Working capital terminal values need to be adjusted for inflation, just like the other
cash flow elements in the project. Because inflation is a significant factor in the cap-
ital expenditure analysis, it is desirable to do a sensitivity analysis using different
rates of inflation in the cash flow and cost of capital analysis.
(f ) Operating Planning and Budgeting. Traditional planning and budgeting control
systems produce information which is misleading during periods of high inflation.
Budgets and plans should be adjusted for inflation where it is an important factor, and
these should be revised and reviewed more frequently. Trends used to project short-
run performance should be deflated for the effects of specific inflation to see the
“real” trend which can then be adjusted for future anticipated inflation.
Firms should look for productivity measures that are in physical units, to avoid the
effects of inflation. Those familiar with the learning curve calculation will remember
that learning is based on inflation deflated costs.^7 In analyzing results, one should
separate the effect of differences caused by prices from the effect of differences
which represent performance.
According to Breden and DeMichiel,^8 some European companies use quarterly
standard costs based on average material purchase costs and a forecast of key over-
head elements. Revenue and other expense budgets are calculated by indexing each
month in the quarter. Monthly reports compare actual to the budget. In Brazil, stan-
dard costs are adjusted during the year by indices on a monthly basis. The indices are
specific for a variety of costs and revenues.
(g) Management Reporting and Performance Evaluation. Just as inflation influences
the plans and budgets against which results are measured, it also influences manage-
ment’s perspective on analyzing actual results. Performance trends should be analyzed,
after the effect of inflation has been removed. Profit analyses should be based on prof-
its, which are calculated after considering the replacement costs of inventory and fixed
assets (through replacement cost depreciation). Holding gains should be removed, and
returns on investment should be calculated based on current costs or constant dollars.
A number of methods may be used to separate the noncontrollable impact of in-
flation from controllable operating results.^9 For example, one method is to identify
the inflation effect in the actual results reported. To do this, the difference between
assumed and actual price levels is calculated and removed to get at the controllable
variance. Another method entails use of a “price adjusted flexible budget.” In this
case, the budget, not actual results, is adjusted for price level changes. The first step
is to modify the budget for volume—a flexible budget—and then the flexible budget
is increased for noncontrollable changes in the price of the input factors—costs.
(h) Pricing. When a company thinks its prices are sufficient to cover the costs of in-
flation and earn a profit, it may not be doing so. The solution is to take into account
the income tax effect. A price to recover replacement cost can be calculated by tak-
ing the cost of a product and increasing it for the effects of inflation.
Prices will probably have to be changed more frequently where there is high in-
flation. They should be changed at least as often as the operating cash cycle, but, if
20 • 8 ACCOUNTING FOR THE EFFECTS OF INFLATION(^7) Kaplan and Atkinson, 1989, p. 142.
(^8) Breden and Demichiel, pp. 53–54.
(^9) Seed, 1981, pp. 86–87.