Run with the wind, but keep a weather eye open. That's an appropriate prescription for any business owner looking for clear sailing in 2006. While economists anticipate a continuation of the fairly good business growth enjoyed over the past 12 months, they also predict greater pressure on profitability as businesses cope with rising expenses.

“We expect continued strength in the economy in 2006,” says Sophia Koropeckyj at Economy.com, an independent research firm based in the Philadelphia suburb of West Chester, PA. Gross Domestic Product (GDP) — the most widely used figure for gauging economic health — is expected to increase by 3.7%, a figure not much different from the 3.6% of the past 12 months.

Even if the nation's economy remains on its upward track, though, its growth won't match the 4.2% rate registered in 2004. “It's clear that we are past the ‘post recession surge’ that characterized the robust activity of two years ago,” says Koropeckyj. “The economy is moving into a more mature phase of the business cycle.”

And how about those multiple hurricanes late in 2005 that caused so much disruption to energy supplies and trade flows? Their effect on the national economy “has not been as devastating as expected,” says Koropeckyj. “A lot of manufacturers are actually going to benefit during the first half of 2006 because reconstruction efforts will create an increased demand for their products.”

Here's one more factor that should contribute to a strong 2006: A fairly high level of business confidence that perked up early in 2005 and, fueled by unexpectedly strong corporate profits, has remained robust ever since. That can only encourage a continuing round of capital spending that will help energize the year ahead.

As for banks, they seem willing to play their part: “Borrowers are willing to lend and interest rates are still low,” says Koropeckyj. Investment in capital goods is expected to increase some 9% in the next 12 months, down modestly from the 2005 rate of 11%, which was virtually unchanged from the previous year.

Businesses should also benefit from these factors in 2006:

  • Steel prices, which have already come down because of weakened demand from the automobile industry, should drop further.

  • Exports should increase by 11% according to Economy.com, thanks to a recent weakening of the European economy against that of the U.S.

  • The dollar should remain fairly steady against the Euro. Economy.com expects the Chinese yuan to appreciate 10% in the coming year against the dollar, which should fall by 15% against Asian currencies by the end of the decade.

  • Long-term interest rates have remained under control despite the continuing escalation of the discount rate by the Federal Reserve.

So much for the good news. Maybe the overall economy is on a fairly robust footing, but everyone is casting a wary eye on the rising costs of doing business.

“Our manufacturers are very busy, to the extent that many of them can't meet the demands from their customers,” reports Michael Smeltzer, director of the Manufacturers' Association of South Central Pennsylvania, a trade group whose members represent primarily smaller operators in a broad range of industries. “Yet, most are starting to see slimmer profit margins.”

Manufacturers seem to be caught between two forces, says Smeltzer. The first is upward pressure from the increasing cost of energy. The second is the ceiling on prices that has been set by the growing presence of foreign competition.

Let's consider each in turn. Certainly the recent spike in the price of oil has become a top-of-mind issue at many businesses. “Our members have seen recent energy cost increases of upwards of 40%,” says Smeltzer, who notes that higher fuel costs have a domino effect when they fatten shipping bills that increase the cost of goods for everyone. Many larger companies selling to other businesses have been able to pass through energy cost increases. That's not the case, though, with companies serving cash-strapped consumers who are likely to snap shut their wallets when confronted with higher shelf prices.

Economists do expect some moderation in fuel costs over the course of the year. “As production returns to normal in the Gulf and as worldwide production steps up, we expect a barrel of crude to drop from its current level of $60 to $50 by end of 2006,” says Koropeckyj. Natural gas prices, though, are “a bit more problematic. We expect them to remain quite high through the end of decade.”

Now for the second force affecting businesses. The foreign competition that has long been a bugbear of American industry has reached something of a tipping point in recent times. A big factor is the low cost of labor in Asia and the rising aggressiveness of companies in that area of the world.

“Our manufacturers are saying they can't increase their prices for fear their customers will look elsewhere,” says Smeltzer. “Or they are afraid competitors from outside the U.S. will try to take their markets.”

Competition from Asia is a particular challenge for smaller businesses that may not be able to establish overseas branches and may need to negotiate deals to purchase more foreign-made parts to keep their products competitive.

Add to the above pressures the continuing rise in the cost of employee health care and the result is a boiling pot of turmoil for business owners looking to maintain the profitability that was a hall-mark of 2005.

The challenge to profit in 2006 will be especially tough for businesses dependant on consumer spending. American shoppers squeezed between stagnant wages and bigger bills for gasoline, home heating, food and other necessities are experiencing a dwindling level of disposable income.

Business challenges are not new, of course, and neither are many of the techniques for meeting them. In recent times, many businesses have improved productivity by streamlining operations.

The primary technique for doing so has been the trimming of labor costs, an exercise that, while effective, seems to have reached a point of diminishing return. “The ability of companies to utilize their existing labor force much more intensively has pretty much run its course,” says Koropeckyj.

Trim as their work forces are, businesses are likely to remain shy of hiring more people, partly because they remember the painful layoffs that characterized the recent recession. “We do not expect manufacturing employment to pick up in 2006,” she says. “Manufacturers still need to maintain labor costs that are appropriate in the face of global competition.”

So what can business owners do to prepare for the next 12 months? Future productivity gains will need to come from investments in innovative technologies and the streamlining of back office and support operations.

“On the product manufacturing side many businesses have done a good job integrating the supply chain into their systems and a decent job in integrating customers into their systems,” reports Smeltzer. “The next logical step is to look at the business side: Are there ways technology can help utilize resources? Are there effective management programs to avoid the use of excessive energy?”

Many times, of course, investing in technology can prove difficult for smaller operators. Things aren't made easier by the increasing cost of money. “Six kicks of the prime rate in 2005 is reason enough for many business owners to rethink expansion or embrace new technology,” says Schackne. “Many smaller manufacturers are looking at rising rates and saying ‘Nah, I don't think I will borrow now.’”

On the human resources side, organizations large and small need to respond to employee nervousness about the rising costs of gasoline and home heating fuel. “Rising costs are weighing heavily on the mentality of workers,” warns Schackne. “The resulting pressure on emotions, I believe, will curtail and hurt production.”

Schackne suggests helping employees organize car pools and expand flex-time programs to accommodate work schedules. And ask employees for ideas that will make their jobs more efficient. “It's amazing what employees can tell you about their jobs if you ask them,” he says.

In brief, 2006 presents American business with an operating environment characterized by steady if unspectacular economic growth. Successful organizations will continue to improve productivity, cutting unnecessary expenses to wring more profitability out of revenues that will be increasingly hard to come by, particularly for those businesses serving consumers.