As inflation surges, here are three steps to protect your small business

Inflation has hit Australian businesses, in a sudden and terrifying development. But in 2022 business owners are familiar with sudden and terrifying. We made it through the pandemic.

Now this.

Nobody said business ownership was easy. It’s a lot of work. There will be stress, there will be frustration. New challenges will constantly pop up.

Here’s what you can do.

How to inflation-proof your business

1. Make a plan

   High inflation is new. This is not something business owners have personal experience with unless they were operating in 1990, or migrated from overseas. Rapidly rising prices are unlikely to be something you will sail through on gut instinct, so it’s time to get strategic. What you should do depends on your business, what you sell, who your customers are, and how they behave.

   They say: if you fail to prepare, prepare to fail. But Aussie businesses are good at preparing. Proof: businesses are failing at low levels in 2022 — the rate of insolvencies is far below pre-pandemic rates.

2. Raise prices

   Input prices have risen, as this next chart shows. It shows producer price inflation (as opposed to consumer price inflation) revealing the price rises that have hit Australia’s biggest SME sector — construction. It gives a hint at the big price rises all businesses are facing.

   

   Profit doesn’t come from sales alone. You need margin. When input prices rise, it’s natural to fear price rises are impossible, that customers will flee. The ABS reports that 57% of Australians businesses have seen higher costs in the last three months, but less than half of those business have passed on even some of those costs on to consumers. What should you do?

   Beau Bertoli, co-founder and chief revenue officer at Prospa, a small business lender, says many small businesses are lifting prices, but ”slowly”. 

   “We understand that business owners don’t feel comfortable and concerned about the reaction from their customers, you’ll be surprised that many consumers will understand if you explain the situation as they themselves are feeling rising costs at home.”

   Look at this example: imagine a business making a nice profit margin of $20 per sale. Pretend it’s 20 cents, or $20,000 if that suits your business more. They sell 12 units. (Imagine that’s per year, per day or per second, depending on your business.) This combination of sales volumes and profit creates a profit of $240 in that period. You can see that number in the red circle. 

   
   Then higher input costs reduce the margin per sale to $10, dropping profit to $120. The business decides it will take action to restore half the lost profit. There are two kinds of option. Try to sell more at the lower margin, without raising prices. Or try to restore margins, accepting that some customers will be lost. These options are shown in the graphic.

   For many businesses it will be easier to raise prices to restore margin. Unless customers are very price sensitive and competitors are all increasing their prices, increasing sales significantly will be a challenge. In the example above, the business that increases prices to restore margin makes as much profit — despite losing a quarter of their sales — as the business that holds prices still and increases sales by 50%.

   You can lag your competitors in raising prices to see if the increase in sales is worth it, but doing so risks a longer period of weak margins. A decent idea is to find out how price-sensitive people are by not raising prices all at once. Lift a little, see what happens. If customers are still buying, lift a little more.

   In the graphic above, the yellow area represents profits under $100. This is intended to convey that businesses have fixed costs. If profits fall into the yellow area, you may be making margin on each sale but not fully contributing to fixed costs. (Whereas in the red area, you lose on each item you sell and the more you sell the more you lose — stop answering the phone, close the door!) 

3. Get serious on costs

   This brings us to the next way to handle inflation — cost focus. Lower fixed costs are a great way to help translate each sale into more profit.

   If higher prices mean lower sales, are all your fixed costs necessary? Could you lease a smaller premises? Lease a smaller fridge? Sell the van and use couriers instead? Make your next staff member casual instead of permanent?

   What about variable costs — whether you can cut, depends on your product and your customer base. Are there products features you’re supplying that customers don’t value much? Does it need to be printed on high-gloss paper? Would normal potatoes be as good as kipflers? Maybe the event should be held at a four-star hotel, not a five-star one etc? This is a risky strategy and should be pursued only if you know your customers well — reputation matters.

   If you can’t reduce fixed costs or cut quality, then what remains is making the same product more efficiently. This could be the time to introduce the process improvement you’ve been thinking of — accounting software, stock management systems, training for your staff in a new technique, a machine that does in 30 minutes what used to take two people a day. These are things that are easy to put off, but there is nothing like the prospect of shrinking margins to focus the mind.

What will consumers do?

Inflation doesn’t mean people aren’t buying at all. Aussie consumer bank accounts are stuffed full, remember. Higher mortgage rates will crimp consumer glee, but most people are ahead on their mortgages. Consumer confidence is down, according to the ANZ Roy Morgan Survey, but not at crisis levels. It is 96 on the most recent reading, much closer to 2021’s high of 114 than 2020’s low of 65.

As people begin to feel budget constrained, there could be a pivot away from luxury goods and towards non-discretionary goods. If you have a web business selling both high-end pet treats and bulk pet food, the latter may be where you want to lavish your attention in this period.

America is well ahead of us on inflation — 8% consumer price inflation in the most recent month – and it provides a lesson. According to the Goldman Sachs 10,000 Small Business Voices survey, inflation is the fastest-growing worry for small businesses in April 2022. 60% have increased prices, and 67% have raised wages. Australian SMEs are sure to follow in their footsteps soon.