“When I was a kid, a dozen eggs was only 90 cents! Have you looked at the price of eggs lately? $4.39 for a dozen! What is the world coming to?”
We’ve all heard people complain about how much better “the good ol’ days” were. Our retrospective rose colored glasses see things as better…and cheaper…than they are now.
While “better” is not necessarily true, “cheaper” usually is, thanks to inflation. But that’s not the whole picture.
According to the U.S. Bureau of Labor Statistics, eggs have increased in price 310% since 1985 and a gallon of gas has increased by 165%.
While we’ve all personally felt the negative impact of inflation at the grocery store, home improvement store, and in utilities, it also affects businesses in ways that aren’t immediately obvious to owners who aren’t dialed in to their gross margin and net profit.
If you are noticing that your business profit isn’t as strong as it used to be and aren’t sure why, inflation may be the culprit. I’d love to serve as your inflation scout. I’m a Fractional CFO who can keep a watchful eye on all of the moving parts it takes to keep your business financially healthy and profitable. Schedule a consultation today.
What is Inflation?
In economics, inflation is a general increase in prices and fall in the purchasing value of money. It is measured as a percentage change in a price over time.
The U.S. Bureau of Labor Statistics’ Consumer Price Index, or CPI, compares month-over-month and year-over-year prices. Over long periods of time, we can expect prices to go up. As mentioned earlier, eggs have gone up 310% since the 80s. Here are a few other examples:
Sources: U.S. Department of Labor; U.S. Bureau of Labor Statistics
Prices can change because of many factors, but the root of all change is supply and demand.
When demand is high and supply is low, prices go up. The pandemic provided us with a real world, front row seat to this economics lesson. Here’s one of many examples: Remodeling companies found themselves suddenly battling high costs of lumber when manufacturing facilities closed due to the mandatory shutdowns. Supply dropped seemingly overnight because no one was regularly cutting, milling, or planing [GH6] [KG7] lumber for the contractors who needed it to build and renovate for their customers. Prices quickly skyrocketed and both companies and customers felt the pinch.
Prices for lumber eventually came back down when people were able to get back to work in the lumber yards; supply increased again. They actually began producing at a higher rate than before, in an effort to catch up with the backlog of orders. Since prices were high, they wanted to capture as much profit as they could! The supply began to balance out with the demand and the prices started to lower. Then the higher rates of production didn’t slow down fast enough to meet demand, and then we had an oversupply. The pendulum swung back the other way. It was a bit of a see-saw effect for a couple of years, until supply and demand were back in balance again. As shown in this graph, the point in which supply and demand find their happy medium is market equilibrium.
A common misconception among U.S. citizens is that the government controls inflation. The government cannot stop or control inflation, but they can do things to try to slow it down. If the government raises interest rates (on the government bonds they sell [GH10]), they are trying to encourage people to stop spending money and save their money instead. This brings demand down, which in turn can stop prices from creeping higher.
Another misconception is that prices can go back down to what they were before. Unfortunately, this is not a realistic expectation. Demand would have to plummet across all goods & services in order for prices to drop back to what they were in 1985. This would only happen if the unemployment rate suddenly spiked to, say, 20%, and thus a lot of people would not have a paycheck to spend. Of course, we don’t want an economy where that many people are out of work. In a healthy economy, prices won’t go back to the “good ol’ days.” Instead, we would have a healthy balance between low unemployment and low inflation.
How Does Inflation Affect My Business?
Inflation affects the entire economy, so by default affects businesses through its operating costs: increasing employee wages, rent, cost of materials, gasoline for shipping and company vehicles, etc. These increased costs can sneak up on you if you aren’t paying close attention to your gross margin and net profit numbers.
Your gross profit is measured in dollars and is your cost of goods sold subtracted from your revenue.
Revenue – COGS = Gross Profit ($)
Your gross margin is measured as a percentage and equals the gross profit (calculated above) divided by your total revenue.
Gross Profit / Total Revenue = Gross Margin (%)
Net profit is what’s left of gross profit after all expenses (salaries, rent, [GH12] general and administrative costs) are deducted. It’s your “bottom line.”
Gross Profit – Expenses = Net Profit ($)
Inflation squeezes out your business’ profits, especially if you aren’t raising prices. It’s imperative that you have a strategy in place to increase prices, otherwise your profit will erode. Learn more about raising prices without losing business.
How Do I Navigate the Impact of Inflation on My Business?
There are a few things you can do as a business owner to navigate the rising costs of doing business to protect your gross margin and your net profit:
Keep a close eye on long-term vendor contracts. Let’s say that your business sells and installs dishwashers. Your supplier, Maytag, offers a 3-year price contract: every dishwasher you purchase is a locked-in price of $300. This sounds great and will protect you from inflation on the cost of the dishwasher, right? Unfortunately, a year into the contract, Maytag can’t keep up with the demand of its various contracts and has a supply shortage. You now can’t buy any at your locked-in rate.
Let’s look at the same situation from another angle: you are still buying from Maytag under a 3-year contract promising to purchase the dishwashers at $300 [GH13] each. As the cost of manufacturing the dishwashers increases, Maytag’s locked-in price with you means they are making less money than they were at the beginning of the contract. Their profit margin has decreased because it costs more to make, but the sales price can’t be changed.
Review your long-term contracts for automatic price escalation. Is the agreement linked to a CPI index you can monitor? If prices are going up and your contract doesn’t allow for increases, you may need to renegotiate to continue receiving products.
Manage employee compensation during inflation. What is your trigger for increasing employee wages? Do you want to wait until they are grumbling about not getting paid enough? Until you lose your first employee over pay? Trust me, you don’t want to lose your great employees – it costs a lot of money to rehire and train. Define your strategy for pay increases and set a proactive trigger for implementing it. I recommend monitoring the CPI and if it goes over a certain percentage, that’s your trigger to increase employee wages.
Protect your cash reserves. If your business has emergency funds set aside (it should!), don’t keep it in a checking account. You are losing money if it’s just sitting there – especially in high inflationary periods. Remember, costs will always increase over time, so unless your money is growing through investments, your money won’t go as far as it could when you first started saving. If $50,000 is what you need now to cover all of your expenses for 3 months, you may need $53,000 to cover the same expenses in two years. $50,000 in a cash reserve account looks good… until you factor in inflation.
Invest in a money market account, CD, or buy Government Treasury bonds to maintain your purchasing power (how much you can buy with what you have) instead of letting it erode. Each one is relatively liquid, but some more than others. Keep in mind how long you are willing to wait to gain access to the cash when you need it. You can also consider purchasing new equipment, machinery, company vehicles, etc. now instead of later. It may be the best way to maintain value. However: don’t buy it if you don’t need it! Keep your cash flow requirements for monthly loan payment streams in mind.
Protect Your Business From Inflation
If you don’t pay attention to how inflation affects your gross margin and net profit, you will find yourself losing money. Don’t let business costs get away from you! Instead, let me serve as your inflation scout: schedule a consultation today.
