The pandemic, supply chain issues, and inflation: The early 2020’s have not been kind to small businesses. This has caused some dismay. For essentially all of 2022 and 2023, the NFIB’s Small Business Optimism Index has been below the 50-year average of 98.
As you know, inflation is when prices in general rise in the economy. It started to pick up in the spring of 2021 and reached its dizzying high of 9.1% in June 2022. The pressure has eased since then, though higher-than-normal inflation is likely to stay with us for some time.
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If you are feeling the impact of inflation on your business, you are not alone.
Key statistics about small businesses:
- Over 50% see inflation as a major obstacle (Source: Chamber of Commerce)
- Around one-third will raise prices on their own goods and services in the next 6 months (Source: Census Bureau)
- Over 50% of small businesses expect to pay higher prices for goods and services in the next 6 months (Source: Census Bureau)
- In the next 3 months, around one-third will pay higher wages (Source: National Federal of Independent Business)
Let’s dig in.
Understanding the causes of inflation
The amount and duration of inflation is hard to predict even for experts. We do know that growth in the money supply is the cause. Each country’s central bank runs the money supply. In the United States, that’s the Federal Reserve.
Monetary authorities cause inflation in three ways:
- Printing cash.
- Devaluing the currency.
- Buying government bonds from banks.
The third is most common. Here banks selling government bonds are paid in reserve account credits. That is a loan of money the government has yet to create.
As new money spreads through the economy inflation happens in three ways:
- Consumers spend more. In response, prices increase.
- Workers expect higher prices for goods and services. So they require higher wages.
- Businesses have to pay more for inputs and labor. So they charge more.
Wage inflation is a general increase in wages. This type of inflation normally happens when unemployment is low as many businesses have to offer better wages to fill open positions. Employees and individuals in general form expectations about future inflation. If people expect that they will have to pay more for what they buy, they will in turn want to charge more for their labor or goods.
As you might guess, inflation is a normal economic process, within reason.
So what’s the sweet spot for inflation?
Over the long run, 2%. Go over for too long, or go over too much in a short time, and issues pop up.
The Federal Reserve, in trying to maintain inflation around 2%, watches a couple of indicators. Over the long run the Personal Consumption Expenditures Price Index (PCE) is most important. This index measures changes across a range of consumer expenses, but it doesn’t include more volatile items like in food and energy.
How can inflation be managed?
If the Federal Reserve believes inflation needs a helping hand to come down, it will raise interest rates.
Banks store money with the Federal Reserve. When our central bank raises interest rates, other banks make more money keeping it stored with the Federal Reserve. So the other banks will loan out less money. That means less investment overall in the economy. This will inhibit the rate of inflation.
The Federal Reserve raised interest rates 11 times between March 2022 and the end of 2023. The rate hit around 5.4%, the highest in a couple of decades. This appears to have been successful. Why?
At the end of 2023, it appeared that general expectations about future inflation had improved. This is based on survey data. Remember, it is people’s expectations of future inflation that continue to drive inflation.
The Federal Reserve notably decided to not raise interest rates in its final meeting of 2023. It may decide to do differently in the future depending on the factors we discussed.
Inflation, then, can be managed to some extent.
By comparison, hyperinflation is a period of uncontrolled, destabilizing price increases. If it happens, you’ll know quickly. Prices for common items would hike daily. In general, price increases would be over 50%. It’s hard to lay plans and set prices during hyperinflation.
Effects of inflation on small businesses
Inflation is a loss in purchasing power. Small business owners can lose money during inflationary periods because every dollar they have has less value due to higher prices.
In contrast, during deflation, prices decrease and purchasing power increases.
Although inflation is a general increase in prices, the truth is some businesses handle inflation better than others. Real estate, for example, tends to improve in value during an inflationary period, though it is affected by rising interest rates which the Federal Reserve will raise in response to inflation. The energy industry can also do well too, since people are willing to pay a lot more for gas at the pump.
Inflation has decreased from pandemic highs. But, a majority of small businesses still consider inflation a major issue.
In sum, inflation represents a loss in purchasing power for most businesses.
- To balance things out many businesses will need to raise prices.
- Your employees will need to make more money outright or receive some other form of value-add arrangement like remote work.
In terms of costs as a business, you have to consider vendors’ prices and wage expectations. But inflation can also decrease revenues for businesses.
- Customers are spending less overall. Some will not spend on your products.
- For accounts receivables, some customers will require discounts or need to delay payments.
- After raising prices out of necessity due to higher costs, you will see even fewer sales. If the price increase is too high, net revenue will be lower than it was before.
Another difficulty created by inflation has to do with investments. Tied into inflation, small business owners are having a harder time receiving affordable business loans from lenders. This is because inflation eats at real returns from investment. Investors want higher interest rates so that inflation will take a smaller bite proportionately.
It is always valuable to try and find the positives in any difficult situation. Inflation makes it necessary to reconsider how you’ve been doing things across the board. Improvements you make during inflation can help put your business in a better position as high inflation lessens.
The companies most affected by inflation don’t adapt in a timely and thoughtful way. Entrepreneurs who both survive and thrive during inflation are open to using different tools.
Strategies to combat inflation
Small businesses can help fight inflation’s impacts on their businesses in a few ways.
1. Consider changes to pricing amount and structure
The pressure of inflation is an opportunity to review pricing. This includes:
- Whether to charge more
- When to raise prices
- By how much to increase prices
- How to change the effective price, i.e. pricing structure
Do you raise the price or not?
It may feel difficult to raise prices on your customers. But part of the value proposition shouldn’t be that prices will stay the same. If it is, then your business is stuck losing purchasing power.
You need actual room to raise the price. That is to say, not so many customers would stop shopping with you that you’d lose more money than you make.
Ask: Assuming you keep paying for inflation, would raising prices make you lose less money overall? Or could you go back in terms of net profit to where you were before inflation pressures rose?
When should you raise the price?
It depends. If rates are set by agreement then you have to wait until renewal time. Otherwise, if certain times of the year have a lot more sales volume, you may want to hold off on changing your pricing strategy.
By how much should you raise the price?
You need to know how much costs are going up right now for the relevant product. The Federal Reserve looks at an average but your business situation may look a bit different. Zero in on the inputs subject to inflation to make the calculation.
If you don’t want to raise prices frequently, then you’ll have to estimate the future inflation rate and its possible impact on your business’s profit margins. If you expect inflation to continue at its present pace, then use the present inflation rate. But the farther out ahead you estimate, the more you’re putting the “guess” in guesswork.
Is inflation a good cover story?
Admittedly some business owners may see inflation as a cover story opportunity to raise prices beyond rising costs. But modern 2024 consumers are savvy and they really don’t like deception — either lies or misleading claims — coming from the marketplace. It will potentially backlash not only for sales but your brand.
Consider pricing structure
If you normally reduce the visible price with promotions of some kind, then offer fewer of them. If the product is sold with invoices, and inflation is for one or a few specific cost items, create a surcharge for that item.
For future dealings, ensure that your contracts with customers have inflation adjustment clauses. Talk with a lawyer, but these provisions ensure that you can scale pricing to match inflation rates. No one will be surprised and you’ll have peace of mind about the process.
Besides addressing the specific problem of inflation, you can also look at pricing generally to see what improvements can be made. This is efficient because you’re looking at pricing anyway. In a simple example, provide as many popular payment options as you can.
In an intricate example, some customers need fewer features and want to pay less. If negotiation is viable, offer a tailored, economic package. If 1:1 customer targeting isn’t practical or even possible, a little creativity in arranging the shelves, product page, etc. could go a long way in sorting customers with different preferences into the most profitable and mutually valued places for everyone.
2. Cost management in the face of inflation pressures
Explore cost-cutting measures. You may be able to cut costs in a way that boosts the bottom line regardless of the state of the economy.
- Inflationary periods are good occasions to ask whether the benefit of whatever you’re buying still outweighs the cost.
- Similarly, you may have previously overlooked a cheaper, equally effective alternative for some input.
Of course, the discussion so far assumes you’ve simply accepted a price increase from a vendor or the expectation of higher wages from talent. What if you consider other options? In the case of a vendor contract with no inflation adjustment clause, the vendor may simply have to wait (ask a lawyer) until the contract is up for renewal to then raise the price.
During negotiations with vendors, on the other hand, you should discuss how much of an adjustment is a good fit for both sides. Too frequent price increases may occasion a need for discussion with a vendor about a more stable pricing progression.
Employees, like vendors, can be amenable to different arrangements. American business owners have found success in attracting and retaining talent in a variety of ways.
- Offer more flexible schedules
- Permit hybrid or remote environments
- Paid sick leave
- Pay more, perhaps tying a new bonus to performance
Other “softer” options include:
- Facilitating personally satisfying mentor-mentee relationships among your employees
- Tailoring task assignments and delegation to the career goals or curiosity of individual employees
- Genuinely and publicly recognizing the effort and accomplishments of valued teams and team members
Obviously, money is money. You can’t expect great talent to come and stay because you flexed soft people skills. But there are many levers to pull when it comes to cost management.
3. Financial management and investment during inflationary periods
Credit could tighten in your industry in part because of inflation.
- Investors could face more lucrative lending opportunities in other industries. I.e., those that do better during an inflationary period.
- The Federal Reserve raising interest rates may cause banks to loan out less money, leading you to face a more generally difficult borrowing environment.
Solicit more sources of financing
You may have to work a bit harder to find investment.
Consider other sources including approaching other banks. You may not get a deal with more favorable terms in the short term. But at least you’ll know that you checked out your other options. And, the next time you try, you’ll be in a better position to know what you need to show a bank.
Build a better relationship with your firm’s bank
In fact, one solid tactic that other business owners tend to overlook is to build a stronger relationship with your bank. A rich network of business connections can help to:
- Introduce you to the right people and companies
- Better help you through the loan process
The benefits depend on your point of contact at the bank trusting you and understanding your business’s situation. Regular, pleasant, and transparent communication between the same people on each side is the most essential ingredient.
Maintain reserve funds
When costs increase and credit tightens, reserve funds will be helpful. Experts recommend storing a 6-month cushion for future operating expenses. Use a savings account with an attractive yield.
In the end, as a small business owner, the odds lean a bit less in your favor during an inflationary period. That’s why you need to work on everything you can, including pricing strategy, cost management, and financing. But if you do change pricing, how should you communicate the change?
Communicating price increases due to inflation
Bluntly lifting rates across the board to cover your costs could hurt customer relationships. The given business wisdom is to make sure that you:
- Explain why
- Are transparent
- Connect price to value
Tell customers the “why” behind the change
Buyers feel a need to figure out why a price increase happens. We all want to know why we’re paying noticeably more for gas at the pump, our guilty pleasure, or anything we care about.
The need to communicate effectively is especially strong if there are negotiations and contracts with clients. The higher price will undoubtedly come up in conversation and they’ll often ask why if you don’t say it up front.
Be transparent toward your customers
Consumer psychology research has found that companies hardly ever find success trying to hide the warts from customers. Don’t try, they’ll figure it out, and you won’t come out looking great. Or happy.
Creativity is not required for well-communicated, inflation-spurred price increases. One solid practice from notable large companies is to announce a price increase and mention the higher commodity costs as the cause.
And while that’s typically standard practice for mega-corporations, it doesn’t mean that a small business like yours shouldn’t also take an extra step when communicating price increases.
Connect the higher price to higher value
Establish a coherent, relatable sequence of actions that contextualize the price increase.
- Realization of a customer need
- Past effort and demonstrable improvement
- New realization of a customer need
- Ongoing effort with the object of improvement
At steps 1 and 3, the business receives information showing a problem or opportunity the customers have. In your case this could be from customer feedback forms, surveys, or in-person complaints. At steps 2 and 4, the business tries to make changes that lead to customer benefit or pain relief.
Ultimately, inflation is just making the things you need to help customers more expensive for you to access. You and the customers are a team and the price increase is part of how you work together. You are in a mutually valued, investment-based relationship of customer problems turning into opportunities for both of you. That’s the accurate and useful narrative going forward.
Adapt to long-term inflation as small business owners
Here are some key takeaways for small business owners navigating inflation:
- The businesses that thrive during inflation are — as always — the ones the owners understand well.
- The core of any business is product and customer experiences.
- Remain customer-centric during inflationary periods.
Potential customers may have less purchasing power during periods of high inflation, but they still want to buy things. Sellers who understand customers better will serve their customers better. Sellers who serve their customers better will tend to sell more stuff at higher prices.
The fair forecast says we’re going to be dealing with inflation for some time. How long is unclear to everyone including the experts. Taking the long view, there will always be inflationary periods to ride out. With that said, prices (while rising) are not rising as much as we saw during pandemic highs. So keep an eye on the future and prepare accordingly.
Disclaimer: This content should not be construed as legal or financial advice. Always consult an attorney or financial advisor regarding your specific legal or financial situation.
