Inflation is on the rise. While economists debate whether the current situation will be temporary or long lasting, manufacturing companies can’t afford to be caught off guard. High inflation can dramatically reduce profits and harm your business. In times like these, preparation is the name of the game.
Let’s start by looking at current signs of inflation. Then we’ll discuss what you can do to minimize the negative impact of inflation on your business.
Current signs of inflation
According to minutes from the Federal Reserve’s April 2021 meeting, the Fed expects inflation to remain slightly above 2% this year before returning to its long-run target of 2% by 2023. But other economists say the inflation rate could go much higher and be longer lasting than the Fed predicts.
With prices for things like lumber, steel, copper, chemicals, semiconductors and other commodities rising, many manufacturers are already dealing with inflated prices for raw materials. This often necessitates passing increased prices on to customers, but with companies and consumers alike bearing the brunt of inflation, the ability to pass price increases on to customers may be limited.
So, what can manufacturing companies do to protect their businesses from a rise in inflation?
Here are two actions you can take.
Evaluate adopting the LIFO inventory valuation method
Using the last-in, first-out (LIFO) method of accounting for inventory has positive results in an inflationary environment because it allows you to deduct a higher cost of goods sold (COGS) by using inflated current costs rather than lower historical costs. This lowers taxable income and the corresponding tax liability, which can help preserve cash flow.
If inflation continues for several years, the benefits of using the LIFO inventory valuation method increase each year—as long as year-end inventory doesn’t decline. However, it’s important to note that the tax savings created by adopting LIFO during a period of inflation represents a deferral of income. When inflation goes away and product prices decline, that deferred income will be recognized, and the related taxes paid.
Fortunately, you don’t have to decide now. You can wait until after the end of your company’s tax year to determine whether LIFO will benefit your company. Just keep in mind that you must use the LIFO method for financial reporting purposes in the first year of the election for the election to be valid.
Reevaluate standard costs and overhead rates
Standard costs and overhead rates are normally calculated on an annual basis to predict costs of production. However, if your manufacturing company is experiencing higher prices now, don’t wait for year end to adjust your standard costs. Changing your standard costs and overhead rates to reflect the current inflationary impact will help you avoid a large year-end adjustment and better reflect the current cost environment.
Another side benefit is that it may lower your taxable income in 2022 when a higher tax rate is anticipated. This is achieved by raising your inventory value in 2021, which will be your 2022 cost of goods sold.
Consider borrowing or restructuring existing debt
In inflationary times, the dollar’s purchasing power erodes quickly, and lenders typically insist on higher interest rates to offset that erosion.
Interest rates are still very low by historical standards. So, if you’ve been considering a loan for capital that will result in reduced costs or increased revenues, now is the time before interest rates start to rise. Insist on a fixed-rate loan instead of an adjustable-rate loan so your cost of borrowing will remain constant regardless of economic conditions.
Some potential good uses of loan proceeds in the face of inflation include real estate and machinery, bulk-discount inventory, or acquiring competitors or suppliers.
You may also want to consider converting term loans or other debt with an adjustable or variable rate to a fixed rate while interest rates are still low. This will help cut down on debt service payments and improve monthly cash flow.
Learn more about how manufacturing companies should respond to inflation
These recommendations may not make sense in every situation, and there are additional administrative costs to file for a change in accounting method to adopt LIFO. For that reason, it’s important to make an informed decision with an actual cost vs. benefit analysis so you can begin creating your action plan for dealing with inflation.
If you have any questions about capital planning, a change in inventory valuation methods, or any other tax issues, please reach out to your Warren Averett advisor, or have a member of our team reach out to you.