Previously published in The Digital CFO Magazine
There’s no escape – at the grocery store, in the stock market, in the news, in the elections, seemingly everywhere you turn, inflation is here, and it’s a whole lot less transitory than the Fed, European Central Bank and others initially claimed. With the latest Consumer Price Index1 (all items) coming in at 8.3%, surprisingly higher than the previous month, and the S&P closing at a new low2 for the year, CFOs are scrambling and looking for new strategies to succeed. For many of today’s finance leaders, this is the first time in their career that they are working within this environment. However, CFOs have more data and technology at their disposal than they did decades ago, and some see the current challenges as an exciting chance to separate themselves from their competitors.
Why does inflation matter?
Inflation affects all aspects of the economy, from consumer spending, business investment, and employment rates to government programs, tax policies, and interest rates. It not only impacts what consumers and businesses pay for goods and services today but also impacts the calculation of investment returns.
It’s easy to think that inflation only exists outside a company’s financial statements at a macro level, however inflation shows up on a company’s financials in a few hidden ways including inventory calculations, interest cost, and higher input costs. Ultimately, this extrapolates out to key finance metrics such as Return on Equity (ROE) and terminal values. If a company’s future cash flows have to be discounted due to higher cost of borrowing or shrinking margins, both future earnings and multiples (due to higher risk) compress, causing a compounding hit to a company’s valuation.
With purchasing power eroding, standing still can feel like moving backwards. “CFOs have little control over inflation itself, but it adds cost pressure that they must navigate their businesses through,” says Alexander Bant, Practice Vice President, Finance at Gartner.3 “When faced with challenges that could harm profitability, the instinctive CFO response is to reduce costs near-term or delay spending until inflation subsides.” While these tools may help some companies, a longer term outlook will help others even more – especially in the face of prolonged inflation.
What tools do CFOs have to respond?
It may be tempting to look back 40 years for insights on responding to soaring prices, however, that would be a mistake. The current environment – and the role of the CFO – fundamentally differ from what they were four decades ago. A global economy, consumer demand shifts, a supply chain disrupted by a pandemic, nearly historic low unemployment4, and other factors unique to today simply did not exist the last time inflation was this high. That’s not to say that CFOs have to just wait until inflation goes away. They can get ahead of it by focusing on value creation for their customers while embracing or accelerating digital transformation efforts.
Warren Buffett has been quoted saying, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” On the flip side, if pricing power is not your organization’s strong suit, how can
it become one? Look to companies like Apple, Starbucks, and even CVS. At first glance, it would seem that these three companies have nothing in common. One makes hardware and software, the other is a strong consumer brand with thousands of competitors, and the third is a pharmacy and convenience store that historically has been a price taker, not a price setter. All three, however, have strong means to combat inflation with their walled ecosystems. Apple’s iOS customers are less likely to switch to a competitor compared to Android users, Starbucks built an entire payment ecosystem in its rewards program, and CVS has diversified its business line to include healthcare providers, which might have some of the strongest pricing power across industries. Three different companies, three completely different approaches bound by a long-term approach to tackling enterprise value creation.
CFOs have little control over inflation itself, but it adds cost pressure that they must navigate their businesses through. When faced with challenges that could harm profitability, the instinctive CFO response is to reduce costs near-term or delay spending until inflation subsides.
Embrace transformation efforts
Businesses also have the ability to embrace or accelerate their digital transformation
efforts. A Gartner survey6 shows that 78% of CFOs will increase or maintain enterprise digital investments through 2023 even if inflation persists. This flies directly in the face of temptations to reduce spend. This is because technology is often deflationary over the long run.
When thinking about how to fund digital bets in an inflationary environment, however, leaders should avoid traditional, rigid funding models that prevent flexible resource allocation. Instead, focus on targeted KPIs that can be measured in real time, and explain a digital deflation story to your investors. Technologies in automation, business process outsourcing, machine learning, and key vendor relationships can all help reduce labor cost in the short and long run while still positioning the organization for future growth.
Robust Scenario Planning
Today’s CFOs have access to detailed data and technology tools that put them in a significantly better place to respond to inflation than in previous decades. The ability to generate cost models based on constantly fluctuating inflation can help CFOs walk the fine line between ensuring profitability and losing customers through
needless price hikes. Organizations can also model the impacts of adjusting product quality and quantity or creating new bundles or offerings. This can provide additional pricing tiers that can keep customers at the original price point while providing additional value for those who are less price conscious.
The pressures of inflation can also present the needed push to realign pricing models all together. For example, organizations
might look to implement a subscription business model or usage-based model that can make them more appealing to price-conscious customers.
Embracing new opportunities.
Forbes describes today’s landscape as “a unique opportunity for leading CFOs to elevate scenario planning activities and other next-generation finance capabilities with the objective of contributing an enterprise wide solution to a puzzling challenge with numerous moving pieces.”
While inflation has not been seen at this level in 40 years, more recent history shows us that some of the most innovative and transformative companies emerged from the financial crisis of 2008. Uber, Airbnb, Doordash, Slack and Zoom are now all household names despite being less than 15 years old. By focusing on value creation, data-driven decisions and a digital-first business model, they were able to rise above market challenges. Today, organizations face a similar pivot point better equipped and with more tools than ever before.