Inflation occurs when prices of products and services rise. Prices of products and services may escalate due to rising production costs such as raw materials and wages, known as cost-push inflation. Demand-pull inflation is when a surge in demand for particular goods drives the prices up.
As the prices of products and services increase, the purchasing power of your dollar decreases. In the 1980s, a loaf of bread was just about 50¢, yet it averages $3 today. If you saved $10 from 1980, it would buy only three loaves of bread compared to the 1980s when you could buy 20 loaves. While inflation may seem negative given this anecdote, an inflation rate of about 2% is optimal for employment and price stability. The whole issue of inflation begins if it rises above 2%.
According to the Federal Reserve’s FOMC Statement last month, inflation is currently “elevated,” reflecting supply and demand imbalances related to the pandemic, higher energy prices, higher wages, and broader price pressure. The low-interest rates during the pandemic stimulated many people to borrow money and spend it, which means that too much money is chasing too few goods (after the shutdown), further bolstering the pressure of prices to go up.
Inflation and small businesses
During inflationary times, you need efficient systems and processes to drive greater visibility into your business so you can act fast and stay ahead of the competition. The costs of materials, inventory, labor, and fuel continue to rise, straining even profitable firms. The real question is, do you know your numbers?
A granular approach
Knowing your financial numbers is critical. Taking an overall approach by simply looking at your monthly bottom line for profitability is no longer enough. The inflationary situation requires a more granular approach to remain a good player. Where should you start?
Know your costs
Start by knowing your costs. A product-based firm should track the cost of goods sold by the item instead of the overall COGS. Knowing the gross profit margin for each product will help you focus your efforts on selling higher-earning products and analyze why you are not profiting from others. This will help you make changes to increase profitability or drop the product altogether.
In a service-based business, for example, the utilization rate of employees is an important metric. The utilization rate formula would be % = total billable hours / total hours available. You can then attach this to payroll expense and break it down by customer, employee, office, etc. Take this further to an organizational level to calculate the overall capacity utilization rate.
Revisit your pricing game plan
As you get to the unit numbers, you can identify what costs increased and how much of the costs you can pass on to your customers. Knowing your product, customers, sales trends, product turnover rates, etc. will help you determine how far you can go without impacting your sales goals.
Review your expenses
Closely review all your operating expenses for non-essential expenses or expenses you have no gain, such as subscriptions to software that you do not even use.
Plan for your cash needs. You may need cash in advance to secure a better pricing strategy with your vendors. Your focus should be a minimum of 45 days of cash on hand, although 90 days is ideal. This formula is determined = (cash currently on hand / average daily expenses) / 365.
Tie your metrics with your business objectives
A sound bookkeeping system ensures a business runs accurate reports, → uses correct numbers for its analysis, → and bases decisions on these numbers. Your business objectives are still the same, despite the inflationary environment, and it is good information that empowers small businesses to succeed. Contact an OnTrack specialist if you need assistance.