What's the best way to incorporate inflation into your cost forecast model?

Inflation is a key factor that affects the value of money over time and impacts the costs and revenues of any business. However, incorporating inflation into your cost forecast model can be challenging, as you need to account for different inflation rates, scenarios, and assumptions. In this article, you will learn some best practices for dealing with inflation in your financial modeling, such as:

1 Use real and nominal values

One of the most important distinctions you need to make when forecasting costs is between real and nominal values. Real values are adjusted for inflation and represent the purchasing power of money in a given base year. Nominal values are not adjusted for inflation and represent the current market prices of goods and services. To convert between real and nominal values, you need to use an inflation index, such as the consumer price index (CPI) or the producer price index (PPI). For example, if the CPI in 2020 is 120 and the CPI in 2021 is 130, then the inflation rate is 8.33% and the nominal value in 2021 is 8.33% higher than the real value in 2020.

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Gonzalo belmar

ingeniería en administración de empresas y finanzas
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GDP deflator, specific benchmark, among other techniques. Additionally, emphasize the importance of promptness in decision-making (especially in unlikely events like the pandemic), so mental processes enabling quick and effective decision-making are necessary.

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Tanmay Gupta CA, CPA

Building FP&A at Tide
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We use real values over nominal values because they provide a clearer picture of the actual purchasing power or economic value of money and facilitate meaningful comparisions of economic data

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2 Choose an appropriate inflation rate

Another key decision you need to make when forecasting costs is what inflation rate to use. Depending on your industry, market, and project, you may need to use different inflation rates for different cost categories, such as labor, materials, energy, rent, and taxes. You can use historical data, market research, industry reports, or expert opinions to estimate the inflation rates for each cost category. Alternatively, you can use a general inflation rate, such as the CPI or the GDP deflator, to apply to all costs. However, this may not reflect the specific dynamics of your business and may introduce errors or biases in your forecast.

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Tanmay Gupta CA, CPA

Building FP&A at Tide
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The use of category wise weighted indices could be made in order to account for the relative importance of different goods and services in the economy. Weighted indices assign higher weights to items that are more commonly purchased by consumers or have greater economic significance. However, it is important to note that the inflation rate ascertained using price indices provides only a broad measure of price changes for a basket of goods and services. It does not capture sector/product-wise changes.

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3 Build scenarios and sensitivity analysis

One of the main challenges of incorporating inflation into your cost forecast model is the uncertainty and variability of future inflation rates. Inflation can change due to various factors, such as economic growth, monetary policy, supply shocks, demand shocks, and expectations. Therefore, it is advisable to build scenarios and sensitivity analysis to test how your forecast costs change under different inflation assumptions. For example, you can create a base case scenario with your most likely inflation rates, a best case scenario with lower inflation rates, and a worst case scenario with higher inflation rates. Then, you can compare the results and see how your costs vary across the scenarios. Similarly, you can use sensitivity analysis to see how your costs respond to changes in one or more inflation rates.

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Serge Radisic

Co-Founder & Managing Partner, Minerva.com.au | Co-Founder & CEO, Uptio.com | I modernise traditional FP&A functions and Siloed Data Environments with Digital Ecosystems that work!
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While scenario planning is valuable for managing inflation's uncertainty, it has limitations. AI/ML offers a powerful new perspective. By learning from vast amounts of data, AI/ML models can generate more dynamic inflation forecasts, capture the interconnectedness of inflation drivers, and reduce scenario-building time.

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Tanmay Gupta CA, CPA

Building FP&A at Tide
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Rollover effects of key economic indicators, monetary policies consumer behaviour and long term trends should be accounted for while stress testing scenarios for inflation

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4 Update your model regularly

Finally, one of the best practices for incorporating inflation into your cost forecast model is to update your model regularly with the latest data and information. Inflation is a dynamic and complex phenomenon that can evolve rapidly and unexpectedly. Therefore, you need to monitor the inflation trends and indicators closely and adjust your model accordingly. By updating your model regularly, you can ensure that your forecast costs are realistic, accurate, and relevant for your business decisions.

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Johnny Castro " El Dinero Nunca Duerme " .

Gestor de Inversiones y Patrimonio ! y Asesor en Crecimiento de Riqueza personal en Puesto de Bolsa Transcomer.
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Aprovechar que los bancos centrales, y otras instituciones, nos dan expectativas de inflación y de tipo de cambio a 6 y 12 meses plazo Estas como cambian cada mes, nos dan oportunidades de revisar conforme a nuestra demanda actual, con la cual proyectamos nuestra producción y abastecimiento de inventario

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Tanmay Gupta CA, CPA

Building FP&A at Tide
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It is highly advisable to monitor inflation data on a real time basis as to be proactive w.r.t to unexpected changes. The model should also account for long term trends on a timely basis

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Gonzalo belmar

ingeniería en administración de empresas y finanzas
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A clear example of how inflation can destroy forecasts and models is what happened in Argentina, where inflation made it impossible to operate, destroying companies every week. That is why companies must voice their concerns and participate in unions that promote economic security.

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What's the best way to incorporate inflation into your cost forecast model?

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1 Use real and nominal values

2 Choose an appropriate inflation rate

3 Build scenarios and sensitivity analysis

4 Update your model regularly

5 Here’s what else to consider

Corporate Finance

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