Forecasting sales and costs with inflation or deflation

How does a price rise change revenue?

Revenue is volume times price, so a price rise helps revenue only if volume does not fall by more. The size of the volume response is set by price elasticity of demand : how much quantity demanded changes for a given change in price.

Think of the two drivers separately: volume vs price growth . In a period of price inflation (a general rise in prices) companies usually raise selling prices, but customers buy less when they do. In price deflation (a general fall) the same logic runs backward.

$$\Delta V \approx -e \times \Delta P$$

Elasticity is written as a positive number here. With elasticity of 0.4, an 8% price rise cuts volume by about 3.2%. Revenue then changes by the compounded effect.

$$\Delta R = (1 + \Delta P)(1 + \Delta V) - 1$$

When elasticity is below 1, demand is inelastic and revenue rises with price. Above 1, demand is elastic and revenue falls. This is the first thing to check in any price-rise question.

The solver turns the same relationship around: the price rise or elasticity that produces a given volume or revenue outcome.

What happens to profit?

A price rise lifts revenue per unit, but the units lost take their margin with them. Costs matter too. Here is Hillcrest Brewing, with invented numbers.

Try the effect of elasticity, the price rise and input inflation on revenue, cost and operating profit.

Go deeper How high can elasticity go before a price rise stops paying?

In the Hillcrest case, the unit margin before the price rise is 100 − 64.80 = 35.20, and after it is 105 − 64.80 = 40.20. A 5% rise lowers volume by 5% times the elasticity. Profit equals the no-rise profit of 202.0 when volume × 40.20 − 150 = 202, so volume is 352 ÷ 40.20 = 8.76m, or 87.6% of the original. A 12.4% volume loss from a 5% price rise needs an elasticity of about 2.5. Below that, raising the price is better than doing nothing. The wider the unit margin, the less elastic demand needs to be for a price rise to pay.

How do you forecast industry and company sales?

Start at the industry, using the inflation in each country where it sells, and the right category rate. Nominal growth is real growth plus inflation, so a country growing 1.6% in real terms with 2.0% inflation is growing roughly 3.6% in nominal terms. Then move to the company: its own pricing power from the five forces, its mix, and currency.

Use the rate for the company’s product category, not just the headline consumer price index (CPI). Beer prices and grocery prices respond to different drivers. For an international company, apply country-level inflation to each market and weight it by that market’s share of revenue.

Go deeper High inflation abroad and the currency

Persistent high inflation in an export market tends to drag that country’s currency down, so local price rises can vanish when sales are translated into the reporting currency. There are two practical shortcuts, and neither is perfect. One lets the high local growth fade to a normal constant-currency rate after a year or two: simple, but it can understate revenue in the near term. The other forecasts the high local inflation in full and offsets it with an expected currency fall, which rests on an exchange rate forecast that is hard to get right. Whichever you use, say so in the model.

How do you forecast costs under inflation or deflation?

Forecast each input at its own inflation rate, by country, and weight by its share of costs.

Cost forecast

• Split by input Use it raw materials, energy, wages, packaging
• Split by country Use it each production country has its own inflation
• Weight by cost share Use it a heavy input moves the total more
• Check timing Know the idea hedges and long contracts delay the effect

A company’s input cost inflation is a blend of its inputs, so use a weighted average.

$$\pi_{cost} = \sum_i w_i\,\pi_i$$

Three things refine the forecast.

• Timing. Hedges and long-term fixed-price purchase contracts delay the effect of price changes. Note when they expire.
• Mitigation. A company may blend in cheaper inputs, become more efficient or cut discretionary spending such as advertising. The last helps profit now at a cost to future revenue.
• Deflation. Falling input prices widen margins until competition forces prices down. Cutting prices first gains some volume, but rivals react quickly, so the benefit is short.

The effect of inflation also depends on cost structure. If the company passes on nothing, a higher cost share means a bigger hit.

$$GM_{new} = 1 - c\,(1 + \pi)$$

Should the company pass costs on or absorb them?

It depends on pricing power and on what management wants to protect. The choice is a strategic one that the forecast must reflect.

Rising input costs

• Pass the cost on Use it raise prices
  • Margin protected full pass-through keeps the percentage
  • Volume at risk size depends on elasticity
• Absorb the cost Use it hold prices to defend share
  • Share protected volume holds up
  • Margin squeezed profit per unit falls
• Offset the cost neither raises nor absorbs it all
  • Substitute inputs change the blend or supplier
  • Efficiency and savings for example less advertising

Cost pass-through means raising prices to recover input cost increases. The margin vs market share trade-off is the decision: pass on the cost and protect margin at the risk of volume, or absorb some of it to defend share.

Exam tip Strong pricing power means pass-through and a small volume cost. Strong rivalry and elastic demand mean margin gets squeezed.

Go deeper Hyperinflation and price controls

In a hyperinflationary economy, forecasts become dominated by the currency and by how fast the company can reprice. Some governments also cap the price of certain goods, which makes pass-through legally impossible. In both cases the usual elasticity logic gives way to the rules of the market, and the analyst should model the constraint directly.