Is your business prepared for the impact of significant inflation?
This post was written by John Miller, President of Passport Software, and we hope you find it useful.
Inflation is back. The Fed says that some inflation is a good thing and not to worry, as it will not get out of control. We all hope this is true, but only time will tell. It is prudent to examine this issue closely to consider the potential impact on your business.
Sources of Inflation
In 2021, as the economy starts to emerge from the economic shutdown, anyone who spends money is aware that inflation is already significant and we are seeing several sources of inflation, including:
· What is being labeled as supply-chain inflation has already hit some commodities such as lumber, due to mill closures and restarting efforts. Lumber prices spiked, but now seem to be coming back down somewhat.
· Similarly, manufactured components such as computer chips seem to be in short supply. Tens of thousands of otherwise finished cars are sitting in storage waiting for needed chips. It is easy to understand this phenomenon for any large-scale supply chain with a pipeline that grinds to a halt as demand slows to a trickle, and must later ramp back up to refill the pipeline, sometimes paying overtime to meet the rapidly increasing demand.
· At the same time, 2021 has brought rising energy costs, which are conveniently excluded from inflation calculations as they are so volatile and we spend so much on them (sarcasm intended.) Excluded or included, they hit our bottom line.
· Rising labor costs have always been a key driver of inflationary pressure, resulting in an inflationary cycle that begets further inflation. With 8 million unemployed, but, 11 million unfilled job openings, the pressure to fill jobs could further drive inflation. And you have the minimum wage increasing toward $15 per hour in Chicago and some other large urban areas, which has resulted in increased costs. And though I do not know how anyone can live on $15 per hour, food service is one of the sectors hard hit by this cost increase.
If your business sells products, you have not had to worry about inflation for a whole bunch of years. Now that you are lulled into a sense of low-inflation-confidence, you know what will hit the fan, don’t you? That’s right, INFLATION.
Let’s review what we know about inflation from history.
First the personal side:
· Often referred to in economics as a “hidden tax” on the poor, inflation has several characteristics that punish you for saving money in cash. Inflation erodes the value of money stuffed in a mattress or in savings accounts. It encourages people to “buy it now” before the price goes up. Sitting on cash works against you. So, inflation punishes savers who keep their nest egg in cash or very-low-interest accounts like savings accounts. Of course, this pressure to spend feeds the inflationary pressure as strong demand leads to rising prices. For example, 10% annual inflation means that $100 watch today will cost you $110 a year later.
· Inflation may result in better periodic salary increases, but that may also tend to move people into a higher tax bracket. So, are they really making more money, or barely keeping up?
A Business Analysis
Now for more of a business analysis:
· We saw the impact on the cost that a person might pay for a watch above. If you are a distributor of watches with a large inventory it may actually produce initial inflationary profits, assuming you adjust your prices for inflation in the retail market prices. However, replenishing your inventory will most likely cost ten percent more too. Pricing your product for sale based on current replacement cost will likely be the most profitable strategy during rising inflation, if you are able to manage your price data.
· Inflation forces businesses to raise prices to keep up with labor and material cost increases, or watch their margins shrink. It can be very difficult to keep up with cost increases unless you use automated systems. And if you have used price contracts for large customers, you may need to renegotiate them to remain profitable.
· Pricing and costing methods for inventory need to be reviewed in light of market trends. Let’s look at costing methods first. LIFO (Last In First Out), FIFO (First In First Out), Standard Costing, Average Costing, and Replacement Costing give you choices to make sure you manage your costs to your advantage. They can have a big impact on your financial results. During rapid inflation, using an automated pricing system capable of pricing based on your cost, LIFO or Replacement costing will generate the highest profits if the market will bear it.
· In a deflationary market the opposite is true, pricing based on FIFO costs will prove most profitable. What business wants to avoid is margin erosion due to inventory costs getting out of whack with the market. For this reason, many companies use an average costing method which averages your actual costs of new inventory received, with your existing inventory cost producing a more gradual adjustment to market. This may not be the most profitable choice, but it is easier to manage and also softens the blow to customers during inflationary times.
· Standard costing, where a cost is assigned to items, is a double-edged sword. It is often used to include actual purchase cost plus some other costs like freight, carrying costs, handling costs, and even sales commission costs. It does require more attention to monitor all those cost factors over time, but its relative stability helps commissioned sales people gauge their commission earnings as they sell.
Cost-plus pricing may help you to minimize the effort to keep up with rapidly changing supplier costs, especially if you stock a large number of SKUs (stock keeping units.) Passport Business Solutions™ will help you adjust to rapid changes by automatically calculating the price from the latest cost and utilizing your chosen costing method. Also, different customers or types of customers may have different pricing to suit your needs.
Of course, your market and your competitors impact your ability to increase your prices. If a competitor is not keeping up with the cost changes, one of two things is happening. Either they bought a whole lot of inventory before the increase hit and are holding the line at that cost, or they are losing money and probably don’t know it. Either way, if may affect you. If you anticipate cost increases and load up beforehand, it can certainly help you stay competitive in a squeeze.
Costs sometimes will decline after a period of time. If we truly are talking about supply-chain inflation, then once the pipeline returns to normal, then costs may revert to their former levels. Or, maybe, the suppliers will keep cashing in. Lumber is declining currently, going through this cycle. Costs are going down, but not back to where they were. Of course, you do not want to load up on inventory when costs are high and then have to sell at a loss if costs recede and the market adjusts. This is why management makes the big bucks, making the right decisions at the right time.
So, what can you do to prepare before inflation or volatility before it takes off? Consider the following steps:
· Talk with your prime vendors about giving you a heads-up if they see significant increases coming. Appreciate that they may be offering you a deal, purchasing their existing inventory that they bought at the old costs before they replace it with higher cost inventory for everyone after you.
· To the extent possible, prepare to load up if the opportunity presents, making financial arrangements as necessary.
· Look at your current special pricing to customers and any contract pricing agreements and figure out how you will address them. They are probably your largest customers, but you may need to renegotiate to a cost-based pricing. You might offer them a deal if they commit to a large purchase that you can roll into the prime vendor PO described above, expecting that they will buy it in the future. But, be careful with how far you extend yourself.
· Consider cost-plus pricing based on your chosen costing system for your normal prices to simplify and automate the adjustment process.