What are the industry’s current expectations concerning inflation? What tools and procedures can financial controllers and senior managers use to respond to high rates of inflation? And what should they keep in mind when planning, budgeting or forecasting?
A multitude of new realities are currently preoccupying senior management teams and financial controllers. They are obliged to work in a permanent state of crisis caused by the Covid pandemic – and this in turn, for over a year now, has been overshadowed by the ongoing war in Ukraine. In our day-to-day work, we are all familiar with the challenging impacts of these issues on our various working relationships and supply chains, so I do not intend to explore them further in this post.
Over the last few months, I have been much more concerned by a phenomenon which, here in Germany, we had almost entirely forgotten: high inflation rates! Over the past 30 years, younger financial controllers have had very little reason to worry about inflationary trends. Ever since the euro was first introduced, the rate of inflation has steadily trundled along at an annual average of 1.4% – meaning that it was almost non-existent. Then, in 2022, we suddenly found ourselves flying high at 7.9%. Forecasts for 2023 suggest that we will probably reach a round 8.0% – a level of inflation which we last experienced shortly after German reunification.
Let us not forget that we are talking, here, about the average prices of a fixed basket of goods. But depending on the specific industry or product, inflation rates may look quite different – the figures may be even higher. Just consider energy price trends, which are especially significant for many industries, or the shortage of products such as sensors and semiconductors in many manufacturing industries, which has achieved headline status in recent months. Energy prices alone have leapt by double-digit percentages over the last 12 months – the price of gas, for instance, by as much as 50%.
So how, as business managers, should we tackle this challenge? The truth is, the issue of inflation has all but disappeared from modern German textbooks. Even so, we can still find some useful tips and recommendations in the literature. For example, some six years ago, the “Taxation and Internal Auditing” working group of the Association of Business Academics (Bund der Wirtschaftsakademiker e.V.) provided some valuable guidance. According to the experts, financial controllers should start by becoming very alert to this issue and observing market price trends perhaps a little more closely than before, while also incorporating inflation-related risks into their risk management scenarios.
Then, to protect existing asset exposures by tackling inflation more effectively or even counteracting it, they may call upon a whole range of instruments. For example:
Another tip is to prioritise e.g. essential investments in machinery while inflation is high or prices are expected to rise. This applies in particular to investments in replacements or upgrades. In the case of foreseeable price increases, stockpiling may also make sense, especially if the anticipated increases are significantly higher than the anticipated financing costs – a situation which still appears plausible in the prevailing interest-rate conditions.
I would also recommend avoiding the distribution of dividends on profits resulting from price increases in sales markets (also known as “sham profits”). Instead, these earnings should be used to replenish production materials; as a rule, these will also have increased in price. Otherwise the company will become less efficient – and less profitable.
All the above suggestions could also be applied to planning and budgeting, as well as regular forecasting. One of the first priorities, based on good controlling practice, would be to work with “real” (i.e. inflation-adjusted) profitability targets. So if the company’s nominal profitability is 4% at a 5% rate of inflation, then its real profitability – adjusted for inflation – is negative and the company is destroying value. This is something planners should seek to prevent; some of the possible measures for doing so are outlined above.
As a logical corollary, financial controllers should play very close attention to product-specific price movements. This is particularly important in the case of energy prices or scarce commodities. They should also use early-warning indicators wherever possible. For this purpose, when gauging general price expectations for the future, it makes sense to apply a key indicator used for financial derivatives: so-called “forward inflation swaps”, which serve as macroeconomic indicators depicting long-term inflation-rate expectations. These are essentially inflation forecasts for a five-year period starting in five years’ time. At present, based on long-term comparisons, this value is comparatively high, at roughly 2.3%. This figure more or less corresponds to the average rate of inflation anticipated by the ECB for coming years, and also coincides with forecasts made by many experts for the next few years, which predict a rate of 2 + x% once the one-off effects described at the beginning of this article finally come to an end. The current forecast for 2025 is 2.3%.
As things stand today, “hyperinflation” is likely to be a temporary issue – but here in Germany, we should be braced to deal with another price driver which will not be so easy to manage by applying excellent financial controlling techniques: a shortage of skilled workers and an employee “price war”. Professional development is and will continue to be a vital tool for retaining talent and preparing controllers to meet the latest market challenges.
This post is an updated version of the following article: Gleich, R. (2022), Wie sollte das Controlling auf hohe Inflationsraten reagieren?, in: Controller Magazin 47 (2022) 4, pp. 48-49