Are you looking at the right numbers in your business?
Many business owners often overlook the rate of inflation when reviewing how their business is performing.
While rising sales and turnover can indicate that a business is on solid footing, this is not always the whole picture. Business owners may be proud that their prices have held steady for many years, but they need to look more carefully to make sure their net profit isn’t being eaten away. Often it is only when cash flow becomes tight that they look at their actual figures in detail. The reality is that unless net profit is increasing at or above the rate of inflation, the business may actually be going backwards.
In 2010 I sat down with a family business and the patriarch was very proud that sales were increasing annually by 15 percent even after the GFC. His clients loved that he did not increase his prices annually like others. On closer examination, their rise in input costs had far exceeded this growth in sales as they sourced a lot of raw material from overseas. In addition, the Aussie Dollar soared towards $1.10 to the USD. Their net profit was being eroded because they had not adjusted their prices to reflect increasing costs for fear of losing customers.
What is inflation?
Inflation is a general increase in prices and fall in the purchasing value of money over time.
The cost of business overheads – such as electricity, fuel, stock or materials, staff wages, insurances, rent and rates – rise steadily over time. In the last 10 years inflation has averaged 2.8 percent per annum. All overheads need to be reviewed on an ongoing basis to monitor increases that affect your bottom line. You need to ensure you maintain your margin of profit over cost of sales.
In Australia, the RBA uses the Consumer Price Index (CPI) which measures quarterly changes in the price of a ‘basket’ of goods and services which account for a high proportion of expenditure by Australians. This ‘basket’ covers a wide range of goods and services, arranged in the following eleven groups:
- Food and non-alcoholic beverages
- Alcohol and tobacco
- Clothing and footwear
- Furnishings, household equipment and services
- Recreation and culture
- Insurance and financial services.
Inflation as measured by CPI is relatively benign at the moment, running at 1.5 percent – or 2.1 percent if you exclude volatile items (fruit, vegetables and fuel).
So what is the effect of inflation when running a business? Well that $5,000 extra in sales 10 years ago would have to increase to $6,564 this year to make the same difference to your bottom line now (using 2004-2014 RBS data). That’s a 33 percent difference.
Keeping an eye on inflation
So what should you be doing to combat the effects of inflation?
- Start by monitoring all your input costs and prices now while inflation is low. Get into the habit of regularly reviewing these figures, and you should not have any nasty experiences as inflation rises in the coming years.
- Build an allowance for inflation into your forecasting and business planning. Identify what factors have an influence on your costs, especially materials or services that you secure from overseas. As for these, you will need to keep an eye on the exchange rate and possibly engage in some currency hedging if they make up a large proportion of your costs.
- Clients don’t like sudden dramatic price increases associated with suppliers. Rather than reacting when you find your prices don’t reflect your costs, you should build an annul CPI increase into your pricing system. Small but regular increases are the key to managing inflation.
Ask your accountant or bookkeeper to sit down with you and actually discuss your bottom-line figures. Begin the process of understanding all the inputs affecting your net profit. (Click here for other ways your accountant can help you increase your profit.)
If you are an accountant or bookkeeper, you should be offering this service to your clients before an issue arises and someone else steps in.