Forecasting Industry and Company Sales and Costs When Subject to Inflation or Deflation

Inflation and deflation affect the accuracy of a company’s forecasts. The impact of inflation and deflation varies in the case of revenues and expenses.

Some companies can pass on higher input costs by raising the prices of their products. Companies that can pass on price increments to their customers are more likely to have stable profits and cash flows than competitors.

Industry Sales and Inflation or Deflation

Increments in the cost of inputs will result in higher prices for end products. Higher costs passed on to customers might hurt a company’s sales volume. The negative impact would depend on the price elasticity of demand, competitors’ reaction, and substitutes’ availability.

• In an inflationary environment, increasing prices too late will negatively affect profit margins, but doing it too soon will negatively affect sales volume.
• In a deflationary environment, lowering prices too soon will negatively affect gross margin, but waiting too long will negatively affect sales volumes.

Company Sales and Inflation or Deflation

Revenue forecasts are based on expected volume and price development. This calls for the understanding of the price elasticity of a company’s products, the different rates of cost inflation in the countries the company operates, the likely inflation in costs relevant to a company’s product categories, and pricing strategy and market position.

The impact of higher prices on volume depends on the price elasticity of demand.

• A company’s sales will benefit from inflation if demand is relatively price inelastic.
• If demand is price elastic, revenues will decline when prices are increased.

When a country exports to a country experiencing high inflation, its profits will be negatively affected. This is because the exporting country will witness a depreciation of its currency.

If a company’s significant input increases in price, it’s more likely to increase the price of its products. An increase in input costs will not necessarily increase product prices for a well-diversified company that does not rely on one major input.

A company that experiences an increase in input costs may decide to pass on the costs to consumers to maintain its margins. Alternatively, the company can accept a reduction in margins to increase its market share.

Industry Costs and Inflation or Deflation

Knowledge about a specific industry’s purchasing trends is key to forecasting industry costs. Some industries use long-term fixed forward contracts and hedges, which can delay the impact of price increments.

Monitoring the underlying drivers of input prices can also be helpful in forecasting costs. For example, weather conditions have an impact on the prices of agricultural products.

If companies in an industry have access to alternative inputs or are vertically integrated, the impact of volatility in input costs can be mitigated.

Company Costs and Inflation or Deflation

Segmenting a company’s costs based on category and geography is as important as evaluating the impact of inflation or deflation on each item. It’s also imperative for analysts to examine the availability of substitutes and increments in efficiency.

Question

Which of the following is most likely a reason for a product’s demand to be negatively affected by an increase in price?

1. Inflation.
2. Price elasticity of demand.
3. Exporting.

Solution

The correct answer is B. 

When the price elasticity of demand is elastic, a slight price increase will significantly decrease its demand.

A is incorrect. Inflation would not necessarily affect a product’s demand unless a company passes on the price increase to its consumers and the product’s demand is elastic.

C is incorrect. Exporting involves selling products and services in foreign countries. 

Reading 17: Financial Statement Modeling

LOS 17 (k) Explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation.