I’m a big believer in keeping things simple, so if something doesn’t add any value to a forecast in terms of accuracy or flexibility, I’d be in favour of leaving it out. Let’s dig a bit deeper to see what, if any benefit is added by building in inflation.
First of all, inflation isn’t a single figure. There are a large number of indices used to measure inflation, common ones being the Consumer Price Index (CPI) and Retail Price Index (RPI). These are based on a ‘basket’ of purchases each month to be representative of what people are purchasing. There are other indices that are more focussed, such as the Resource cost index of house building, which shows an increase for Labour and plant from 100 to 220 between 1995 and 2009 [source: ONS website]. That’s quite a significant increase and if you are in the House building business, it could make a big difference to your forecast.
OK, so if cost and revenues inflate differently it might be important, but what about companies who have costs and prices that rise broadly in line with RPI? Why not in that case keep everything in real terms?
The Big differences
The other big differences that sometimes make it important to model inflation are tax and debt. If you borrow £1m today and have high inflation, the real cost of paying that loan back diminishes with time. Similarly the timing differences between your receiving cash and having to pay tax on the profit that earned you that cash can make the tax bill less significant in real terms. With the low inflation we’ve had in recent times, this may not be material and that should be the acid test – if something isn’t material to your decision, you can probably safely avoid modelling it. Just be sure to think through whether it really is immaterial before you decide to leave it out.
