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Inflation

Inflation has its biggest impact on the reported profits of businesses with sizable inventories. Consider the following example:

Patrick's PC Shop reported sales of $100,000 last year. Its cost of goods sold was $75,000, which meant gross profits of $25,000. Now, assume Patrick's PC Shop sells exactly the same number of units this year, but — because of inflation of 5 percent — raised its prices 5 percent. Also assume that its cost of goods rose 5 percent, but that 1/2 of its sales will be made from "old" inventory purchased last year, at last year's cost. So, for the current year, Patrick's PC Shop reports sales of $105,000 and cost of goods sold of $76,875 ($75,000 + 5% ( 1/2 x $75,000)). Patrick's gross profits rose by $1,875 — at least some of which will show up in net income — even though its level of business activity remained unchanged.

The increased profits of Patrick's PC Shop in the example above cannot be attributed to improved performance. They are merely "inflation profits."

Inflation also distorts reported income when the costs of fixed assets are charged to income through depreciation. The increased costs of replacing fixed assets are not reflected in the depreciation charge.

Inflation has an impact on how a business is valued by investors and prospective purchasers, who do not value inflation profits highly. A business that fails to take this factor into account in its financial planning may see the value of the business decline, despite steady or modestly rising profits.