How does inflation affect businesses? What changing rates mean for your bottom line

From the rollout of new technologies to changes in how tax is calculated, many outside influences can impact your business. Inflation is one major factor you can’t afford to overlook.

Inflation refers to the rate at which prices rise over time. For example, with 5% inflation, an item costing £100 today will cost £105 in a year, meaning your money buys less over time.

Some inflation can be a good thing – it’s why the Bank of England targets a 2% inflation rate. However, when inflation rises higher, it can squeeze business finances by driving up costs for everything from raw materials to utilities and wages.

On the other hand, low inflation – or even deflation – might sound less alarming, but the drop in prices that typically accompanies it can indicate an economic slowdown, often leading to reduced consumer spending and slower business growth.

Knowing how to handle inflation is important when you’re running a business. With that in mind, we’ve created this guide to answer the question “How does inflation affect businesses?” and provide practical tips to help you manage it better.

How does inflation affect a small business?

In the UK, the Office for National Statistics (ONS) tracks inflation using various price indices, such as the Producer Price Index and the House Price Index.

However, the most widely recognised measure of inflation, and the one that grabs the headlines, is the Consumer Price Index (CPI). This tracks price changes in over 700 everyday items, such as food, clothing, and household goods. The ONS updates this basket of goodsevery year to reflect current spending habits.

For businesses, the CPI shows how much more (or less) your customers are spending, which can influence their ability and likelihood to buy. But how does a rise in inflation affect businesses?

Let’s run through the way it can make its mark.

Materials and supplies

When inflation kicks in, the costs of raw materials and supplies for your business will usually rise too.

For instance, an independent bakery might see flour and sugar prices spike, while a retail business could see the cost of popular items climb. It can also affect you if you’re working on online business ideas. For example, there may be a rise in packaging costs for sending items to customers.

Either way, these rising small business expenses can eat into your bottom line, reducing profits by driving up the cost of the materials and supplies that keep your business running.

Supply chain

Inflation can create bottlenecks in the supply chain. Just like your business, your suppliers will also grapple with rising costs during high inflation, which may lead them to scale back production or reduce how often they ship products. This can result in delays in getting the inventory you need.

For instance, a small boutique may struggle to keep a popular style of trainers in stock due to supplier delays, affecting sales and customer satisfaction.

Staff

When inflation is high, the rising cost of living often leads employees to push for higher wages – as seen in the UK in recent years, with high-profile disputes between trade unions and train companies, as well as record-breaking strikesby NHS workers.

But these issues aren’t limited to large organisations; small businesses face similar challenges. Balancing your small business budget while still being able to motivate employees and meet their salary expectations can be challenging when inflation creeps up.

Rent and utilities

Rent and utilities often rise during high inflation periods, especially if your lease is tied to rates. This will put extra demands on your small business finances,particularly if operating costs are already high. For example, in hospitality,where energy use is often essential for guest comfort, higher utility bills will significantly increase expenses.

For those working on business ideas from home,the impact might be less severe, but it’s something to keep an eye on. Higher utility costs can still add up.

If you’re leasing a commercial space, things can get tricky. Long-term leases can become challenging during periods of high inflation. The rent you agreed to a few years ago might not stretch as far today, and landlords may push for higher rent or increase maintenance and service charges to make up the shortfall.

Customers

High inflation can really hit consumer spending, especially on non-essential items. As prices rise, people might start tightening their belts, looking for cheaper alternatives, or cutting back on luxury purchases altogether. 

This shift can lead to fewer transactions being racked up on your point-of-sale system,especially in markets where price sensitivity is high.

Take the food and drink industry as an example. A restaurant might see fewer diners as people choose to eat out less to save money. Even regulars might start opting for more affordable dining options, or just cook at home to save the pennies.

Similar scenarios can affect all types of businesses, particularly those located in competitive areas where plenty of alternatives make it easier for customers to switch to cheaper options.

Financing

When inflation is on the rise, borrowing money gets pricier. That’s because interest rates typically go up as well, making business loans and credit cards more expensive.

This can be a significant challenge if your business relies on financing for expansion, equipment purchases, or simply managing cash flow.Higher interest rates mean you’ll be paying more in the long run, which can tighten your budget just when you need flexibility the most.

Insurance

Inflation doesn’t just impact the obvious areas like materials and wages – it can also sneak into your insurance costs. As the value of assets increases with inflation, the cost to insure those assets tends to rise too.

Rising insurance premiums adds pressure, especially when coupled with other cost increases for your business.

How to manage high inflation

So, now that we’ve talked through the answer to the question “How does inflation affect small businesses?”, let’s dive into some ways you can tackle those issues head-on.

Pricing strategies

When costs rise, it’s natural to consider passing those increases onto customers – a tactic known as cost pass-through. While sometimes unavoidable, be careful not to raise prices too quickly, as this can push customers away.

Before you rethink how to price a product or service, it’s worth learning how to do a competitor analysis to see how others in your industry are handling price increases. If you decide to move forward, be sure to clearly communicate the reasons behind the changes to maintain customer loyalty.

One effective approach is value-based pricing, which focuses on your unique selling point(USP) to justify higher prices. For example, if you run an online store selling handmade jewellery, you can lean on the uniqueness of your pieces. By highlighting what sets your products apart, you can convince customers that the price is worth it.

Additionally, consider offering promotions like discounted gift cards or introducing flexible small business payment options like Buy Now Pay Later (BNPL). These tactics can encourage customers to spend, even when overall prices are higher.

Cash flow management

Managing cash flow properly is even more important during high inflation. Rising costs can strain your finances, making cash reserves and regular reviews of your cash flow statement essential.

Offering a broader and more efficient range of payment options can also help ramp up cash flow. For example, using remote payment options like payment links and QR codes, along with digital invoices, can streamline your billing process, helping you get paid faster and keep cash flow steady.

You might also renegotiate payment terms with suppliers or explore short-term financing options to improve cash flow and bridge any gaps. A strong business credit score will help you secure lower interest rates, easing money worries, but if traditional financing becomes too costly, small business crowdfunding or grants could be good alternatives.

Suppliers

If inflation starts driving up costs and causing supply chain hiccups, it’s smart to mix up your suppliers. Relying on just one can leave you open to delays and price increases.

By working with a few different suppliers, you’ll be in a better position to dodge these risks, secure better deals, and keep your stock levels steady. This way, you’ll be better equipped to meet customer demand and keep your business going, even with rising inflation.

Staff

As we discussed earlier, inflation often leads to demands for higher wages. To manage this without constantly raising salaries, consider offering non-monetary perks like flexible hours, professional development, and recognition for hard work.

Focusing on how to create a positive working environment can help keep your team motivated, even when budgets are tight. But it’s also important to pay staff fairly, especially as costs rise. Fair payboosts morale and loyalty, making it easier for a small business to enjoy high employee retention rates, even during tough times.

Business models

When inflation is really high, it could be worth rethinking your business model to keep costs under control.

For example, if you’re running a brick-and-mortar store, you might explore adding online sales to complement your in-store business. This can increase your income and spread out overhead costs like rent and utilities, giving you a bit more breathing room in your budget.

Another strategy to consider is setting up a limited company instead of staying as a sole trader. While this might seem like a big step, a limited company can offer tax advantages and protect your personal assets, which is especially important during difficult economic times.

Investments

It’s natural to wonder, “How does inflation affect business investment?” The answer is that it can cause some business owners to tighten their purse strings and put a halt on new investments. Conversely, others may decide to move quickly on investments to avoid even higher costs down the line. 

Before making any big investment decisions, always consider the potential return. You may find that, even in the midst of inflation, it’s worth diverting some of your profit towards tech solutions that will streamline your business and ultimately fortify you against adverse economic conditions.

For example, adding self-service kiosks for selling food and drink at a live entertainment venue might feel like a significant upfront cost, but it can pay off by increasing average order values and freeing up staff to focus on other tasks.

How does low inflation affect businesses?

By now, you’re probably feeling more confident about answering the question: “How does a high inflation rate affect businesses?”, but what about low inflation?

Low inflation might seem like a relief compared to high inflation, but it comes with its own challenges. When prices for goods and services barely increase, or stay the same, it can signal a slowing economy. This often leads to reduced consumer spending and slower business growth.

The strategies to manage high and low inflation can sometimes overlap, as we’ll now discuss.

Pricing and sales

In a low inflation environment, customers may hold off on purchases, expecting prices to remain stable or even drop. This can lead to slower sales, especially for non-essential items.

You might find yourself facing the same challenge as with high inflation – how to keep sales steady without introducing significant price increases. While it might sound counterintuitive, strategies like offering promotions or bundling products can still be effective in encouraging spending and maintaining revenue.

Cash flow and investment

Just as with high inflation, cash flow management remains critical during low inflation. While lower interest rates can make financing cheaper, slower revenue growth can still strain your cash flow. Maintaining a steady income stream and controlling costs is essential, whether inflation is high or low.

Wages and staffing

Low inflation might reduce the pressure to raise wages, but stagnant pay can still affect employee morale. The strategies we discussed earlier, like offering non-monetary benefits and creating a positive work environment, are just as important here to keep your team motivated and committed.

Understanding deflation

Deflation, where prices actually fall, can be even trickier to negotiate. It might seem like a win for consumers, but for businesses, it’s a different story. It often means customers delay purchases, waiting for prices to drop even more. This can squeeze your margins and force you to cut costs.

Navigating deflation means focusing on keeping customers loyal and encouraging them to buy now, rather than later. Some strategies might sound familiar – like cutting costs without sacrificing quality – but they’re even more important when deflation hits.

Learning how to use social media for small business can be a cost-effective way to keep your customers engaged without incurring a high advertising spend. Similarly, finding ways to lower your operating costs, such as reducing credit card merchant fees,can help keep your business resilient.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.