Meeting the Challenge of Inflation
FIRST SEEN IN FUEL OIL NEWS | We have all seen the cost of doing business increase. Wages, especially driver wages, vehicles, propane tanks, service parts, vehicle fuel, and many other operating expenses have had substantial increases. The Consumer Price Index rose 9.2 percent from April 2021 to April 2022, the largest 12-month increase since the period ending June 1982. Energy prices rose 33.3 percent over the last year, and food prices increased 6.3 percent.
Knowing how this affects your business is a key to keeping your company in good financial health. Our company provides M&A advisory services and performs business valuations. Forecasting financial performance for our clients is at the heart of what we do. In the past we have used an inflation rate of 1.5%-2% on most operating expenses and 5% on health insurance and recently on driver wages. This has helped our clients manage their business by identifying how much they need to increase margins or cut expenses to continue to be profitable.
The chart below is an example how inflation is projected to affect operating expenses. We kept the analysis very simple and we encourage you to work with your accounting and financial staff and advisors to plan strategies more specifically for your business.
Keep in mind that some expenses are related to revenue, such as bad debt, credit card processing fees and vehicle fuel. These are related to the cost of energy regardless if your vehicles run on diesel, gasoline, or propane. Energy and food are excluded from general inflation statistics due to their volatile nature. Since they are a significant part of our business, we need to account for the increases separately.
You should also note that in addition to payroll costs increasing, related items such as payroll tax, unemployment, retirement contributions and workers’ compensation insurance will also typically increase.
In our analysis we only used gallons to determine margin to keep it simple. There are many other revenue streams contributing to bottom line profit. A more detailed analysis can reveal a better understanding of your specific business and help determine the course of action which is right for your company.
We kept operating income the same to see how much gross profit was needed to offset increased operating expense. We also define gross profit as revenue minus cost of fuel or parts.
Also not addressed in the chart is the increase in cost of vehicles and propane tanks, which are both in short supply. We typically value businesses based on a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Another common valuation method is Free Cash Flow (FCF), AKA: Distributable Cash Flow (DCF). Basically, DCF is EBITDA minus capital expenditures. An owner needs to continually invest in capital assets to keep a business running.
In the above example, if $200,000 per year was spent on capital expenditures, and now the same trucks, tanks and other improvements have increased by 40%, then the company will need to generate an additional $80,000 per year in profit for an owner to take the same distribution. That equates to an additional $0.026 per gallon to pay the increased capital costs.
Marketers have always competed in business their whole lives and these challenging times are not new, just different. Increasing margins when prices are rising is uncomfortable for most marketers. This past February, I made the suggestion to a client to raise margins substantially ($.12-$.15) for a month and have all his people track complaints. He called me yesterday and let me know that of his 3,000 customers, of which 50%-60% took a delivery in that month, he did not have one price complaint. The value you provide to your customers is likely worth more than you think.
Managing Director, Cetane Associates LLC
First published in Fuel Oil News, July/August 2022 issue