As earnings season gets under way early in 2011, investors should perhaps look at the profit margins of producers, especially those who need to buy raw materials to make their products (CHART BELOW).

US producers face higher costs/inflation. However, they can't pass off that cost to their customers.

From the conversion of raw materials to the finished products that's eventually sold to consumers, business at all production stages swallow a portion of the cost (meaning no one fully passes on the cost to their customers, be they corporate customers or the end consumer).

Those who are the closest in the manufacturing chain to raw materials likely suffer the most.

Consider the month of December 2010, when year-on-year inflation surged 15.5 percent for raw goods, 6.5 percent for intermediary goods, 4.0 percent for finished goods, and only 1.5 percent for consumers.

Consumer inflation -- by the government's CPI measure -- includes the consumption of services and raw materials, so overall CPI isn't an entirely accurate measure of consumer costs for manufactured goods.

Nevertheless, inflation for consumer goods are likely tame compared to those for producers.

Below is a chart showing inflation for raw materials, intermediary products, finished goods, and consumer prices for 2010.


The chart illustrates the assertions stated above, namely that:

1) compared to 2009, the cost of raw material has skyrocketed.

2) each level of production swallows a portion of production cost

3) those hit the hardest are likely the producers closest to the raw material stage

One reason costs can't be passed on to consumer is that wages are stagnant and the labor market remains poor. However, as raw material costs increase and producers are further squeezed, something has to give.

An optimistic scenario is that consumer confidence and balance sheets improve, so they agree to pay higher prices. An adverse scenario is that consumers can't afford the higher prices, so businesses go bankrupt and consumers forego certain goods.

At the onset of the recovery after the financial crisis, companies posted impressive rebounds in earnings as they brutally slashed costs. However, they were weaker in revenues growth.

Now, a new pattern is emerging for some companies: solid revenues, but shrinking profit margins and less-than-stellar earnings.

Below are several companies, across various industries, that exhibited this pattern in recent earnings reports (for the costs, I tried to get the metric that most accurately reflects the effects of inflation):

                          %Rev growth        %Cost/inflation growth

Pepsi   PEP        36.5                         41.3

Cisco CSCO      6.03                         19.04

Sara Lee SLE    -0.42                         2.24

Humana HUM     9.4                           13.23

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