I hear a lot about inflation, so I wanted to check on the latest numbers. Inflation calculated from one common measure, the Consumer Price Index (CPI), hit an annual rate of 8.6% in May 2022. Some economic forecasters expect double-digit inflation soon. What can and should we do to equip our businesses to survive?
As I have indicated previously, I am not an economist, accountant or financial advisor. I did, however, have a great financial advisor when running a manufacturing company in the late 1970s and early 1980s. Inflation in March 1980 hit an annualized rate of 14.8%, so I can offer some guidance from a manager/owner perspective. Every business differs but all of them have tools to leverage inflation and try to limit the downsides.
I think we all know the story about the hardware store owner and the hammer. His hammers cost him $9 and he sells them for $13. But when he orders more stock, inflation pushes his cost up to $11. He was making $4 profit, but inflation just ate $2 of it. In this way, inflation can kill cash flow. At my company, to head off surprise inflationary increases like that, we costed our raw material inventory at replacement cost.
In this early ’80s period when inflation started climbing, my company was very busy — especially in the shallow oil and gas industry in Pennsylvania, New York, Ohio and West Virginia. Being busy helps when inflation spikes, but keep a keen eye on raw material costs. This holds particularly true for some manufacturing businesses, where raw materials could make up 70% of product cost.
How bad was it back then? We would get quotes on mill orders for tubes but the actual price was determined at time of delivery. Tubes that cost $11.58 per foot could rise to $14.98 for the next order. Lead times for mill orders stretched beyond lead times for product orders, which meant we ordered based on the hope of future sales.
How do experts calculate the official inflation rate? They base it on changes over time in the cost of a standardized “basket” of hundreds of everyday products. That Consumer Price Index includes items with volatile prices, like food and gas, but other inflation measures (like “core” inflation) do not. Of course, when businesses in this industry feel inflation, the cost of fuel often tops the list — particularly for those running heavy equipment like drill rigs. In that respect, when we think about how inflation affects our own bottom lines, we should focus on our own “basket” of expenditures. That might include things like energy and labor, since our employees may need more frequent raises to cope with family needs.
The techniques we can use to hedge against high inflation can work against us when the inflation rate subsides or turns into stagflation or even deflation, where what you have in stock could be more costly than if you bought it now. Inventory becomes a cash liability. As long as changes in inflation rates are gradual, we can manage them. We survived the early 1980s by closely monitoring our current and future raw material costs, along with our employee, overhead and consumable costs. Business was good enough to pass on these price increases.
Being a native of Punxsutawney, Pennsylvania, I believe we could all use a market groundhog, a seer of seers to guide us through volatile market times. If he sees his shadow, 6 months of good economic conditions. If not, expect volatility on the horizon. From a manufacturing business perspective, that late ’70s, early ’80s time had interesting challenges, from trucker strikes to gas lines due to the oil embargo. Then, we survived 14% inflation only to run smack into one of the worst recessions since 1950. Let’s hope we fare better this cycle.
In a recent article by Jeremy Verdusco, he talked about knowing your weaknesses. Since most of us are not CPAs or finance experts, having a financial person in the crow’s nest is always a good idea.