Understanding the Impact Inflation Can Have on Your Small Business

In June, the Consumer Price Index (CPI) surged by 5.4% year-over-year (YoY), coming in above expectations of a 5% gain. The inflation rate rose at its fastest pace since 2008.

If you feel like you’ve heard a very similar story over the previous couple of months, you’re right. In April, we saw a 4.2% rate of inflation, higher than the 3.6% expectation and, at the time, the fastest pace since 2008. In May, prices rose by 5%, topping consensus estimates of 4.7%. Again, the May numbers marked the highest rate of inflation since 2008.

The Federal Reserve continues to believe that price increases won’t continue for long and has no immediate plans to scale back the $120 billion a month of asset purchases. But with the inflation rate on an unmistakable upward trajectory, there are reasons to doubt the Fed’s expectation that inflation is transitory.

So, where exactly are the biggest price increases occurring? And what is the impact of inflation on small business owners?

Let’s start by breaking down the CPI, so we can understand where inflation is coming from.

The CPI is a Typical Basket of Goods and Services

The Consumer Price Index essentially measures the cost of living. It represents the goods and services most commonly bought by US households – weighting the categories based on their percentage of household costs. Since housing is the largest expense for most US households, it makes up roughly one-third of the CPI. Gas and vehicle purchases, on the other hand, make up a much smaller percentage of household budgets, which is reflected in the CPI weightings.

In June, the cost of shelter increased by 2.6% over June 2020. Food makes up around 14% of the CPI, and it increased by 2.4% over the last year. So, shelter and food, which, combined, make up nearly half of the CPI, rose by around half of the headline number. What gives?

The rising prices can largely be attributed to gas and used cars and trucks. These two categories account for less than 7% of the CPI, but experienced massive price increases, allowing them to exert a huge influence over the headline number. Both categories are up around 45% over the same period a year ago.

The high inflation in gas prices isn’t shocking when you consider that we were in the early stages of the pandemic in June 2020. At the time, millions of people were staying home unless they were essential workers. Now, with people getting back to their normal lives, they are returning to the office and taking vacations, increasing the demand for fuel.

With used car and truck prices, there’s something else going on. We are seeing supply shortages limit the production of new cars. Ford, for example, is cutting its vehicle production in six of its US plants because it is facing a semiconductor chip shortage. The lack of new cars leads to more demand for used cars, driving up the prices.

There are actually supply chain bottlenecks in a number of industries. The pandemic exposed the downside of just-in-time (JIT) inventory systems. As efficient as these systems can be in the best of times, they can fall apart in the event of a downturn.

Is the Inflation Rate Going to Decrease if Supply Chains Get Back to Normal?

There are economists who believe that supply chains will normalize when the pandemic is over. With the pandemic likely to end in the next year – if not sooner – businesses could soon have the raw materials they need to return to full capacity.

While normalized supply chains would alleviate some inflationary pressures, they wouldn’t get rid of all of them. Between February 2020 and February 2021, there was a 26% jump in the money supply – the largest increase since World War II.

The Fed’s accommodative monetary policy – not only is the central bank purchasing $120 billion in assets per month, but it is also maintaining extremely low-interest rates – is leading to surges in asset prices. We are seeing price increases in the stock market, real estate, and even speculative assets like cryptocurrency and collectibles.

Then there are the spending plans that are coming from the White House. President Joe Biden has proposed trillions of dollars in spending. The spending should help to spark economic growth, but at the same time, it means that more dollars will be injected into the system.

All to say: there is evidence that supply chain normalization won’t be enough to prevent higher prices.

What Does Inflation Mean for Small Business Owners?

For the time being, the effects of inflation have been concentrated in a few areas. But if we see continue to see higher and higher inflation – or even hyperinflation – there could be rising prices across the economy.

As a small business owner, you could notice higher costs in the following categories:

  • Labor
  • Raw materials
  • Interest

Let’s look at these one-by-one:

Labor

In the month of June, average hourly earnings increased by 0.3%, which sounds great for workers… until you see that real (inflation-adjusted) hourly earnings dipped by 0.5% for the month. Before long, workers are going to realize that their purchasing power is decreasing and demand cost-of-living increases – at the very least.

The wages for some workers, however, will increase by more than others. It can be challenging for salaried employees to command higher wages, particularly if they are not in a high-demand profession. But freelancers are often more aggressive with rate increases – if someone has six clients making up an equal portion of their income, the risk of losing any one client is a lot lower.

Raw Materials

Earlier, we touched on the supply shortages that are happening in certain industries. But we didn’t talk about what happens in the short-term in the event of shortages – prices are increased. If we see a sustained period of higher inflation, additional distortions will be created across the economy, and supply shortages will pop up in other industries.

As a business owner, you also have to consider the indirect impacts of inflation on your business. If the cost of labor rises for a key supplier, they are likely to pass that higher cost on to you.

Interest

Over the last decade, we’ve seen low-interest rates as deflation was more of a risk than inflation. While interest rates remain extremely low by historical standards, they have increased from last year’s lows. The increase is largely due to the increased expectation of inflation; higher prices mean that lenders get paid back in increasingly worthless dollars.

But in the event that inflation is here to stay – or if there is a widespread expectation that it is here to stay – interest rates could increase a lot more.

How to Keep Costs Down in an Inflationary Environment

In an inflationary environment, the higher costs of labor, raw materials, and interest threaten to squeeze profit margins… unless you take measures to prevent those costs from increasing too much.

Labor

With labor, you can’t really lock your employees into long-term contracts. But you can offer them non-financial incentives to stick around. Just make sure that you’re offering them something that they really care about. More time-off is good. A ping-pong table in the office, on the other hand, isn’t a game-changer.

Raw Materials

There is a lot you can do to lower your supply chain risk. To start, you want to look for vulnerabilities in your supply chain:

  • Do you have long-term contracts with your suppliers?
  • Are you relying on one supplier and have no backup?
  • Do you have a JIT supply chain or do you have a time buffer?
  • Are your suppliers all located in one country?

Answering these types of questions is the first step in mitigating the risk of higher prices. From there, you can take countermeasures including:

  • Signing long-term contracts with suppliers to lock in prices.
  • Establishing alternate supply chains.
  • Building a time buffer into your supply chain (if possible).
  • Introducing geographic diversity into your supply chain.

Interest

If don’t intend on financing anything for your business, then higher interest rates might not have much of an effect on your business. But if you plan on financing an expensive piece of real estate or equipment, you may want to secure financing sooner rather than later.

Of all the effects of inflation, higher interest costs may be the most devastating for your business. That’s because they can be long-lasting. For example, if you take out a 20-year term loan for $250,000 at a 7% interest rate, you’d be paying $1,938.25 a month. But at an 11% interest rate, you’d be paying $2,580.47 per month. Over a period of 20 years (240 months), that adds up. A lot.

Don’t Keep Too Much Cash

You may have a high cash balance in your savings account for a rainy day. It’s prudent to keep some cash on hand – particularly in such an uncertain economy – but you don’t want too much cash. A good rule of thumb is 3-6 months of cash, but it varies based on your situation.

The reason why you shouldn’t stockpile cash is because the buying power of that cash rapidly decreases in an inflationary environment.

So, what should you do with your excess cash?

There are two possibilities: invest in your business and invest in other assets.

If you invest in your business, there are countless possibilities including:

  • Equipment or real estate
  • Hiring new staff
  • Launching a new product
  • Acquiring another business

You can also elect to invest in other assets including:

  • Equities
  • Bonds
  • Treasury inflation-protected securities (TIPS)

You should talk to a Certified Public Accountant (CPA) or financial advisor before making any investment decisions, but these are a few of the most common options.

The Bottom Line

From April through July 2020, the inflation rate was below 1% each month. But the only constant is change, and a year later, there are fears that the annual inflation rate will rise to the high-single-digits – if not higher.

As a small business owner, it’s important to understand the impact of inflation, and take action to counteract its effects – before it’s too late.



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