I need some help this month, I have a new theory, I won’t keep you reading for long, but feel free to correct me if I am wrong.
Inflation is the bain of our current economic life, I struggle to resist the constant urge to up prices. In a world where everything seems to be going up all the time, what are we supposed to do? Do we actually know how often a bar of chocolate or the price of rice goes up? Do they stick to a rigid once-yearly 5% increase?
The reason for this post this month is firstly the cost of some areas of our hosting has gone up 100% i.e. doubled… That was a shocker… and no those prices went up last year as well.
This month it’s Telecom giants, mobile and broadband, and all the main companies are putting up their prices mid-contract by 3% plus September inflation rate (8.9%). So even though inflation is currently closer to 4%, British Telecom and EE are upping prices by closer to 12% and mid-contract so normal people cannot leave. That somehow does not seem right. Read up on Martin Lewes‘ calling out of these crazy increases.
My Theory
Let me get this straight. If I sell a widget for £100 and inflation is 5%… and assume I will make a profit on every widget I sell… for the sack of simplicity let’s assume I make £10 per widget in profit.
This means it costs me £90 to bring a £100 product to market, which includes ALL costs, staff, marketing, production, storage, wrapping, delivery – you name it. I am making £10 profit per widget I sell.
Now, 1 year later, inflation is running at 5%… my prices for my widget have gone up by inflation to £105. And because I am one of the good guys I have increased my wages to staff by 5%, in fact, I increase all my costs to bring the same widget to market by 5%.
I appreciate this may not be a real-world example, but it is the principle that counts.
My widget – now costs £105. But my costs were £90 – bit with 5% added on – this equates to £94.50. but hey look at that… my profit margin is now £10.50.
It is simple maths, if I can balance everything then if Inflation goes up 5% you can expect my profits to go up 5%. That has to be a mathematical fixture.
The Crunch
So now I hear you saying, life is not like that. There are far too many ifs and buts and in the real world, my profits won’t increase at the same rate as inflation. But that’s not true either. And here is why.
Let’s assume you kept your profit at the same level, i.e. you made £10 per widget sold. Now your costs may go up 5% to £94.50 instead of £90… but your retail price can only go up to £104.50 (£10 profit). But you are no longer putting your prices up 5%. You’re no longer in line with inflation.
The truth is if you keep your profit the same – prices will come down and deflation will occur. It has to it’s mathematical. Worse than that, your prices will eventually continue going down all the way to zero. There will be a permanent imbalance between the costs of the product and what you can sell it for.
This is true if you decide to either keep your profit the same or less. I.e. if you try to maintain a £10 profit at all times, you will enter deflation and prices will go down.
This means in practice, literally, you have to increase your profits or die. So your profit will grow. Where this quite gets us all is anyone’s guess, certainly, our governments will benefit, more profit more tax.
The other thing that happens in real life is that we compete for profits, but the metrics above we have to, if you’re not the rise to increase prices you will be the loser, it’s again a mathematical certainty. To succeed you have to put your prices up more than anyone else and before anyone else.
This I suspect is what our big Telecom giants can see. if they don’t take our money mid-contract someone else will. The force of competition is too great and the downward spiral is a bigger risk to these companies than losing a few pissed-off customers.
More Profits
My next mathematical take on inflation-busting pricing is supplier increases. If you have a supplier of widgets and they up their prices at inflations 5% standard rate… In turn, you will probably up your prices by the same amount. 5% – makes sense why wouldn’t you?
Please bear with me, the world is not made up of Harvard Geniuses – most small business owners are just trying to get by and may well not have had a golden education. In fact, they just get on with things. But accounting is often not their strong point… nor is maths. So this is what happens.
My supplier sells me a service for £20 – then ups it to £21… But I just this service to sell other services to my customers… an example, an accountant using software, or indeed a website designer managing servers.
If I sell 20 line items based on my suppliers’ original service for £10 each… but then up my prices 5%, I’ll sell all 20 line items for £10.50… my net total will have gone from £200 to £210. Whereas the cost of sale went up £1… my revenue has gone up £10.
I want to explain that with more exaggerated figures to illustrate the point. If you buy a paintbrush for £5 today, you can do 30 paint jobs with it… But after inflation that same paintbrush costs £6… but all your 30 paint jobs have increased in price by the same amount… you’ll make a heck of a lot more money.
Inflation does this, we see it all the time, it eats into debt and it spirals out of control. The huge winners are nearly always the people at the top,
Conclusion
At this point, I need to suggest that this is our problem… Much of what we do allows us to piggyback of others… If I pay for Broadband the price increases by 14% (i.e. 3% plus Inflation), then that’s what I feel I need to increase my prices by. It won’t quite happen like that, because it’s only an extra £5 a month, but I still have to make up that £5 each month, I am unlikely to spread that evenly across all our customers because that would be around £0.12 per month. Instead, I am much more likely to increase by a far higher amount. But not at 14%.
Another thought is that each year we increase by 5%, if that were the case, this would mean every year increasing by ever larger amounts. It does not make mathematical sense. £10.50, £11.03, £11.57, the gap gets wider and wider. That’s why we can look back even 20 years and remember Mars bars at 15p… because the increases each year have grown. Just Maths.
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