Inflated expectations

Monday 13 November 2017

Article

Data is driving more and more business decisions, with increasingly complex models being used to predict and manage costs, demand, staffing levels, revenue targets and a myriad of other things. In our client work, we’re ingesting more data, and running more sophisticated algorithms to look at sourcing, pricing, labour, headroom for growth, and so on. Businesses are only going to have more data, and so our consulting capability is building to have far more data/ analytics content.

But…a model is only as good as the numbers that you put into it, and that is where something new is happening.

Businesses are starting to have to look at the impact that changing inflation and interest rates have on their numbers. For the last 10 years, inflation rates have been so low, they’ve largely being ignored in business plans. But in the 90s (you had to be there!) we typically built what would now be seen as relatively simple models in constant prices/ volume and inflated all the numbers over the five years of a plan.

So in this week’s blog we are exploring this new environment of higher interest rate and inflation and how it is creating some interesting challenges. 

With that in mind hear are our 6 rules for operating in this new paradigm of addressing inflation in business models: 

  1. Be clear
    Firstly make it clear when you are accounting for inflation, with better labelling of market growth (which if taken from third party market reports will typical include inflation, i.e.: nominal prices) in slides, and revenue lines, costs lines in models. In the new paradigm you can no longer be silent. All work should come with a clear statement of intent e.g., “this model is expressed in nominal prices and therefore includes inflation”, or, “this plan is expressed in constant prices and therefore excludes inflation.”
  2. Be consistent
    If inflation is in the revenue line, it needs to be included in the cost lines. We have seen examples of plans using market growth (including inflation) in models to justify a revenue line that have not included a corresponding inflation in input costs. 
  3. Differentiate
    Different costs inflate at different rates – the pressure on wages vs property are not the same.  For coffee shops rents might be rising at 4%, while labour is increasing at 5.5%, and COGS inflation is increasing at 2%, creating a very different outlook vs a flat 3% inflation in the model. And these numbers soon add up.  For example, businesses with high marketing costs (e.g.: price comparison sites), advertising cost inflation at 5.5 is 31% over 5 years, likely higher than inflation in the like for like revenue line.
    Inflation rates also vary across countries. For example, 7% Mexico (40% in a 5 year bridge) vs 3% in U.K., so a model that included Mexico and U.K. will have to include differential inflation as well a currency assumption.
  4. Discriminate
    Price increases are not the same as inflation.  It can help to separate the two, showing inflation and "price increase above inflation" (if you can sustain these) as separate buckets in a “bridge” or waterfall slide. It is noteworthy that 3% pa inflation 2017 to 2022 is 16% in a “bridge”.
  5. Calculate correctly 
    If you are trying to calculate Return on Investment, it is important to ensure you have appropriately reflected the way in which any model has used nominal or constant prices. For example, a Weight-Average Cost of Capital inherently does not have inflation stripped out, so if used to deflate future profit streams, those profits have to be expressed in nominal (i.e.: including inflation) values. The same is true of all cash return calculations and cash flow.  And this is something that needs to be done backwards as well as forwards - with the advantage that historical inflation rates are at least something you don’t have to guess.
  6. Raise awareness 
    Overall, the most important recommendation is that those using or building models, reading "bridge" slides, or making decisions based on them, will need to be increasingly aware of the issue. Ask the question and make sure that it is a deliberate decisions to include or exclude inflation, insist that all charts and models are properly labelled in nominal/ real values. Where material, they can take the next step, and consider taking account of differential inflation in costs lines for labour, rent etc increasing faster. 
    The difference between using 3% inflation and 7% inflation is 24 percentage points over 5 years, it is important to not only make sure that you are using consistent, accurate figures but to use the figures that are relevant to your business in terms of revenues and costs. 

David Sinclair, Partner

James Walker, Partner and Global Head of Analytics

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