No matter how you slice it, inflation is here. The growing prices of freight and raw materials combined with increasing wages due to the much-discussed labor shortage make for unavoidable cost increases for businesses.
So what’s a business owner to do?
There are two things that you can do as a business owner to prepare for inflation and protect your profit. The first thing is to monitor costs and secure your prices from suppliers, either over the short-term or long-term. The second thing is to raise your prices.
What’s Covered in This Blog?
- How to prepare your business for inflation
- How to forecast for inflation
- Raising your prices for inflation
How to prepare your business for inflation
To prepare for inflation, first aim to understand the impact on your margin and profitability. It will depend on the increases to both your cost of goods sold (COGS) and your cost of labor.
No matter which industry you find yourself in, if you are a business owner, you should be updating your forecasts for the rest of this year and next year with the assumption of higher costs. With inflation forecast to be upwards of 4% at the end of this quarter and remaining around 3% into next year, it bodes well to build these updated rates into your forecasts.
Next, you should use these updated forecasts to identify how to increase your prices so that you can sustain a consistent gross profit margin in the midst of inflation.
How to forecast for inflation
To plan your pricing for post-pandemic transitional costs, examine all drivers affected by inflation. For example:
Track gross and net profit margin by service or product line to monitor optimal performance.
To get an idea of the cost of increase from your suppliers, look at your historical gross and net profit margins using the basket approach:
- First, compare your profit margins from last year to this year. Note the percentage change for year-to-date (YTD).
- Next, look at your original budget for the year. Take your product cost and increase it by the percentage increase you found from last year to this year. That will give you an updated projection for profits for the year, assuming you don’t make any changes to your pricing.
- Along with increasing product costs, have you or are you planning on giving any raises? If so, that will hit your bottom line as well.
- Finally, figure out how much you want to raise your revenue for the rest of the year to get to an acceptable net profit margin and that will tell you by how much you need to raise your prices.
Once you are correctly tracking and forecasting the drivers affected by inflation, you can build in those cost increases in your pricing.
Raising your prices for inflation
Go ahead and raise your prices (because everyone else has)
Should you raise your prices? The easy answer is yes. Not only have your costs likely been affected by inflation, but your consumers and clients won’t be surprised.
Thankfully, because so many business owners are in the same boat, there will likely be less backlash from your customers because most people know it is warranted. Even expected.
How to raise your prices for inflation
The simple way to offset pricing for inflation is to take the consumer price index (CPI) rate increase and raise your prices by the same percentage increase. Without doing any further analysis, you could justify raising your prices for inflation by that amount. So, for example, if CPI is up by 5.4% from June 2020 to June 2021, and you haven’t raised your prices in the last 12 months, you might simply raise them by 5%.
However, because CPI is an average you might want to be more exact in your estimation. There are expense areas that are more inflated than others. For example, freight has increased significantly– gas is up 45% compared to last year. So, for businesses that rely on overseas suppliers, costs have likely far exceeded the 5% seen in the CPI. In fact, many companies with international freight costs have experienced a two-pronged effect of inflation:
- It is now taking longer than before to ship via marine transport, which is affecting fulfillment and inventory turnover; and
- Many have had to resort to shipping by air – increasing expenses further – in order to speed up their orders.
So, if you are a business incurring the kind of cost increase seen above, you would want to get more granular in forecasting inflation and raising your prices as a result. You could instead use the basket approach mentioned above to calculate how inflation is affecting your profit margins.
Example: Take a few bills from suppliers from a year ago and look at the freight costs, compare it to your current bills and use the percentage change to determine a price increase that is more specific to your business than the general CPI.
While the Federal Reserve Bank suggests that this period of inflation is transitional, mid-size companies are no doubt feeling especially pinched. With supply chain rates increasing, but having little experience in how to adjust their pricing without losing customers, it’s no wonder business owners are feeling panicked by inflation. If this sounds familiar, we are here to help. Get in touch to learn more about how business owners can prepare for inflation using our outsourced controller services.