Inflation and the P&L: When Nominal Growth Hides a Real Decline

Inflation flatters a P&L. Revenue grows every year, records are broken, bonuses are paid on growth targets, and the business can be shrinking the whole time. In an economy with 2% inflation the difference between nominal and real growth is a rounding error. At 10% or 20% a year it is the difference between a company that is expanding and one that is quietly losing customers, volume and purchasing power.

Five years that look like growth

Consider a company in an economy where inflation runs at 8%, 15%, 20%, 12% and 9% over five years. It raises prices every year, a little below inflation to protect volume. Its reported revenue grows 63%. Management presents it as a strong performance.

Deflated by consumer prices, the same revenue has fallen 10%. Volume is down 2%, and the real price, what the product buys in the rest of the economy, is down 8%. Every nominal record was in fact a step backwards. And the P&L hides a second problem: if wages, energy and imported inputs rose faster than the company's prices, the margin has been eroded too.

Where inflation hurts the business

• The price-cost gap. Costs reprice continuously; prices reprice at list changes and contract renewals. The lag between the two is a permanent margin loss while inflation lasts.
• Phantom profits. Inventory and fixed assets carried at historical cost understate the cost of goods sold and depreciation. Reported profit includes gains that must be spent just to replace the same stock and equipment.
• Working capital. Receivables lose value every day they are outstanding, and the same physical inventory needs more money every year.
• Taxes on nominal gains. Taxes are paid on profits that are partly inflation, which raises the real tax rate.

When inflation becomes extreme, accounting standards step in. IAS 29 requires companies reporting in the currency of a hyperinflationary economy, usually one whose cumulative inflation over three years approaches or exceeds 100%, to restate their financial statements in current purchasing power. By then, management should have been doing it internally for years.

Managing in real terms

1. Report growth in volume and in constant money next to nominal figures, in every management report. A revenue bridge split into price, volume and mix shows immediately how much of the growth is inflation.
2. Set targets in real terms. A bonus paid on nominal revenue growth rewards inflation, not performance.
3. Shorten the pricing cycle. More frequent, smaller price changes, indexation clauses in contracts and authority to reprice quickly reduce the price-cost gap.
4. Track the margin at replacement cost. Value inventory and depreciation at current cost in management accounts to see the margin that can actually be sustained.
5. Treat working capital as a priority. Collect faster, pay in line with terms, hold less stock: every day of working capital is worth more when money loses value quickly.