12 Jul Proactive Moves to Shield Against Inflation
Inflation, inflation, inflation. Not a fun topic. If you look up the US Inflation calculator, it says inflation is up 9.1% as of the end of June 2022 – a 41-year high. However, I have observed that the marketplace rate of inflation is increasing faster than is reflected in the US Inflation Calculator. This is especially true for heavy materials-based businesses. Some of our clients are paying between 34% and 100% more than they did in January 2022. That said, their cash position is deteriorating by the minute. As a result, they are operating at a loss. Is there a way to shield against inflation like this?
The labor shortage and increased cost of payroll for small businesses are having the same impact on net profits. They appear to be falling by the moment as costs continue to escalate in the USA. It is not a pretty picture. It’s one that I think we, as a community of small business owners, have to get in front of now. We need to be proactive before the situation drives our businesses to the depths of despair. This month, let’s discuss some ways that we can stay on top of inflation, or at least at pace with how it is impacting our businesses.
How inventory-based businesses can shield against inflation
The method of inventory valuation becomes critical in an inflationary environment. What may have been just silly accounting-jargon terms to you in the past can now make or break your business.
Here are the 3 types of inventory methods and how they impact a business in an inflationary period:
FIFO-First in/First out
This assumes that the first product added into inventory will be the first one going out of inventory. Think of it like a big cargo unit that you load with inventory. This cargo unit has a front door and a back door. You load everything through the back door, and it pushes things towards the front door. The only way to release inventory is by taking it out the front door. The first items you place in the cargo unit will be the first items you release from inventory. If you purchase the product from your vendor in January at $100 per unit and you sell it in July, you will set your markup based on the price you paid in January.
- LIFO-Last in/First out
This assumes that the last product added into inventory will be the first one going out of inventory. In the cargo unit example above, you are loading inventory into the cargo unit through the back door. There is no front door, so you are removing inventory from the same back door. That means the last items you added will be the first items you release from inventory. If you purchase the product in January at $100 per unit and it goes up to 20% to $120 in March and again another 12% in May to $134 per unit, then when you sell it in July, you will base your markup on the price of $134 per unit.
- Average Cost
This assumes an average weighted cost to all products. So if you purchased 1 unit in January at $100, a second unit in March at $120 and a third unit in May at $134, then when you sell the product in July, the average cost would be $100 + $120 + $134 = $354 divided by 3 units = $118 per unit.
Which inventory method should you use during an inflationary period?
Our clients use QuickBooks Online software, and the inventory method default in QuickBooks Online products is set to the FIFO method of management. Often, our clients are using add-on industry-specific software for inventory management. That software may allow for different methods of inventory management. It is said that in an inflationary environment, the LIFO method supports the business owner the most because it forces you to set your markup based on the highest cost, thereby losing the least amount of margin.
This would be particularly hard on your salespeople, however, as they will have to fight to get the price increases from clients who are pushing back. This is especially painful in long lead-time situations like construction jobs. The salesperson sold the job to the customer at a certain cost but it takes several months to complete the job. By the time the job is completed, the pricing has increased double digits. There will be pressure and pushback from both the customer and salesperson alike to honor the original price. However, if you do so, you risk the next job coming in which will have to go out at a much higher billing rate.
How service-based businesses can shield against inflation
Managing the increased payroll and labor costs in an inflationary market will require excellent bookkeeping and accounting skills on behalf of your team. Without detailed financial reports, costs will escalate faster than your measurement can track. It is so important to have good benchmarks and consistent key performance measures to review prior to inflation ramping up, and especially now, to show the variance comparatively. This helps you set yourself up to quickly adjust and pivot to make up for lost margin due to inflation.
Service-based businesses typically operate either on an hourly pricing rate for their services or a value pricing model, where the client may be paying a flat rate for the service based on the value it provides. With either method, if the cost of labor is increasing, one must keep a close watch on the sell price to ensure ample markup.
As a small business owner, we must fully understand the difference between margin and markup as it relates to a service-based business. They are not the same thing. Markup is the amount of money that you add to your cost to determine your price, usually expressed as a percentage. Margin is the difference between the cost of a product or service and its price, usually expressed as a percentage of the ratio of gross profit to price. Please see the below graphic for further explanation, or download our Markup vs. Margin Calculator to try it for yourself.
|MARKUP FACTOR||MARGIN PERCENT|
At Reconciled Solutions, we run a service-based business, and our payroll costs have been escalating. Here are some key metrics that I like to track to ensure that I stay on top of escalating payroll costs:
- Revenue per employee
- Contributing margin per employee
- Hourly revenue per employee
- Operating profit per employee
- Operating revenue per employee in comparison to industry benchmarks
These metrics help me keep a pulse on the cost of doing business and help me ultimately decide when the market is driving a price increase.
Bottom line: we need visibility and clarity to our financials
In the end, the most important thing we can do for our small business is to have visibility and clarity to our financials. We need to have accurate, timely, and frequently reviewed financials, and it is critical to know your numbers during times of high inflationary periods. While this article discusses the production costs in your business, I would like to remind our community of entrepreneurs that operational expenses are equally important to track and trim on a regular basis. I am a strong believer in the Profit First method, which requires me to review expenses in the business no less than once per quarter when I do quarterly distributions. If you feel that costs are escalating more rapidly, please do not wait to review costs once per quarter.
As we can see in 2022, costs are rising so rapidly that a 90-day review is just not often enough! We must stay on top of escalating costs, both on the production side of the business and the operational side of the business. It matters!