How Does Inflation Affect a Business?
Ronald Reagan, former US president once said, inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. An individual is aware about inflation when buying day-to-day consumption products. Companies consume a lot of goods and services too. In a highly competitive market, inflation can eat into profits.
What Causes Inflation
There are two major causes of inflation: Demand-Pull inflation and Cost-Push inflation. Demand-Pull inflation simply means that market demands drive prices of goods and services. Cost-Push inflation, on the other hand, means an increase in price levels due to increase in input costs.
In either case, the underlying concept of inflation is simple—it erodes the value of your money. For example, you have Rs. 1,000 and you put it in FD with 10% interest. At the end of the year, you will have Rs. 1,100 with you, which sounds great. However, inflation in the economy represented by the consumer price inflation rate or CPI, is 11%. So, an item that cost Rs. 1,000 earlier will now cost Rs 1,110. However, you have just Rs 1,100 to buy the item. Thus, a higher inflation rate forces you to add money to buy goods.
How Companies Are Affected
From a business perspective, a high rate of inflation (ideally 3% or more) would imply an increase in the input costs. This raises a dilemma for the business owners:
- Increase prices of the product and thereby pass the rising input costs to the consumers
- Retain the product price and take a profit cut.
If they increase the product prices, companies may lose market share. This, in turn, would take a toll on the profit. Thus, one major impact of inflation would be an amplification of the effects of fierce competition. However, if companies absorb the high input cost and keep prices low for customers, they have to take a cut in profits.
Inflation and The Economic Cycle
Effects of inflation will also include an impact on the sales volume. The consumers will be forced to buy fewer goods. This could create lower demand. Companies would then cut production and put a halt to any future expansion. This leads to a slowdown in the economic activity as more companies try to reduce production of goods and services.
We can say that a high inflation rate leads to a vicious cycle that hampers the business.
However, a benign inflation rate can work wonders for the business. Though there is no ideal inflation rate, an inflation rate just above 2% can cause an inflationary spiral. If you were a student of economics, you would be aware of the importance of a benign inflation rate.
In this case, the price of the product has increased. However, since it is still under check, the demand for the goods would also increase. The businesses would have to hire more or do salary increments to meet the increased demands. This would, in turn, lead to a revival of the economy that is hurt by a persistently high inflation rate.
Thus, inflation if kept under check, can contribute to the growth of the business.