Over the centuries the American economy has weathered depreciating low valleys and surging high economic mountains. The oil boom, stagflation and great depression of the 1900’s are typical examples of the good, the bad and the ugly economic times respectively.
May 2022, saw the US annual inflation rate ballooning to an unprecedented 8.6%. The highest record in nearly four decades, from December 1981 until date.
This staggering rate has left a bout of concern in the hearts of business owners. This is due to increased cost of production owing to increased energy prices, incessant hike in utility bills like electricity, cost of staffing amongst other significant increases in major factors of production.
This upward trend can result in low profit margins or pure loss for businesses if not appropriately managed.
What is inflation, its causes, how it affects a business, how can business owners hedge their businesses from the unfavorable effects of inflation and possibly benefit from inflation? Have any of those questions in mind then this simplified article is for you.
UNDERSTANDING INFLATION
A couple of years ago, 1 dollar could purchase more product compared to what it can purchase today. A dollar bill today may not afford half what it could a decade or half ago. This downward purchasing power of a currency is as a result of inflation.
Inflation is simply an increase in price level usually resulting in higher cost of living for consumers. For businesses it results in higher costs of production. Inflation basically devalues the purchasing power of a currency.
For example, Miss Susie runs a bakery, previously it costs her bakery $500 to produce a thousand units of bread. However, owing to inflation, $500 dollars can only produce 600 units of bread, 400 units short of what it could originally produce. Losing its purchasing power by 40%.
WHAT CAUSES INFLATION
The primary causes of inflation are fiscal policies and regulations, high production cost and increased market demand over supply. Inflation within a healthy range can be beneficial to an economy because it encourages spending. With people not willing to save or hoard money due to its depreciation, more money is circulated within the economy.
Inflation pegged at a 2% rate is healthy for a growing economy and a good indicator of economic growth. However, this is nearly 4 times above the current inflation rate benchmarked at 7.8% in May, 2022.
Inflation can be measured using two main methods: consumer price index (CPI) and producer price index (PPI). The difference between the both is that while CPI measures inflation from the consumers perspective while PPI measures inflation from the producers perspective.
HOW YOUR BUSINESS CAN BENEFIT FROM AN INFLATION
Businesses can potentially benefit from inflation that is caused by excess demand over supply, especially if their products and services include essential commodities such as food and beverages, healthcare or education.
By leveraging on their pricing power businesses can increase their pricing within a reasonable range to cover for the increased cost of production while still operating within a healthy profit margin.
Using Miss Susie’s bakery again for an example. If operating at a low-middle margin profit when producing 1000 units of bread with $500. With $500 dollars now producing a lower unit of bread, her business would be running at a major recurring loss. Maintaining a production unit of 1000 loaves of bread will cost her even more.
The only way her business can become and stay profitable is by increasing the selling price of her product.
Businesses can also decide to focus on high-profit margin products that are in demand over low-profit products. Materials used for production can also be substituted for lower priced products within the same value range this can significantly reduce the overall cost of production.
Additionally, your business can profit from inflation by rebalancing your already existing business investment portfolio to assets that are inflation hedged. These assets rather than depreciate in value remain fairly constant or increase considerably in value during inflation. Asset classes such as energy stocks, gold, real estate, REITs and inflation indexed bonds are good examples.
In conclusion, although mainstream opinion about inflation has a negative undertone. Channeled appropriately, inflation can be a great tool to boost your business profit margin.
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