As companies and lenders evaluate performance risk and expectations for 2022, the trends previously considered to be emerging need to be considered a permanent part of the 2022 business environment. At this point, it is unrealistic to consider inflation transitory, and businesses will need to develop tools to plan for and manage through an inflationary period. In this article we will first review the inflation indicators, and then discuss approaches business management can take to survive and thrive in this environment.
Inflation: CPI
The consumer price index (“CPI”) and producer price index (“PPI”) have continued to increase in December, with the CPI posting its highest increase since June of 1982. The 12 month change in the CPI, as reported in December 2021, was 7.0%. To have experienced this level of inflation, a business owner or lender would have had to been working in 1982, which is almost 40 years ago.
Businesses are feeling the impact of rising energy costs, which experienced an overall increase of 29.3%. This level is down from the November inflation index for energy of 33.3%, yet it is clear that year over year businesses are experiencing increasing costs to operate and employees are experiencing stress. The employee stress furthers the impact of rising costs on the businesses, as the financial standing of the employees those businesses need to source and retain is increased. In December the inflation factor for gasoline was 49.6%, for natural gas the rate was 24.1%, and for electricity the rate was 6.3%.
Individuals certainly feel this increase as they consider heating their homes and buying gasoline to take them to work. Companies need to heat their facilities, run their plants, and purchase fuel for their vehicles.
Individuals are also being significantly impacted by food price changes. The CPI for food at home increased 6.5%, food away from home increased 6.0%, and overall food increased 6.3% from December 2020 to December 2021.
Businesses that are using food in their production and businesses that are providing benefits that involve food for employees are feeling this increase firsthand. All businesses are feeling the inflation in food prices at least second hand.
Excluding food and energy from the CPI, the index is at 5.5%. The CPI excluding food and energy is at the highest level in at least 20 years.
The economy has been experiencing increased CPI trends since May of 2020, with the steepest spike in prices occurring from April to December of 2021. Coming out of the pandemic shutdowns and lock downs, inflation was expected. However, the level of rising prices and the speed of those increases surprised many.
The Fed is talking about a rate increase as early as March of 2022, and there is the expectation the Fed will shrink its own balance sheet; however, businesses should not expect prices to return to previous levels. There may be specific components of the CPI that reduce during certain times, but a review of the overall cost of the market basket of goods in the CPI basket shows that prices only come down for short periods of time when there are stresses in the economy.
The next chart shows the cost of the CPI market basket of goods from April of 1947 to December 2021. During the financial problems in 2008 and 2009, there was a decrease in costs, but to expect that to happen in 2022 is not realistic unless the economy experiences a repeat of that level of upheaval. And, if that would happen, history tells us the price reduction is temporary and prices quickly return to earlier levels.
Inflation: PPI
The December 2021 PPI is reported at 9.7%, which is similar to the 9.8% in November 2021. The PPI remains more than double the previous 10 year high of 4.5% which occurred in July and September of 2011.
The PPI for energy in December is reported at 31.4%, which is a decrease from 43.0% in November. The PPI for transportation and warehousing is at 16.6%, which is a further increase over the 14.5% reported in November. These categories represent direct cost impacts for most businesses.
Inflation: PCE
The Fed uses the Personal Consumption Expenditure (“PCE”) Price Index to measure inflation, in part because this index is thought to provide less volatility. The most recent reported PCE is the November 2021 index of 5.7%, which is an increase over the previous high of 5.1% in October 2021. The PCE market basket of goods is at $16,423.2 billion in November 2021, compared to the pre-Covid 19 peak of $14,769.9 billion in January of 2020.
Analysis Tools
Even if the CPI and PPI increases begin coming down in future months or if the indices show a percentage decrease, this high inflationary level is unlikely to be reduced to the extent that costs return to the previous levels. It is unreasonable to expect a period of negative price changes to offset the price growth the economy has experienced in 2021. As a result, businesses and consumers need to expect higher prices to continue and should not expect prices to return to historic dollar levels. The percent increase may reduce but expecting a negative CPI and PPI to counteract this inflationary period should not be part of the financial planning process for a business.
A business must consider inflation’s impact on both costs and revenues in 2022.
It will be important for business management to move past the excuse of inflation and develop an analysis and a plan. Management needs to ask questions of the management team and challenge the team to anticipate issues and plan for solutions. A management meeting where the discussion topics are inflation’s impact on each line item of the income statement will be an important first step. Here are some examples of questions.
Contracts:
What contracts are tied to changes in the CPI, or components of the CPI?
Are there some contracts that are not tied to the CPI that should be?
Bidding:
What escalation clauses are in the existing price quotes?
What should be included?
What opportunities does a business have to increase prices?
What is competition doing with pricing?
Utility Costs:
If natural gas is used for heating or production, what does the spike in price mean for utility costs?
What does the fuel price mean for transportation expenses?
Food Costs:
If the business uses food in its operation, the changing food prices must be evaluated.
Commodity Price changes:
Does the business have fixed input or fixed sale prices?
Are there ties to commodity prices?
Is hedging being used?
How is each expense line item on the income statement being impacted?
Uniform prices?
Cleaning costs?
Travel and entertainment?
Every line item is impacted by upward price pressure.
Second, management needs to track and analyze performance.
Month end reporting:
Waiting three weeks after month end for month end performance reporting does not give management time to respond to issues.
Consider tracking key prices weekly.
Consider tracking volumes weekly.
In addition to the typical budget to actual reporting monthly, reforecasting for the remainder of the year must occur. In the middle of the current quarter, a business needs to reforecast the remainder of the year. Continue to track performance to the original plan but be aware of the impact of changing prices and costs on performance as the year progresses.
Weekly reporting: Weekly working capital tracking is key.
Use roll forwards of working capital components.
Accounts receivable.
Inventory.
Accounts payable.
Cash.
Weekly cash flow management and BBC tracking.
KPIs (Key Performance Indicators):
Are the current KPIs sufficient?
Are they being produced fast enough to allow time to react?
This is a time to emphasize best practices. Management cannot accept the excuse of inflation. The entire management team needs to engage in strengthening their analysis tools to respond as quickly as possible to changing prices. Inflation does not spell doom for companies. The lack of planning and response to inflation is what translates to doom.
Most business managers today have not experienced this level of inflation – the US last saw this inflation level 40 years ago. Helping management deal with stress and uncertainty will be important for achieving performance goals for 2022 and beyond.