Causes of inflation and 6 strategies for companies to deal with it
What is inflation and what can a business do in order to deal with economic turmoil and rising prices
It’s important for businesses to understand the consequences of a contracting economy while inflation drives up prices. In this guide, you’ll find an introduction to inflation and 6 strategies for dealing with inflation and changing market dynamics.
Inflation erodes the purchasing power of customers and affects businesses, and is the measure of price increases over a given period. Rising prices result in fewer people being able to afford certain goods or spending a larger portion of their income to purchase those goods and services. But inflation is also natural and usually results from an increase in productivity.
But this time, the effects are much broader and far-reaching and felt from many sides. Expansionary monetary policy by central banks was introduced to spur growth in the domestic economy, global supply chains collapsed, and the almost unlimited growth of stock markets drove up prices as expectations of future profits were inflated.
Although inflation is normal and usually due to an increase in productivity, many factors have contributed to the rise in inflation. They are also why inflation is not going to stop anytime soon.
Understanding the causes of Inflation
Many causes contribute to the rise in inflation. Some are macroeconomic, and others are at the microeconomic level. This means that there are several levels at which the overall economy and the economy’s ability to supply goods and services (macroeconomics), as well as industry-specific or internal company motivations (microeconomics), play a role in price developments.
Macroeconomic causes of inflation
- Demand for goods and services exceeds pre-pandemic levels.
- Covid restrictions and lockdowns worldwide result in unstable production capacities and supply chains.
- China’s Zero-Covid strategy with frequent lockdowns is further tightening international supply chains, leading to shortages of goods and increasing prices
- Global tensions and political pressure from sanctions and restrictions lead to disruptions in supply chains and lead to shortages
- Protectionism and import tariffs increase prices
Microeconomic Causes of Inflation
- Lack of talent increases the competition; therefore, the prices for talent are rising as well as the costs for the companies which further leads to price increases
- Price increases due to supply chain constraints and macroeconomic developments lead companies to increase prices. Often the price changes are bigger than needed, leading to an accelerated inflation
- Microeconomic scarcity might also lead to increased prices. When industries deliberately don’t want to scale up production to meet the increased demand as they might not want to expose to extra costs when the demand drops, or they want to limit supply in order to increase prices and margin artificially
- Price-Opportunism – If companies are not directly impacted by supply chain or other reasons, they see that the prices are increasing and take a chance on increasing their prices to increase profit margins
The global risks of protectionism
As mentioned earlier, one of the macroeconomic reasons for rising prices is the increasing protectionism of countries. Many have seen that the global supply chain has had difficulty adapting to the COVID situation; therefore, many political forces are trying to become self-sufficient and independent. This also leads to decentralization and less efficient production.
Globalization took advantage of economies of scale that allowed some producers to increase production, reduce costs, and supply larger markets (worldwide) with their product. As import tariffs rise to protect less efficient local production and other protectionist measures, end-user prices will also rise.
Another price-increasing issue is protectionism combined with military spending. Since military spending is not used for real economic spending, it will have a negative impact on the overall economy and increase taxes, which may lead to further price increases as less money from the government budget is spent on the economy.
6 Strategies for companies to tackle inflation
Given the latest inflation figures, we will most likely not see any signs of a decline in inflation in the near future. With the added risk of an economic bubble bursting, we would also see a rapid decline in a short period of time. So companies need to act and react to the changes, but also prepare for the worst when it comes to economic development.
1. Understand what is going on in the world
Try to follow developments regularly to see what the international climate is like in the markets. Stock markets, commodity prices (try to understand also related commodities that your supplier needs for their production), or even labor market data could be good leading indicators to follow and monitor. Try to pay special attention to these developments and politics and discussions about international alliances, as protectionism could bring politics back into the variables of your value chain.
Understand the relevant global developments for you AND your suppliers.
2. Understand your finances very well
Spruce up your financial structure to have longer maturities. Analyze your vulnerability to external takeovers, try to structure your equity and preferred stock, and secure long-term loans from your banks and even your suppliers. Other ways to arm yourself include looking into convertible debt and securing guarantees for outstanding loans. When it comes to financial planning, the uncertainty increases. You also need to consider that higher interest rates could significantly change the numbers in your business plan.
Try to maintain a comfortable cushion, not to become exposed.
3. Understand and map the whole value chain
It is important that a company understands the entire supply chain (or value chain) and, in particular, examines the exposure to external shocks in supply and demand. This understanding also includes working out potential risks directly or indirectly related to suppliers. It may be necessary to maintain adequate inventory levels and develop strategies for alternative sourcing when stocks run low, and just-in-time supply breaks down.
4. Prepare employee retention and communication early
Don’t just look at your company’s external suppliers and value chain. Employees are an important factor, and it’s important to keep morale high and keep them from leaving or changing jobs. Especially in uncertain times, employees lose productivity, and hiring and training new employees is extremely expensive. Therefore, it is very important to keep morale high and employees in the company to be operationally flexible, save costs, and avoid labor shortages. Examples of a more employee-friendly environment include childcare, home office options, flexible work schedules, or even unusual holidays when the workload might decrease.
Focus on your employees’ wellbeing, keep the morale high, and lower employee fluctuations.
5. Adapt your strategy
In times of extensive growth and high-profit margins, investing in the future, exploring new opportunities and activities, and investing in a long-term vision are important. Suppose the outlook for revenues and general economic development is uncertain. In this case, it is important to streamline activities and act more in the short-term survival mode.
Streamline and rationalize your projects, segments, activities, investments and product lines to refocus on your core values and emerge stronger when the economy picks up. Keep your long-term strategy in mind, but try to streamline where possible without sacrificing key initiatives for the future core business. It’s also a good opportunity to weed out promising and less successful projects.
Switch from long-term diversified investment to short-term focus on core areas.
6. Don’t use the “Universal Ax.”
When faced with economic challenges, companies tend to use the “universal ax” to cut spending. Everything from salaries, headcount, R&D spending, talent acquisition, and employee training to advertising and sales capacity is cut. But these harsh measures can have many impacts, from suppliers to customers to employee morale and even the ability to retain key talent within the company. Creating scorecards to fine-tune business growth and consider future profitability and opportunities can help make better decisions. Therefore, I would recommend looking at specific metrics:
- Calculate Return on investment (ROI) based on current market values, not on historical values
- Factor in risks and uncertainties like shortage of talent, supply chain, logistics, or even the customers’ ability to afford this product/service in future
- Focus on fast cash operating cycles – this is the time between investing in the product/service until the customer money reaches the account (shorter is better)
- Competitors and their behavior – try to factor how the competition moves and addresses the issues. Maybe new market opportunities appear as some scale-down or cut expenses
- Factor in the total addressable market and a realistic market share that could be achieved
- Growth potential in short-, mid-and long term
Create company-wide scorecards to evaluate the best projects and ideas to focus on them
Final thoughts and conclusion
As a business, it is difficult to operate in times when markets are shrinking, inflation and supply chain bottlenecks are affecting day-to-day operations, and the outlook is uncertain. It is very important to clearly understand the key aspects of the business, from talent acquisition, employee retention, finances and market developments to the global political landscape.
In these times, it is good to better understand which projects add value and which core business activities need more support. It’s also a good idea to understand where to strengthen the business and focus more on future opportunities and growth areas and maybe also focus on scalable digital business models.