Margin Management in an Inflationary Environment

Margin Management in an Inflationary Environment

By Dr. David Kohl

In a matter of 12 months, businesses and consumers have gone from an environment with inflation rates at a 30 year low to one reminiscent of the 1970s. Digging deeper, inflation, as measured by the Consumer Price Index (CPI), hovered under five percent all but one year since 1992. When compared to World War II, the post-World War II era, and the 1970s when inflation reached 15 to 20 percent, one could say inflation looks tame today. However, behavioral economists would quickly state that inflation has been a moot point for so long that these increases are a shock to human emotions.

Causes of inflation

The contributors to the recent burst of inflation represent a convergence of events. The amount of government stimulus and the double-barreled approach of accommodative fiscal and monetary policy by central banks around the world in an attempt to lift and maintain economies let the “inflation genie” out of the bottle. Government stimulus amounted to approximately 14 percent of the $85 trillion world economy. Generous checks to individuals and businesses coupled with a lockdown of the service-based economy and the extended unemployment benefits added fuel to the inflation fire. The inflation rate has been hovering above five percent and just below 10 percent, as measured by the Producer Price Index (PPI). The next culprits were supply chain bottlenecks in oil and energy. The pullback from globalization with tariffs and trade restrictions accelerated supply chain issues. Computer components and manufactured goods for service economies have been bottlenecked in supply chains. Finally, the movement away from fossil fuels to green energy and disinvestment in traditional sources of energy has given leverage to Russia and OPEC, who have been flexing their negotiation powe

Depth and duration

What is the depth and duration of this inflationary period that could provide some perspective in the business planning and decision-making process? Inflated input costs will be a fact of life for this year and most likely the following year. Oil and energy issues will not be resolved quickly. Any political or military threat that disrupts oil and energy production or distribution will cause volatility. For example, China and Russia are large producers of components used in fertilizers and sprays. Any military action involving these countries will likely cause a spike in prices.

Bottlenecks in shipping and trucking as a result of the retirement of the baby boomer trucker workforce and intense regulation will result in additional pressure and higher inflation. The Federal Reserve will raise interest rates to cool inflating trends, but will it be enough if consumer confidence picks up and $2.5 to $2.8 trillion of unspent government stimulus filters out into the economy?

In the longer term from 2025 to 2030, inflationary pressures may soften as a result of automation replacing labor, which is a high priority strategy for most large businesses. Second, as baby boomers age, spending patterns will become more conservative, resulting in inflationary pressures not only here in the United States but in Europe, Japan, and China.

Managing the inflationary cycle

Managing through the inflationary cycle requires innovation, focus, and intensity in decision-making. Good and bad decisions compound over time, but inflation accelerates the difference in an exponential manner. Budgeting will be a high priority during the decision-making process over the next several months. When developing budgets, a three-pronged approach will be necessary.

On the cost and input side, every line item will need to be examined and carefully scrutinized. Production decisions will be linked to operational efficiency with breakeven scenarios. In a recent seminar with agriculture producers, over half were utilizing enterprise budgets to ascertain breakeven points. This information allows one to make decisions with a focus on the most profitable combination of crops and livestock. Breakeven points will be a moving target this year as a result of inflation and pricing uncertainty.

The second prong of the analysis will be pricing your production. Keep a close eye on weather in the Southern Hemisphere, Ukraine, and other production belts around the world to incorporate this data into the decision-making process. Having a disciplined marketing and risk management program will be a tall order for 2022. Profit and, in some cases, minimization of losses will be the result of objective decision-making.

The third prong of the budget process is interest rates. The Federal Reserve has signaled three and possibly four interest rate increases in 2022. After writing this article, I will finish developing the cash flows and business plan for our creamery. In the financial sensitivity analysis, two increases of 25 basis points and four increases of 25 basis points on our variable debt has been inputted. The worst-case scenario would be more than four interest rate increases. What will be your strategy?

Finally, margin management will require close monitoring of your balance sheet, specifically working capital. Hopefully, in the last two years you were able to build some reserves. Negative margins may require drawing on these reserves. In some instances, the reserves may be used to capitalize on input or marketing decisions to garner stronger returns in your business. Remember, working capital is a pivot strategy to block adversity and capitalize on opportunities.