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The success of a small business can depend on macroeconomic factors beyond its control, such as inflation. During inflationary periods, prices of goods and services increase.
The potential impacts include both direct effects, including higher costs and reduced profits, and indirect effects, such as decreased consumer demand and purchasing power. By studying these effects, how they vary, and how they may apply to their own organizations, small-business owners and managers could more effectively prepare to cope with inflation.
What Is Inflation?
Inflation's definition in business is a sustained increase in the general price of goods and services across the economy over time. It’s typically measured by aggregate metrics such as the Consumer Price Index (CPI) or Personal Consumption Expenditures (PCE). During inflation, the purchasing power of currency decreases.
While inflation affects businesses of all sizes, small businesses may face greater challenges when costs rise, as they may have fewer resources and less bargaining power than large firms. Because of this, smaller companies may struggle to absorb increased costs without significantly raising prices. Large companies, on the other hand, may have more flexibility to negotiate with suppliers and implement cost-saving measures to help maintain margins without raising prices substantially.
Why Inflation Matters for Small Businesses
Inflation could directly impact businesses’ profitability and long-term viability because it might lead to increased operating costs, including higher prices for raw materials, utilities, and labor. These increased expenses may impact cash flow, leaving businesses with less money to invest in growth, innovation, or marketing.
While inflation affects businesses of all sizes, small businesses may face greater challenges when costs rise, as they may have fewer resources and less bargaining power than large firms.
While a small business’s challenges vary by industry, customer base, and myriad other factors, owners could turn these periods of increased economic pressure into opportunities for self-reflection, strategic planning, and improvements. But to make lemonade out of inflationary lemons, small-business owners might want to first understand how inflation will affect them. With this knowledge, they could create a leaner, more agile, and ultimately more profitable organization.
The Impact Inflation Has on Small Businesses
How does inflation affect small businesses? From surging expenses to shifting consumer behavior, inflation is far-reaching and could touch nearly every aspect of running a business.
Higher rent: As real estate costs rise, small businesses could face increased expenses for their physical locations. If rent starts cutting into profits, businesses can reassess their needs and consider relocating to more affordable areas or renegotiate lease terms. Another option is to consider moving workers to remote or hybrid schedules, which helps allow the business to downsize office space and reduce overhead.
Higher equipment costs: When inflation drives up equipment prices, businesses could invest in more efficient equipment or more robust maintenance processes to help prevent breakdowns and replacements. Buying used or leased equipment may be cheaper than buying new equipment, presenting an opportunity for cost savings.
Higher labor costs: During high inflation, workers may demand higher wages to keep up with the cost of living. But the decision to instead recruit and train new hires could mean losing existing staff’s expertise and productivity, potentially increasing labor costs even more than targeted raises would. By prioritizing employee retention through competitive compensation and fringe benefits, you may maintain a skilled and motivated workforce. This approach also offers the added advantage of potentially outperforming rivals who struggle with high turnover.
Rising interest rates: To help reduce high borrowing costs, businesses may be able to leverage existing relationships with financial institutions to get better lending terms. They could also explore alternative funding sources, such as investors or revolving credit lines, especially if they have a strong financial history.
Does Inflation Impact All Small Businesses Equally?
Inflation’s impact on small businesses may vary depending on the industry and products and/or services sold. While virtually no business is immune to inflation, some may experience a smaller drop in sales when prices rise and buyers become more selective. Essential goods and services, like health care, gasoline, and groceries, may be more resistant to inflationary pressures. This may prove especially true if there is limited competition, such as there being only one grocery store or health clinic in town. Customers may continue to pay higher prices for these necessities until they can no longer afford them.
But when consumers have less money left over after buying their essentials, they may start reprioritizing their spending on non-essentials, also known as discretionary spending. Therefore, small businesses that sell luxury items, entertainment, and travel may experience a sharper decline in demand as inflation rises and consumers cut back on these optional expenditures. Because of this, prolonged inflationary periods may lead to financial strain and cash flow problems if businesses in non-essential industries fail to cut costs or bring in customers.
Strategies to Help Mitigate Inflation
Aside from just raising prices, here are some other revenue-generating techniques businesses could employ to help get through inflationary times. These tips may help increase efficiency during any period, not just inflation, and may help your business not only survive high prices, but come out healthier than ever.
Cut non-essential expenses: Consider reviewing every business expense and identify areas where you can reduce costs without compromising the quality of your products, services, or worker morale. Targeted cuts could free up cash until inflation cools. For example, consider canceling subscriptions, opting out of non-essential travel, and delaying marketing campaigns or large investments.
Focus on productivity: Tailoring efficiency improvements to your workforce’s needs and responsibilities may offset high labor costs. For example, by investing in new technology or equipment, you could automate processes, reduce waste, and minimize equipment downtime. These improvements may ultimately enable staff to work more efficiently without expanding the labor force, bringing benefits long after prices stabilize.
Retain your customers: If you must raise prices to maintain margins, some customers may seek cheaper alternatives, especially for non-essential goods with common substitutions. Be transparent about cost increases, listen to feedback, and consider implementing gradual, predictable price adjustments to avoid blindsiding price-sensitive customers. Additional incentives, such as extended payment terms or loyalty discounts, may also keep customers coming back.
Rethink cash-flow management processes: Some small businesses may have more waste in their cash-flow management than they realize. Consider automating some routine tasks, like accounts payable and receivable, to free up your staff to focus on finding other cost-cutting measures, like reducing days sales outstanding (DSO) or optimizing how you generate invoices and pay bills. These optimizations, along with strategic payment scheduling, may help maintain a healthier cash reserve to cover inflation-driven cost hikes.
Potential Upsides to Inflation
Rising costs can prove challenging for any business. But some aspects of inflation may lead to good or bad outcomes, depending on how the business reacts. Some positive opportunities from inflation might include:
Higher revenue: If competitors raise prices, you may be able to do the same without losing customers. Higher prices can bring higher revenue and positive year-over-year growth.
Increased market share: Some businesses may struggle to adapt during periods with high inflation rates. This presents opportunities for well-prepared businesses to potentially expand and capture a larger market share as competitors fall behind or leave the industry.
Debt reduction: Inflation may benefit businesses with fixed-rate debt, as the real value of this debt decreases as currency loses its purchasing power. As your business generates more revenue from higher prices, you could pay down this debt more easily, helping to improve your overall financial health and better position the business for future growth.
Offsetting Wholesale Price Increases
Inflation touches every aspect of the economy, but not every business is affected the same way. Understanding why and how their company might be affected could help business owners prepare for inflation’s impacts on their industry, customers, and workforce. Smart business leaders see opportunities in every challenge, and rising prices from inflation is no exception.
A version of this article was originally published on November 7, 2022.
Photo: Getty Images
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