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Inflation: what are the effects on your business and the best actions to protect it?

03/23/2022
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Inflation is a phenomenon that has not been seen for a long time in the European and American context. We can say that a whole generation of entrepreneurs is not familiar with it, and this is to be considered dangerous because it could lead to poorly thought-out choices. Currently, the inflation rate reported an increase of +5,8% in Europe and +7,9% in the USA for February 2022. The number speaks for themselves, and we can expect them to grow. 

 

What does inflation mean in 2022? 

For consumers, as inflation increases, there will be a reduction in purchasing power. To give an example, the same amount of milk always costs more when inflation rises. Creditors who have taken out fixed-rate mortgages will see the value of their loans fall and, conversely, debtors will see a reduction in the value of their debt. Investing in government bonds with such low fixed interest rates is likely to be a bad investment, for example. In contrast, index-linked contracts with variable rates will keep pace with inflation and sterilise its effects.

However, we must say that the situation in the US and the EU is very different from that in countries like Chile or Argentina, or even Turkey, which have a very different structural inflation and social-political background. The danger of inflation getting out of hand in Europe is remote. The ECB is, in any case, able to intervene and could not fail to do so.

The real danger is another. The balance of power between those who wish to continue expansionary policies and those who would instead like to return to austerity (for instance, to recessionary policies, that strengthen the strong and weaken the weak) could change to the advantage of the latter, perhaps backed by the irrational fear of the countries of the East. However, considering the current political setup in the main countries, this danger does not seem imminent either. If anything, there could be a compromise, somewhat along the lines of what France and Italy are trying to achieve on public debt and the budget.

 

So, when inflation is rising, which are the best actions that you can take to protect your business?

First of all, you shouldn’t panic. Speculative phenomena could emerge, especially in certain sectors, such as semiconductors, rare earths, raw materials in general. In other words: the world in which we find ourselves for some time now is less ‘oiled’ than the one we used to know. We are now beginning to realise that this may not be as a temporary phenomenon as we have thought. For now, we have only observed a little inflation in a less orderly, riskier, and more uncertain world. But also more flexible.

At the managerial level, therefore, we need to display a cautious attitude and master some key competencies. Here are some examples of very beneficial business strategies to keep in mind while inflation rises.

Keep your supply management under control

In sectors where the cost of raw materials is constantly rising, such as the construction industry, increasing attention must be paid to the planning capacity of production, to the scouting of alternative suppliers by the purchasing department and to building an increasingly ‘just in time‘ planning system. If having money tied up in a warehouse with slow-moving products is always a detriment, it is now even more so. Of course, one might think that having a very large inventory might be a competitive advantage.

However, in our experience, in ever more volatile markets with interest rates tending to rise, it is not wise to embark the company on speculation that can either yield excellent results or disastrous losses. The speculative component can drag the company down and away from its fundamentals. The company should aim to insure itself against all risks not directly related to its specific business and not embark on potentially dangerous purchases.

There is an increasing focus on procurement planning software as it moves beyond basic, infinite capacity MRPs towards finite capacity MRPs.

Communicate your sales management choices regularly

Businesses can offload rising raw material and salary costs by increasing their list prices. However, this list adjustment is not automatic. If you don’t find a way to engage your customers by communicating this in good time, you risk not increasing your list prices for too long. Consequently, you will be forced to make sudden adjustments that your customers will find hard to digest. The company must be able to communicate new increases to its customers on an ongoing basis, implementing targeted strategies that involve the sales network. If the need is to increase prices from next month, it will be necessary to communicate this to customers in good time. Perhaps you can suggest that they shop within the month if they want to enjoy a cheaper price.

Inventory value planning: be strategic in your choice of LiFo or FiFo 

The valuation of inventories at the end of the year, for the purposes of the financial statements carried out in the absence of inflation can be LiFo or FiFo without impact. Conversely, in periods of high inflation, this valuation method can make a difference. The FiFo method will tend to give a higher stock value than the LiFo method.

Let’s consider the following scenario. We bought raw materials at the beginning of the year at 100 and bought the same raw materials at the end of the year at 200. The LiFo method (Last in First out) will value the entire stock at the oldest price. The FiFo method, on the other hand, will value it at the most recent price. The two methods can obviously lead to two quite different valuations. Given inflation and consequently price growth at a higher value, FiFo (First in First out) represents a more convenient option for your business in contexts of high inflation, like the one we are currently experiencing.

Don’t underestimate the role of financial planning

Financial planning and the role of the CFO are growing. There will be loans and credit lines to recontract, business plans to review, expected cash flows that may be strongly influenced by changes in interest rates. Make sure your team includes adequate and expert resources to deal with your financial assets.

HR Management can help you to secure the right employees for your business

The pressure exerted by human resources may lead to an increase in salaries. This can be a good opportunity to review the definition of your objectives. Indeed, a salary increase has the potential to make your team more motivated and productive. At the same time, finding new people to hire is likely to become more difficult. Rising prices lead companies to follow demand and hire more employees. This is why it’s not easy to find good quality people at pre-inflation salaries. Structuring an appropriate, rewarding growth path is another fundamental strategic asset for companies wishing to compete in a renewed competitive landscape.

 

By: Alessandro Guerrucci, CFO

Connect with him via Linkedin.

 

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