The word "inflation" sends shivers down the spine of most business owners.
However, the word "deflation" should be just as alarming. Why? Because like inflation, a period of deflation can have a dramatic impact on companies that haven't adequately prepared for an economic environment that features rapidly fluctuating prices.
Deflation is an economic term that describes a period characterized by declining prices. Consumers tend to welcome deflationary times – until they realize that the backend of deflation limits the ability to grow personal income through pay raises and increased profit margins.
Businesses, on the other hand, recognize the inherent dangers of deflationary economics. Although the amount of money they spend on supplies and raw materials goes down, the prices they can charge for their products may also decrease. In some cases, business may even find themselves forced to pay higher prices for raw materials while the price of their products falls in the marketplace.
The Deflation Dilemma
There are a lot of reasons why deflation is a negative economic scenario. During deflationary periods, people expect prices to decrease. That expectation causes them to spend and borrow less money now, creating a stagnant economy. People with existing debts find themselves in a difficult position because today's dollars have more buying power than the dollars they borrowed. In other words, they are forced to repay their debts with dollars that are worth more than they were when they borrowed them, and will reduce their spending as a consequence. Lower prices translate into lower wages. For the average household, spending really isn't an attractive option during deflation.
Strategies for Business Owners
- Plan for multiple scenarios. Scenario planning is the best business defense against deflation. A typical scenario might see across the board price decreases and belt-tightening. If you've planned ahead, you will be prepared to deal with the possibility of supply cost increases while the prices you charge for your products is forced down.
- Avoid long-term vendor contracts. If you believe that deflation is likely to occur, avoid locking yourself into long-term contracts with suppliers and vendors. Instead, let the market dictate the cost of supplies and buy short-term. Conversely, you'll want to lock your customers into long-term contracts as soon as possible.
- Consider buying capital. If you've planned ahead, deflationary periods can be ideal times to purchase capital, especially when equipment prices drop at a rate that is equal to or greater than the average rate of deflation.