Weighing the impact of inflation on profits

Home Columns Al's Column Weighing the impact of inflation on profits

inflationBroadly defined, inflation is the overall rise in the prices of goods and services over time. These increases mean the dollar buys less than it used to. However, inflation can have a positive impact on the economy. In fact, the Federal Reserve sets an inflation target; it wants a healthy core inflation rate of 2%, which takes out the effect of food and energy prices. The central bank wants a little, which also leads consumers to believe prices will continue rising. When inflation rises faster than expected, problems can arise.

How does inflation impact business owners? Naturally higher inflation costs place pressure on gross and net profits. However, the impact of rising prices will vary for different cost types. The rising cost of raw materials will erode gross margins if sales prices are not increased. Keep in mind, the reduction in gross margins may not be immediately apparent. This is because an existing stock that was purchased at lower prices will be used first. However, that inventory will eventually need replenishment. To that end, it is best to use the current or predicted cost of raw materials when making pricing decisions when inflation is high.

When the prices of energy are affected, distribution costs will likely increase. Such rising costs will impact both shipments to customers and suppliers. While service providers may be able to avoid certain negative impacts, they will experience an increase in the cost of travel.

As expected, all overhead costs tend to rise under high inflation periods. These rising prices will begin to eat into net profit that is already being impacted by raw material and distribution costs. While it will take longer for it to increase the cost of long-term fixed-price contracts (i.e., rent, maintenance contracts, etc.), you could see significant annual increases in these costs if inflation remains high for an extended period.

With the impact of rising inflation on businesses, consumers feel the effects as well. This can lead to pressure from employees to increase wages and salaries. Businesses that do not adjust pay in line with inflation often risk losing workers. When the employee turnover rate is high, recruitment and training costs will be incurred and a drop in productivity will often occur. This encourages businesses to increase wages and salaries in order to retain employees. An erosion of spending power will affect both businesses and consumers alike. B2B (business-to-business) and B2C (business-to-consumer) companies could very well experience a drop in demand.

The degree of the drop in demand will depend on the sector of products or services. For example, demand for luxury and non-essential products will tail off quickly and demand for low-cost alternatives could rise. As inflation grows higher, so will interest rates. Consequently, servicing existing debts will become more expensive. It very well may become a challenge to obtain new financing. Additionally, inflation devalues money.

High inflation certainly presents challenges to businesses. However, the effects of rising prices can be managed. If costs are controlled, cutbacks are made when needed and sales price increases are made in a timely manner.

Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. Bart Basi, senior advisor with the firm, co-authored the article.

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