In this comprehensive guide, we will tell you everything you need to know about inflation: including what causes it, how rates change, how it will affect your business, and what you can do about it.

Periods of drastically rising inflation can feel daunting for small businesses, but don’t panic – there are steps you can take to protect yourself and your business.

What Is Inflation?

Inflation is a sustained increase in the general price level of goods and services in an economy. When the prices of most goods and services rise, and consumers need more money to buy them, we call this inflation.

The Consumer Price Index (CPI) measures inflation. The CPI is a basket of everyday household items tracked over time to see how their prices change.

According to Veem, over three-quarters of small business owners have felt inflation pressure at least some of the time in their business. One-quarter have concerns over the survival of their business due to inflation.

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“Inflation is judged by a rise in the price of everyday household items.”

What Causes Inflation?

Many different factors can cause inflation, but the most common is increased money supply. When more money is chasing after fewer goods and services, prices go up. Other causes of inflation include supply and demand imbalances, government policies, and global events.

Read more about the most common reasons for inflation below:

Demand-pull inflation

Demand-pull inflation occurs when there is too much demand for goods and services in an economy. This can happen when an economy is growing too quickly.

Cost-push inflation

Cost-push inflation occurs when the costs of production rise. This can be caused by things like increases in the price of raw materials or wages.

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“One type of inflation is caused by rising costs of production.”

Exchange rate inflation

Exchange rate inflation happens when a country’s currency becomes weaker relative to other currencies. This makes imported goods more expensive and can lead to higher prices for domestic goods.

Monetary inflation

Monetary inflation is when there is too much money in circulation. This can happen when a central bank prints too much money or if there is too much credit available in an economy.

How Have UK Inflation Rates Changed Recently?

Inflation in the UK is currently at its highest since 1992. 

Coronavirus affected inflation rates for a variety of reasons. Amplifiers of this were the uncertainty and lack of confidence in financial conditions. Due to the lockdown, household spending decreased as people were not going out and spending; and some were actively partaking in saving money as a precaution for the unknown. 

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“The pandemic affected inflation rates as people were spending money in a very different way to normal.”

Household spending decreased for a variety of reasons. Some items were physically unable to buy as shops closed, and the government had advised people not to leave the house. Also, there are items that people no longer had the need to buy because they were not leaving the house, for example, new clothing, footwear and petrol. 

Spending on non-contact luxury goods (e.g. landscaping services or home swimming pools) didn’t seem to change. However, there was a considerable reduction in spending at hair salons and restaurants, as they required contact.

These are unusual things to happen, with the addition of unpredictable circumstances, making it difficult to measure the inflation rate around different lockdowns.

Some firms also had to make workers redundant due to loss of revenue, creating a catch-22 situation resulting in loss of household income and reduction in spending. 

Changes in supply and demand also occur, which causes the rise in inflation. 

How Does Rising Inflation Impact the Cost of Living?

Rising inflation means that the cost of living is increasing. This is because people need more money to buy the same goods and services. As a result, people’s real incomes (their income after taking inflation into account) are lower than they would be if inflation were not rising. This can lead to a decrease in people’s standard of living.

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“Inflation causes the cost of living to increase.”

How Does Inflation Affect the Economy?

Inflation can both positively and negatively affect an economy. Some of the most common effects include:

Higher Prices

Inflation leads to higher prices for goods and services. This can be a good thing if wages are also rising, as people’s incomes keep up with the cost of living. However, it can be harmful if wages are not growing as purchasing power decreases.

Increased Borrowing Costs

Inflation can lead to higher interest rates. Lenders will demand a higher return on their loans to compensate for the increased prices. This can make it more expensive to borrow money and lead to less investment in the economy.

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“Inflation generally leads to everything rising, from prices to interest rates to exchange rates.”

More Volatile Exchange Rates

Inflation can cause exchange rates to become more volatile. Investors will be more likely to move their money out of currencies that are losing value. This can lead to economic instability and reduce international trade.

Redistribution of Wealth

Inflation can lead to a redistribution of wealth, as those who hold assets that increase in value will see their wealth grow. In contrast, those who own assets that lose value will see their wealth decrease. This can be a good thing if it leads to an equal distribution of wealth, but it can be a bad thing if it increases inequality.

How Does Inflation Affect Small Businesses?

Inflation can have both positive and negative effects on small businesses. The main effect of inflation is the erosion of purchasing power. This happens when prices rise, and incomes do not keep up, so people can buy less with their money. Higher costs also reduce profit margins, making it difficult to invest and grow a business.

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Some business costs may increase with inflation, while others remain the same or even decrease. 

Reduces the Business’ Value

Inflation reduces the value of inventory and equipment and the value of their buildings. Inflation also imposes costs on businesses to constantly update prices, which can be a hassle and take up valuable time and resources. These factors can lead to decreased profits and a general decrease in value and losses for businesses.

Inflation causes the value of money to diminish, thus leading to a decrease in the value of inventory, equipment and buildings. This leads to a decline in profits too. If you keep your prices the same, you’ll receive the same amount of money, but that money won’t be worth as much as it previously was.

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“Inflation can cause your business and its assets to decline in value.”

Lowers Purchasing Power

Inflation causes lower purchasing power across the board – both for your business and your clients. If you have a typical monthly spending budget, you may find that it no longer covers the cost of what it used to and what you need it to.

This can hurt businesses that rely on consumer spending. When consumers have less money to spend, they are less likely to make discretionary purchases (like going on holiday or out to eat), especially if they don’t receive a pay rise in line with inflation. This can also lead to decreased sales and profits for businesses in the affected industries.

After adjusting for inflation, small businesses may find that their sales revenue is not growing as fast as previously. This can make it challenging to invest in or hire new equipment.

Raised Business Costs

Businesses have to factor in the cost of inflation when setting prices for their products and services. They also have to account for higher costs of raw materials, transportation, and other expenses. As a small business owner, you may not have the facilities to make or distribute your products on a mass scale and have to outsource supply etc., rather than develop in-house.

Suppliers are likely to increase their fees as the cost of production rises, putting you at risk.

The cost of raw materials and finished goods will usually go up along with other prices in the economy. This can put pressure on profit margins, especially if businesses cannot pass on all of the increased costs to their customers.

Small businesses may also have to pay their employees more money as the cost of living goes up.

If you own your business premises, your rent may increase with other property prices. On the other hand, if you lease your premises, your rent payments may stay the same in real terms (after adjusting for inflation).

Supply Chain Shortages

Supply chain interferences can lead to shortages of raw materials, which can cause production delays and ultimately lead to higher prices for customers.

Changes occur in rates of supply and demand. Panic buying can lead to lower supply and increased demand – making it harder for your business to fulfil consumer needs.

Inflation isn’t just a problem for businesses; it also imposes costs on consumers. When the cost of living goes up, so do the costs of essentials like food, housing, and healthcare.

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“Inflation can lead to supply chain disruptions which can leave your business without the things it needs to run.”

Increases Loan Interest

If you have debt, inflation will increase the cost of your debt payments. This is because when inflation goes up, the value of money goes down. That means it takes more money to buy the same goods or services. So, if you have a fixed loan payment, the real value of that payment will go down as inflation increases.

Interest rates on loans are usually higher than general inflation rates. This means businesses will have to pay more interest on their loans, which eats into profits.

Narrower Profit Margins

As businesses incur higher costs, they may be forced to raise prices to maintain profit margins. However, if they raise prices too much, they risk losing customers to competitors. This can lead to a vicious cycle of price increases and decreases that can hurt businesses and consumers alike.

Changes to Inventory

Inflation can also cause a business or company to change their pricing system since the cost of operating and making their product has gone up. However, they may not be able to increase prices without losing customers.

As inflation continues to rise, small business owners note affordability strains as their biggest struggle, with 20% saying it has been the most challenging thing they’ve faced. 

Positives of Inflation

Inflation can have some positive effects on businesses. However, businesses and economies generally see it as a bad thing, as the negatives outweigh the positives.

Some businesses may benefit from inflation if their costs increase more slowly than the prices of their products or services. This can lead to higher profits and market share gains.

Inflation can also spur economic growth by creating demand for goods and services and encouraging businesses to invest. This can lead to increases in productivity and efficiency, benefitting businesses and consumers alike.

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“While there are many negatives to inflation, it can help spur economic growth and productivity.”

Inflation can also encourage people to spend rather than save, which can benefit businesses that depend on consumer spending.

Inflation can help businesses become more efficient by encouraging them to find ways to reduce costs.

Ultimately, how businesses are affected by inflation depends on various factors, including the current  economic climate and the company’s specific circumstances.

Managing Cash Flow at a Period of Raised Inflation

As a business owner, you should always be aware of the current inflation rate and how it might affect your prices, costs, and profits.

There are a few things you can do to manage your cash flow during periods of raised inflation:

Review Prices

Business owners should review prices regularly to ensure they align with the current cost of living. It would help if you came up with a pricing strategy to find a way to benefit your business the most. For example, you could use the inflation rate as a guide and increase your prices in line with the rate at which your costs have increased.

Alternatively, you could use a competitive pricing strategy. Small businesses can utilise competitive pricing during times of inflation. This involves pricing your products in line with your competitors and similar products. There are a few options to consider with this. 

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You may choose to price your product above your competitors. This strategy suggests you offer more value for money, implying a premium product.

Clients may be more likely to come to you if you undercut the competition and price your product below others. This strategy could be risky as your product does not look as valuable, and you risk losing profits.

If you price at the same level, customers can directly compare products and have a general idea of the standard and quality even if they have never tried it before.

By utilising this model, you can maximise the potential of your product and find your place in the market despite rising costs.

Monitor KPIs to evaluate the best business and pricing plan. Your pricing strategy should consider the varying factors, including your costs, profit margins, and competitors’ prices.

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“Review your prices regularly to ensure you are charging customers according to the current cost of living.”

Monitor Costs

Keep an eye on your costs and find ways to reduce them where possible. You should review your costs regularly and find ways to save money without compromising the quality of your product or service.

You can do this by negotiating with suppliers, looking for cheaper alternatives, or making changes to the way you run your business.

You could invest in new technology to streamline your processes and utilise automation – giving you more time for other business areas. This could be a sizeable outright payment but could save you money further down the line – and make even more profit.

Networking with suppliers is another way you could keep your costs down. You could do this by nurturing your existing relationships and ensuring they deliver a quality product that will benefit you. If you have a good relationship with them, they may be less inclined to increase prices. Alternatively, you could shop around to find a supplier that provides a similar product/quality but for a lower price.

If you are struggling to keep up with rising costs, you may need to consider alternative financing options. You could look into government grants or loans, investments from venture capitalists, or crowdfunding.

Inflation is a complex economic concept that can affect businesses, both positively and negatively. As a business owner, it’s essential to be aware of how inflation might affect your business and take steps to manage your cash flow during periods of raised inflation.

By taking the time to review your prices, monitor your costs, and consider alternative financing options, you can ensure that your business is best prepared to deal with the effects of inflation.

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“Monitor your costs to see if there is anywhere you can curb your spending to save elsewhere.”

Understand Your Profit Margins

Make sure you have a good understanding of your profit margins to make informed decisions about price increases.

Your profit margin is the percentage of revenue you keep after deducting the cost of goods sold (COGS). To work out your profit margin, divide your net income by your total revenue.

For example, if your net income is £50,000 and your total revenue is £100,000, your profit margin would be 50%.

If you don’t understand your profit margins, you may find it challenging to make pricing decisions that align with your business goals.

It’s also important to keep in mind that your profit margin will be affected by any changes in the cost of goods sold (COGS). For example, if the price of raw materials increases, your COGS will also increase, reducing your profit margin.

Plan

Stay up to date with the latest economic news and developments so you can plan for how they might impact your business. This will allow you to prepare for inflation. You don’t want to be caught out with no savings or plan for what to do when inflation hits. Use the inflation calculator on the Bank of England website to help you plan.

inflation calculator

“Use an inflation calculator to help you plan for the future.”

Relationship Between Small Businesses and the Economy

Small and medium-sized enterprises (SMEs) contribute considerably to the UK economy, making up 99% of businesses currently operating in the UK. In 2021, SMEs had a combined turnover of £2.3 trillion. As they make up such a large percentage of all UK businesses, they also contribute largely to employment, employing 16.3 million people. Their success and failure directly and severely impact the UK economy. 

Small businesses innovate and bring new products and services to market. They help keep money within local communities because much of the money small businesses spend stays within the local area. In contrast, large companies often source their supplies outside the area. This is important because it helps lower unemployment and increase economic activity.

How Have Small Businesses Responded to Inflation?

It’s all well and good giving advice on how to respond to inflation in theory, but how have small business owners responded in practice?

Based on the findings of a 2022 survey carried out by Capital One and NextGen Chamber of Commerce, this is how US business owners changed their business model in reaction to inflation.

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They surveyed 1,200 small business owners with total annual revenues of less than $20 million.

Getting a Business Loan to Combat Inflation

When inflation occurs, costs go up, but revenue doesn’t always follow at the same pace. It causes profits to erode and makes it harder to invest in growth. A business loan can help reduce the effects of inflation by giving you the funds you need to invest in your business. Investing in new equipment and inventory can help increase productivity and offset the higher prices associated with inflation. Not only will it help keep the business afloat, but a business loan can also help to expand operations, which can create new jobs and help to stimulate the economy.

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“You could use a business loan to fund your business during periods of inflation.”

 Conclusion

Inflation can have several effects on businesses, both positive and negative. As a business owner, it’s essential to be aware of how inflation might affect your business and take steps to manage your cash flow during periods of raised inflation.

By taking the time to review your prices, monitor your costs, and consider alternative financing options, you can ensure that your business is best prepared to deal with the effects of inflation.