Article Reviewed by a licensed insurance professional: Sam Meenasian (CA dept of insurance license #0F75955).
Estimated reading time: 6 minutes
Inflation is a hot topic in the news these days. While most of us understand that inflation means higher prices, many business owners don’t fully understand how inflation affects their businesses. Yet business owners are some of the first to get hit by inflation because inflation affects the supply chain and overall costs required to run a business. Let’s take a closer look at how inflation affects businesses.
What Is Inflation?
Inflation is a broad increase in the prices of goods and services over time, which reduces purchasing power. The Fed defines inflation as a general increase in the overall price level, not simply the price change of one item or a decline in the value of money.
Inflation doesn’t just affect the cost of goods. It also affects wages because employees need to adjust to higher living costs. For the most part, inflation is expected and can be tracked as an average over time. However, there are periods where inflation is far higher than expected, putting an unexpected pinch on consumers and business owners.
What Causes Inflation?
Economists can argue the many causes of inflation. The reality is that any factor can lead to an inflationary market. Inflation can be driven by demand, supply conditions, and inflation expectations. Monetary conditions can matter, but they are only part of the story. The Cleveland Fed explicitly explains inflation through demand, supply, and expectations, not just two causes.
The cost-push effect is an inflationary model that directly affects businesses. As materials or energy costs go up, the business owner pays more to produce goods and services. This means that they may try to pass the increased costs on to the consumer by way of higher prices. It’s a chain effect that you can’t get away from.
How Is Inflation Measured?
Inflation is tracked by economists so that they can assess its effect on the economy, businesses, and consumers. The Consumer Price Index (CPI) is the most common measurement used to track inflation. The CPI measures the average change over time in the prices paid by consumers for a representative basket of goods and services. The common goods include transportation, food, medical care, and energy. As prices go up, the CPI goes up.
The Impacts of Inflation on Businesses
Business owners often feel the effects of inflation before consumers do. This is because they might experience higher costs in several areas that they eventually need to pass on to consumers to offset the higher production costs and remain profitable.
Contractor’s Example of Inflation Effects
For example, take a contractor who is working in the community. The contractor might first have an increase in insurance costs. This reduces his profit margin. He then has to account for higher prices of materials. With inflation on the rise, it now costs more to do the same job he did just months earlier. This further eats into his profit margin. Then, as he hires subcontractors, he has to pay them a higher wage because they must earn enough to adapt to inflationary environments.
All of this eats into his profit margin. In order to continue to do jobs and make money, the contractor must charge more for the project. This is where consumers feel the crunch of inflation resulting from the business’s rise in costs.
Retail Example of Inflation Effects
We can look at another example of inflation in the retail sector. A retail store owner must address supply chain issues that lead to higher prices. When the demand is high, but there is no product to sell, the prices will rise. However, there’s more to inflation for the retail sector than just supply issues.
Inflation leads to higher materials costs. This means that the cost of goods sold goes up for the retail seller. This alone will negatively affect profit margins. On top of this, retailers must deal with higher energy costs to keep the store open. This further affects profit margins. Like the contractor, the retailer may also be dealing with higher insurance costs as well as higher wages for employees. All of this gets factored into the costs of goods and leads to a rise in prices. That is passed on to the consumer if the retailer doesn’t want such slim profit margins.
What Can Businesses Do To Combat Inflation
Business owners can’t gauge when inflation will slow down. Ultimately, they are at the mercy of the economy with regard to rising prices. However, there are some things that business owners can do to combat inflation in their businesses.
Raise Prices
Many business owners don’t want to raise prices immediately because they are trying to retain their customers. However, there comes a point where the prices to run the shop cost so much more that the business can’t remain profitable without raising prices. Ideally, business owners are able to raise prices slowly so as to create as little of an impact on customers as possible. Having a dramatic jump in prices will often put off customers who would be able to better deal with gradual price increases.
Cut Business Expenses
Business owners should always have a keen eye on their business expenses and look for ways to reduce costs where possible. Business owners may need to get creative when looking to cut business expenses. You may need to buy materials in bigger bulk than you usually do, or shop around for supplies to find the best prices. In some cases, you may need to reduce your labor force, though this is typically an action of last resort.
Apply for a Business Loan
A loan or line of credit can help with working capital, but borrowing should be based on repayment ability, cash-flow needs, and current lender terms. SBA 7(a) rates are negotiated between borrower and lender and are subject to SBA limits, so the original sentence is too speculative.
Retain Existing Workforce
Do what you can to keep employees on the payroll and stop them from leaving your company. It costs money to recruit, onboard, and train new employees. Retention can reduce disruption, but compensation decisions should reflect market conditions, performance, legal requirements, and budget. Invariably, it is not defensible without current labor data.
Automate Processes Where Possible
Automation is important in today’s marketplace. It saves business owners time and money. Look at your systems and processes to see where you can automate tasks so that you can remain profitable during inflationary times.
Final Thoughts
Business owners will likely be the first to feel the effects of inflation. It’s important to recognize the problems that inflation brings and address them head-on as soon as possible. While you can’t prevent a rise in costs, you can take the steps necessary to mitigate how you pass those costs on to your customers. Remember that customers will appreciate a company that minimizes the effects of inflation on them. It’s one way to get a loyal consumer base.
