No, I get it. The economy has been tough in many parts of the country. In some cases, for years now.
Further, overall inflation seems low. Look at oil prices or interest rates, for example.
But I still think you need to get much, much more disciplined about regularly bumping up your prices by some percentage for inflation. And just to get this admission out, so should I.
Let me in this post, therefore, outline the math behind this suggestion and then share three comments that may help you think more concretely about and also feel more comfortable with this idea.
Reviewing the Math of Inflation
Let’s start by quickly outlining how the math of inflation works if you don’t adjust your prices regularly for changes in price levels.
Assume for purposes of illustration that you run a business with $200,000 in revenue. Further, assume half of that revenue, or $100,000, goes to pay the expenses of running your business. The remaining half represents your profits.
The table below shows what happens if over three years inflation runs 2% (so hardly enough to worry about) but you don’t bump your prices by 2% annually.
|Description||Year 1||Year 2||Year 3||Year 4|
I rounded the numbers shown in the table to the nearest thousands—which makes the table easier to read but sort of understates the problem. But you see what’s going on, right? Every year that you don’t in this hypothetical situation adjust your prices for inflation, you lose a little bit of profit.
No year’s reduction in profits kills your business, obviously. But the profits are slowly deflating.
And now let me make three points.
This Situation is Critical
Here’s a first thing to consider. While the slow reduction in profits in the given hypothetical situation seems minor, in truth, the situation is critical.
Profits of $94,000 doesn’t seem that much less than the $100,000 in profits enjoyed only three years ago. If you or I actually confronted this exact situation, we can surely figure out ways to continue operating, right? (Maybe we just work a little harder ourselves.)
Further, even if we do take home a few thousand less in income, we can surely deal with such a shortfall by cutting expenses at home. (Maybe we can temporarily stop saving money for retirement.)
But really a hypothetical pattern like the one described here is terrible. And let me point out two factors to support this statement.
A first factor… We can’t fairly compare that $94,000 of year 4 profit to the $100,000 of year 1 profits. With 2% inflation over the last three years, we need to compare the $94,000 of year 4 profits to the $106,000 you or I should be making in year 4 in order to “keep even” with increasing prices. (If we would have bumped our profits by that 2% a year—like the operating costs bumped up by 2% a year—that $106,000 is what we would be earning in year 4.) In year 4 dollars, in other words, the business is actually be “down” by about $12,000. That’s a lot.
A second awkward factor to this slow-motion disaster: The situation keeps getting worse as long as you or I procrastinate about adjusting our prices for inflation. Ugh.
But Aren’t Prices Flat?
Let me share another comment about those inflating operating expenses. You might look at those and say, “Well, sure Steve, I get the math. But my prices aren’t really inflating. Or at least not by much. Seriously, interest rates are low. Oil is cheap. There basically isn’t any inflation if you look at the consumer price index…”
Okay, so I sort of agree with you… except that you (and I) need to be careful about assuming that overall price inflation accurately measures the inflation we’re experiencing in our small business’s operating costs.
Our business expenses may be flat or increasing at a barely noticeable rate. Or, and maybe especially for small service businesses, lots of our business expenses may actually be increasing at rates rather in excess of what the consumer price index shows.
Note: You can get producer price index information by industry code from the Bureau of Labor Statistics (click here for that information). Note that you’ll need to fiddle a bit to turn the index values at various points in your industry’s history into annual inflation rates.
Further, the inflation you’re experiencing in your personal living expenses plays into how you adjust prices for inflation, too, since your business profits need to stretch to cover the costs of taking care of your family.
My small business’s costs for labor, insurance, and taxes, for example, are all increasing at a rate rather more than the consumer price index. I bet the same is true for your small business.
You have a Good Explanation
One final comment about all this. But a reminder first: This isn’t a political blog, it’s a how-to blog. So I’m going to mention a couple of political topics but I’m only talking about them because they connect to inflation-triggered price adjustments. And with that point made, let me share a couple of things.
First of all, as a country, we are engaged in important discussions about bumping up minimum wage levels. Some localities, including the Seattle area where we work, have already done this. Other areas are talking about it. And all of the major candidates for president in the next election say that we as a country need to do this. Keep that thought in your head for a minute.
Now on to something else. The law of the land says that all but the smallest businesses need to provide health insurance to their employees. And that’s a cost bump for many small businesses. Further, for any businesses that do provide it, healthcare costs and therefore health insurance costs continue to increase in price by a rate greatly in excess of the overall consumer price index.
I don’t mention these two factors to start a political argument. Let’s do that someplace else. But it seems like we can all agree, no matter what our political feelings, that these factors drive up the labor expenses and therefore the operating costs of small businesses.
Further, it seems like the roughly half of your customer-base who support politically the candidates who’ve brought these issues forward have to accept you bumping your prices to cover the cost increases.
And, just to be practical, even the roughly half of your customer-base who don’t politically support something like a big bump in minimum wages or a requirement for businesses to provide health insurance get that you and I need to follow the rules, that following those rules pushes our costs up, and that we need to pass along those cost increases to customers in the form of price increases.
Summing up the situation, if society instructs small businesses to bump up their operating costs, I think small businesses can take that instruction as a license to raise prices to cover the cost increases.
My final comment then? Go ahead—do it. Bump your prices by some amount that reflects a “cost of living adjustment.” And then continue to make the bump each year from this point forward. I think the facts and circumstances totally justify this practice for most small businesses. Really, I do.