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What is this Inflation Thing?

by | Nov 9, 2021 | CASHFLOW, RESOURCES, Tax | 0 comments

A fortnight ago we discussed the importance of planning, while looking at potential tailwinds + headwinds that may impact the market and our business. And last week, we provided our eBook on the Business Model Canvas to help with your planning for next year.This week, we want to provide more information regarding a headwind that appears to be picking up momentum around the globe.You are probably seeing more in the media regarding inflation starting to raise its head, and there is a fair chance many of us have not experienced a high inflation environment before and are perhaps a little unsure of what it means for our businesses.And if we reflect back on our recent article on tailwinds & headwinds, many business people around the world are stating inflation is up there with supply chain disruptions as major headwinds for the coming year. I would also say they are closely related, with supply chain disruptions being a major contributor to inflationary impacts.

In economics, inflation is a general rise in the price level of an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of the real value of a dollar.Is this good or bad for business?

Business Inflation Strategies

What is causing inflation?

Inflation is a decline in the purchasing power of currency. Like all macroeconomic phenomena, it is affected by both supply and demand shocks. Currently the global and New Zealand economy is experiencing inflationary pressures due to:

  • Supplier shortages & supply issues due to months of Covid-19 lockdowns and related constraints- global & local freight costs have increased by more than 500% in some cases.
  • Government asset purchasing actions more than doubling the money supply in some countries.
  • Government stimulus payments issuing unprecedented amounts of cash to individuals and businesses around the world.
  • Vaccine rollouts re-opening the global economy and unleashing pent-up demand.
  • Knock on effects with goods in short supply – New motor vehicles are a good example here, as are fruit & vegetables.

These actions combine to make consumers and investors hungry to spend cash, but without as many goods and services to spend it on. The result is a bidding-war that raises prices starting with basic goods like steel or oil and trickling all the way through the economy to things like cars, fuel, and produce.We do expect the cost of labour, especially skilled labour to face pressure too as a result of the lack of skilled immigration and a reduced workforce in some cases due to vaccination mandates or changes in participation rates.

How inflation impacts small businesses

While you may be feeling inflation pressures already, it is possible inflation has not yet fully impacted your business. Inflation ripples through the economy in different ways and at different times, impacting each business in unique ways.The immediate impacts of inflation are supply shortages that prevent finished goods from being completed. Consider, for example, how Ford has thousands of nearly finished but still unsellable F150 pickups waiting for computer chips to come in. Manufacturers, large and small, can have millions tied up in inventory-in-process while waiting for valuable parts to come in. Those who embraced the industry best-practice of Just In Time Manufacturing (JIT) are especially vulnerable today to shortages.Immediate shortages are typically addressed by bidding higher prices, expediting shipments, and hiring extra workers or paying overtime. This all puts pressure on the costs of a business, many of whom are unable to pass these extra costs onto their customers due to contracts or competition. That means the extra costs come out of the bottom line, often increasing already existing losses from Covid-19.Even if your business is not experiencing raw material shortages, you may soon hear your workers demanding higher pay. That’s because the company down the road from your business is offering higher and higher wages to clear out their backlog and keep up with strong demand. Or, if you have lower-wage workers you may find them priced out of your geography as house prices rise. With an average home price of over $ 1,000,000, only higher earning individuals can afford to own a home in Auckland, driving lower income workers to other towns & cities, and then pushing up prices in regional New Zealand like we are seeing now.

How to manage inflation in your small business

Here are the steps that I recommend every business owner needs to take to proactively manage inflation in their business:1. Strengthen your pricing power.Every business affected by inflation will be tasked with passing on the price increase to their customers. Even if you are not eventually impacted by inflation, strengthening your pricing power improves your competitive market position. Here’s how we recommend increasing your pricing power:

  • Identify what differentiates you from the competition and lean into that product, service, and marketing message.
  • Improve the uniqueness of your offering through enhancements, bundling, de-bundling, or branding.
  • Target less price sensitive customers in your selling and marketing strategies.
  • Shorten your contract lengths or add variable pricing mechanisms, such as service fees.
  • Invest in your customer experience through more staffing, better training, or better selling processes.
  • Vertically integrate your offerings to make yourself a one-stop shop.
  • Offer complimentary services, subscriptions, or warranties for your products.

As an example, a business with 30% gross margins and 40% of cost of goods sold (COGS) exposed to raw materials, assuming inflation of 20%, will need to implement and capture an 8% price increase just to keep gross margin unchanged. Even higher increases may be necessary with more exposure to raw materials, increased labour costs or even higher inflation as demonstrated below.

2. Evaluate your supply chain risk.Supply chain is a complex profession that manufacturers especially cannot afford to ignore. There are entire books written about managing supply chain risk, but some key vulnerabilities to look for during inflation include:

  • Single-supplier dependencies.
  • One commodity representing over 10% of your costed COGS.
  • Long lead-time suppliers (e.g. overseas suppliers).
  • Bulky, heavy, perishable, or hazardous materials that are difficult or expensive to store.
  • Materials you run through a JIT supply chain.

Consider taking the following actions to mitigate high-risk supplies:

  • Establish alternate supply chains (not just alternate suppliers).
  • Establish an expedite supply strategy, such as a domestic alternative to a foreign supplier.
  • Consider stockpiling critical supplies with low holding costs.
  • Review safety stock levels at all levels of JIT supply chains.
  • Engage in commodity hedging, where appropriate.

3. Evaluate your labour market vulnerability.The impact of inflation on labour markets is a bit unpredictable. While we cannot foresee the exact professions and skillsets that will be impacted, we can reasonably expect the following labour markets to feel some effect of inflation:

  • High-demand professions like software developers.
  • Low-wage and minimum wage jobs.
  • Contract labourers, who typically can reprice their wages faster than salaried workers.

If your business is highly dependent upon the above professions, develop a human resources strategy to attract and retain talent. This should be done through market-rate pay raises, but also through non-monetary compensation such as career development and employee benefits. If your employees hate their job and only show up for their big salary, your business is much more vulnerable to inflationary pressures than one where employee satisfaction is derived from intangible benefits like a sense of community and purpose.4. Forecast what-if inflation scenarios.Use scenario planning to run “what-if” scenarios to test the potential impact of inflation, such as:

  • Wages increases of 25-50%
  • Raw material prices doubling
  • Supply chain disruptions causing 25% or greater revenue delays and inventory build-ups

Anytime you are forecasting what-if scenarios, you need to answer the following tactical questions:

  • Will I have enough cash in all scenarios?
  • What evasive manoeuvres will I take in each scenario?
  • Can I manage risk now with preventative measures?
  • What metrics will I watch as leading indicators that one of these scenarios is occurring?

5. Take out a loan.Now is a great time to borrow money!  As long as you can generate a return higher than the interest rate, and have the certainty that you can make the repayments over the loan term.Debt can be a great investment, especially in higher inflationary times with historically lower interest rates – this means the nominal rate (the interest rate less the inflation rate) can be very attractive for the right investments. With interest rates being low and inflation potentially high, you will likely be paying back the loan with cheaper money than you borrowed due to the impacts of inflation. Good investment opportunities during inflationary periods to consider are:

  • Marketing that strengthens and differentiates your brand (to build pricing power)
  • Real estate and machinery
  • Bulk-discount inventory
  • Technology that improves productivity & increases margins
  • Acquire other businesses such as competitors, suppliers, or customers

Particularly, look for investment opportunities that can create scale where your revenue growth results in your fixed costs decreasing as a percentage of revenue, therefore increasing your margins with higher revenues. Or it results in a decrease of  your variable costs as a percentage of your revenue -increased buying power & process improvements are often a good example here as is reducing wastage or leakage.

Preparing your business for inflation

No matter what industry you are in, you need to know your numbers and key profit drivers. The most important thing is to scenario plan, go through those “what ifs” and have strategies to mitigate. Increasing prices is one strategy but if you can build efficiency that protects margins, you can build an even stronger competitive advantage.In a high inflation environment, those that have the ability to pass on prices as well as gain efficiencies win market share and increase profits – and as part of your 2022 planning process, now is the time to work through these challenges and opportunities.And if you need a hand, we are here to help via our Business Sustainability Service, for which your business may be eligible for a subsidy of up to 50%.