What is inflation?

February 2024 | Published by Xero

Inflation (definition)

Inflation is the rate of increase in prices over time. It is calculated based on the average price changes of selected goods and services.

Inflation results from the complex interplay between supply, demand, the money supply in the economy, and certain market-specific things like the level of competition within markets for certain goods and services.

Although some inflation is normal in a healthy economy, it can be challenging for small businesses if it grows too quickly.

What is the inflation rate?

The inflation rate is the percentage by which prices rise over a specific period.

Although inflation is generally reported as a single percentage figure that represents general cost inflation throughout the economy, inflation doesn’t necessarily occur consistently – energy prices may increase faster than food prices, for example.

Calculating the inflation rate

Here’s the basic equation for calculating the inflation rate of a good or service:

The inflation formula is new price minus old price, then divide by the old price and multiply by 100.

The Reserve Bank of Australia monitors and manages inflation, so you can usually find the official rate of inflation there.

Why inflation matters to small businesses

In some cases, inflation can benefit businesses because it increases the cash value of assets like property or inventory, and small business debts decrease in real terms because the value of money falls as inflation rises.

But inflation usually presents challenges to small businesses:

  • It may be difficult to pass rising costs along to consumers
  • Businesses that sell nonessential goods may face greater challenges because customers' spending power decreases with inflation, which may force them to prioritise essentials over discretionary purchases
  • Businesses that borrow money may eventually face higher interest bills because central banks often raise interest rates to combat inflation

How small businesses can deal with inflation

Small business owners can mitigate the effects of inflation:

  • Find ways to cut expenses, such as by switching to lower-cost suppliers, renegotiating leases or reducing elective spending
  • Monitor margins to understand when profitability is threatened, and adjust pricing as needed
  • Strategically increase prices, such as by offering loyal customers flexible payment terms to make price increases more acceptable
  • Manage cash flow; credit is typically more expensive during inflationary times, so do your best to maintain liquidity without taking on more debt and if you need to borrow, shop around for the best terms

See related terms

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This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.