Have things been more expensive for your business? You can put most of the blame on inflation. 

Yes, the inflation rate has cooled (but is still increasing) and consumer sentiment may be improving—but that doesn’t translate to an immediate increase in spending or lower prices. 

This leaves business owners in the same position they’ve been in for over two years. Making tough decisions, with potentially long-lasting consequences for customer loyalty and overall business health.

But, just because inflation is out of your control, doesn’t mean the impact has to sink your business.

Let’s dive into the impact of inflation on small businesses and how you can make strategic changes that don’t alienate customers or leave you financially vulnerable.

Key takeaways

• •Inflation continues to impact pricing and lending rates—making new cash harder to come by and cash flow management a top priority.
• •There’s no one perfect solution to overcome inflation. Test multiple internal and customer-facing changes to identify what works best.
• •Communicate and listen to your customers as you make changes to avoid harming your brand reputation.

What is inflation?

Have you ever heard your grandparents and parents talk about how much more they used to be able to buy with $20 compared to today? That’s inflation.

• •The most basic definition of inflation is the rate at which prices for goods and services increase over time. However, there are other
• •Kevin Hassett, former Chairman of the Council of Economic Advisers, says that “wages aren’t keeping up with prices,” meaning “real incomes are going down.”
• •Investopedia defines inflation as the decline of purchasing power of a given currency over time.

The most common measures of inflation are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The U.S. Bureau of Labor Statistics (BLS), the government agency responsible for reporting the CPI, said that the current inflation rate was up 7.5% in the 12-month period of time ending January 2022. 

This is the largest 12-month increase since June 1982!

What causes inflation?

So what causes inflation? 

Economists generally agree that inflation occurs when a country’s money supply increases faster than economic growth. Issuing more money, as many countries did during the pandemic, is one factor contributing to the inflation we see today. 

Another way inflation can occur is when the government loans new money into existence through the banking system. 

Again, amidst the pandemic, lending rates were cut—impacting interest rates on everything from credit cards to home and auto loans. Combine that with an influx in stimulus money, and you suddenly have more consumers taking out short and long-term loans.

In all cases, the money supply increases, and the money loses its purchasing power.

How does inflation impact small businesses?

Inflation isn’t always a bad thing and is something that occurs in every healthy economy. The problem arises when inflation happens too quickly and businesses cannot adjust to the following effects.

Increased costs

One way inflation impacts businesses is through higher costs (aka Cost-Push inflation). This is when production costs (COGS) increase prices. 

For example, the underlying cost of making food items goes up as wages and the cost of raw materials increase. As a result, your small restaurant business will see higher prices when purchasing products and ingredients for your menu items.

Raised prices and decreased profit margins

Rising prices of goods and decreasing profit margins are other outcomes of inflation. 

For example: 

• •You’re a small business that sells paper for $9 per ream.
• •The cost of paper rises from $5 to $7 per ream.
• •Your profit margin has shrunk by $2.

When these price increases occur, many businesses respond by raising prices to prevent their profit margins from shrinking. However, when prices are increased too quickly or too much it can impact sales as customers are priced out.

Deters customers

Another possible consequence of inflation is that it can deter customers from buying from your small business. This can be true even if you avoid raising prices. 

Consumers often begin shifting their buying preferences in response to inflation, trading brand-name products for store brands and generic alternatives.

Frivolous expenses like going to the movies and date nights are also susceptible to inflation. For example, if your small business is a restaurant, customers may spend less on eating out and more on eating in.

Supply shortages

Supply chain shortages are another potential consequence of inflation. 

This is called Demand-Pull inflation. 

In a Demand-Pull scenario, demand for goods and services exceeds production capacity. In this case, simple macroeconomic principles apply — consumer demand outpaces the supply, and as a result, prices increase.

In many areas of the country, wealthy property owners are selling their homes and relocating to less expensive areas. 

The result is a huge housing crunch. 

Prices in areas that used to be cheap have skyrocketed, and housing is in short supply. With fewer houses available, the prices go up for everyone.

Change to brand reputation

There are many ways that your small business’s identity can become damaged. Mishandling customer data and failing to adhere to PCI compliance guidelines are in your control, but inflation isn’t. Customers may respond negatively to changes in:

• •Pricing
• •Service quality
• •Product offerings
• •Sales and promotions

While these are all areas you should explore changing. Just keep in mind that inflation can damage your brand reputation precisely because it’s out of your hands.

Damage to overall business health

Inevitably, inflation, with its many consequences, can cause long-term harm to businesses. You may eat through your cash reserves, have to lay off employees, forego a salary, or even have to close down.

Aside from the fiscal health of your business, the damage of inflation can also negatively impact your overall outlook. If money is hard to come by and it doesn’t look like things will turn around any time soon, that can hurt your resolve and drive as a business owner. 

Yes, entrepreneurship always has risks. But when most of that risk is from something completely out of your control, that can be harder to deal with.

8 Strategies to manage inflation in your small business

So, how is a small business owner supposed to navigate the challenges that arise from inflation? 

To start I advise you to create or update your financial forecasts and lay out the start of a crisis plan. These two things will help you understand the state of your business and execute one or all of the following strategies.

1. Strengthen your pricing power

Pricing power refers to the quantity demanded of a product relative to the change in the product price. It is linked with the price elasticity of demand or the degree to which demand changes in response to a product. 

For example, luxury brands carry a high pricing power because few alternatives exist. 

Strengthening your pricing power can be tricky. Focusing on offering essential services or goods is a great way to strengthen your pricing power in an inflationary economy. 

If that’s not possible, then look for ways to position your product as a premium, better, or cheaper solution in the market. The path you take ultimately will depend on your customer base and who your competitors are. 

2. Revisit product offerings

Closely related to pricing power are your product offerings. Some products might be more susceptible to inflation than others. 

Eliminating these poor-performing products can be another way to manage inflation in your business. Doing that can help keep your business healthy and prevent you from wasting time and energy on inventory that doesn’t serve you any benefit.

Revisit your overall sales and expenses associated with each product. If you’re not selling enough and margins are becoming too thin, it may be time to cut back on production.

3. Expand your business plan visibility

Conducting a monthly plan review meeting can help your business a lot. However, sometimes these meetings aren’t available to everyone, or they can even be a waste of time for some employees. 

That said, plan visibility is a great way to ensure everyone is on board and understands how the business is doing. 

By educating your employees and other stakeholders about your company’s health, you can give them information that makes them want to invest themselves more in its well-being. 

All you have to do is make this information more widely available.

4. Minimize unnecessary costs

Since rising costs are one of inflation’s main consequences, reducing and cutting unnecessary costs can save you money. Adjusting financial forecasts can help determine where you can cut some of these costs.

Reducing costs in other areas can help you balance your budget if you’re unable to raise prices too. By keeping your prices low, you can avoid a lot of negative consumer reactions to inflation.

A good way to identify unnecessary costs is by figuring out what adds value to your goods and services. 

For example, eliminating things like excess packaging can be a great way to reduce costs without harming value-adding activities like great customer service, marketing, and research & development. Simply using less tape to seal boxes for shipping will yield big savings in the long run.

5. Explore what-if scenarios

Part of responding to the uncertainty that occurs during economic changes can require making alternative plans and building what-if scenarios. 

Once you’ve begun building these scenarios, you can start adjusting goals and milestones in response to how you expect things to change.

What-if scenarios can be used as part of decision tree analysis, a popular operations management tool. The tree-like model of decisions and their consequences utilizes chance event outcomes, resource costs, and utility. 

For example, when mapping out a decision tree, you might have several possible scenarios where inflation increases, stays the same, or reduces. By mapping out these possible scenarios for a product, you can decide whether or not keeping that product is a good option. 

6. Bring in more cash

Cash flow is almost always the number one concern of small businesses. 

It’s no surprise that most accountants use a statement of cash flows to track how money flows in and out of your business. Without cash coming in, you can’t pay your invoices and will end up relying on credit. 

Ultimately, improving cash comes down to increasing revenue and decreasing expenses. Which may lead you to:

• •Increase prices
• •Sell assets
• •Delay paying bills
• •Speed up customer payments
• •Cut unnecessary expenses
• •Take on a loan or investment

What you do to bring in more cash depends on your specific situation. Explore all of your options, keep an eye on your cash flow and runway, and identify what a healthy cash position looks like for your business.

7. Audit current projects and spending

Earlier, we discussed how inflation can eat up your profit margin. 

As part of your inflation plan, consider auditing your spending and current projects. This is good advice, even if you’re not worried about inflation. Performing an audit is a great way to determine what projects are working and how much money you’re spending.

A common mistake many people make is called the Sunk Cost Fallacy. 

Psychologically, people are more inclined to continue investing in something once they’ve already put time, money, and effort into it. But in many economic theories, only future costs are relevant when making a rational decision. 

Often, this causes people to fail to cut their losses.

Think about it this way; if you purchased 200 t-shirts to sell but then only ended up selling 25 of them and did not break even, you might be inclined to continue selling the t-shirts. Maybe you would consider investing more money in an advertising campaign to try and get the product moving. 

The fallacy is considering the past costs of the shirts rather than accepting that your cost is sunk. By performing project and spending audits, you can figure out which projects are working and then decide if they are worth continuing or not.

8. Invest some of your money to hedge against inflation

One way to hedge against inflation is to invest your money. Over the long term and even through financial turmoil, markets tend to recover. Many companies hedge their risk by purchasing complex financial instruments known as options and futures. Usually, these are used in commodities trading.

An excellent example of how this works is companies that consume large quantities of commodities might be worried about the price of their commodity increasing. 

To “bet” against this, they will purchase options or futures that can be sold for a profit if the price goes up. This way, you minimize your total expenses through hedging. 

If you have cash reserves, consider placing them in a high-yield savings account to take on increased interest. Purchasing short-term bonds is also a relatively safe way to generate a reasonable return. 

The bottom line on small business inflation

Inflation continues to be a major concern for small business owners. 

According to the U.S. Chamber of Commerce’s Small Business Index, 55% see it as their top concern. 

To weather the storm of inflation, you should continue planning and revisiting projects, financials, and your company’s spending habits to evaluate whether or not they are working fully. 

When the economy is healthy, it’s easy to become complacent and just ride the success. If you’re not already, create a business performance dashboard that you can regularly monitor. 

By tracking your financials, you can stay on top of your planning and prepare your business for the best and worst that may come your way.