Inflation seems to be all over the news today. Rising gas prices and interest rates, increasing costs of food, and a housing market that appears to be ready to burst are all discussed when you see the word inflation. After being hammered by the Covid-19 pandemic, small business owners are particularly vulnerable to the effects of inflation.
Let’s take a look at inflation and how it impacts small businesses. We’ll also discuss strategies your business can implement to help combat the harmful effects of inflation.
What is inflation?
85% of small business owners say they are worried about surging inflation. Much of these pains end up being passed on to consumers in the form of higher prices. Kevin Hassett, former Chairman of the Council of Economic Advisers, says that “wages aren’t keeping up with prices,” meaning “real incomes are going down.”
Hassett’s words perfectly describe what inflation is. Investopedia defines inflation as the decline of purchasing power of a given currency over time. Have you ever heard your grandparents and parents talk about how much more they used to be able to buy with $20 compared to today? That’s inflation.
The most common measures of inflation are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The U.S. Bureau of Labor Statistics (BLS), the government agency responsible for reporting the CPI, said that the current inflation rate was up 7.5% in the 12-month period of time ending January 2022. This is the largest 12-month increase since June 1982!
What causes inflation?
So what causes inflation? Economists generally agree that inflation occurs when a country’s money supply increases faster than economic growth. Issuing more money, as many countries did during the pandemic, is one factor contributing to the inflation we see today.
Another way inflation can occur is when the government loans new money into existence through the banking system. In all cases, the money supply increases, and the money loses its purchasing power.
How does inflation impact small businesses?
Inflation isn’t always a bad thing and is something that occurs in every healthy economy. The problem arises when inflation happens too quickly and businesses cannot adjust. As a small business owner, leveraging business problem-solving techniques can help mitigate these issues and keep yourself competitive.
Before we can understand how to fight inflation, though, let’s examine how inflation affects small businesses.
One way inflation impacts businesses is through higher costs (aka Cost-Push inflation). This is when production costs increase prices. For example, the underlying cost of making food items goes up as wages and the cost of raw materials increase. As a result, your small restaurant business will see higher prices when purchasing products and ingredients for your menu items.
Raised prices and decreased profit margins
Rising prices of goods and decreasing profit margins are other outcomes of inflation. Rising overall prices often cause increased costs, but they can also lower profit margins.
For example, imagine you’re a small business that sells paper for $9 per ream. If the cost of paper rises from $5 per ream to $7 per ream, your profit margin has shrunk by $2. When these price increases occur, many businesses respond by raising prices to prevent their profit margins from shrinking.
Decreasing profit margins can also mean that the income from your small business is affected. Losing income can happen to anyone, but investing in a life insurance policy is one way to protect yourself. This way, if you’re unable to work, you still have an income.
Another possible consequence of inflation is that it can deter customers from using your small business. This can be true even if you avoid raising prices.
Customers might avoid buying from your company due to inflation because other, more important, areas start eating up their spending. Consumers often begin shifting their buying preferences in response to inflation, trading brand-name products for store brands and generic alternatives.
Frivolous expenses like going to the movies and date nights are also susceptible to inflation. For example, if your small business is a restaurant, customers may spend less on eating out and more on eating in.
Supply chain shortages are another potential consequence of inflation. This is called Demand-Pull inflation. In a Demand-Pull scenario, demand for goods and services exceeds production capacity. In this case, simple macroeconomic principles apply — consumer demand outpaces the supply, and as a result, prices increase.
In many areas of the country, wealthy property owners are selling their homes and relocating to less expensive areas. The result is a huge housing crunch. Prices in areas that used to be cheap have skyrocketed, and housing is in short supply. With fewer houses available, the prices go up for everyone.
Change to brand reputation
There are many ways that your small business’s identity can become damaged. Mishandling customer data and failing to adhere to PCI compliance guidelines are in your control, but inflation isn’t. Inflation can damage your brand reputation precisely because it’s out of your hands.
Many small business owners leverage eCommerce to be successful. As costs rise, they may have to raise their prices or cut product lines to stay competitive. These sorts of changes can damage the reputation of your business and your brand.
Damage to overall business health
Inevitably, inflation, with its many consequences, can cause harm to businesses. So, how do businesses deal with inflation? If left unchecked, inflation can even cause your business to close. It’s important to learn how to create a crisis plan and implement the right strategies if you want to avoid some of these issues.
8 Strategies to manage inflation in your small business
Inflation and its effects are largely outside of a small business owner’s control. So, how is a small business owner supposed to navigate the challenges that arise from it? Let’s take a look at eight things your small business can do to manage inflation.
1. Strengthen your pricing power
Pricing power refers to the quantity demanded of a product relative to the change in the product price. It is linked with the price elasticity of demand or the degree to which demand changes in response to a product. For example, luxury brands carry a high pricing power because few alternatives exist.
Strengthening your pricing power can be tricky, but offering essential services or goods is a great way to find stronger pricing power in an inflationary economy.
2. Revisit product offerings
Closely related to pricing power are your product offerings. Some products might be more susceptible to inflation than others. Eliminating these poor-performing products can be another way to manage inflation in your business. Doing that can help keep your business healthy and prevent you from wasting time and energy on inventory that doesn’t serve you any benefit.
3. Expand your business plan visibility
Conducting a monthly plan review meeting can help your business a lot. However, sometimes these meetings aren’t available to everyone, or they can even be a waste of time for some employees. That said, plan visibility is a great way to ensure everyone is on board and understands how the business is doing.
By educating your employees and other stakeholders about your company’s health, you can give them information that makes them want to invest themselves more in its well-being. All you have to do is make this information available.
4. Minimize unnecessary costs
Since rising costs are one of inflation’s main consequences, reducing and cutting unnecessary costs can save you money. Adjusting financial forecasts can help determine where you can cut some of these costs.
Reducing costs in other areas can help you balance your budget if you’re unable to raise prices too. By keeping your prices low, you can avoid a lot of negative consumer reactions to inflation.
A good way to identify unnecessary costs is by figuring out what adds value to your goods and services. For example, eliminating things like excess packaging can be a great way to reduce costs without harming value-adding activities like great customer service, marketing, and research & development. Simply using less tape to seal boxes for shipping will yield big savings in the long run.
5. Explore what-if scenarios
Part of responding to the uncertainty that occurs during economic changes can require making alternative plans and building what-if scenarios. Once you’ve begun building these scenarios, you can start adjusting goals and milestones in response to how you expect things to change.
What-if scenarios can be used as part of decision tree analysis, a popular operations management tool. The tree-like model of decisions and their consequences utilizes chance event outcomes, resource costs, and utility. Many people also use decision-tree analysis in machine learning.
For example, when mapping out a decision tree, you might have several possible scenarios where inflation increases, stays the same, or reduces. By mapping out these possible scenarios for a product, you can decide whether or not keeping that product is a good option. Decision tree analysis and what-if scenarios are just one possible tool you can use as a small business owner to grapple with inflation.
6. Bring in more cash
Bringing in more cash can also help your business. Cash flow is the number one concern of small businesses. It’s no surprise that most accountants use a statement of cash flows to track how money flows in and out of your business. Without cash coming in, you can’t pay your invoices and will end up relying on credit.
Find ways through advertising and marketing to make sure your goods and services are being sold, and you’ll ensure healthy cash flow for your business. Carefully analyze where you can cut back on costs to ensure more cash is going into your bank account. Also, take a peek at your accounts receivable to see if there are any outstanding invoices that have not yet been paid to you.
7. Audit current projects and spending
Earlier, we discussed how inflation can eat up your profit margin. As part of your inflation plan, consider auditing your spending and current projects. This is good advice, even if you’re not worried about inflation. Performing an audit is a great way to determine what projects are working and how much money you’re spending.
A common mistake many people make is called the Sunk Cost Fallacy. Psychologically, people are more inclined to continue investing in something once they’ve already put time, money, and effort into it. But in many economic theories, only future costs are relevant when making a rational decision. Often, this causes people to fail to cut their losses.
Think about it this way; if you purchased 200 t-shirts to sell but then only ended up selling 25 of them and did not break even, you might be inclined to continue selling the t-shirts. Maybe you would consider investing more money in an advertising campaign to try and get the product moving. The fallacy is considering the past costs of the shirts rather than accepting that your cost is sunk.
By performing project and spending audits, you can figure out which projects are working and then decide if they are worth continuing or not.
8. Invest some of your money to hedge against inflation
One way to hedge against inflation is to invest your money. Over the long term and even through financial turmoil, markets tend to recover. Many companies hedge their risk by purchasing complex financial instruments known as options and futures. Usually, these are used in commodities trading.
An excellent example of how this works is companies that consume large quantities of commodities might be worried about the price of their commodity increasing. To “bet” against this, they will purchase options or futures that can be sold for a profit if the price goes up. This way, you minimize your total expenses through hedging. Buying cryptocurrency like Bitcoin or Ethereum is another, albeit risky, way of hedging against inflation.
The bottom line on small business inflation
Inflation and supply chain disruptions have repeatedly been hitting news headlines. Despite this, consumers have not reached a breaking point yet. To weather the storm of inflation, you should continue planning and revisiting projects, financials, and your company’s spending habits to evaluate whether or not they are working fully.
When the economy is healthy, it’s easy to become complacent and just ride the success. However, regularly monitoring your business can help you avoid many of these issues and navigate any fallout quickly. Stay on top of your planning and prepare your business for the best and worst that may come your way.