Inflation affects businesses of every scale. If you’ve noticed higher operation, supply, or labor costs, you’ve likely been impacted by this economic phenomenon.
Although increased costs are considered a bad thing, inflation isn’t necessarily bad. In many cases, inflation represents healthy growth in the economy, something that can be a boon for your business if you know how to take advantage.
But to know how to react to inflation, you need to know what it is, how it works, and what its causes are. Getting familiar with inflation helps you know when it’s an opportunity or a challenge to overcome.
What is inflation?
Inflation refers to a sustained increase in the price levels of goods and services in an economy. These price increases aren’t temporary, but rather reflect an ongoing rise in costs across all sectors.
Economists measure inflation as an annual percentage. If a bundle of supply costs were $10,000 last year but $10,500 this year, the rate of inflation would be 5%.
It’s important to separate inflation from one-time, temporary price spikes. If there’s a forest fire, the price of lumber may increase as there are fewer trees to turn into products. It’s assumed the price would fall back down once supply is back to normal, meaning it’s a temporary price spike.
When prices increase due to inflation, it’s because all costs are rising together over an extended period. It’s not likely that prices will fall back down to a “normal” level; rather, what’s considered a “normal” level is changing.
While increasing prices seems bad, a small amount of inflation (around 3%) is considered healthy, signalling a growing economy. But higher rates of inflation, especially hyperinflation, are problematic as they reduce the purchasing power of consumers. Government policy aims to keep the rate of inflation in line with the growth of consumer wealth.
Types of inflation
Inflation occurs for different reasons, which are typically categorized into three main types.
Demand-pull inflation
Demand-pull inflation occurs when the demand for products or services is greater than the economy’s supply. When demand exceeds supply, there are more buyers (and more money) pursuing fewer goods, which drives up prices.
Think of demand-pull inflation like an auction: when supply is limited, businesses will try to increase prices to maximize their revenue from the people willing to pay the most.
Demand-pull inflation happens when money supply and consumer confidence are high. More disposable income means a higher willingness to spend and consumption increases.
For businesses, this is initially a positive trend as more customers want your supply. But as prices adjust, the consumer's purchasing power, and thus demand, falls back to expected levels.
If you’re experiencing demand-pull inflation, try to maximize the immediate future with increases to price or supply, but remember that the growth is likely temporary.
Cost-push inflation
Cost-push inflation occurs when the costs of production increase. As the cost of providing a good or service increases, businesses are forced to raise their prices to maintain a profit.
The most likely causes of cost-push inflation are when the costs of universal inputs like labor or energy (such as oil or gas) increase, or when there are supply chain disruptions. Nearly all businesses are impacted by these trends, and prices increase throughout the economy.
You’ll likely notice the effects of cost-push inflation on your income statement through increased labor, shipping, and raw material costs. Profit margins tighten, potentially forcing your hand into raising prices.
Built-in inflation
Built-in inflation is also called “inflation expectations.” It refers to how the expectation of inflation changes both consumer and business behavior, ultimately causing inflation to persist.
The most common cause of built-in inflation is the relationship between prices and wages. Workers, anticipating that prices will increase, demand higher wages to secure their financial well-being with a higher cost of living. Employers, who are now paying higher wages, need to raise prices to protect their profit.
The expectation of prices increasing ultimately leads to changes in the market that increase prices.
Built-in inflation is difficult to plan for as there aren’t clear signals that it will occur. Instead, businesses often assume that prices will increase and incorporate that assumption in their financial forecasts and budgets.
Causes of inflation
Inflation is treated as a given, pushing the prices of goods and services up over time. But there are underlying causes of inflation that can help businesses anticipate inflationary periods, giving them an opportunity to plan and prepare.
Money supply
Central banks and governments influence the rate of inflation by controlling the money supply, which refers to the total amount of money circulating in the economy.
Through the interest rate of government bonds and stimulus programs, it’s possible to increase the money available to consumers, and thus increase demand. When demand increases beyond supply, inflation occurs.
Look out for one-time stimulus payouts or other government policies that inject cash into the economy. These programs often increase consumer confidence, leading to increased spending behavior.
Supply chain disruptions
Global supply chains are both ubiquitous and sensitive. Natural disasters, trade disputes, and government policy are just a few factors that can strain supply lines, interrupting the importing of raw materials or manufactured goods.
These supply chain disruptions lead to shortages that drive up prices and extend delivery times. Because all industries depend on the same supply chain infrastructure, nearly all businesses are affected.
It’s difficult to know when a supply chain disruption could occur. But if you have a feeling one may be on the horizon, it’s worth considering securing yourself a delivery before prices increase.
Labor market dynamics
Laborers are both contributors to production and consumers of the output. When there’s a shift in the labor market, you’ll see the effects on both supply and demand.
When wages increase, the costs a business faces increase. But this also increases consumer confidence and the ability to afford higher prices.
When wages decrease or remain stagnant, the business may save some money. But with less purchasing power, consumers would need prices lowered to maintain demand.
This interplay is what leads to built-in inflation: the expectation of prices increasing leads to a demand for increased wages, increasing the costs of production, and increasing prices.
Remember this when thinking about the hiring pool: when you benefit from the current state of employment, you could feel the effects on your revenue.
Energy prices
The cost of energy used in transportation or manufacturing, like oil, gas, or electricity, ripples throughout the entire economy.
When the prices of these resources increase, so too do the costs of shipping and manufacturing across all industries.
These price increases can also stem from a period of high consumer confidence. For example, when consumers have more money available, they’re more likely to travel. That increase in demand then spills over into increased demand for oil and gas.
This makes energy resources a good barometer for how inflation is, or will be, trending.
Global economic factors
In a globalized economy, small factors of variance in one area can have a large influence on inflation in another.
A major contributing factor is exchange rates and the values of foreign currency. For example, if your company’s production is done in China and the value of the yuan increases relative to the US dollar, the costs of producing in China increase.
This change doesn’t just affect your operations, but rather every business producing in China. All impacted businesses need to increase their prices as a result.
Any fluctuation in the economic well-being of one country could ultimately impact inflation in another.
Effects of inflation on the economy
Inflation impacts the economy in both positive and negative ways. Understanding the effects of inflation will help you know when there’s an opportunity to take advantage of, or a potential challenge you need to plan for.
Consumer behavior
Consumers make decisions based on their purchasing power (i.e. their ability to afford goods and services).
If prices increase and consumers have the same level of money, their purchasing power decreases, and they adjust their behavior by reducing what they buy or exploring lower-cost alternatives.
During an inflationary period, businesses may need to adjust their prices or forecasts to account for a decrease in demand.
Interest rates
Central banks react to and influence inflation through interest rates. During periods of high inflation, central banks typically increase interest rates to incentivize consumer investment over short-term spending.
This trickles down to lenders who ultimately increase the interest rates on the loans and lines of credit they offer. Businesses may find it harder to obtain affordable credit to finance their expansion or purchase of new capital.
But when interest rates decrease to incentivize consumption, there are opportunities to be had in securing a loan at a low interest rate and taking advantage of cheap credit.
Viability of international markets
When one country experiences inflation, it may lose a competitive edge it previously had over others.
Periods of high inflation often affect exchange rates, making the local currency less valuable on the global scale. When this happens, the revenue businesses make from abroad is suddenly worth less, and the costs of any goods or materials imported go up.
Plus, if a business increases its prices abroad due to inflation experienced locally, that good or service might no longer be a viable option to those international consumers.
Business planning and investment
Investors expect a certain return on their money when they fund a business. Part of that process involves forecasting a business’s revenue, expenses, and growth potential years down the line.
But inflation adds uncertainty to this equation. What if consumer behavior changes? What if a business’s costs go up? What will the economy look like years from now?
When inflation is as expected, these questions are simple enough to answer. But in inflationary periods, both internal and external investment in the business slows down until things find their balancing point.
How inflation impacts prices
Inflation is the phenomenon of prices persistently increasing over time. But inflation doesn’t affect all prices equally—look at your past purchase history and you’ll see that prices don’t automatically increase by the rate of inflation.
There are five factors that affect how inflation impacts prices:
- Input cost transmission: It’s often businesses that face the effects of inflation first on the costs of their inputs. This increases the cost of producing one good or service, reducing the profit margin on a single sale, requiring a price increase to maintain margins.
- Price change strategy: It’s up to the business to decide how much of the cost increase gets passed onto consumers. Some businesses may opt to eat the extra cost to maintain a certain competitive advantage, while others may need to increase prices to have sustainable operations.
- Menu costs: “Menu costs” is a term that refers to the costs of changing a price, named after the need to print new menus. The higher a business’s menu costs, the less frequently it will update its prices.
- Price change timing: Inflation is a continuous effect, which means businesses need to think about when they implement a price change. For example, retailers may want to wait until after the high-volume holiday period to increase prices.
- Loss tolerance: A business like Nike has a higher tolerance for short-term loss than a small-scale shoe manufacturer. If a business has sufficient capital, it may take a loss in the short term to maintain customer loyalty and beat out the competition.
While it’s a given that inflation will increase prices, not all prices will increase at the same time or to the same degree. In your own operations, think about when is the best time to adjust your prices and work closely with your suppliers to try to buy low before the effects of inflation kick in.
Measuring inflation with price indexes
Price indexes are the main tool used to measure the effects of inflation. Using different methodologies and economic data, they provide an at-a-glance measurement of how inflation may affect your operations.
There are three price indexes you can use to understand the effects of inflation:
- Consumer Price Index (CPI): CPI tracks the prices of the most common goods or services consumers purchase, like food, energy, and housing. If CPI is increasing, consumers likely have less purchasing power.
- Producer Price Index (PPI): PPI measures the effects of inflation on wholesale goods by tracking the prices that manufacturers receive for their production. PPI is most often used by businesses to understand how their costs are trending.
- Personal Consumption Expenditures (PCE) Price Index: The PCE price index is a measure of how much American households are spending over time. It’s used to understand how consumer behavior is adjusting due to price changes and economic status.
Beyond these price indexes are more specific measures of price changes. This includes industry-specific indexes and regional price indexes, which look into a specific industry type or area, respectively.
These indexes can give early indications of how your costs and consumer behavior are changing. Checking in once in a while may give you the heads up you need to plan and prepare for an inflationary period.
How to manage finances during inflation
Being proactive and adaptable are key to weathering an inflationary period or making the most of a favorable economy. However, it’s important to balance the short-term and long-term elements of your strategy.
Understand inflation’s impact on cash flow
Start with understanding the impact on your cash flow. If your costs are higher and lending has tightened up, you may find yourself in an unexpected cash crunch. Regularly review your cash flow and cash reserves to ensure you have sufficient capital to survive an inflationary period.
Optimize your pricing strategy
It’s essential to regularly review prices, but that’s especially true during a period of inflation. Rather than having brash, reactionary pricing changes, set checkpoints for when pricing needs to be increased. For example, you could set a rule that if the per-unit cost of production increases by $10, prices increase proportionally.
Work closely with suppliers
Having a strong relationship with suppliers has multiple benefits during a period of inflation. If you’re close, they may give you advance notice of price increases or give you a grace period of the original pricing. It’s also worth exploring longer-term contracts or volume commitments to lock yourself into a given price.
Improve your inventory management
If you’re smart about inventory management during inflation, you’ll find creative ways to keep your costs down while other companies need to increase their prices. Putting in orders in anticipation of price increases or locking in a contract at a fixed price can keep your costs in check. But remember that inflation also affects consumer demand, and you risk being saddled with inventory you’re struggling to move.
Update and adjust your financial forecasts and budgets
Use inflation measurements (like the price indexes listed above) to estimate the effects of inflation on the costs you face. These assumed increases can be incorporated into your financial forecasts and budgets so you’re anticipating the impacts of inflation on your bottom line.
Plan around employee compensation
Workers expect wages proportional to their cost of living, matching or exceeding the rate of inflation. During an inflationary period, you may need to plan on wage increases or alternative forms of compensation that are more cost-effective forms of retention.
Confidently manage your expenses through inflation
If you want to understand the impact of inflation on your expenses, you need a clear record of how your expenses have trended over time.
Traditionally, this means reconciling bank and credit card statements, processing invoices, inputting receipts, and managing employee expense reports. But with a simple change to your tech stack, you can automate and streamline these processes to save time and reduce errors.
Enter BILL Spend & Expense, automated expense reporting that keeps your books up-to-date with real-time visibility. As expenses are processed, you’ll see how overall spend is trending with categorized breakdowns for additional insights.
Upgrade your expense management with BILL’s corporate and virtual credit cards that offer expense controls to keep costs in check and reduce fraud.
Reach out to schedule a demo and learn how BILL can save you time and provide deeper insights on your business’s expenses.
