What is the best way to account for inflation in an operating budget?

1 Why account for inflation?

Accounting for inflation is important because it helps you plan and manage your cash flow, profitability, and financial performance. By adjusting your budget for inflation, you can avoid overspending on your costs, or underselling your products or services. You can also compare your actual results with your budget more accurately, and identify any gaps or deviations that need corrective actions. Accounting for inflation also helps you communicate your budget assumptions and expectations to your stakeholders, such as investors, lenders, suppliers, and customers.

2 How to estimate inflation?

In order to account for inflation in your operating budget, you need to estimate the inflation rate that will affect your business or project. The inflation rate is the percentage change in the average price level of a basket of goods and services over a period of time, usually a year. To do this, you can look at historical data from your industry, market, or country, and use it as a basis for your projections. Additionally, you can use inflation forecasts from reputable sources such as government agencies or central banks. You can also use inflation indices that measure the changes in the prices of specific goods and services relevant to your business or project. However, when using any of these sources, you should be aware of any changes or trends that might affect the future inflation rates, as well as any limitations or uncertainties with forecasts and indices. Additionally, make sure that the index you use reflects the composition and quality of your costs or revenues, and apply any adjustments or weights as needed.

3 How to apply inflation?

Once you have estimated the inflation rate that will affect your operating budget, you need to apply it to your budget items. There are two main ways to do so, depending on how you prepare your budget. A bottom-up approach involves applying the inflation rate to each item separately, allowing for different inflation rates for different items if required. This can be more time-consuming and complex, as more data and assumptions are needed for each item. Alternatively, a top-down approach involves applying the inflation rate to the total level first, then distributing it to the items proportionally. This is simpler as a single inflation rate can be used for the entire budget, such as the average inflation rate for your industry or market. However, this approach may be less accurate and realistic as it assumes all items are equally affected by inflation.

4 How to monitor inflation?

After you have applied inflation to your operating budget, you need to monitor the actual inflation rates that occur during your budget period, and compare them with your budget inflation rates. This will help you evaluate your budget performance, and identify any variances or errors that need to be addressed. You can monitor the actual inflation rates by using the same sources and methods that you used to estimate them, such as historical data, forecast data, or index data. You can also use tools and techniques, such as variance analysis, sensitivity analysis, or scenario analysis, to measure and explain the impact of inflation on your budget results.

5 How to improve inflation accounting?

Accounting for inflation in your operating budget is an ongoing process that requires regular review and revision. To improve your inflation accounting, use reliable and relevant data sources to estimate and monitor the inflation rates that affect your business or project. Additionally, update your budget inflation rates when there are significant changes or events that influence the inflation outlook. Furthermore, document and communicate your budget inflation assumptions and calculations to your stakeholders, and incorporate contingency plans and buffers in your budget for unexpected or extreme inflation scenarios. Finally, learn from your budget experience and outcomes to apply the lessons learned to future budget planning and management.

6 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?