Inflation and the impact on CF 4 / 6

How Inflation affects budgets

If inflation is expected it should be included in the budget

In the annual budget simply use an average rate of inflation for the year 

For cash budgets though, these are often done monthly or quarterly - making it trickier

Including inflation in a MONTHLY cash budget

Estimate when costs or prices may rise.

  1. For wages - estimate the annual increase, and include in the budget for the end of the month after the pay rise takes effect.

  2. For monthly utility bills estimated the increase in costs from the relevant payment month.

  3. Sales budget should increase from the time of the sales price review.

  4. For other costs - just make a monthly inflationary estimate, for example, 2%every month or higher in the last few months if you expect inflation to rise

With carefully-made assumptions, inflation can therefore be included within cash budgets and forecasts.

The effect of inflation on cash flow and profit

Affect on Profit
Inflation usually hits your costs before you then react and put up your prices to deal with this. This reduces profitability - in that period where the costs have gone before you put up your prices

However, price competition means you might not be able to put up your prices enough to cover the inflated costs - thus reducing your profitability more 

Affect on Cash-Flow
The same here - your costs increase before your sales so liquidity and cashflow is reduced

  • Inventory purchases increase first, then labour. 

    Both mean higher costs of finished goods.

  • When sales prices are eventually increased, trade receivables rise, and so working capital (Inventory + Receivables - Payables)  will increase.

Inflation usually has the effect of decreasing liquidity and causing cashflow problems

Illustration

Cow Co. has inventory of $60,000, receivables of $50,000 and trade payables of $40,000. 

There has been an increase of 10% in its costs, including costs of materials and labour. 

Sales prices have not yet been increased.

What will be the effect on working capital, and on cash flows in the short term?

ANSWER

In the short term inventory will increase by 10% ($6,000) and trade payables will increase by $4,000. 

Until sales prices are increased, trade receivables are unaffected. 

The net increase in working capital - and reduction in liquidity - is $2,000.