Last reviewed 9 February 2022
The UK inflation rate of 5.4% is at its highest for 30 years. While this is low compared to the high rates of the 1970s (over 9% for the whole decade and up to 24% in 1975), a 5.4% rate can easily erode profits.
Inflation could easily rise further and a 7% inflation rate will halve the value of money in as little as 10 years — so it is necessary to double the value of your business just to stand still. The imperative to protect value against the corrosive effect of inflation is clear.
What costs are impacted by inflation
The inflation rate is not even across all goods and services. Some items may increase at a greater rate than the headline rate of inflation and others at a lower rate. Expenses that are expected to increase significantly are shipping and other transport costs, road fuel and gas prices and financing costs. These may increase at a greater rate than the 5.4% headline rate. These costs will feed also into other supplies that the business will receive.
For budgeting purposes the business should estimate what its future costs will be for each line of their expenses. Contracts with suppliers should be reviewed to see if they are permitted to increase prices and, if so, by how much. Suppliers should be contacted about future costings so that the budget process can be completed to ensure the business can still afford to make purchases, or to enable it to adjust its prices to customers.
Once future costs are known, or estimated, the business can determine the level of necessary cost cutting (if any), that increased prices will cause. It is prudent for a business to review expenditure periodically, and this is more important when costs are rising. What costs are not necessary, where can savings be made? Can alternate suppliers be identified that can provide goods and services of the same quality at a lower price? Can savings be made by altering the product sold, can goods be redesigned to make them cheaper to produce?
Once costs have been quantified the business can determine the price it needs to charge to maintain profitability. Where prices need to increase it is advisable to speak to customers to determine if the new prices are acceptable. An alternate to increasing prices is to alter the product provided. It is common when costs are increasing, for example, for items like confectionery to be reduced in size slightly to maintain their price point. What can be done to your products to reduce the cost to maintain a price point? Can a less expensive formulation be used, sizing altered, or cheaper components used?
When thinking about pricing, there needs to be a note of caution. While customers are price sensitive, they can also be quality and quantity sensitive. It is necessary to determine what drives the customers to your products. If customers are quality sensitive and are attracted to your products due to their quality it is not wise to reduce quality to avoid a price rise. Quality sensitive customers are less likely to be price sensitive. Where the customers are not quality sensitive, it may be possible to reduce quality to maintain a price point. It should also be noted, that where the customer is quality sensitive an increase in quality may enable a higher price to be charged. Indeed, this may allow a diversification with a higher quality product being charged at a higher price, while reducing quality for a standard product at a lower price. The same principal applies to quantities.
A period of inflation is an opportune time to review pricing policy. One strategy that can be used is to introduce a more expensive version. This can be done in one of two ways. Either a luxury version could be launched with a higher margin (but probably less volume) to attract customers attracted to high image brands or luxury products. Alternatively, the introduction of a high priced version can direct individuals to a mid-priced product. It is human nature to move to the mid-priced product. For example, a brewery was selling two versions of beer, a low-price product and a standard version, with the majority of sales being of the low price product. To increase the number of purchases of the standard version a premium product was launched at a higher price. A few people purchased the higher priced product (giving better profit margins), but the main effect was to migrate customers from the low-price product to the standard product, increasing overall margins.
This may also be an opportune moment to assess the value that customers are obtaining from the product. If a product is overpriced for the value provided, and there is significant marketing expenditure to maintain its price point, a period of inflation can be a good time to reduce marketing spend and use these savings to reduce the price of the product. It is more common, however, that products are under priced compared to the value of the product. This can be because the price of the product has not changed for many years. Low prices can be corrosive to the product, it is regarded as a cheap low quality product as it is sold at a low price. When there is a period of inflation, customers may expect a price rise, and this can be an opportunity to increase the price to match these expectations and to properly position the product.
When considering price changes it is also important to review what competitors are doing. Where a competitor is slashing prices it can often be a poor strategy to try and match them. The competitor may have greater resources and may use the inflationary period to undercut rivals to force other competitors to reduce prices and become unprofitable. This can push less resourced companies into financial difficulties. Where the business cannot afford this “race to the bottom”, it should consider how it needs to market its product to ensure it can maintain its price point in the face of competitors’ reduced prices. Strategies to consider could include providing better quality products, better service, or a comprehensive after care service.
When reviewing prices it may reveal that some customers have been getting too good a deal. It can reveal that you have been operating at a loss in servicing the customer. In such circumstances it is necessary to either increase prices to a realistic level or “fire the customer”. In reality, nobody wants to lose a customer, but if it is costing you money the situation cannot be continued. An alternative to just raising prices would be to adjust what is provided, or to change the model of how prices are charged to the customer.
Change the price model
A method of manipulating the price is to offer a product as a service. The price point can be lowered by using a price per month, or per mile, or per unit consumed model. This reduces the headline price in the mind of the customer. It can also be more transparent and manageable to the customer. Software companies have been very successful in doing this as they have offered a monthly charge for the use of their software rather than offering outright purchase of the software. Car manufacturers can offer leasing deals rather than purchase. Service businesses can offer a monthly retainer fee instead of charging by the hour. For example, a plumber or electrician can offer to perform regular maintenance for a set monthly fee (often plus parts). A law firm can offer a monthly retainer charge to a large customer. Some insurance companies are changing the way they charge for their products (especially for younger drivers). A monthly charge for car insurance is made according to how the individual is driving the car (using a tracking device), rather than using the traditional insurance model of age, claim history and location.
Having cash available is always a useful buffer, especially if business conditions worsen. It should be noted, however, that the buying power of cash reduces with inflation, and the interest earned is often less than the rate of inflation. Too much cash on hand may, therefore, not be the best use of resources and it may be better utilised by acquiring new assets, such as new machinery to improve productivity. Alternatively, the business may invest in non-productive assets such as shares or real estate to provide a better return. Conversely, inflation erodes the capital cost of debt so debt becomes less of a burden. A consequence of debt is the interest charge and this charge may become too great a burden as interest rates increase. Reviewing cash holdings and debt is, therefore, a priority. The right amount of cash holdings and debt levels will reflect the business’s attitude to risk.
Although inflationary pressures are rising, they have not reached the heights of the 1970s. But, increasing costs of supplies and the erosion of cash value means that a prudent business will conduct a review. Determining the correct level of debt and cash holdings will be an individual decision, but knowing how inflation can impact debt and cash is an important strategic judgment. Inflationary periods are optimum tines to review costs, pricing and pricing models and to review the relationship with both suppliers and customers.