With the global economy being more connected than ever before, economic conditions in different parts of the world can have an effect on businesses everywhere. Just like the effects of inflation, deflation in businesses and the economy is one of the conditions that pose a threat to companies and to the market as a whole. In this article, we’ll share more about how businesses can prepare and even benefit from a situation where retail and wholesale prices fall. This blog post is part of our series on economic conditions where we share information on topics like high interest rates’ impact on business, what businesses flourish in recession, and managing inflation optimally.
What Is Deflation in Business and How It Affects Them
Deflation is the antonym of inflation. It is an economic state where prices of goods and services decrease over time. When the supply of money is fixed, deflation is the natural state of the economy. It’s caused by factors like technological progress, globalization, and falling business operating costs. However, as deflation might lead to recession and a deflationary spiral, governments and central banks try to mitigate it with various fiscal and monetary policies.
Let’s dive a little deeper into the main ways deflation in business affects companies and markets.
- Decrease in revenue. The impact of deflation in business is similar to the effects of economic stagnation. With the drop in prices, businesses experience a decline in revenue and profit. This is further escalated by the fact that spending slows down and consumers are less likely to buy products and services.
- Increasing debt. Companies that have borrowed money see the actual value of their debt increase.
- Employee concerns. As profits and revenue fall, businesses might try to freeze or even reduce wages in order to lower labor costs. That leads to dissatisfaction amongst employees.
- Credit tightening. One of the impacts of inflation on businesses is that banks and other lending institutions have a lot of liquidity and are more likely to lend money. The opposite is true during a period of deflation in businesses and the market.
- Uncertainty and investment delays. Businesses that have planned strategic growth of their operations are likely to freeze their plans. As uncertainty rises and the economy might head for a deflationary spiral, companies are less likely to invest in additional production facilities or assets.
Key takeaway: Deflation means a state of the economy where the prices of services and goods decrease. It’s often called negative inflation. During a period of deflation, the market is expected to be in a stationary state.
How Companies Can Prepare for Deflation in Business
Economic growth affects businesses positively, but the same cannot be said for deflation or stagnation. That’s why businesses need to be prepared for these scenarios. Let’s examine how.
Using professional business analytics tools, companies should have a good understanding of their cost structure and identify ways to optimize it. Some of the ways to do so include automation, investments in technology, and cutting non-essential expenses.
When the first signs of stagnation or deflation in businesses arise, they should aim to diversify various aspects. That includes introducing new products and services or adapting to market demands by exploring additional eCommerce options. Furthermore, companies need to find suppliers that can reliably deliver products and other goods in case their current suppliers stop their operations. That’s especially true for the restaurant industry and hospitality groups. Their services are very dependent on predictable deliveries of things like wholesale produce or wholesale dairy products.
Long-Term Contracts and Customer Loyalty
Ensuring customer loyalty means clients won’t easily opt for a competitor that has lowered their prices because of deflation in business and the market. Additionally, having long-term contracts with fixed prices can be very important in a market where prices drop.
Have a Financial Buffer
Having enough cash on hand can be the difference between just trying to survive during a period of stagnation or deflation and coming out as a winner after it. Companies with robust cash flow and capital will have different options like keeping their price levels or investing in marketing.
How Companies Can Benefit from Deflation
Reduced Cost of Operations
As raw materials, services, and energy prices fall, businesses can lower their production costs and increase their profit margins. The longer a company can benefit from stocking products at lower costs while keeping its prices intact, the higher profit it will register.
Better Climate for Borrowing
Borrowing can be done for projects related to automation, technology, or strategic acquisition of another business that’s struggling with the market reality.
As we mentioned strategic acquisitions, this is one of the major ways for businesses to benefit from falling prices. They can buy assets like real estate or other valuable assets that are expected to rise in price after the difficult period ends.
Increase of Wages
Even if companies freeze wages for their employees, they will see their purchasing power increase. In addition, businesses are afraid to make investments during stagnation or deflation. That means employees have fewer options on the job market and quitting becomes more costly.
Survival of the Fittest
Companies that are well-prepared will come out as winners after difficult periods. That’s why a business that has properly planned different scenarios and has made the necessary adjustments can expect to be among the winners at the end of the deflationary period.
Frequently Asked Questions about Deflation in Business
As falling prices can pose a big threat to companies, it’s expected for managers and C-level executives to want to know more about deflation in businesses. Below we have answered a few of the common questions regarding deflation.
What Should Businesses Invest in During Deflation?
As prices drop, businesses that have a lot of liquidity are in a much better position than those with limited cash on hand. These companies can benefit from their position and further reduce the cost of goods sold by investing in various things. Here are some potential investments to consider during a period of deflation in business.
- Marketing. As consumers and business owners are less keen on spending, companies should invest in marketing in order to create additional demand for their products and services;
- Operational efficiency. Investing in automation and streamlining business processes can reduce costs and improve productivity;
- Acquisitions. A lot of businesses might struggle during economic conditions like deflation or supply chain disruptions. That gives businesses that are in good shape the chance to buy out their competitors or diversify their portfolio by acquiring other businesses;
How do Central Banks and Governments Manage Deflation?
Central banks can fight deflation by lowering interest rates. That makes borrowing more attractive. Companies might decide to get more debt and invest it in acquiring manufacturing equipment or purchasing real estate for the needs of the company. Another way for central banks to tackle deflation is quantitative easing. It should be noted that these monetary policies should be executed with caution. Their role is to make spending and investments more attractive. If they are done on a larger scale than necessary, the economy might start to overheat and the result will be inflation which often has a negative impact on businesses as well.
How Does Deflation in Businesses Affect Consumers?
Deflation leads to less spending by consumers, especially on non-essentials. Businesses and households are likely to postpone purchases as they wait for prices to drop even more.