The surge in global inflation following the COVID-19 pandemic has reignited interest in the often complicated ways through which inflation affects the economy, attracting attention from investors, regulators and business leaders alike. However, very few instruments exist to hedge against overall inflation, with even the conventional hedges having become less effective during recent times. While studies from economists like Rubio Cruz demonstrate that firm characteristics can influence return sensitivity to inflation, they primarily focus on inflation risk stemming from unexpected events during FOMC meetings. Moreover, recent surveys reveal that inflation is a top concern for business executives, particularly in small enterprises. Of particular interest is inflation-induced production cost pass-through, where firms transfer rising costs to consumers. A survey conducted by KPMG shows that business executives estimate inflation rates to be significantly higher than what consumers expect. These executives estimate that approximately 75% of increased costs will be passed on to consumers. Furthermore, numerous sources emphasize that cost pass-through affects not only consumers but also firms and managers alike.
However, the effect of inflation on production costs is likely to vary based on the type of cost. For instance, sticky costs should be less impacted than non-sticky costs. Consequently, firms with different cost structures will experience varying impacts on their cash flow due to inflation, which, in turn, will influence their return sensitivity to inflation—commonly known as their inflation beta. This naturally brings us to the question: How does a firm’s cost structure affect its inflation beta? The answer to this question would have an important bearing on how firms manage inflation-induced shocks through their production cost structure. Additionally, it may assist in identifying potential hedging instruments suitable for mitigating inflation risk.
The Fixed Cost Puzzle!
In a recent paper, I explore this question in the cross-section by splitting the production cost structure into fixed and variable components and investigating the inflation sensitivity of firms with these different cost structures. This decomposition is essential because any inflation shock’s impact on cash profits depends on how it influences revenues relative to costs, and fixed and variable costs are likely to respond differently to inflation. I define fixed costs as the ratio of Selling, General, and Administrative expenses (SG&A) and interest costs to revenue, while variable costs are defined as the ratio of Cost of Goods Sold (COGS) to revenue. Inflation surprise is quantified as the residual from an Autoregressive Moving Average (ARMA 1,1) model applied to the Consumer Price Index (CPI). Subsequently, I sort firms, within industry, in quintiles on each of variable and fixed costs, then form long-short portfolios. The coefficient of regression of the return of these portfolios on inflation surprise provides us with the `inflation beta’ for variable and fixed costs respectively.
At first glance, I encounter an intriguing puzzle. Conventional wisdom suggests that fixed cost should have a positive inflation beta in the cross-section; in other words, the sensitivity of stock returns to inflation should be positively related to a firm’s fixed cost. The rationale behind this expectation stems from several factors. First, fixed costs are sticky, as explained in a paper by Mark Anderson, an economist at UT Dallas. Additionally, real wages, an important component of fixed cost, have had a negative correlation with unexpected inflation, as observed in the data, also demonstrated in an article by IMF Economist Benedikt Braumann. Furthermore, inflation tends to erode the real value of nominal liabilities. Therefore, when an inflation shock occurs, firms with higher fixed costs should experience a smaller relative increase in costs compared to revenues. This results in a positive cash flow shock and, consequently, a positive sensitivity of firm returns to inflation.
However, empirical results show exactly the opposite, that is long-short portfolios formed on fixed costs have a negative inflation sensitivity, and as such, could act as an inflation hedge. In other words, firms with high fixed costs seem to be negatively impacted by inflation surprise, which is puzzling.
Inflation Sensitivity is driven by Variable Cost
To address this puzzle, I focus on variable cost ratios, recognizing that it would be insufficient to analyze fixed costs in isolation. My findings reveal that variable costs significantly dominate firms’ cost structures, typically more than three times the magnitude of fixed costs and exhibit a negative correlation with fixed costs. Additionally, I observe that variable costs have a statistically significant positive inflation beta, which is economically larger than that of fixed costs. This suggests that firms with higher variable costs tend to benefit from inflation shocks. Crucially, after orthogonalizing fixed costs with respect to variable costs, the fixed cost inflation beta becomes insignificantly positive, whereas no similar reversal occurs when variable costs are orthogonalized with respect to fixed costs. These findings lead me to hypothesize that variable costs are the primary driver of a firm’s inflation sensitivity and contribute to the negative inflation beta observed for fixed costs. From a managerial perspective, this suggests that addressing inflationary effects on variable costs may be more critical when managing overall cost sensitivity to inflation.
To further investigate the mechanisms driving the positive inflation beta of variable costs, I examine the cash flow sensitivity of both variable and fixed costs to inflation surprises. Specifically, I regress the median cumulative future real cash flow growth of long-short portfolios—sorted on fixed and variable costs, respectively—on contemporaneous inflation surprises. The analysis shows that firms with higher variable costs experience significantly greater revenue growth and operating profit growth compared to firms with lower variable costs. Conversely, firms with higher fixed costs exhibit lower revenue growth and operating profit growth than their lower fixed cost counterparts. These results suggest that inflation surprises positively affect the profit growth of firms with higher variable costs.
Additionally, I observe that the inflation beta of variable costs is particularly pronounced during periods of high inflation and positive unexpected inflation. I interpret these findings through the lens of the Rational Inattention Hypothesis, as proposed by Sims (2003) and more recently supported by Weber et al. (2023), which posits that consumers pay more attention to inflation during periods of elevated inflation. My results thus suggest that positive inflation surprises affect consumers such that inflation surprises cause favorable cash flow shocks for firms with high variable costs, while negatively affecting firms with lower variable costs.
Since the portfolio sorting was performed within industries, these findings suggest that the observed heterogeneity in inflation sensitivity primarily arises from differences among firms within the same industry. As a result, I hypothesize that during periods of high unexpected inflation, consumers tend to shift their consumption toward substitute products from high-margin (low variable cost) firms to those offered by low-margin (high variable cost) firms. Importantly, both types of firms operate within the same industry and offer similar products, illustrating that while consumers continue to engage in their “basic service consumption,” they appear to compromise on their “brand consumption.” This shift suggests that in response to high inflation, consumers prioritize essential services over brand preferences, opting for more cost-effective options within the same product category.
High Inflation Causes Customers to Switch from High to Low Price Firms
When inflation rises, consumers’ budgets are strained, leading them to switch from high-priced products to lower-priced alternatives. By definition, firms with high prices or high margins often have low variable costs, whereas those with low prices or low margins typically have high variable costs. This could potentially involve a slight reduction in quality, such as switching from Coca-Cola to Shasta-Cola, or Ralph Lauren to more affordable imitative brands like La Go Go. It may also reflect subtle changes in preferences, like choosing Coors beer over Jack Daniel’s whiskey. This shift in consumer behavior increases the revenue and profitability of high-variable-cost firms while diminishing that of low-variable-cost firms.
To validate this hypothesis, I analyze the relationship between the variable cost inflation beta within each industry and various industry-level measures, including margin dispersion, customer loyalty, and customer switching behavior. Margin dispersion is measured as the standard deviation of firm margins. Customer loyalty data is sourced from the American Customer Satisfaction Index, and customer switching is assessed using two methods: the mean of the absolute value of changes in market share among firms within an industry and the 1-R² value from a rolling regression where firm sales growth is the predictor variable and industry sales growth is the dependent variable. The latter method assumes that in industries with high switching rates, firm-level sales growth should offset at the industry level, making industry sales growth a poor predictor of individual firm sales growth.
Industries with a single price point or margin offer no switching opportunities. Analogously, high-margin industries are expected to exhibit greater inflation-induced customer switching, leading to higher inflation betas. Similarly, industries with lower customer loyalty should experience more switching and consequently higher inflation betas. Lastly, I also perform direct testing as to whether industries with higher inflation betas also have higher customer switching rates. All my tests show intuitive findings: within the industry, variable cost inflation beta is positively related to customer switching rate and margin dispersion, and negatively related to customer loyalty.
Substitution between service consumption and brand consumption
I propose a two-firm, single-industry static economy, where consumption is divided into basic service consumption (Cs) and brand consumption (Cb). In adverse conditions, consumers aim to conserve their basic service consumption (Cs) while reducing their brand consumption (Cb). In this setup, Firm 1 is characterized by high variable costs, resulting in lower prices and a lower brand value, while Firm 2, with low variable costs, has higher prices and a stronger brand value. Basic service consumption (Cs) is inversely related to the net price; therefore, when an inflation shock occurs, the net price rises, leading customers of Firm 2 to switch to Firm 1 to maintain their basic service consumption (Cs) at the expense of brand consumption (Cb). This shift results in a positive impact on the real quantity for Firm 1 and a negative impact on Firm 2. Consequently, high inflation appears to benefit firms with high variable costs.
Conclusion
In conclusion, the impact of inflation on a firm, as mediated by its cost structure, is predominantly influenced by variable costs. Portfolios formed on positive (negative) exposure to fixed cost (variable cost), could be used to hedge against inflation. During periods of high inflation, it is advisable for managers to focus on managing variable costs to safeguard firm value. The positive inflation beta observed for firms with high variable costs is largely driven by customer switching behavior. Specifically, during times of high inflation, customers tend to shift their spending from high-price firms to lower-price alternatives, resulting in a positive cash flow boost for firms with high variable costs. These insights are crucial for both managers and academics seeking to understand the intricate dynamics of how inflation affects firms.
Tuhin Harit is a PhD Candidate in Finance in Management Science at the Naveen Jindal School of Management at UT Dallas.
