Effects of Inflation on Businesses

When we think of inflation we usually think of how it affects us as consumers. But the effects of inflation are wide ranging, including not only individuals but also businesses and even countries. Consumers and businesses alike have to deal with the impact of inflation, both good and bad. Here are some ways in which inflation affects businesses:

1. Consumer Purchasing

This is the most obvious impact to businesses. Rapidly rising prices will cause consumers to (as Samuel Goldwyn famously said) “stay away in droves”. There are ways for businesses to plan for inflation to reduce the chances of revenue loss. Gradually increasing prices will prevent a sudden price hike, and if your competitors don’t respond similarly, they’ll have to increase their own prices suddenly, which will cause “sticker shock” for their consumers causing them to look for more affordable alternatives. Another sneakier option that businesses often resort to, is to shrink the package size while keeping the price the same. This is sort of “stealth inflation” because most consumers won’t notice the quantity change because they are more focused on price.

2. Inventory Costs

Rapidly rising prices not only affect the price consumers pay, they also affect the cost businesses have to pay for materials and inventory. When replacement inventory costs more than the inventory you just sold, it can lead to inventory shortages. In the highly inflationary 1970’s rising inventory costs led many U.S. companies to adopt the Japanese model of Just in Time inventory management (JIT) as opposed to “Just in Case” inventory management, so they wouldn’t have to stock so much inventory. Toyota is said to have been one of the first to use JIT. “Toyota started with just-in-time inventory controls in the 1970s and it took more than 15 years to perfect. Toyota sends off orders for parts only when it receives new orders from customers.” This requires precise timing and reliable inventory channels since a single delay could halt production altogether.

JIT allows companies to stock less inventory, thus saving on carrying costs but even the most prudent business management may not be able to overcome the effects of high inflation. JIT is also useful in times of Deflation when prices are falling, as happens frequently in the electronics industry. In that case you do not want to carry inventory in stock which if held too long, you might have to sell at or below cost.

3. Price Changes

When service and product prices fluctuate, businesses have to spend money printing new menus or changing price tags to list the correct prices. These costs are called ‘menu costs’, and they affect brick and mortar businesses most heavily. Imagine the labor involved in going through Walmart and changing all the price tags! And then imagine having to do that every day. In an effort to reduce the labor involved in changing prices in the 1970’s large department stores stopped putting tags on individual items and only put them on shelves instead.

Hyperinflation can make matters even worse. The (German) Weimar Republic is perhaps the quintessential example of hyperinflation. In the book “Paper Money” by Adam Smith he says:

“Prices rose not just by the day, but by the hour — or even the minute. If you had your morning coffee in a café, and you preferred drinking two cups rather than one, it was cheaper to order both cups at the same time.”

If businesses can’t predict their costs in advance and so they also don’t know how much they will have to charge, they spend more and more printing and reprinting items. Over time, the menu costs add up. To avoid this issue, highly variable items will simply be listed as “Market Price” and you will have to ask the server what the going price is. In addition to the cost of changing price tags, if the rate of inflation is widely variable (compared to steadily increasing) it makes projecting costs and profit margins even more difficult and thus larger expansion projects are put on hold simply due to uncertainty, which slows the economy, eventually stifling it altogether see Zimbabwe hyperinflation.

In times of hyperinflation, people rush out to spend their money before it loses value, so inventory turns over rapidly this is called the Velocity of Money.

4. Borrowing

Early in the inflation cycle, banks are actively expanding their loan portfolio as the easy money policies of the government kick the economy into overdrive. During this artificial “boom” many businesses succumb to the lure of easy money and think that getting a business loan is a good idea. They figure that because inflation rates are rising, the cost (in purchasing power) of paying the loan back will be less than the value of the loan taken out. However, as is the case with any debt, companies must be smart about how much they take out and for what, because even cheaper money won’t bail them out if profits didn’t increase from the new business venture or expansion. Plus, like all games of “musical chairs” eventually the music stops and someone is left without a seat.

Later in the inflation cycle, businesses will find it harder to take out a loan, because banks and other financial institutions view a business with a low cash flow as a risk, since it’ll be harder to pay back the borrowed funds. At this point, in order to protect themselves against the impact of inflation, lenders increase interest rates to cover not only the cost of the depreciating value of the money, but also the cost of increased market uncertainty. This lack of borrowing power will reduce the liquidity of many enterprises who rely on credit to fund inventory or operations, and may lead to insolvency, or reduce the ability of businesses to invest in growth. As problems in the economy snowball, lenders become more cautious and eventually all credit dries up, so even good credit risks are unable to obtain financing.

At this point, people like Warren Buffett (who have wisely stockpiled cash) swoop in and make offers to the cash starved organizations that they “can’t refuse”, primarily because they have no other choice. For instance, in 2008 in the depths of the Great Recession, Buffett’s Berkshire Hathaway loaned GE $3 Billion dollars (actually they purchased $3b worth of preferred stock) under terms that no individual investor could have received. GE needed the cash infusion due to problems with its financing unit, GE Capital. And GE was desperate for funding after Bear Stearns and Lehman Brothers went belly up. According to a USA Today article, “Berkshire, based in Omaha, Neb., is buying $3 billion of preferred shares of GE, which carry a 10 percent dividend. The terms are similar to those Buffett struck with Goldman Sachs. Berkshire also has the option to buy $3 billion worth of GE common shares for $22.25 each at any time over five years. GE’s shares closed at $24.50 Wednesday.” Five years later, at the end of 2013 those shares were trading at about $28, so Buffet could buy them at $22.25 and immediately turn around and sell them at $28.

5. Investment

For businesses hit hard by high inflation, upgrading outdated electronics and equipment becomes nigh impossible. The office might benefit from a new computer, and a remodel might appeal to customers, but those kinds of upgrades aren’t going to be possible. Not only are profits low, but high inflation makes even normal, everyday costs expensive.

High inflation stymies major investment. When inflation rises materially above the federal target, investor confidence in the economy is reduced. This causes punitive interest rates on loans as investors seek a return on their investments. This is because they want compensation for the increased risk of lending money. In the long term, this reduces business growth preventing businesses from taking advantage of market opportunities.

6. Employee Wages

One of the major costs of doing business for most companies is employee wages. Typically, employees suffer more than companies due to inflation. Remember back to the example of Weimar Germany when prices were going up hourly. Now imagine what would happen if employees didn’t get wage increases except for once a year. Very quickly that employee would quit coming to work. The same thing happens on a lesser scale when inflation is lower. For simplicity sake, suppose an employee is earning $10 per hour. If inflation is 5% per year, something that he could buy for one hour’s labor in January will cost him $10.50 in December, but he hasn’t gotten his raise yet, so in effect if prices rise rapidly the employee is always a year behind. Over time, that employee will start to struggle financially, because their dollar counts for less than it once did. This happens even when the inflation rate is low, but when it’s high, this phenomenon is even more pronounced.

In addition, inflation gives businesses an opportunity to reduce the cost of employee wages. Employees won’t agree to a pay cut, but by increasing employee wages by a rate lower than the inflation rate businesses can lower their employee wages expenses.

7. Foreign Exchange

As inflation occurs, the purchasing power of the dollar falls, relative to other currencies. If the dollar falls in value, costs for international purchases increase. With supply chains in today’s increasingly globalised world spanning many countries, purchases of raw materials and component parts often need to be made in foreign currencies. A weaker dollar increases the cost in dollars for each unit purchased. With complex supply chains, it is often impossible to switch to domestic suppliers in the short term, making increased costs unavoidable.

On the flip side, a weaker dollar, increases demand for goods from overseas consumers, because it becomes relatively less expensive to purchase finished goods from countries with weaker currencies rather than from countries with relatively stronger currencies. This may alleviate the impact of foreign expenses, or, depending on the scale of the depreciation in the dollar, may prove a net benefit to the business. A lot depends on the ratio of foreign sales to foreign raw materials costs. In other words if your income is in one currency and your expenses are in another, the direction of the currency value changes can have either a strong negative or positive effect. Most companies in this situation use currency hedging to protect against adverse currency fluctuations.

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