Inflation is squeezing your paycheck, but you aren't the only one feeling the pinch. Consumer staples makers like McCormick (MKC -0.19%) are getting hit, too. In fact, the price hikes these companies are pushing through might be partly to blame for the inflation you are feeling. McCormick thinks 2023 will be the year it gets its costs under control. Here's why.

Not a pretty sight

Food makers like McCormick have been facing intense cost increases as inflation has raged around the world. That takes shape in many forms, but notably includes things like ingredient costs and production costs. Rising costs have put material pressure on the company's gross profit margin, which is basically the difference between its revenues and the price it pays to produce what it sells.

Chart showing McCormick's gross profit margin falling since early 2021.

MKC Gross Profit Margin data by YCharts

This is a really important number for consumer staples companies, because innovation is largely funded from gross margin. And to keep sales growing, companies like McCormick need to continually bring out new and improved products. That's what draws customers into stores to buy products and, in turn, drives retailers to stock McCormick's offerings. 

It's vital for a company like McCormick to protect its margins so it can keep innovating. That said, it is a large and financially strong company, so it can support ongoing spending through periods of margin weakness. But it still needs to fix a margin trend if it is going in the wrong direction, as it has been of late.

The game plan

There are a few things that consumer staples companies commonly do to expand margins. The first is the most obvious: pass rising costs on to customers. McCormick has been doing this and has been relatively successful in its efforts. But there's a balancing act. 

In the company's flavoring division, which is effectively a business-to-business offering, fiscal first-quarter 2023 sales increased 12%, adjusting for currency fluctuations. That was a mix of 13% increase in pricing and a 1% reduction from volume declines. If you raise prices, you often sell less product.

This was on much clearer display in the company's consumer-oriented business. It saw a constant currency sales increase of 1%, which came from a 9% price hike and a volume decline of 5%, along with declines related to business divestitures and the company's exit from Russia. The big takeaway is that you can only push on price so hard before customers, particularly the average person, start to push back.

That's why McCormick has also been working to reduce costs. The problem is that cutting costs, perhaps ironically, usually costs money, including for things like severance. So this can lead to worse margins before the benefits flow through. In fiscal 2023, McCormick is expecting to face another $50 million in costs related to "previous organizational and streamlining actions."

And then there's a more aggressive approach to margin enhancement, which would include things like selling or shutting down less profitable businesses. McCormick sold its Kitchen Basics division and exited some of its less profitable business in India. Although these moves can shrink the top line, they can have a material benefit on the bottom line because it improves the overall margins of the company.

When all is said and done, McCormick is expecting a mixed year in 2023, with sales projected to increase between 5% and 7%. That will largely be driven by price increases. But combined with its cost-saving efforts, management expects to materially offset the impact of inflation. Earnings are projected to fall between $2.56 and $2.61 per share, up from $2.53 in 2022, adjusted for one-time items. That's a modest 1% to 3% improvement, but is directionally a good outcome given the headwinds, noting that 2021 earnings came in at $3.05 per share.

Still working on it

Gross margins were down 80 basis points in the fiscal first quarter of 2023, so McCormick's path toward pre-COVID margins is still a work in progress. But that was a vast improvement over the 420-basis-point year-over-year drop in the fourth quarter of fiscal 2022.

McCormick believes fiscal 2023 will be a turning point as it continues to focus on improving its profitability, and if it is correct, shareholders will be pleased with the outcome. Perhaps that only means a slight improvement in earnings in 2023, but it will set the company up for a much better fiscal 2024.