How to Price Products to Account for Inflation

In this article, you’ll learn all about pricing products to account for inflation, including:

• Why expense projections are the first step
• How to add value to your products and grow margins
• How to increase prices to account for inflation

In April 2021, the consumer price index (CPI) – perhaps the most popular measure of the inflation rate – increased by 4.2% year-over-year (yoy), marking the highest increase since 2008.

The rate of inflation continued climbing into the summer of 2021, but Federal Reserve officials believed high inflation would be short-lived. There was good reason for this belief, as pent-up demand, supply chain lags, and the previous year’s weak levels were pushing the inflation rate higher… but things were expected to normalize in 2022.

It didn’t turn out like that.

The inflation rate has continued moving higher and higher between April 2021 and May 2022; the CPI increased 8.6% year-over-year (yoy) in May 2022, the biggest jump since December 1981.

The Federal Reserve is aggressively raising interest rates to fight inflation, but it’s unclear when the inflation rate is going to head back towards Fed policymakers’ 2% inflation target.

So, as a small business owner, you have to price your products to account for inflation.

Your expenses have a big impact on those decisions.

Create Expenses Projections

In a low-inflation environment, you may be able to get away with pricing your products based on your previous year’s expenses. This strategy wouldn’t be ideal, but if price inflation is between 1-3% yoy, you may not face any serious issues.

The above strategy is not a viable option in 2022, however. The headline inflation rate is approaching 10%, which is already very high – and that’s the weighted average. For some small business owners, overall expenses have increased by 15-20% vs. a year ago.

In any case, you have to do expense projections for the next year. You should consider the following:

• How much do you have to increase salaries to retain employees?
• Are there going to be cost increases in raw materials?
• Do you have a lease on your office space that takes you through the next year? Or do you need to negotiate a new lease? If it’s the latter, how much do you expect to pay on your next contract?
• Are your other costs going to move higher?

You have to not only consider the percentage increases, but also the dollar increases. Let’s look at an example:

• Your raw materials and rent are expected to increase by 5% a piece. They combine to make up 20% of your expenses.
• Your labor costs account for 60% of your expenses, and you expect to increase salaries by 15% across the board.
• Your other operational costs and general costs account for 20% of your expenses, and you expect them to move 10% higher.

In this example, your expenses increase by 12% overall, even though all of your expenses besides labor increase by 10% or less, as the 60% weighting of labor heavily impacts your small business.

It’s a good idea to consider projected expenses by product, as well. For example, the raw materials for one product may increase by 10% and the raw materials for another may increase by 20%. Or you may need specialists to create certain products… and that specialist labor may increase by more or less than your overall labor costs.

If this all sounds a little too complicated or time-consuming, you might want to get help from a Certified Public Accountant (CPA) to reach accurate expense projections – they can help your small business beyond tax season.

Maximize Value

So, you determined your expenses are going to increase a lot over the previous year. You could just say to your customers, “Hey, prices are increasing by 10% across the board. Have a nice day.” This could work out for your small business, but there’s a decent chance a lot of customers are going to be dissatisfied and consider other options.

Ideally, you would increase the value provided by your product at the same time as prices rise.

You may be thinking: it costs money to add value, and prices are going to be increased to simply maintain margins.

That’s valid feedback, but it’s possible to add value for a low price and increase prices by a little more to account for the rising costs. The key is figuring out what is valued by your customers.

For example, you sell a product for $50 that cost $30 to produce last year. You expect the product to cost $33 over the next year if you keep it the same, and you want to maintain your 40% margins. You identify an improvement that would cost $3 more for each unit sold, and research indicates your customers would happily pay $60 for each unit after making the improvement. The $60 product would cost $36 a piece, and you would maintain your 40% margins.

The improvement combined with the potential messaging is much better in the above situation. You could say, “We are raising prices to offer you a better product,” and your customers are unlikely to know or care that they are paying $10 more for something that cost $3 for your small business.

You may or may not be able to pull this off – it depends on your small business. But it’s worth considering, as it has a good chance of success when done right.

How to Determine Prices in Any Situation

While maximizing value and communicating that value is an excellent strategy for raising prices, it’s not applicable in every situation. Here are some questions to ask that can guide the pricing of any product for any small business owner:

Can your customers afford higher prices?

Are your customers living paycheck-to-paycheck, possibly unable to afford your product if you increase prices at all? Or do they have the ability to pay higher prices?

You don’t want to sacrifice margins, but you may not have a choice if your customers are very price-sensitive. In this case, the better of the two bad options could be to maintain the same prices.

It’s important to not only consider the price of your product, but also the price paid by your customers. For many small business owners, these two numbers are very similar. But if a large number of your customers finance their purchases – perhaps with a term loan – they could already be paying higher prices due to rising interest rates.

Do you have a diverse customer base?

You may have certain products that appeal to value-oriented consumers… and others that attract people with a lot of discretionary income. With this in mind, your pricing decisions may need to be different for each product. You might get a lot of pushback if you raise prices on your value items by a small amount, but it’s possible you won’t notice any dip in sales if you push prices on your luxury items a lot higher.

It’s important to know your customers, as you don’t want to be forced to revert back to old prices.

What are your competitors doing?

You could have an amazing product that enriches the lives of your customers, but if you have competitors that offer a similar product at a slightly lower price, your small business may see declining sales.

So, it’s important to look at the pricing actions of your competitors. Are they raising prices? How much are they raising prices? Are they improving their product to justify higher prices?

The answers to the above questions should heavily impact your pricing strategy.

How to Execute Price Increases in Times of Inflation

As touched on earlier, there’s a right and a wrong way to increase the prices of your products. You don’t want to increase prices – effective immediately – with no improved value proposition and no explanation.

Here’s how to execute price changes in an inflationary environment:

Give Advanced Notice

It’s not possible to give advanced notice in every situation, but in many cases, small business owners know they are raising prices ahead of time. Let’s say you plan to raise prices in three months. If you inform customers right away, they have time to process and adapt to the new pricing and may have a better reaction.

Contact Customers Directly

As with advanced notice, you may or may not be able to directly contact customers ahead of a change in prices. But if you sell big-ticket products and have a small customer base, you may want to consider this option. A phone call or an email is an opportunity to let a customer know that they matter to your business and directly address any questions or concerns.

Be Transparent

Again, you don’t want to inform customers of higher prices with no explanation. It’s better to tell them why prices are moving higher and be completely honest. In our inflationary environment, there’s a high chance that you are raising prices because of your costs. Your customers likely know a lot about inflation, and if you tell them what’s happening, they are more likely to understand and stay with your small business.

Be Careful with Promises

As we’ve seen, economists don’t know exactly when the inflation rate is going to come back to healthy levels. With that in mind, you shouldn’t promise customers that price increases are going to be a one-time thing, as it’s possible the inflation rate is going to remain elevated in 2023 – potentially forcing you to increase prices again.

The Bottom Line

As a small business owner, it’s important to control what you can control. The inflation rate is currently very high by historical standards, and there’s no way of knowing when it’s going to return to healthy levels, but there are actions you can take to mitigate the effects on your small business.

The right actions vary depending on your small business, but by asking yourself a few questions, you can figure out the best way forward.

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