4 Considerations when Forecasting with Inflation

Aug 1, 2022 | Established Business

For most businesses, the process of creating a dynamic financial forecast is challenging and often a crystal-ball exercise. The benefit of building a forecast is that, if built properly, a forecast model will help you and your management team make impactful business decisions at the right time, and understand the impact of those decisions over the coming months and years. Given that forecasts rely heavily on management assumptions and estimates, it is important to factor in as many known inputs as possible and increase the probability that the forecast will represent reality. 

With inflation at levels not seen in many years, it’s time to relook at how your current financial models factor in inflationary impacts. The following considerations are a quick gut-check to test whether your forecast numbers are as accurate as possible, or if they are based on the “that’s how we’ve always done it” model.

  1. Cost of Labor
    1. When modeling your future labor costs, the typical 3% to 5% annual increase may not be appropriate if inflation continues to outpace those figures. Retention is an important part of any business plan, and often prevents unwanted costs. Taking a hard look at what salary adjustments are most realistic to keep workers from feeling wage pressure is worth the effort.
  2. Cost of Product & Services
    1. During high inflationary periods, many of your vendors are recalculating their unit pricing and “passing on” the cost of inflation to their customer base. An important step in understanding your future costs is to keep close contact with your top suppliers and understand their pricing direction. Often your suppliers will warn you of an increase ahead of the change, which gives you and your management team time to review your procurement strategy.
  3. Cost of Capital
    1. Rising inflation is generally the proverbial cart before the rising-interest-rate-horse. Depending on your debt structure, borrowing costs may increase and reduce your cash flow. Reviewing your debt agreements and including potential interest rate hikes in your debt service calculations will reduce the chance of surprises.
  4. Purchasing Power
    1. While reviewing your debt structure, another consideration is the amount of available leverage versus your working capital needs through the next year. High inflation quickly erodes the purchasing power of the dollar – given that your current lines of credit are at a fixed dollar cap, they may not be enough to service the business needs through the next year of inflationary pressure. Restructuring now for additional headroom while interest rates are still low will provide you working capital when you most need it.