase in attacks is staggering. These impacts are not only felt at the business level but by all vendors, customers, and members of a company’s supply chain. A combination of actions are necessary to prevent these breaches from occurring. The first step is to take an inventory of the assets you have in place for data, technology, and other cyber security assets. The second step is to protect what you own. The development and fortification of those assets in your business come from password updates, patching software and hardware, routine backups, and employee education which is often overlooked. The genesis of over 90% of breaches is through spear phishing and the first line of defense is your employees. By providing routine cybersecurity awareness trainings, you can create a virtual human firewall.
These cyber security systems should be tested throughout the year by doing penetration and vulnerability tests to determine where your strengths and weaknesses are, so that in case of a breach you are prepared. In our experience, most businesses believe they are adequately protected with the combination of their existing in-house or external IT providers, but unfortunately, many companies are only receiving the most basic services from their IT providers without the implementation of cyber protection. Basic matters, like firewall updates and software patches, are not being performed as timely as they should be. Utilizing a third-party cyber specific resource can help identify these weaknesses before a potential breach occurs.
One key trend in 2023 is cyber criminals targeting the supply chain. According to Verizon, the genesis of almost two-thirds of system intrusion incidents is the result of an organization’s partner. Compromising a key service provider in the supply chain can result in exponentially more unauthorized downstream attacks, making it imperative that businesses evaluate their third-party vendors’ cyber defenses. By implementing third-party risk management policies and procedures, vendors that could cause a potential compromise would be evaluated from procurement to offboarding, helping to ensure they are meeting or exceeding the standards needed to keep your company secure.
How Citrin Cooperman can help
Citrin Cooperman’s Manufacturing and Distribution Practice is one of the leading practices in the country. Our dedicated team leverages specialized knowledge to provide a full range of attest, tax and specialty tax, business advisory, economic advisory, and transaction support services. Our consultative approach to all services, coupled with our depth of experience, allows us to help our clients achieve their goals in 2023 and beyond. If you need assistance with any of the topics discussed in this article, please contact your Citrin Cooperman advisor.
Interested in more information on the topics mentioned in this article? Click on the links below for more thought leadership on the topics discussed.
- Debt-Financed Taxpayers Might Not Be Able to Deduct All Interest in 2022
- ERP Implementation: The 5-Step Methodology You Need To Go Live Without A Hitch
- Key Considerations When Evaluating Your Manufacturing and Distribution Company’s Profitability
- Top Considerations for 2022 Year-End Tax Planning
- Six Cybersecurity Trends That Will Shape the Landscape for 2023
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