How Inflation Reaches Company Margins, and by How Much

Inflation reaches a margin along two routes: what a company pays for what it buys, and what the company can charge for what it sells. The two routes do not arrive together, because suppliers reprice on their own schedule and selling prices move only as far as buyers allow. The margin is squeezed in the gap between the two.

Inflation itself, how a shopping list of prices becomes one published figure, and what sits inside that list, are settled where inflation and prices are covered. How far a cost increase travels before it becomes a shelf price is settled there as well. Margins are introduced elsewhere, and that is where a thin profit line is shown to swing by much more than the two large lines above it. All of that is taken as given here.

Only the assembly is new, along with one straight answer to a question people ask constantly and are rarely given a number for. Prices in an economy rise by some published amount. A business sits inside that economy. How much of the published amount actually lands on that business, on which line, and in what order? Follow it through and something turns up that catches out most readers the first time they meet it: the two lines can both go up while the figure everybody watches goes down.

The economy used throughout is the Republic of Sankhya, invented for teaching, and the business standing inside it is Nirvi Engineering, invented along with it. Nirvi Engineering is kept deliberately thin: revenue of Rs 1,000 crore, costs of Rs 900 crore, and the operating profitWhat is left of revenue once the costs of running the business have been taken off, before interest and tax. How it is built up line by line is covered under financial statement analysis. of Rs 100 crore left between them. The operating margin is 10.00 per cent. Neither a balance sheet nor a valuation is needed to answer the question at hand.

By what two routes does inflation reach a company's margin?

The household version has an identical shape, and it is one most readers already live inside. A street vendor selling idli buys rice, dal, oil and gas. When the gas cylinder goes up, that lands on the vendor the same week, whether or not the vendor is ready. When the vendor raises the plate from Rs 30/- to Rs 35/-, that is a separate decision made on a separate day, and it depends entirely on whether the office workers in the queue will keep queueing at Rs 35/-. Two events, two dates, one stall.

Nirvi Engineering is that stall with three more zeroes on it. Inflation does not arrive at a company as one number; it arrives twice, on two different lines, from two different people, and the margin is whatever survives the difference. The first arrival is on the cost line, and Nirvi Engineering does not control it. Suppliers of steel, freight, power and labour reprice because their own costs moved, and Nirvi Engineering finds out when the invoice comes. The second arrival is on the revenue line, and Nirvi Engineering does control the attempt but not the result. Nirvi Engineering can print a new price list on any Monday it likes. Whether the customers accept it is a different matter, and the customers are the ones holding that pen.

The double arrival rules something out. A sentence like "inflation was 6.70 per cent, so the company's profit fell 6.70 per cent" has quietly assumed that the number arrived once, on one line, and did nothing else. Every interesting thing about inflation at a company sits in the fact that it arrived twice and the two arrivals were different sizes. A note that treats it as a single arriving figure has not simplified the mechanism. The note has deleted it.

Why does inflation reach costs and prices at different speeds?

Because the two arrivals have different people behind them, and those people are answering different questions.

The cost arrival is fast and it is not negotiated. A supplier who has decided to charge more sends the invoice, and Nirvi Engineering pays it or stops buying. There may be a contracted priceA price fixed in writing for a stated stretch of time, so neither side can revise it inside that stretch even if the market has moved. How such terms are drafted and enforced is covered under contracts and commercial law. holding a particular input still for a few months, and that is a real delay, but it is a delay with an end date printed on it. When the contract runs out, the whole accumulated movement lands at once.

The price arrival is slow because it is a negotiation with everyone the company sells to, conducted one order at a time. Nirvi Engineering can announce a new list in March. A buyer with a purchase order already placed pays the old price. A buyer with a substituteSomething a buyer can switch to instead: a rival's product, an imported version, a cheaper grade, or simply doing without for a while. How buyers choose between alternatives is covered under microeconomics. available goes and gets a quote from the substitute. A buyer with nothing else available pays, but grumbles and starts looking. The new list price becomes the actual average selling price slowly, in pieces, and sometimes never fully at all.

The margin is squeezed in the gap between the two clocks, and the size of the squeeze is the size of the gap. That is the whole mechanism, stated in one line. If the two clocks ran together, inflation would move both lines by the same proportion and the margin would sit exactly where it was. The two clocks do not run together. One is set by an invoice and the other by a negotiation, and an invoice is faster than a negotiation in every business anybody has ever run.

What decides how much of a cost rise can be passed on?

Three questions decide it, and every one of them is about the buyer rather than about the cost.

The first: does the buyer have somewhere else to go? A household buying salt has nowhere else to go and pays. A household buying a particular brand of biscuit walks four feet down the aisle. Nirvi Engineering's buyers sit somewhere between the two, and where exactly is a matter of opinion held by people who know that market.

The second: is the price fixed for now? If Nirvi Engineering has signed a two year supply agreement at a stated rate, the answer for those two years is that nothing gets passed on, whatever happens to costs. The agreement that looked prudent when it was signed is the thing holding the price down while the cost line climbs.

The third: are the competitors carrying the same rise? The third question is the most easily missed and often the most important. If every maker of the same equipment buys the same steel and the same freight, then everybody's cost went up together and everybody can raise together without losing a single customer to anybody. If the rise hit Nirvi Engineering alone, raising the price hands the order to a rival who did not have to.

The share of a cost rise that reaches the selling price is a judged input and not a measured one, and every honest note says so out loud. There is no ledger anywhere in Nirvi Engineering with that number in it. Revenue is measured. Costs are measured. The operating profit is measured. The share that gets passed on is somebody's answer to three questions about a market, and two careful people looking at the same market will give two different answers. A judged input is not a weakness in the method. Knowing which input was judged identifies exactly which part of an analysis to argue with, and that makes it the single most useful thing to know about one.

Why can a margin fall while both revenue and costs rise?

Here is the arithmetic, in full, with nothing left out. Suppliers reprice, and Nirvi Engineering's costs go up 5.00 per cent. Nirvi Engineering raises its own prices, and after the negotiating is done its revenue has gone up 3.00 per cent. Sixty per cent of the cost rise reached the selling price, and that 60.00 per cent is the judged input from the block above.

Costs move from Rs 900 crore to Rs 945 crore, a rise of Rs 45 crore. Revenue moves from Rs 1,000 crore to Rs 1,030 crore, a rise of Rs 30 crore. Operating profit is Rs 1,030 crore less Rs 945 crore, or Rs 85 crore, against Rs 100 crore before. The margin is Rs 85 crore on Rs 1,030 crore of revenue, or 8.25 per cent, against 10.00 per cent before.

Both lines rose and the margin fell, and anybody reading the revenue line on its own has read one line out of three. That is not a paradox and it is not an accounting trick. Revenue rose by Rs 30 crore and costs rose by Rs 45 crore, and Rs 45 crore is more than Rs 30 crore. Of the three figures, only the margin shows which of the two rose faster. Read it last and read it hardest.

What does the same cost rise look like if all of it is passed on?

Run the identical cost rise again and change one thing. Costs still go up 5.00 per cent, to Rs 945 crore. In this second run Nirvi Engineering passes the whole of it on, so revenue also goes up 5.00 per cent, to Rs 1,050 crore. Operating profit is Rs 1,050 crore less Rs 945 crore, or Rs 105 crore. The margin is Rs 105 crore on Rs 1,050 crore, or 10.00 per cent, exactly where it started.

Pass the whole cost rise on and the margin comes back to exactly 10.00 per cent. The judged pass-through share was the entire cause of the fall. The cost rise did not change between the two runs. The company did not change. The only thing that moved was the judged share, and the margin went from 8.25 per cent back to 10.00 per cent. So when a note says inflation squeezed a company's margin, the honest translation is that the company could not pass all of it on, and the argument worth having is about that share and nothing else.

The exactness is not a coincidence of these particular figures, so the arithmetic behind it is worth one line. If revenue and costs both rise by the same proportion, then profit rises by that proportion too, and a proportion divided by the same proportion leaves the ratio where it was. Full pass-through holds the margin exactly at 10.00 per cent whether the cost rise is 2.00 per cent or 12.00 per cent, and the panel below allows that to be checked directly.

How much of a headline inflation figure actually arrives?

Less than the headline, almost always, and occasionally a great deal more. Which of the two it is depends on something nobody puts in a headline.

A published inflation figure is a weighted averageAn average in which each item counts in proportion to its size rather than equally, so a large item moves the result more than a small one does. Where such an average comes from is set out where inflation and prices are covered. of a fixed shopping list, and each item in that list carries a weight standing for how much of a typical budget it takes. The published figure is the sum of every item's own move times its own weight, and that per-item amount is the item's contributionThe part of a published headline that one item put there: that item's own price move multiplied by its weight in the list. How contributions are read off a release is covered under reading inflation data.. A three item version of Sankhya's list, simplified so the arithmetic fits on one line each, adds to the same 6.70 per cent reading settled under inflation and prices.

Nirvi Engineering's own buying sits beside it. Nirvi Engineering makes equipment. The company buys no food at all, so the item carrying 40.00 per cent of the household list carries nothing whatever of Nirvi Engineering's cost line. Fuel and energy are 10.00 per cent of its costs, the Rs 90 crore established earlier. The remaining 90.00 per cent is everything else. Applying the same three moves to Nirvi Engineering's own weights, the arithmetic is nothing times 6.00, plus 10.00 per cent of 26.00, plus 90.00 per cent of 3.40. The three parts are 0.00, 2.60 and 3.06, adding to 5.66 per cent.

A published inflation figure is a weighted average of a list, and no company buys the list, so it is not a cost increase for any particular company. The same 6.70 per cent means 5.66 per cent to Nirvi Engineering. Change one weight and it means something else entirely. A business where fuel and energy are 40.00 per cent of costs rather than 10.00 gets 40.00 per cent of 26.00 plus 60.00 per cent of 3.40, or 10.40 plus 2.04, adding to 12.44 per cent. One published reading, three businesses, three different arrivals, and the middle one is not even in the same neighbourhood as the highest.

So the arrival happens in two stages, and both of them shrink or stretch the headline. The first stage is this one: the published figure gets re-weighted into the company's own buying, and out comes a different number. The second stage is the judged pass-through set out earlier: whatever cost inflation actually arrives, only part of it reaches the selling price, and the margin absorbs the rest. A note that skips both stages and writes the headline straight onto a profit line has done neither job.

Why does a 5.00 per cent cost rise take 45.00 per cent of the profit?

Because Rs 45 crore is a small slice of Rs 900 crore and a very large slice of Rs 100 crore, and it is the same Rs 45 crore both times.

Take the cost rise on its own, before any of it is passed on. Costs go from Rs 900 crore to Rs 945 crore. Revenue has not moved, so operating profit goes from Rs 100 crore to Rs 55 crore. The cost line rose 5.00 per cent and the profit line fell 45.00 per cent, nine times as far, with no leverage, gearing or clever structure involved anywhere. The profit is simply the small difference between two large numbers, and a small difference moves violently when either of the large numbers twitches.

A 5.00 per cent cost rise taking 45.00 per cent of the profit is what makes inflation a company question rather than only a macro one. A reader who hears 5.00 per cent thinks small. A reader who sees what 5.00 per cent does to a 10.00 per cent margin business never thinks that again. The same lever explains why the judged pass-through share matters so much: with a lever that long, the difference between passing on three fifths and passing on all of it is the difference between a bad year and no change at all.

What does a lender, an analyst or a household do with this?

A lender reads it as a covenantA condition written into a loan agreement that the borrower has to keep meeting, such as holding profit above some multiple of the interest bill. What happens when one is breached is covered under credit and lending. question. A lender who has lent against Nirvi Engineering's ability to cover interest out of operating profit cares that the profit line can fall 45.00 per cent on a cost movement the borrower did not cause and cannot stop. So the lender asks two things before the loan and again every year: how much of the cost base can reprice inside twelve months, and what has the borrower actually managed to pass on the last three times it tried. The second question is the one that turns a judged input into something with evidence behind it.

An equity analyst reads it as the place where a forecast is really made. Every earnings model of a business like Nirvi Engineering contains a pass-through assumption whether or not the person who built it noticed. If the model has revenue growing 3.00 per cent and costs growing 5.00 per cent, it has assumed a 60.00 per cent judged share, and it should say so on the face of the work rather than leaving it buried inside two growth rates. Naming it is what lets a second reader disagree with the right part of the work instead of arguing about the conclusion.

An investor reads it as a question about which businesses have the third condition on their side: are the rivals carrying the same rise. A business whose whole industry buys the same input has a very different pass-through problem from one whose cost rise is its own. Naming those businesses takes case-by-case judgement, and asking the question at all is most of the work.

A household reads it in the mirror. The salary is the revenue and the monthly spending is the cost, and they move on two clocks in exactly this way: the gas cylinder, the rent and the school fee reprice on their own schedule while an increment is negotiated once a year at somebody else's discretion. If a household's spending rose 5.00 per cent and its salary rose 3.00 per cent, the amount still in hand on the last day of the month dropped hard, even though both figures on the household's side of the table went up. The household is running the same arithmetic in a smaller currency, and it is worth working through on real household numbers once.

What can this arithmetic never say?

Whether Sankhya's prices rise at all, and by how much, is unknowable in advance, and whether Nirvi Engineering's costs follow is a second unknown sitting on top of the first. Every figure above starts from an assumption someone stated and carries it through arithmetic, and the arithmetic is the only part that can be checked. An assumption carried through arithmetic returns the assumption, magnified and made explicit, and never anything more.

The 60.00 per cent used throughout is nobody's correct pass-through share. The judged share is the arguable input, and it sits on the face of the work rather than hidden inside a result. That is the practical difference between a note that can be disagreed with usefully and a note that can only be accepted or rejected. A reader who thinks Nirvi Engineering's buyers have fewer alternatives than that can move the slider, watch the margin, and turn that disagreement into a number.

A margin is not a value, and a fall in a margin is not a fall in a value. A lower policy rate does raise what a stream of future money is worth today, and the model behind that belongs to another subject, covered separately.

The Republic of Sankhya and Nirvi Engineering are invented.
Educational material. Not advice on any investment, tax, budget or market position.