A cost of living crisis: what does inflation really mean for UK businesses?

‘Inflation’ is a word in the minds and mouths of many UK residents and business owners. Continuous lockdowns caused by a global pandemic, increased energy costs, and the war in Ukraine have all had a role to play in the rising cost of goods and services.

Experts are warning that Britain could face the first double-digit inflation rate for the first time in 40 years. But what is inflation? And how can we expect it to impact UK businesses? Business Leader investigates.

What is inflation?

According to the International Monetary Fund, economic inflation is the measurement of the increased price of goods and services within a year.

We know the rate of inflation because the Office for National Statistics looks at the price of a range of the most commonly used goods and services in the UK – this may include a pint of milk, a loaf of bread, a car, or a holiday.

The overall cost of these items tells us the Consumer Price Index (CPI) for that year. The CPI is then compared to the previous year to find the rate of inflation for that year – this year the rate of inflation is 9.1%, but experts expect this could increase to 10% by the end of 2022.

Inflation happens for a variety of reasons. In this case, the Covid-19 crisis had a major impact on driving up the price of goods and services.

When society re-opened after the pandemic, the demand for goods increased. Some businesses struggled to get products, particularly products from abroad, to their customers – this caused goods to rise in price.

Global factors are also having a major impact on the price of goods in the UK. The pandemic and Brexit had already caused major supply chain issues. Additionally, the price of gas and oil increased, the war in Ukraine caused energy prices to hike further and continued lockdowns in China have made it difficult to import goods to the UK – all these factors have driven up the rate of inflation.

What is the government doing to mitigate the impact of inflation?

The government has ambitions to get the rate of inflation down to 2%, but there isn’t much the government can do about external factors abroad impacting the cost of energy and goods.
Despite this, The Bank of England has said there are things they can do to control inflation and bring it back down if it continues to rise.

Increasing bank interest rates is one way to keep inflation stable. This makes it more expensive to borrow money and encourages the public to save, helping to push inflation down over time.
Although achieving the government’s goal of inflation at 2% isn’t impossible, the country’s central bank has predicted it will take at least two years before we reach this number.

Which industries will be impacted the most?

Inflation is likely to impact industries that are more volatile. Consumer-facing businesses, construction and capital goods industries – including tools, machinery, vehicles and computers – are likely to feel the impact of inflation too.

As rising costs cause a squeeze on household income, the public is making careful decisions about where they want to spend their money. This has included cutting back on luxury and ‘big-ticket’ spending such as for holidays and cars.

Even streaming-giant Netflix saw a major decrease in its stocks in the first quarter of this year, partly due to a large percentage of paying users opting out of their subscription due to decreased spending money.

Small-to-medium sized businesses will also be impacted at a disproportionate rate as they have fewer financial resources to help them absorb the cost of inflation. Paul Christensen, CEO at Previse feels that the government needs to do more to support businesses.

He comments: “With inflation now forecast to reach 10% before the end of the year, its impact will continue to be particularly hard felt by small and medium-sized firms, which lack the financial legroom to absorb the cost of soaring prices.

“If these businesses are to successfully battle inflation, Westminster must find new ways of tackling the real cash flow problems that they face – like slow payments and difficulty accessing finance.

“Slow and late payments, for example, continue to stifle SMEs of much-needed cash and have been a problem for years. Three-in-five UK businesses are currently owed money in late payments, while over 400,000 SMEs are on the brink of closure due to the late payment of invoices.”

How are businesses responding to inflation?

When inflation occurs, businesses experience increased supply chain, manufacturing, and overhead costs. Most businesses will attempt to absorb the increased costs that arise from inflation to avoid losing customers. Consumer goods companies can scale back any discounts and offers, reduce their supply chain to achieve larger margins, and reduce the size of their products – as consumers are more likely to respond to increased prices over smaller sizes.

Lynne Blakey, Director in the Advisory Consulting team at Tilney Smith & Williamson, explores what businesses can do in the face of inflation. She comments: “With inflation currently at 7%, and the Bank of England predicting it could rise even higher, businesses and individuals alike are feeling the squeeze.

“Businesses, particularly those operating on low margins, need to take action to deal with the impact of increasing costs and energy pricing and rising interest rates.

“One obvious strategy is to increase the price point at which you sell your goods or services. The extent to which you can do this will depend on the price elasticity of the products or services that you supply. However, remember that your customers are facing the same inflationary pressures. Therefore, you must ensure that these increases are sustainable and not negated by any reduction in demand.

“When operating in an inflationary environment, it is important that businesses have clear visibility of their end-to-end costs split by category, functions, and processes. Businesses should make sure that they have a robust budgeting process in place, reviewing profit and cash flow forecasts regularly against actual results and sensitising them to understand the worst-case scenario. Where are you potentially exposed and what levers can you pull to address this?”

The way businesses deal with rising costs varies. Larger businesses may have the resources to smooth out prices where there are input costs. Whereas smaller-to-medium sized businesses may not have the financial resources to do this. As a result, these smaller businesses are likely to feel the impact of inflation more obviously.

Christensen: “Liquidity challenges are compounded by difficulty accessing finance itself. A recent survey by the Federation of Small Businesses found that the proportion of SMEs having their applications for finance approved was at a seven-year low. These factors seriously dent the ability of firms to manage inflationary pressures, leaving them without the cash flow they need to adapt to soaring bills.

“It doesn’t have to be this way. When the technology is ready and available to tackle these challenges, the government must move away from vouchers, incentives and traditional forms of financing, and instead support companies to harness tech-driven solutions as a means of addressing these long-term pain points.”

According to a recent report, lending to UK businesses is set to grow by 2.8% in 2022 and 3.3% next year – back to the pre-pandemic rate. Despite this, experts expect funding for businesses is likely to decrease due to geopolitical and economic uncertainties.

Dan Cooper, UK Head of Banking and Capital Markets at EY, comments on the report’s findings: “It is a financially challenging time for many UK households as the cost of living rises and for businesses recovering post-pandemic. For the lenders supporting people through this period, the picture is mixed. Growth is expected on all lending fronts – albeit subdued in many cases – and interest rates look likely to increase further, which will help boost interest margins.

“However, we cannot ignore that loan defaults – which have largely been kept low thanks to the pandemic support offered by the Government and Bank of England – are expected to rise this year, especially on the consumer credit and business loan side. Overall, while the banks will, of course, continue to offer assistance to those facing financial difficulty, care will be needed as they manage their balance sheets in the face of persistent economic headwinds.”

What can businesses do in the face of economic uncertainty?

Experts have suggested that the road out of inflation will not be a short one. Businesses will need to make decisions about how they are going to absorb the costs of inflation wisely and create a long-term plan for dealing with economic and geopolitical uncertainty.

Adrian Palmer is a Professor of Marketing and Head of the Department of Marketing and Reputation at Henley Business School. His research covers consumer behaviour and the impact of inflation on businesses.

He comments: “In the short term, firms may sacrifice margins and hold prices, especially in competitive consumer markets where being first to raise prices will be noticed. Firms sometimes use ‘tricks of the trade’ to mitigate the effects of inflation, for example, shrinking pack sizes while prices are held, and restricting supplies of less profitable product formulations and distribution channels. Once prices start moving, inflation can become built into buyers’ expectations.

“In the medium-term, firms can reformulate products to reduce reliance on expensive inputs – such as replacement of sunflower oil with cheaper palm oil. Where labour costs are rising fast, there is heightened pressure towards automation in labour-intensive sectors. With competitors’ prices continually changing, this can be an opportunity for firms to strategically adjust their price positioning in a market.

“The longer-term raises bigger questions for firms. Rising prices without having rising wages based on productivity gains are likely to reduce overall demand in the economy, first affecting end-consumers who make small cuts in their spending. This soon filters through to capital goods companies who face much lumpier cuts in capital expenditure as consumer goods companies’ falling levels of confidence leads to reduced or deferred investment in production capacity.

“These are the classic precursors of a recession. In the longer term, recessions tend to reduce inflation as demand collapses. The big question in business planning is whether governments can continue to intervene to support economies without stoking further inflation, or will this be too much for governments, leading international economies to collapse into recession? Economics is never dull, but this is the big question facing many businesses right now.”

What will happen next?

The possibility of a double-figure inflation rate makes many reminiscent of the 1970s. Thankfully, inflation is currently only a fraction of what it was at this point in history – believe it or not, the UK economy is growing and experts have said it is expected to grow by 3.8% this year.

What makes experts nervous for the future is the sharp increase in the rate of inflation that has occurred. This may mean that despite a growing economy currently, a higher rate of inflation and even a recession may be on the cards.

The National Institute of Economic and Social Research (NIESR) predicts that GDP will fall 0.4% in the last three months of this year. This would show two consecutive quarters of contraction, a commonly used indicator of recession.

According to reports, a recession could leave 1.5 million households in the UK struggling to pay for their energy and basic necessities like food. The knock-on impact this will have on businesses is yet to be seen.