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  • Juanita Schwartzkopf

Can Businesses Stop Worrying About Inflation Now?

Last week the July CPI and PPI were published and showed a decrease in the year over year inflation rate. The June CPI was 9.1% with the July CPI moving to 8.5%. The PPI was 9.8% in July after reaching 11.3% in June. A deeper analysis into the components of the CPI and PPI is necessary to better assist readers of financial statements in producing more accurate performance risk analysis for the remainder of 2022 and into 2023.

A big driver of the July PPI reduction was the reduction in energy inflation from 53.8% in June to 36.8% in July. The transportation and warehousing category also decreased but to a lesser extent, with a change from 22.9% in June to 20.3% in July. The energy and transportation and warehousing categories benefitted from reductions in the per gallon cost of fuel. The June inflation results in the PPI and CPI were impacted by peak per gallon fuel costs in mid-June. Unleaded gasoline has reduced from its June 14, 2022 peak of $5.016 and the per gallon cost of diesel has reduced from its June 19, 2022 peak of $5.816. As of August 15, 2022 those prices were $3.956 and $5.033 per gallon.

From the perspective of the CPI, energy also was a contributor to the overall reduction in the inflation index with energy posting a decrease from 41.6% in June to 32.9% in July. It should be noted that while gasoline inflation rates decreased, electricity inflation increased from 13.7% in June to 15.2% in July. Food inflation has increased from 10.4% in June to 10.9% in July.

The largest contributor to the June to July reduction in the inflation rate was the reduction in the cost of fuel. The cost per gallon for fuel varies significantly by state, with the regular unleaded prices in California at $5.366 while the cost in Texas was $3.456.

The state-by-state labor market is as varied as the state-by-state fuel costs. The unemployment rate by state ranges from 2.0% or less in Minnesota, Nebraska, and Utah, to 4.0% or more in Alaska, California, Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maryland, Michigan, Nevada, New Mexico, New York, Pennsylvania, and Texas.

Energy cost increases are varying widely by state. The year over year electricity rate increases by AES Ohio were 131%, at AEC Texas the increase was 76%, XCEL Colorado increased by 37%, and FP&L Florida increased rates by 19%. Looking at rate increases within a state can also be telling. In Pennsylvania West Penn Power increased rates 44.6%, PENELEC increased rates 35.4%, PP&L increased rates 26% and PECO increased rates 11%. A large contributor to electric rate increases is the cost of natural gas, as that is the source of the majority of US electricity. Natural gas has increased from $3.30 per MMBTU on August 16, 2021 to $9.00 per MMPTU on August 16, 2022. Rate increases for should be expected to continue as regulatory authorities are agreeing to rate increases to cover costs. Increased costs of natural gas should also be considered for the winter heating season.

This next graphic is provided by the US Energy Information Administration and shows the range of electrical costs per kwh. While the US average retail price in May 2022 was $12.09, by state the averages range from $3.78 to $39.61.

Depending on the state a business is operating in, the cost structure may be significantly different. Specifically review labor, energy, and transportation on a state-by-state basis.

To Evaluate Performance Risk Today

A short list of areas to consider when evaluating performance risk as related to the ongoing inflation pressures is provided next. To best prepare this analysis, 2019, 2020, 2021 and 2022 year to date performance will need to be laid side by side to determine which income statement categories are at most risk of additional impacts from inflation.

Costs to evaluate are:

  • Year over year labor costs. There is continuing upward pressure on labor rates.

    • Consider both FTE levels and cost per FTE.

    • Evaluate bonuses and commissions also.

  • Energy costs.

    • Fuel versus electricity. Impact on financial performance of both changing fuel costs and changing power costs needs to be considered. Look at opportunities for hedging or locking in power costs in high usage companies.

    • Consider the heating season as summer draws to a close. Make sure forecasts and cash flows are considering the impact of rising natural gas and electric costs.

  • Food costs.

    • Consider the reliance on commodity products and evaluate hedging positions.

    • Consider the input and output costs related to food specifically in food processing companies.

  • Fuel costs.

    • Consider direct fuel usage.

    • Evaluate where transportation costs are included in the income statement expense items and consider if those cost increases are at inflationary levels or there will be additional upward pressure on certain expense line items.

  • Interest expense.

    • Consider variable rate increases.

    • Consider fixed rate resets.

The key is to analyze the year over year changes in expense structure for each income statement line item. Look for expense items that are at the most risk from changes in labor, fuel, energy, and food costs. Specifically evaluate the impact of changing interest rates.

If line items have not increased at the overall rate of inflation for that category, evaluate whether that will continue, or cost increases should be expected.

It is important to evaluate specific line items as well as the overall cost structure of the business to identify performance risk for a particular company. Consider the impact of the state or states the business is operating in. For example, fuel and energy costs are higher in California which means using the overall US inflation rate for a company in California may understate the additional inflationary pressures.

It is also important to continue to evaluate the potential for waves of increased costs. For example, with fruit and vegetable prices increasing 9.3%, but labor costs and transportation costs increasing more than 9.3%, will fruit and vegetable prices need to further increase to account for labor and transportation increases? Will items increasing at lower rates than the overall inflation rate continue to rise to meet the increased costs, which will further increase prices measured by the CPI and PPI.

This is the time to emphasize deep dive analysis to determine future performance risk.

Q2 results have been delivered to lenders and investors. Challenging management to complete this type of analysis will improve future financial performance and increase the likelihood of continued success.

Contact FMG to discuss tools and ideas for completing this type of financial performance risk analysis.


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