Fight Inflation – 6 Strategies to Help Your Company

Intro:

We are all (still) experiencing the effects of inflation in our everyday lives. If you have a business, you know this all too well. But some businesses are impacted more than others. Corporations and larger businesses with more net value have access to cheaper capital. This allows them to offset higher costs. Those businesses whose products and services have more demand – if there are fewer satisfactory alternatives, for example, are much better positioned to not only sustain their operation but to grow.

Ironically, loose money policies often create inflation, but for small businesses, inflation creates situations that force owners, partners or shareholders to tighten their spending. Small businesses do not have unlimited pricing power – so, they cannot raise their prices to completely offset higher costs (over the long term) because higher prices drive down demand and ultimately sales for their products or services. The result? Small business owners are often in a continuous struggle to try and maximize sales revenue based on their pricing, and volume mix, while employing marketing strategies and tactics (like discounts and offers) to increase sales.

For a short 3-5 minute read from the Harvard Business Review:  click here – 6 Strategies to Help Your Company Weather Inflation to link to the article. Even though this article is focused toward large businesses, there are elements (and suggestions/tips) in it that apply to companies of all sizes – the only difference being, how you should scale your effort. 

Now that I’ve linked to HBR’s perspective, here are my (more in-depth and specific suggestions) on what to do if you’re a small business fighting the effects of inflation.

1. Evaluate Changes in Your Unit Costs or Job/Project Costs:

1.1 How Much have Your Direct Expenses Increased?

First, You need to figure out what direct expenses have increased and by how much. By direct expenses, I mean those that are directly tied to creating and delivering each unit of your product/service or those that are required to complete each job/project. Direct expenses are also referred to as variable expenses – these expenses vary directly with increases or decreases in business (sales).

After evaluating how much your direct expenses have increased, this will allow you to determine how much your gross profit has eroded, gross profit being the difference between net sales and your direct expenses either on a per unit basis or by job/project.

1.2 Determine the Impact to Gross Profit

Gross profit is probably the single most important measure of a business’s health, because the amount of gross profit pays for everything else – insurance, office expenses, rent, subscriptions, utilities and gross profit (largely) determines whether a business generates a net profit or not.

1.3 Make Accurate Comparisons to Quantify Increases in Expenses

Each cost or cost category should only be compared against very similar or identical costs and you should use actual costs not estimates or budgeted costs. You’re trying to assess how much your actual costs are increasing due to inflation, so, the comparison to be made is actual costs (current-inflationary) against actual costs (prior-inflationary).

Pre-inflationary actual material costs should be compared against (current, inflationary) actual material costs or (pre-inflationary) actual labor costs or labor rate per hour vs. (current, inflationary) actual labor costs or labor rate per hour. If labor costs only include wages paid for construction site labor, you should only compare the change in wages for construction site labor.

1.4 Tools that Allow You to Track Increases in Expenses

If you use a Customer Relationship Management (CRM) tool as a way to estimate new jobs or projects, then your actual costs (accrued or expensed) at the completion of the job or project compared to your (budgeted) estimate shows you either a favorable or unfavorable variance between actual expenses and estimated expenses. This is different than comparing the changes in your actual expenses due to inflation which is the focus of this article. 

Many accounting platforms (like QuickBooks Online) have project features that can simplify tracking costs over time and calculate gross profit margins so that similar jobs or projects can be compared.

Unit costs (for manufacturers or some service providers) are often constructed using Bill’s of Material (BOM’s). BOM costs often include standards that estimate the amount of material and labor required to make each unit. Variances between standard costs and actual costs does not measure cost increases due to inflation – this is either a cost or efficiency variance (or both). Cost increases due to inflation need to be updated in Bill’s of Material and tracked. For more on standard costs click this link – Business Performance Standards.

1.5 The Mechanics – How to Determine Cost Increases

• Analyze cost changes by Client/Customer, if there are differences in how products/services/jobs/projects are created, completed or delivered. Differences in creation, completion or delivery will drive differences in cost.
• For Gross Sales, ask your Clients/Customers. Ask them about their demand or what jobs/projects they need your help to complete in the next 6 months and try and review this with them quarterly. You want to get their read on Sales you can expect, but you also want to plan for adequate staff and employees to meet Client/Customer demand.
• Unit Costs = labor cost/hour multiplied by hours needed to complete each unit + material cost/unit + any other costs (on a per unit basis) to create and deliver one unit of product or service.
• Job/Project Costs = labor costs + material costs + any other costs to complete/deliver each job or project.
• Gross Profit = (Gross Sales – discounts, returns and adjustments) – Direct Expenses (labor, materials, supplies and anything else required to create and deliver your product/service/job/project). For per unit costs – multiply actual volume by your unit costs to get an actual gross profit amount.

1.6 Compare Cost Increases and Gross Profit Decreases

• Now, compare your “pre-inflation” costs with your (current) inflationary costs or compare the year-over-year (Y-o-Y) changes in your costs.
• Then, compare your “pre-inflation” gross profit with (current) inflationary gross profit or your year-over-year (Y-o-Y) changes in your gross profit.

1.7 About Overhead Costs

Overhead costs are costs that are spread over many units of your products/services/jobs/projects that require some work to unravel and tie to your unit costs or job/project costs.

Why should you assign overhead costs to your unit costs or products and services? Because, unit costs or job/project costs that don’t include overhead do not represent your true costs. If you do not assign general and administrative expenses, insurance, office expenses, rent, utilities, and other shared costs, how can you ensure that your pricing or sales volume will be sufficient to generate a net profit or an adequate return on sales?

By including overhead costs in the calculation, only then will you understand your true unit/job/project costs and how much each product/service/job/project is delivering to your bottom line profitability.

Don’t cheat using some oversimplified and inaccurate method of “allocating” overhead costs like using sales revenue or simply disregard including overhead in your unit/job/project costs. Disregarding overhead in your unit/job/project costs understates your true costs and overstates your gross margins. Doing this could create a separate issue – for example, if you base pricing on understated costs it may cause you to underbid new contract work.

• Overhead Costs = those costs that are spread (or shared) over more than one product/service/job/project that need to be tied to unit costs, jobs or projects to get an accurate representation of your true costs.
• Gross Profit – Overhead Costs = Net Profit contribution to your total bottom line from each product/service (on a per unit basis) or by job/project.

Overhead Suggestions/Tips:

– If you’re trying to tie electricity costs to your unit costs, use machine time (for example) as the cost driver. The idea is to use a cause and effect relationship between what drives overhead costs (and the resulting cost amount) because choosing the better cost driver will yield a more accurate unit or job/project cost.

– You may ask, “How can I possibly break lump sum Insurance Costs and tie these amounts to each product, service, job or project that would yield any additional accuracy, and why would I want to?” Insurance is priced for risk. If your products, services, jobs, or projects are equally risky, spread the costs equally.

2. Expenses – Your Vendors:

Now that you’ve analyzed the changes in your direct expenses (1. above), you need to go to work on your suppliers and vendors. Ask yourself –

• Can less expensive alternative materials, services or supplies be used?
• What about other suppliers or vendors (with similar products or services) that may offer more flexibility in their pricing or terms?
• Is this expense really necessary?
• Evaluate new expenses under consideration by asking if the expense saves enough time or provides a return that exceeds the cost of the expense.

In Addition:

– Negotiate better pricing with cash payments in lieu of using credit cards since in a period of high (or rising) inflation, you want to avoid high interest payments to conserve cash.

– You also want better (or stretched) payment terms. If you have Net30 terms, try for Net45.

– Regardless (inflation or not) you should get in a habit of shopping your critical (either necessary to your operation, or large annual expenses) vendors at least once a year to keep them competitive.

3. Pricing and Sales – Accelerate Cash Receipts:

In periods of inflationary pressure, you’re going to have to negotiate increased pricing with your existing clients/customers. To blunt this sharp edge, offer them/discuss with them:

• Something in addition to your current offering that does not increase your costs or effort(s) appreciably.
• Stress, and more importantly, demonstrate the value you bring to remove their objections to your position.

In Addition:

– Remember, your clients and customers are experiencing the effects of inflation themselves, so money is tight and this puts pressure on your sales revenue. To boost sales and remain profitable, your outreach and tactics could include discounts or offers as long as you thoroughly understand your costs. The last thing you want to do is commit to a marketing strategy that creates a cash “crunch” because you focused on maximizing top-line revenue with less consideration of the cost of the campaign.

– Accelerate client/customer receipts to improve your cash flow by offering them a discount percentage (or fraction of a percentage) for every 10 days they agree to shave from your current terms.

– Have your clients/customers pay (by cash or check) in lieu of credit or debit card’s to avoid transaction fees.

4. Labor and Wage Expenses – Increase Productivity:

Very important, and you may not want to consider this (but you should) –

• Offer an incentive program (with bonuses) in lieu of increased pay (due to inflation) for your employees that is tied to performance.

Higher levels of labor productivity is like a stick hitting a Piñata (inflation). You may think that this is difficult (if not impossible) to do in an inflationary period, but I disagree. I have several clients that introduced incentive/bonus programs to their staff (during 2024 – a lot inflationary pressure) and within a period of a few months, their financials greatly improved.

Yes, there will be some degree of employee attrition and churn, but you will end up with improved morale and a more loyal base. You should also emphasize in your internal training programs how your employees can earn more to reinforce the types of behavior(s) that you want.

5. Create and Adhere to a Cash Budget:

As I mentioned above, small businesses cannot simply raise the prices for their goods and services and offset, dollar for dollar, the increases in their costs due to inflation. So, my argument is that businesses need a mechanism or an enforceable way to conserve cash in inflationary periods. And this needs to be enforced at all levels of the organization – it won’t work if staff is constrained, but owners, partners or shareholders take a reckless, free-wheeling attitude, because they own the business.

In 1. (above), the idea was to determine, as best as possible how much your actual expenses have changed based on how your business is structured, how it operates and the goals/mission you’re trying to achieve. In creating a budget, you want to create cost targets based on your best estimates of actual expenses for a period of time, usually a calendar or fiscal year.

Additionally, in 1. (above), direct expenses were the focus, so you could determine the impact to your gross profit. Now you want to analyze those costs “below” direct expenses – overhead costs that are shared across products/services/jobs and projects, for example – sales, general and administrative expenses, insurance, office expenses, rent, utilities, etc.

5.1 Putting the Budget Together

• You should create two columns in your spreadsheet to compare actual expenses incurred or paid against your budgeted cost targets.
• In inflationary periods, you want to update budget targets (referred to as rolling your budget forward on a monthly or at least quarterly basis) to capture the affects of inflation on your cost targets – a dynamic budget.
• If material costs or insurance costs change abruptly and you do not update your budget to reflect this, it will show large unfavorable variances and appear as if the organization failed to control spending.
• The intent is to use this document to control spending below the organization’s ability to increase prices to avoid (as best as possible) the destructive effects inflation has on the value of your business.
• You can use your Profit and Loss Statement and transform this into a (monthly) cash budget by eliminating non-cash transactions like depreciation. Divide this template into three sections – Operations, Financing and Investments.
• Focus on your operating activities because this is the engine that generates cash. If you’re relying on Financing to fund your operating activities (beyond using lines of credit or credit cards to fund occasional cash shortfalls) this is a problem that needs to be fixed immediately.

Budget Suggestions/Tips:

– Again, budgets are forward looking, they are most often completed before the start of the calendar or fiscal operating year.

– To re-emphasize, budgets are most often static, meaning that they don’t change. But in periods of high inflation, static budgets are not practical. Dynamic or rolling budgets need to be used to update how cash is to be managed/spent when costs are rising.

– Many expenses are billed monthly, so this lends itself to creating a monthly budget. You can use inflation rates that are published by the government and “uplift” your expenses by this amount. But in reality, costs for insurance, rent and utilities have greatly exceeded (published) inflation rates which calls into question how inflation rates are calculated. Different story.

– As an example, your insurance provider or landlord will (usually) send you an invoice (for the total amount due) in the next fiscal or calendar year that they intend to bill, monthly.

5.2 Include the Following in the Budget

• Include the analysis of gross income, direct expenses and gross profit (in 1. above) in this cash budget.
• As mentioned, exclude non-cash items like depreciation in your budget. Calendarize your plan by month.
• Include in your plan a cash break-even point. You should know how much you need in cash collections (by month) to break even against cash payments. Include Owner draws, Partner draws (Partnership) and Shareholder distributions (S-Corporation) in your budget.
• Include additions and subtractions to income and expenses based on what you know of the current period and planned actions you intend to take.
• Include the costs of any planned large capital purchases in the current period (and all future affected periods) and what this does to your expected cash requirements for the immediate period – calendar year or fiscal year. In periods of inflation, finance charges are fluid and typically increase, so you need to factor in interest rate increases.

5.3 More on Cash Budgets

To reiterate – do not focus on paper profitability – focus on cash. Profitability measures performance, but performance does not automatically translate to cash. If you have large amounts of debt, you can be profit rich (on paper) but cash poor, because debt and interest payments chew up cash.

• You need to have a solid cash plan (preferably by month), to combat the affects of inflation that shows any seasonality or changes in sales, expenses, planned investments or major cash expenditures to make the plan credible and practical.
• Include a 15-20% cushion factor in your cash requirements (per month). Unforeseen events always happen. Include this or an adequate amount of cushion in any plan you form.
• Important. Leadership needs to agree on how budget deviations are to be handled. Internal control is important here. Ensure separation of duties and responsibilities. Deviations to the plan need to be approved by a group that is separate from the individual or group that may benefit from the approved action(s).

5.3.1 A Financing Tip

• Cash shortfalls should (ideally) be addressed with a revolving line of credit that is used (only) for operating needs – revolving lines of credit are often cheaper then credit card rates.

5.4 Monitor Capital Expansions for Returns

• If you made capital purchases to expand your product or service offering or to break into an adjacent market (new customers or new product offerings) these capital purchases/expansion plans need to be monitored for adequate returns.

5.4.1 More About Capital Expansions

• It’s not just about covering your financing costs, you need to monitor the return on your investment(s) to ensure that they meet/exceed whatever hurdle rate you set when you made your decision to approve the expansion.
• Investigate returns below expectation and take corrective actions to improve.
• If corrective actions are not enough and operating expenses exceed returns (over some period – 6-12 months) and there is no “light at the end of the tunnel,” consider (strongly) the need to pull the plug on this investment.

6. Automation, Business Processes and Debt:

6.1 Automation

The Harvard Business Review article, talks about automation. But automation is not cheap and it takes time to design, configure, deploy (and monitor) results. Of course, you should automate your repetitive and well-understood office tasks using AI tools to the extent you can. But, a word of caution. Understand that AI models learn over time, so you should monitor results to ensure accuracy as the AI model gains proficiency.

6.2 Processes

This may seem like common sense, but change can be difficult in organizations where inertia (and politics) have built up over time in how tasks are interpreted and “worked.” Even small businesses can suffer from an inability to create efficient work tasks that are repeatable and effective. Process “owners” may look at processes as the means to an end, when in fact it’s about solving tasks or problems as simply and quickly as possible.

• Map your processes by defining your current “as-is” state of work tasks/events required and create a future desired state then,
• investigate (challenge/eliminate) those tasks that duplicate effort or lack value.

6.3 Debt

Probably the single most destructive reaction to inflation, itself. As stated previously, inflation actually tightens money and spending, because costs are rising faster than paychecks or sales to pay these increased costs. So, some owners reach for the obvious “painkiller,” DEBT to paper over their underlying financial problems and try and sustain their operation at current levels.

The increased financing and interest costs and (often times) very aggressive repayment terms create further pressures on cash and impacts the business’s ability to operate. This goes from bad to worse. If the business is unable to pay it’s obligations, creditors could “call in” the balance of the loan and force the business to liquidate it’s assets. Creditors will do so if they believe they can reclaim more of the outstanding debt than allowing the business to continue.

In periods of inflation, you need to tighten your fiscal wallet by cutting unnecessary expenses and avoiding new debt which comes at a higher cost because of inflated interest rates and financing expenses. If you’re forced to downsize your operation, so be it. Many companies in their history went through periods of downsizing and reduced growth because of factors beyond their control, only to emerge much stronger with an improving economy.

Avoid debt. Instead, offer an equity stake – a less risky option if you’re (urgently) looking for financing options.

Closing:

The overall idea for this article (if you’re serious about either sustaining or growing your business in this difficult period) is to blunt the damaging effects that inflation can have on the equity value (or net-asset value) of your business.

Remember, inflation is cumulative. Even if the inflation rate decreases, it just means that costs are not going up as much. A reduction in inflation does not mean costs are going down – probably the single biggest misunderstood aspect of inflation.

In closing, unless your business is a Monopoly (it isn’t), 

that enjoys unlimited pricing power (it doesn’t), 

that can always offset higher costs for inputs – like labor, materials, supplies, S,G & A, etc., with higher prices (it can’t),

you (the Owner, Partner, Shareholder) need to take actions to sustain (or grow) your company by preserving the equity value of your business.

This is not an exhaustive list of everything you could or should be doing to fight inflation. Should you wish to discuss additional strategies/tactics or need help implementing them, Contact Engineered Accounting Solutions.