January 19, 2022
5 Finance Functions to Evaluate While Navigating an Inflationary Economic Environment
As our pocketbooks are feeling the pinch of the recent price increase of everyday goods and services, so are the bottom line of most start-ups, mid-size businesses, and public entities. The cost of supplies and materials is currently increasing at a rate faster than forecasted. According to inflationdata.com, as of December 10, 2021, the annual inflation rate exceeds 6.8% and is rising. At the same time, labor costs are increasing as the job market is tightening. Subsequently, businesses raise customer prices to cover these costs, which is always a tricky proposition. To navigate this environment, it is essential to plan strategically for these rising prices and to avoid reactionary business changes.
Some industries can be aided by inflation, such as real estate or commodity industries. However, industries particularly vulnerable to these inflationary times are low margin/high volume businesses that rely on ordering large amounts of materials and supplies and can have high employee turnovers, such as the manufacturing and restaurant industries. No matter the industry, below are 5 financial areas that a company can address in advance to mitigate profit decreases or increase profit margins in an inflationary economic environment.
Expense Management of Materials, Supplies, and Services
Rising material and supply costs are the main threat to forecasted profit margins. There are two ways to mitigate this vulnerability – controlling the volume of expenditures as much as possible (which will be addressed below) and having visibility into the future pricing of expenses. One way to achieve visibility into the prices of materials and services needed to produce products is by locking in future pricing through longer-term vendor contracts. Renewing materials and supply agreements to longer term contracts will allow you to hedge against sharper future inflation and accurately forecast costs in the long term. It is possible that you will have to lock in a slightly higher prices for now, but this mitigates future inflation risks going forward, as well as factoring in average inflation that happens in most economic environments.
Reduce Products and Services Offered to Focus on Those Most Profitable and Important to the Bottom Line
By nature, most growing companies are focused on introducing new products and services to generate new revenue streams. This can be a problem during an inflationary economic environment. If the margins of the core products are being squeezed, then the new and ancillary products that can have significantly lower margins or even negative margins can eliminate all profits from more profitable core products. Suspension of lower margin products should be considered to preserve current margins. During inflationary times, there may be reduced consumer spending and an appetite for new products. Also, the supplies and materials for these products will increase, further decreasing margins.
Additionally, economic challenges often force businesses to focus on what they excel at. The most economically efficient route to increase profits will be for the business to focus on the high-margin core products that they are adept at providing. Focusing on these products and services will result in a company culture of improving the production of those products and services.
Revisit and Optimize Strategy for Operating, and Capital Spend
As a result of the strategy outlined above (#2), all operating and capital spending should be evaluated in relation to the core products and objectives of the business. Naturally, the spending of ancillary products will be eliminated with the decision to reduce products. Additionally, a review of business expenses should be conducted to ensure that most, if not all, expenses will support the core products and services and any potential growth.
Also, consider if capital can be strategically spent to reduce future labor needs. Can some production be automated and produced more efficiently with less labor through capital expenditures? These questions directly affect the next area of focus.
Increase Production with Decreased Labor
Labor costs are also increasing in an inflationary environment. To keep a healthy workforce, this must be factored in future spending forecasts. It may be advantageous to convert variable-wage employees to full-time salaries to lock in their wages so that you will have a clear forecast of your labor costs. Also, this can help retain key personnel and avoid disruption of employee turnover.
As stated above, capital investments that can minimize labor needs should be considered.
Review Pricing Strategies for Customers
When all costs are reviewed and forecasted, optimal pricing strategies can be implemented to optimize margins. Of course, ultimately, the market will dictate your final pricing of products and services, and long-term customers will be incentivized to lock in current prices over a more extended period to protect themselves against future price increases. However, there are areas of pricing strategy that can be revisited and optimized to cover current expense increases and maybe even increased margins.
First, review past pricing strategies on various sales channels that might be outdated and reconfigure the pricing structure to meet the new economic reality for new customers. These pricing changes probably should have taken place in the past but haven’t because of current customers’ expectations. Also, these pricing structures may not have been built to consider rising costs of individual cost components, such as growing costs for shipping, insurance, or customization.
Second, consider implementing variable pricing structures with new customers so that the margins can fluctuate with pricing fluctuations of supplies and materials, as well as the aforementioned individual cost components. This can level-set the expectation of costs going forward for new customers. Finally, review any current customers with pricing agreements that are not profitable due to the current economic environment and make changes where needed.
These steps can not only help mitigate or even increase profit margins but also allow you to better forecast margins.
Bridgepoint Can Help
If you know you are in an inflationary economic environment, there are five financial areas in which you can plan for future inflation and mitigate or possibly increase future profit margins. Navigating through this environment can even help obtain a clearer vision of your company’s core mission and help you improve the quality and efficiency of your core products and services. Don’t know where to start? Bridgepoint Consulting can help.
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