Replacement costs and their limitations during rapid inflation

Consequent to the global inflation challenges, which have seen many economies battling with rapid or galloping inflation, it is imperative to take another closer look at the concept of replacement costs as one of the many alternatives deployed by sellers to edge against those associated with the phenomenon.

First, what are replacement costs, and how do suppliers of goods and sometimes services use them?

In its elementary description, replacement cost is a costing system that fixes pricing based on the current price of inputs in the market plus the usual margin or markup, as the case may be.

The primary justification for this process is that the current selling price should enable sellers to conveniently replace the sold items with similar products without incurring any form of loss. It means that the prices being charged today are not lower than the costs of inputs plus margin/markup for replenishment of the sold products.

Let us also remind ourselves that engaging in business activities aims to make some gains by exchanging products and services. So, if the current prices cannot conveniently replace the items sold, the logical explanation will be that the profit made based on previous costing has been eroded.

To avoid the erosion of profits, especially where there is rapid instability in the price of inputs, the sellers have no choice but to think about replacement costs. That is, the amount it will cost to replace the inventory of products.

Ordinarily, replacement costs should not be anything complicated or unusual. However, in reality, it has become so.

There are, therefore, some challenges if the rate of increases in inputs continues unabated. Some of the consequences of such incidences are:

Pricing may become unstable and even unreliable. The sellers may have some difficulties tracking the changes so much that tracking effectively becomes even more challenging, resulting in some form of unjustifiable arbitrariness in fixing prices.

Products may become unaffordable. It may get to a point where products may become unaffordable. Except where the sellers deal in essential products, they are monopolists, and there are no viable alternatives, products may become outpriced.

Patronage may be halted. Similar to the above, consequential low patronage may exist even if the products are essential without viable alternatives. In this instance, some customers may, despite the outpricing, continue to buy. Even such may not be guaranteed for a long time if nothing changes.

Possible closure or bankruptcy. If the situation continues unabated, the numbers two and three issues above can lead to the abrupt closing down of such businesses and may eventually lead to bankruptcy. It can become more complicated if the business is indebted to lenders, which may become difficult to pay back due to pressure on cash flows beyond the ordinary course.

Stockpile of unsold inventory. There is a high possibility of unsold inventory or stockpiling when outpricing and low patronage exist. The consequence is that products may be susceptible to damage, obsolescence, theft, and other similar things that sum up to a total loss of revenues.

Given some factors above, are there feasible solutions that may make sellers stay afloat and continue to be in business in a time like this?
Yes, there are some things we may try our hands on to at least keep the head above the waters. Some of those things we think we can do are explained below.

We should have some market intelligence. Understanding the market, especially its levels of volatility and resilience may help sellers position themselves well. Part of that knowledge is understanding the elasticity of demand for the products and the purchasing power erosion of regular customers.

Avoidance of bulk purchases. Whereas bulk purchases help reduce average input costs in regular times, such may become a burden during rapid inflation. In the short term, bulk purchases may make the sellers take advantage of higher margins, primarily if the bulk of the inputs were sourced at old, cheaper prices. In the long run, it may lead people away as the pricing becomes more affordable. This may pressure the sellers on how to dispose of ‘excessive’ inventory available to them.

Option for a lower margin/markup. Consequent to number two above, the viable option may be to narrow down the margin/markup of the products. This may enhance reasonable patronage and quicker disposal of inventory. While this may not be too attractive to any seller that has the ‘shylock’ mindset, those who have an understanding of the marginal benefit concept will readily embrace it. The marginal benefit concept thinks more about gaining little as against the alternative of losing all.

Just In Time (JIT) stocking system. Where the supply chain is effective in terms of logistics and communications, the sellers who make use of JIT may not be easily thrown off balance. Even at that, combining this with the number three above may be a better way to stay afloat from the pricing headaches of rapid inflations. Another advantage of this option is that if there is a sudden sharp drop in input prices, the sellers may not need to panic to sell off ‘huge’ inventory with higher input prices.

All in all, all sellers must note that deploying replacement costs will not always work in their favor. Replacement costs cannot be endless without any negative consequences. While it is reasonable to cover costs and make decent profits to remain in business, there are times to look at other complications that may not seem obvious and devise means to mitigate them. No business is risk-free. It is the understanding of the risks associated with the overall economy that helps businesses prepare for its mitigations.

Therefore, some of the issues discussed above can help discerning business persons make more informed decisions. Replacement costs are helpful during inflation, but they also have limitations.

Oluwadele, Ph.D., is a Chartered Accountant, author, and Public Policy Scholar based in Canada. He can be reached via: [email protected]