Q3 SME Cost Inflation Report November 2013

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1 Q3 SME Cost Inflation Report November 2013 Helping your business stay one step ahead through our insight Research

2 Contents Executive Summary Executive Summary UK Economic Overview SME Cost Inflation Trends SME Credit Conditions SME Business Confidence This report was produced by Centre for Economics and Business Research (Cebr) for Aldermore. Cebr is not licensed in the conduct of investment business as defined in the Financial Services and Markets Act Any client considering a specific investment should consult their own broker or other investment adviser. Any views on investments expressed by Cebr, or on behalf of Cebr, are intended to be generic only. Cebr accepts no liability for any specific investment decision which must be at the investor s own risk. Annual cost inflation for the average UK small and medium-sized enterprise (SME) fell to its lowest level since Q in Q This reduction in input prices, together with falling interest rates on loans, suggests that the improvement in the UK economy is feeding through to the smallest of businesses. The reduction in SME cost inflation was largely driven by a significant year on year decrease in the price of financial and legal services. This particularly benefited business services firms, who saw costs fall on an annual basis in Q3. Construction firms, by contrast, who use fewer of these services, saw cost inflation rise slightly, driven by increasing prices among construction sub-contractors and rising costs of physical inputs. Business insolvency statistics, however, confirm that conditions remain relatively difficult, with the number of companies entering liquidation falling only very slowly. Annual cost inflation among SMEs fell in Q to 0.7%. This is the lowest annual SME cost inflation rate since Q The decline was largely driven by an 8. decrease in the costs of legal and financial services UK Business Insolvencies Appendix: Cost Base Analysis Contact and Methodological Note Whilst every effort has been made to ensure the accuracy of the material in this report, neither the authors nor Cebr will be liable for any loss or damages incurred through the use of this report or associated materials. Across the UK, the business climate continues to strengthen. GDP expanded by 0.8% quarter on quarter in Q3, building on 0.7% growth in Q2. Further acceleration is anticipated in 2014, when the UK is expected to see stronger growth than any other advanced economy, at around 2.7%. This should make 2014 a brighter year for the UK s vast population of SMEs, although the prospect of interest rate increases as the economy recovers could cast a shadow over some of these firms in later years. Construction SMEs faced the highest cost inflation, while business service SMEs found costs fell year on year. 2 Contents SME Cost Inflation Index Q3 SME Cost Inflation Index Q3 Executive Summary 3

3 UK Economic Overview UK annual GDP growth UK economy on course to pass 2007 peak in % The UK economy expanded at a quarter-on-quarter rate of 0.8% in Q3 2013, a slight increase from the 0.7% growth experienced in Q % Growth continues to be broad-based, with all four major industrial groups agriculture, manufacturing, services and construction expanding in Q3. 2% The services sector, which makes up around four-fifths of the UK economy, provided the largest contribution to growth in Q3 around 0.57 percentage points. Construction output has been boosted by a resurgence in the housing market, partially driven by the government s Help to Buy scheme. This acceleration in growth suggests that the UK economy will expand by 1.6% over 2013 as a whole. This would be the strongest growth in the economy since % -4% Forecast Forecast The improvement in economic prospects is expected to persist through 2014, buoyed by rising consumer and business confidence. The economy is expected to expand by 2.7% in 2014, with output finally surpassing its 2007 peak. -6% UK Economic Overview SME Cost Inflation Index Q3 Source: ONS, Cebr analysis SME Cost Inflation Index Q3 UK Economic Overview 5

4 SME Cost Inflation Trends Falling fees for financial and legal services subdue SME cost inflation Annual average SME cost inflation fell to 0.7% in Q3 2013, from 1.2% in Q2. This is the lowest annual change in costs since Q The latest reduction in inflation was largely driven by cuts in legal and financial fees, which fell by at an annual rate of 8. in Q These costs have now fallen on an annual basis in four consecutive quarters, but the decline in Q3 2013, of 8. was by far the largest experienced since the start of the series in Slower growth in employment costs, also helped to reduce the rate of inflation. Wage expenses rose by just 0.8% year on year in Q3 2013, down from 2. in the previous quarter. Average SME annual cost inflation rate 6% 5% 4% 3% 2% 1% Telecoms and IT costs continued to come down, falling by 0.9% year on year, after declining by 0.5% in Q2. The price of physical inputs, such as chemicals and metals, however, rose by 1.7% year on year in Q3 2013, up from 0.9% in Q2. The annual rate of inflation for energy and utilities also increased, reaching up to 5.3% in Q3 from 4.5% in the previous quarter. -1% Q Q Q Q Q Q Q Q Q Q Q Q Changes to the back history of this indicator reflect changes in ONS methodology see back page for further details. 6 SME Cost Inflation Trends SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 7

5 SME Cost Inflation Trends Cont... Driven by employment costs, construction and physical inputs Employment costs, construction and physical inputs each made sizeable contributions to SME cost inflation in Q Physical inputs, such as metals and chemicals, contributed 0.34 percentage points to the 0.7% annual increase in average SME cost inflation this quarter. Construction costs contributed a further 0.28 percentage points of the rise, and employment costs 0.26 percentage points. Percentage point contribution to headline annual SME cost inflation rate 0.8% 0.6% 0.4% 0.2% Finance and legal fees continued to place significant downward pressure on cost inflation. Headline SME cost inflation would have been 0.3 percentage points higher without this fall. This is largely driven by a dramatic annual reduction in the costs of financial service fees, where business conditions remain difficult. -0.2% -0.4% Telecoms and IT costs also provided a marginal negative contribution to the headline inflation rate. Utilities prices continue to exert some upwards pressure on headline cost inflation, but remained relatively muted through Q3, adding less than 0.1% to the overall rate of annual cost inflation. Finance & Legal* Telecoms & IT Commercial Rent Q Q Other Services Business Services Transport & Storage Energy & Utilities Employment Costs Construction Physical Inputs 8 SME Cost Inflation Trends SME Cost Inflation Index Q3 * Includes financial services, insurance, accounting and legal services Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 9

6 SME Cost Inflation Trends Cont... Construction SMEs experience highest cost inflation while other business services see costs fall Small and medium-sized construction companies saw the highest annual cost inflation in Q3 2013, at close to 1.5%, up from 1.2% the previous quarter. The main driver of this increase was the rising cost of purchases from other companies in the same sector. These account for more than a quarter of all inputs to construction SMEs, which tend to be highly specialised and sub-contract widely. Business services costs fell by 0.7% year on year in Q3 2013, after rising by 1.8% in the previous quarter. Annual pay growth across the sector fell in Q3, while cuts in legal and financial services fees also made a significant contribution to the sector s decline in cost inflation. SME annual inflation rate by selected industry 2% 1.5% 1% 0.5% Annual cost inflation for small and medium-sized manufacturers remained largely stable in Q3 2013, at around 0.8%. Rising costs of physical inputs placed upwards pressure on the rate, as did employment costs and energy bills, but these were partially off-set by falling legal and financial costs. Reduced legal and financial fees also provided some respite to retail SMEs in Q3 2013, prompting annual cost inflation for these firms to fall back to 0.8%, despite rises in the costs of raw materials and labour. -0.5% -1% Business Services Manufacturing Q Q Retail Construction Note that the chart here is of selected industries only and is not exhaustive of the entire SME economy. The overall SME inflation index presented on page 7 does, however, cover all SMEs. 10 SME Cost Inflation Trends SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 11

7 SME Cost Inflation Trends Cont... Cost inflation remains subdued for manufacturing SMEs Annual cost inflation for manufacturing SMEs remained stable in Q3 2013, at 0.8%. The main contributors to cost inflation for these firms, however, changed over the course of Q While in Q2, rising employment costs accounted for three-quarters of the increase (0.6 percentage points), a slow-down down in wage growth means this fell to a third (0.3 percentage points) in Q3. Rising prices for physical inputs, such as metals and chemicals, now make up the largest component of inflation for small and medium-sized manufacturers. These inputs accounted for 0.7 percentage points of headline inflation for these firms in Q Energy and utility price increases also continue to place pressure on SME cost inflation. SME annual inflation rate, manufacturers 8% 7% 6% 5% 4% 3% 2% 1% Together, these factors would have been sufficient to cause cost inflation for SME manufacturers to rise in Q compared to Q2. Cost inflation held steady, however, thanks to the dramatic year on year fall in the price of legal and financial services, which pushed the headline rate down by 0.3 percentage points. -1% -2% Q Q Q Q Q Q Q Q Q Note that the chart here is of selected industries only and is not exhaustive of the entire SME economy. The overall SME inflation index presented on page 7 does, however, cover all business types. 12 SME Cost Inflation Trends SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 13

8 SME Cost Inflation Trends Cont... Cost inflation rises for small and medium construction firms Construction SMEs saw annual cost inflation rise slightly in Q3 2013, to 1.5% from 1.2% in the previous quarter. Employment costs have pushed cost inflation up for these firms, contributing 0.6 percentage points to the overall rate. Annual employment cost inflation for the sector rose from 0.9% in Q to 1.4% in Q3. Rising employment costs also appear to have increased the costs of construction services purchased from other companies. As many small and medium-sized construction firms specialise in a single task roofing, plumbing or plastering, for example these firms often subcontract others, and increases in the cost of doing so added 0.8 percentage points to the sector s headline SME cost inflation rate in Q3. Falling fees for legal and financial services also had a negative impact on cost inflation in this sector, but as they make up a much smaller proportion of total inputs, the effect was more muted than in other industries. SME annual inflation rate, Construction firms 8% 7% 6% 5% 4% 3% 2% 1% -1% -2% Q Q Q Q Q Q Q Q Q Note that the chart here is of selected industries only and is not exhaustive of the entire SME economy. The overall SME inflation index presented on page 7 does, however, cover all business types. 14 SME Cost Inflation Trends SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 15

9 SME Cost Inflation Trends Cont... SME retailers benefit from falling legal and financial fee costs Annual cost inflation for small and medium-sized retail firms fell back to its lowest level for three years in Q After remaining stable at around 1. for the past three quarters, cost inflation for these firms dropped to 0.8% in Q3. This fall came despite an acceleration in the growth of prices for physical inputs and labour. Employment costs added 0.4 percentage points to retail SME inflation in Q3 2013, up from 0.3 percentage points in Q2, while physical inputs contributed 0.5 percentage points, up from 0.3 in the prior three month period. These increases were negated, however, by the sharp fall in the prices of legal and financial services. The 15.3 percent year on year fall in financial services prices took 0.6 percentage points off the headline rate of inflation for SME retailers. SME annual inflation rate, Retail firms 8% 7% 6% 5% 4% 3% 2% 1% -1% -2% Q Q Q Q Q Q Q Q Q Note that the chart here is of selected industries only and is not exhaustive of the entire SME economy. The overall SME inflation index presented on page 7 does, however, cover all business types. 16 SME Cost Inflation Trends SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 17

10 SME Cost Inflation Trends Cont... SME cost inflation tumbles for business service firms SMEs providing business services saw annual cost inflation reach its lowest level since Q in Q3 2013, with costs falling by 0.7% year on year. Labour is the single largest input for business services SMEs, and a 0.9% fall in average labour costs shaved -0.5 percentage points off the headline rate for SMEs in this sector. A more dramatic year on year decline in the costs of financial and legal services also made a significant contribution to the downwards move. Reductions in the cost of these services pushed inflation for business service SMEs down by 0.4 percentage points. A slight increase in the annual cost of physical inputs, transport and storage and energy and utilities prevented the rate from falling further. SME annual inflation rate, business service firms 8% 6% 4% 2% -2% -4% -6% Q Q Q Q Q Q Q Q Q Note that the chart here is of selected industries only and is not exhaustive of the entire SME economy. The overall SME inflation index presented on page 7 does, however, cover all business types. 18 SME Cost Inflation Trends SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 SME Cost Inflation Trends 19

11 SME Credit conditions Borrowing costs fall for even the smallest SMEs Over the past three months interest rates have begun to fall back, even for the smaller SMEs. The average interest rates offered to smaller SMEs fell to 4.71% in August 2013, down from 4.78% in May and from 4.75% a year earlier. Median interest rates on variable-rate facilities for SMES, three month average 5% 4.8% 4.6% 4.4% Although rates for these firms remain elevated, they have fallen in five consecutive months, suggesting efforts to retarget the Bank of England s Funding for Lending scheme (FLS) since April to focus more tightly on small businesses are working to increase the flow of credit to small companies. The average interest rate offered to medium SMEs also fell back in August 2013, to 3.3, down from 3.37% in May and from 3.47% a year earlier. Interest rates offered to these firms are now at their lowest level since December % 4% 3.8% 3.6% 3.4% Further interest rate falls are expected in the months ahead, as the changes to the FLS continue to feed through the banking system. 3.2% 3% Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Smaller SMEs Medium SMEs Source: Bank of England. Smaller SMEs are those with annual debit account turnover on the main business account of less than 1 million. Medium SMEs are those with annual debit account turnover on the main business account of 20 SME Credit Conditions SME Cost Inflation Index Q3 between 1 million and 25 million. SME Cost Inflation Index Q3 SME Credit Conditions 21

12 SME Business confidence Among SMEs hits a high Business confidence continues to soar, with the ICAEW/Grant Thornton Business Confidence Monitor reaching the highest level in its 10 year history. This suggests that the economic recovery continues to gain momentum, and that GDP growth is likely to strengthen further in the coming months and into the New Year. Confidence among SMEs climbed for the fifth consecutive quarter in Q4 2013, and is now far above its level at the same time a year ago. In line with improvements in confidence, SMEs are becoming more willing to invest. The average SME expects to increase capital investment by 2. over the next year still below the pre-crisis growth around 3., but an improvement on the 1.6% growth seen over the past year. Business Confidence by company employment size More than half of all SMEs (6), however, continue to operate below capacity. -15 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q SMEs (0-249) Large (250+) Very Large (1000+) Source: ICAEW / Grant Thornton Business Confidence Monitor Confidence scores are calculated by asking the question how confident are you in business prospects in next 22 SME Business Confidence SME Cost Inflation Index Q3 12 months, versus last 12 months, with positive and negative answers being balanced to give overall score. SME Cost Inflation Index Q3 SME Business Confidence 23

13 UK Business Insolvencies Total number of UK company liquidations Business failures continue to fall, but slowly 6,000 In Q there were 4,094 company liquidations in the UK. This is 6.8% lower than the number in Q2 2013, and 3.6% down on a year earlier. However, the number of businesses failing remains elevated by pre-financial crisis standards. While the UK economy is strengthening, these figures suggest that businesses continue to face challenging conditions. Low interest rates have allowed many firms to survive the turmoil of the last few years despite limited profitability, but with the economy rapidly picking up pace, and unemployment falling, the Bank of England may be forced to raise interest rates sooner than previously anticipated. 5,000 4,000 3,000 2,000 1,000 Upward revisions to Bank growth forecasts in the November Inflation Report suggest that the 7. target for unemployment, after which interest rates may begin to rise according to existing forward guidance, may be breached as early as Once interest rates rise, the number of insolvencies may increase once again as firms find they cannot afford to refinance loans. 0 Q Q Q Q Q Q Q Q Q Q Q UK Business Insolvencies SME Cost Inflation Index Q3 Source: UK Insolvency Service SME Cost Inflation Index Q3 UK Business Insolvencies 25

14 Appendix: Cost Base Analysis Breakdown of business costs, % of total, by SME type Employment costs and physical inputs make up the bulk of average SME costs Purchases of physical inputs and labour costs are the largest costs for SMEs, accounting for some 2 and 3 of total businesses expenses for the average SME. On top of this, a further 21% of total costs are spent on business services such as legal & accounting, advertising, IT & telecommunications. SMEs in manufacturing are heavily weighted toward physical inputs more than 5 of total cost is on these intermediate goods. SMEs in retail have a strong transport and storage weighting in their cost profile. Meanwhile, over half of the costs for business services SMEs are on employment Employment costs Physical Inputs** Business Services* Construction Transport & Storage Commercial rent Energy & Utilities Other services * Including finance, legal & accounting, IT & telecoms ** Including raw materials such as those from agriculture, mining and forestry, as well as manufactured products such as steel, textiles, timber, chemicals and foodstuffs. All SMEs Manufacturing Construction Retail Business Services 26 Appendix: Cost Base Analysis SME Cost Inflation Index Q3 Source: Cebr analysis SME Cost Inflation Index Q3 Appendix: Cost Base Analysis 27

15 For any questions or comments on this report please contact Holly Marshall, Head of Corporate Affairs, Aldermore Methodological note: The figures presented within this report are calculated from a range of data provided by the Office for National Statistics (ONS), including the Producer Price Indices (PPI). In November 2013, the ONS updated the methodology of this series, rebasing from 2005 to 2010 to reflect changes in patterns of input use by firms and new products which have come to market in recent years. This update has changed historical PPI data, and has resulted in some small changes to past readings of the Aldermore SME cost inflation indices. Any differences between figures reported in this and past reports is due to these changes in official data, and reflects the best information available to the authors at the time of publication. Aldermore Bank PLC is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority (Financial Services Register Number ). Registered Office: 1st Floor, Block B, Western House, Lynch Wood, Peterborough PE2 6FZ. Registered in England no