For business managers, inflation makes planning much more difficult and results become much less reliable. It is because inflation in a country adds to uncertainty about forecasting the future.
This happens especially when forecasting future sales revenue, planning workforce, deciding on pricing strategies, conducting investment appraisal or investing on the stock market. These areas all require estimations of future pricing and figuring out present values of future cash flows.
Let’s dive into details of two situations which can possibly happen in any country: low inflation and high inflation.
Scenario 1: Low inflation
The government usually does its best to keep inflation low as countries with low inflation enjoy economic prosperity.
Businesses in a country will low and stable inflation will have less unpredictable costs and there will be less uncertainty on the markets.
Keeping low inflation is also necessary to achieve and maintain good economic growth making citizens rich, keep unemployment at the low level and achieve healthy international trade balance.
A country with a relatively lower inflation rate is more price-competitive when trading with other countries. And an increase in export earnings will bring trade surplus.
Benefits for businesses from low inflation, and business strategies
Low rates of inflation, such as 2%−3% annually, can bring many benefits for businesses:
- With a general increase in prices in the economy, small cost increases can be passed on to consumers more easily (in the form of higher prices) without causing any drastic decreases in sales revenue.
» Business strategy might focus on raising prices of goods and services.
- Companies that are heavily in debt relying on bank loans to finance their operations (firms with large long-term liabilities on their Balance Sheets) will see a reduction in the real value of their liabilities. It is because the present value of money is falling, and when a debt is repaid, it is repaid with money of less value than the original loan.
» Business strategy might focus on paying off existing loans.
- Companies that hold a lot of Fixed Assets such as land, buildings and equipment will see an increase in the value of Fixed Assets on their Balance Sheets.
» Business strategy might focus on ensuring that those increases are properly reflected in final accounts.
- Increased value of Fixed Assets will increase the overall value of a business making the company more financially secure. As the business is now more valuable, therefore it will have more collateral to use against any future borrowings to pay for future expansion.
» Business strategy might focus on borrowing more money from banks to invest in business growth.
- Businesses that hold large inventories will experience higher profit margins in the future. It is because while inventories are bought in advance for lower prices, the final products will be sold later after the final prices have already been adjusted for inflation.
» Business strategy might focus on stocking up on inventories of raw materials, semi-finished goods and finished goods for future sale.
Scenario 2: High inflation
Uncontrolled high inflation is a very serious threat to the country and all businesses operating in that country.
It is because of higher price uncertainty on the markets and unpredictable costs. High inflation will lead to a rise in prices of raw materials domestically, so that local firms may have difficulties with maintaining profit margins due to higher costs.
It will also affect the international competitiveness of a country leading to higher unemployment.
As exported goods will become too expensive for buyers in other countries to purchase, a fall in export earnings will cause trade deficit.
Drawbacks for businesses from high inflation, and business strategies
High rates of inflation, such as 5%−10% annually, can have serious consequences for businesses:
- Employees will become much more concerned about the real value of their incomes. Higher wage demands from production workers are very likely to happen. This may cause an increase in industrial disputes and worsen employer-employee relationship.
» Business strategy might focus on reducing labor costs and improving motivation.
- Consumers are likely to become very price sensitive. They will most likely reduce spending on luxury products, and look for bargains instead. No name products and own labels will see increased demand as people may not be willing to spend extra money to pay for branded products. Consumers may even stockpile some items and cut back completely on non-essential items.
» Business strategy might focus on including cheaper products in the product portfolio.
- Rapid inflation will often lead to higher interest rates set by the central bank, and charged by commercial banks. These higher rates could make it very difficult for highly-geared companies (those having a lot of debt) to find the cash to make interest payments, despite the fact that the real value of the debts is declining.
» Business strategy might focus on reducing long-term borrowing to levels at which the monthly interest payments are manageable.
- If inflation is higher in one country than in other countries, then businesses will lose competitiveness in overseas markets. Because prices of exported products are now higher due to high cost-push inflation, there might be much less demand from overseas buyers.
» Business strategy might focus on reducing profit margins to limit price increases to stay competitive against international rivals.
- Businesses that sell goods on credit will be reluctant to offer extended trade credit periods to their customers. It is because the repayments by creditors will be with money that is losing value rapidly. So, it is better for a firm to receive more valuable money today, than to wait for receiving much less valuable money in the future.
» Business strategy might focus on reducing time period for customers to pay trade credit in order to receive cash sooner. Or, even completely cancel giving trade credit and demand immediate cash payments.
- Many businesses may experience cash-flow problems. It is because when prices of raw materials increase dramatically and workers demand higher wages, businesses may struggle to find more money to pay those higher costs.
» Business strategy might focus on reducing investment spending, lowering spending on advertising, limiting innovation or cutting back on Research and Development (R&D) of new products.
There are many questions which business managers need to answers when it comes to inflation.
- Will the rate of inflation go up again raising prices? If yes, how much?
- Will the rate of inflation continue to go up raising prices? If yes, then for how long?
- Will the government take corrective actions by increasing interest rates which could reduce business profitability? If yes, then when?
It is not easy to answer these questions, as future is unpredictable. Yet, business managers need to consistently come up with successful business strategies that can guarantee business growth and profitability. It is surely not an easy job.
