Inflation has been a highly debated phenomenon in economic circles. Generally, policymakers view moderate inflation as a good thing for the economy because it drives consumption. The underlying assumption is that higher levels of spending are necessary for economic growth. However, high inflation rates threaten the stability of any economy by eroding purchasing power. Worldwide the conversation about the negative impacts of high inflation has shifted from rhetoric to reality. In 2022, Americans experienced a rise in annual inflation to 9.1 percent – the highest it has been in four decades. Although this figure eased slightly to 8.3% in August, everyone, from manufacturers to consumers, continues to feel the heat.
In a survey released by the National Association of Manufacturers, 75% of manufacturers claim that pressures from inflation are worse now than they were six months ago. Additionally, 54% claim that increased costs make it difficult to compete and turn a profit. Consumers have also seen prices rise sharply for various goods and services. Plane tickets, construction supplies, food, housing, and electricity bills have become more expensive. This situation can have knock-on effects. From a behavioral perspective, consumers reduce spending. Moreover, a complete slowdown could contribute to a recession since consumer spending makes up around 70% of US economic production. In this post, we explore how inflation affects both manufacturers and consumers.
What Is Inflation?
Inflation refers to an overall surge in the price of goods or services in an economy. To that end, what a dollar can buy decreases over time. For example, an item that cost $1.20 in 1970 might cost $10.20 in 2022. Prices rise in response to shortages and/or high demand for goods and services. For example, corporations increase prices if shortages make it necessary to spend more on materials, labor, or shipping. Due to shortages, businesses also increase prices if they discover that consumers are prepared to pay more. Historically, we have always lived with some level of inflation. The Federal Reserve generally aims to keep inflation at around 2%. This enables it to balance its goals of maximizing employment and keeping prices stable. However, the more than 8% increase we are currently experiencing exceeds the Fed’s 2% goal.
Why Has Inflation Increased?
We are experiencing inflation brought on by increased demand as well as decreased supply. Inflation has increased for some of the following reasons:
- Shortage of goods and services. The pandemic set the stage for a toxic combination of events. Beginning with a shortage of goods of all kinds as a result of factory closures and logistical challenges in some of the most significant export hubs in the world, such as China. This resulted in a decreased availability of everything from refrigerators to shoes and a shortage of items. In response, businesses raised their prices.
- Overspending. While the pandemic lasted, nations worldwide pushed money into their economies to aid people and businesses. The goal was to help those suffering from pandemic revenue loss. As a result, people went on spending binges with their savings and government assistance as the lockdown eased.
- The war in Ukraine. The Russian invasion of Ukraine in February made inflation worse by interfering with the grain, oil, and natural gas trade flow. Due to this, the costs of heating or cooling homes and businesses, refueling automobiles and aircraft, and hauling products by truck increased. Wheat, a staple in much of the world, also increased in price. The war also increased the cost of fertilizer, thus impacting the cost of growing food.
- A robust job market. Cost increases in a few categories are not the only reason for rising prices. Instead, inflation has now become more pervasive across the economy because of a robust job market that is increasing wages, pressuring businesses to raise prices to match rising labor costs, and providing more consumers with disposable income, thus leading to demand-driven inflation.
How are Manufacturers Affected by Inflation?
The manufacturing industry is feeling the negative effects brought by high inflation. Inflation impacts manufacturers through price increases, contract restrictions, labor changes, and input problems, which then impact inventory and capital expenditures.
The pricing strategy manufacturers adopt influences how severely the effects of growing inflation are felt since costs are rising faster than prices. Manufacturers who utilize cost-based pricing are more likely to suffer than manufacturers who don’t because, as expenses rise, it is difficult to raise enough prices to cover their expenses. Therefore, their profit margins decrease unless businesses can find a means to lower the price of their raw materials or other inputs. To defend their shrinking margins without pricing themselves out of the market, manufacturers must rely on savvy financial leadership to direct their pricing decisions.
Currently, manufacturer expenses exceed consumer costs, with the PPI (Producer Price Index) above 11% and the CPI (Consumer Price Index) above 9% (although we have begun to witness some decrease). Major manufacturers are generally in a stronger position than smaller or medium-sized firms because they are more likely to have contracts with their suppliers that afford them some level of cost certainty. However, these agreements don’t last indefinitely, so manufacturers may face a stark increase in price when the contracts are up for renewal.
Component manufacturers occupy the most precarious position regarding contract restrictions because they are more likely to sell at a locked-in price. Because they are frequently used as Tier 2 or Tier 3 suppliers rather than as the primary supplier, they typically lack the negotiating power to secure long-term contracts. These manufacturers are also more likely to adopt labor-intensive production methods because their output isn’t sufficient to warrant the usage of pricey automation.
The manufacturers who are least impacted by rising inflation are those whose production processes are value-added and more capital-intensive than labor-intensive. Even though salary increases for unskilled labor jobs may not always result in actual wage improvements, rising labor expenses have increased the cost of labor used in manufacturing. Due to the need for access to a less expensive labor force, experienced financial leadership has recently made the case for outsourcing manufacturing operations. Consequently, more manufacturers are striving to eliminate manpower from the manufacturing process in favor of digitization because as inflation rises, manufacturers must cut spending in other areas where costs are also rising.
Petroleum, diesel, and natural gas prices have surged along with inflationary material price hikes, putting further strain on factories that significantly rely on these inputs for their operations. Moreover, since there is no simple method to remove these inputs from their processes quickly or cheaply—and in some situations, there is no way to do so at all—manufacturers are forced to absorb cost increases as they arise. All of these factors have affected the cost of production and consumers are at the receiving end, having to deal with galloping prices.
How Is Inflation Affecting Consumers?
Inflation appears to be affecting certain categories of consumers differently. Unsurprisingly, the population that is hardest hit and affected by rising inflation rates is the low- income. Affluent shoppers have continued to splurge on new outfits while lower-income customers are pulling back on discretionary items. Consumer behavior specialists claim that when store prices continue to rise, many consumers purchase or switch to less expensive options. In addition, most of them cut back on non-essential expenses, like dining out.
Fast food chains like McDonald’s are noticing the change in consumer behavior. In its latest earnings call, McDonald’s indicated that customers are switching to its bargain products. Similarly, superstores Walmart and Target have observed that sales are leaning more toward food than general merchandise like clothing. Interestingly, economists have observed the “lipstick effect” wherein customers are still prepared to splurge on tiny “feel-good” indulgences like perfume or high-end beauty products.
Debt is another area in which the effects of inflation can vary depending on the category a consumer fall into. While the inflation wave may drown some, some groups benefit. Inflation benefits people (as debtors). Generally, consumers with fixed-rate mortgages and other loans that don’t fluctuate based on market interest rates may find it easier to pay off those prior debts. We see this where consumer wages are outpacing generally rising prices. The National Association of Realtors observes that the value of a typical home sold in May by current owners exceeded $400,000 for the first time, and it increased by about 15% from a year earlier.
What Can Manufacturers and Consumers Do Until Everything Cools Off?
There are several strategies that both manufacturers and consumers can use to manage inflation. Manufacturers can:
- Consider adopting the LIFO inventory evaluation method. LIFO refers to the last-in, first-out method of accounting for inventory. Using this method is useful during an inflationary period because it allows manufacturers to deduct a higher cost of goods sold by using inflated current costs instead of lower historical costs. Accordingly, this lowers taxable income and tax liability which can help preserve cash flow.
- Reevaluate standard costs and overhead rates. Standard costs and overhead rates are generally calculated annually to predict production costs. However, if a manufacturing company is experiencing high costs now it doesn’t have to wait until the end of the year to adjust standard costs. Changing standard costs and overhead rates will serve two purposes- it will help companies to avoid a large end-of-year adjustment and better reflect the current cost environment.
- Consider borrowing or restructuring existing debt. The good thing is interest rates are still fairly low. If a company has been considering a loan for capital that will lead to reduced costs or more revenue, now is the time before interest rates begin to rise. A fixed-rate loan is always preferable to an adjustable-rate loan so that the cost of borrowing remains constant.
- Dine out Less. In the past year, 48% of consumers have cut back on eating at restaurants. Restaurant meals tend to fall into the category of luxury because food establishments generally mark- up the items they serve. Even though cooking at home is more time-consuming it is unquestionably more cost-effective.
- Drive Less. Gas prices have been soaring since last year. Although we’ve been given a reprieve from high prices, they are likely to climb again. As a result, 35% of consumers have started driving less. Strategically planning errands to minimize trips and carpooling where possible are also smart ways to save money.
- Reduce credit card debt. Studies show that 21% of consumers have started depending on credit cards in the past year. While convenient, credit card debt can be costly. It is much better to cut expenses and use cash to avoid accumulating a large amount of debt.
- Look for a better-paying job. In positive news, the labor market has been strong since 2021. If a consumer’s wages are not covering their bills this is the perfect time to see if there are better opportunities available.
How Long Will This Last?
Unsurprisingly, there is no clear consensus on how long this period of high inflation will last. Some economists predict that Americans should prepare for several years of higher inflation than they’ve seen in decades. Other economists are more optimistic believing that we will experience decreasing rates in the next two years. This projection is based on the end of the Covid 19 pandemic and the war in Ukraine. Already, there are some signs of supply-side improvement with reduced shipping costs, reduced supply chain congestion, improved production, and rising inventories. However, while headline inflation is reducing- commonly known as the CPI and includes more volatile date food and energy price data – core inflation is still a concern.
Ultimately there is a strong belief that this current inflation period is not here to stay. To that end, Deloitte predicts that the current inflation is “transitory,” meaning it will subside over time. They predicted that CPI inflation would soar to nearly 8% in 2022. However, they also predict that overall inflation will drop to 4.3% by 2023 and 2.2% by 2024. Since the former has already happened, we hope inflation will decline as predicted. Until then…
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The Waterways Company is committed to meeting you right where you are during this time. We are all feeling the effects of high inflation but trust that there are easier economic times ahead. Contact us today for all your water filtration and dispenser needs!