How should small businesses approach high inflation? We asked economist Max Wolff for his take on the subject. Wolff is the founder of Multivariate Solutions and teaches economics and finance at the Graduate Program in International Affairs at The New School. Lendio: What exactly is inflation? How much is normal and what are we seeing now that has people so worried? Max Wolff: We tend to only talk about inflation when we're into the painful variety, but it's always there. Inflation just means a general increase in prices. So if you go to the store, what it costs you to check out with the same items in 2019 is less than 2020, and 2020 is less than 2021, and onward. But lately, it can be a bit of what's called sticker shock, where you say, “Wow, I used to buy two bags of groceries for 60 bucks, and now it's more like 90 bucks!” Inflation tends to get elevated in the US when it's above 4% or 5%. We haven't seen prices go up that fast for most things for the better part of 40 years. And it always hurts people. Because our wages aren't compensating as quickly as what we buy. Lendio: Is there anything different about this period of high inflation? Max Wolff: A lot of the story here for small businesses is they were hit with a 1-2-3 punch–a trade war that messed up supply chains; a major long-standing pandemic, which was very hard to foresee and to plan around; and then inflation. So it’s a lot of things hitting all at once. Lendio: As a small business owner, you see supply chain issues and your costs going up, what do you do? Try to wait it out? Fight back? Max Wolff: The question is how big is the hit on them? Are they spending a lot of money already on food or fuel, which has been running up? Good news if you're not, bad news if you are. And then the all important question: do you have what's called pricing power? If you do face higher prices, you need to be able to pass them along. If you can't, then it comes out of your margins, and most small and medium enterprises don't have very big margins anyway. So taking a piece out of something that isn't that large can quickly become existentially dangerous, or at least substantially unpleasant. Lendio: What can a small business owner do in that case? Max Wolff: Have a really candid communication strategy with your clients or customers about how you are passing along as little as possible as late as possible. You have to level with people, but the bottom line is you have to pass along those price increases, because one of the scarier things about this is, unlike the milk in your refrigerator, inflation doesn't come with an expiration date. Lendio: This might be counterintuitive, but is there any benefit to scaling up during tough financial times? Max Wolff: Access to capital is key if you want to be able to keep your lights on and keep a steady bank account through the turbulence. It’s sometimes said that it’s good to be greedy when other people are scared, and scared when other people are greedy. Because it's a tough time, if you can put together a compelling business plan, it makes a lot of sense to grow. And the reasons are economies of scale and pricing power. If you're bigger in the market, you can sometimes get better pricing from your suppliers. You can also pass along more of your price increases to your customers because you have less competition to worry about. Lendio: Are there other lessons we can take from bigger businesses? Max Wolff: It's always risky to be competing in the market on price. Because if you have the most price-sensitive customers, they might be the first to turn and run if you can't match the price that somebody else has. You want to build a relationship around a brand or customer service, or some sort of intimacy with your client base, where there's a connection to you. If your value proposition is not just price, you're going to do better in all kinds of disturbances in the economy. You could gain market share and maybe even some clout. Lendio: So if you're able to weather it successfully, you actually might come out of inflation with a bit of a competitive edge? Max Wolff: For example, if you have substantial debt, inflation is kind of your friend. If I borrowed $100,000 from you last year and I'm slowly paying it back, next year, when $100,000 buys a lot less and my prices have gone up, it becomes easier for me to service the loan. If I now get 10% more for everything I sell and my interest rate is 8%, I'm still better off even with the borrowed money than I was before. Because I get to keep a little piece of the increase in prices and the rest I pass along to a lender. Another thing is, it always depends on what's inflating. If there's general inflation, but your costs aren't going up, then you get a lot more love from your users and buyers. If your prices aren't going up, but other people's are, people tend to notice that. Lendio: Why might your costs not be going up? Max Wolff: The bout of inflation we’re going through right now is very centered around cars, gas, and food. And those are very painful, because you go to the grocery store and fill up your car pretty frequently. So you really see those price increases. But lots of other prices aren't going crazy high. Inflation is always uneven–some prices are rising, some are not. If you're in a business that doesn't spend a lot of its total cost on food or fuel, you're relatively better off. So if you can produce without having your prices going up in a market where people expect the prices to rise, you can have abnormally large profits for sometimes a protracted time period. Lendio: And if your costs are going up and you’re struggling, what can you do? Max Wolff: It's never too late to have a plan. If you can structure buying supplies over a longer time period, with more price visibility, you'll always be better off. If you say to a supplier, “I'm not going to pay you 20% more for food this month and next month, but I'll pay you 10% more for the next year,” you share the risk with the supplier. And you can do the same thing–offer memberships and long term contracts with clients. Say, “We're going to let you lock in the prices now, so if the prices go up, you won't have to bear the brunt of it” – especially if you think you're near the peak of the inflation. That's a commitment to keeping price visibility forward for your users, but it also shields you a little bit. Two, invest in more efficiently using your resources during inflation. If you can figure out how to squeeze waste out of your process, then you will be offsetting some of the price increases. The other thing is substitutions. If you're a restaurant that specializes in beef, but beef prices go up 40%, it might be a good idea to have a few vegetarian and fish dishes because those are inflating much less. So figure out how to move around it, or figure out how to make the food taste a lot better, so that you can get away with a four-ounce serving instead of a five-ounce serving. Particularly if you have a lot of servings, that difference of 20% is pretty meaningful. It might be that the 20% increase in beef prices is offset by a 1 or 2% increase in sort of the finery with which you produce. Lendio: So you’ve tried all that, at what point do you have to start raising your prices? Max Wolff: Pretty quickly. As soon as it cuts into your margin, you have to start to plan at least to game out higher prices and provision for them. Tell people you're doing a partial temporary price increase where you're splitting the cost with your users. Because if you wait until you're on the ropes, you have no degrees of freedom and you might have to shock the prices upward. You’re much better off telling people about a temporary 5% increase, and then maybe have to go up another few percent. The shock will get you much less understanding. Again, it's very dangerous to be the low price competitor. If you're competing on some other basis, it's much better. If you're just the cheapest hamburger, then you really just have to eat the price increases and hope they don't kill you, or raise your prices slower than everybody else. But if you're the fastest, or the friendliest, or the tastiest, or have the most choices, that’s different. Be creative. Figure out how to offer people something that the price isn't going up on and offer more of that. If you sell hamburgers and fries and you’re getting crushed on beef prices, give people a ton of french fries and tell people why. If you try to hide it, it gets tricky. Lendio: When can we expect inflation to end? Max Wolff: The good news is the food and fuel inflation has probably peaked–unless there's a turn for the worst in Ukraine. We're also starting to see the Federal Reserve tighten monetary policy. And we've seen a lot of reduction in the stimulation to the economy done around helping us get through COVID. So inflation will probably slowly lessen in many areas, although it'll linger. And in some areas, it may linger quite a bit more than others. The important thing to remember is in any stress environment, the rigid shatters and the flexible bends. Flexibility can mean with your business model, access to capital, good communication with your staff and customers, or honesty about the process. If you try to make the world bend to you, you’ll shatter. If you bend with the world, without giving up your core values, you’ll prosper. Economist Max Wolff is on Twitter @MaxFWolff and LinkedIn. "Disclaimer: The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.