The Widget Game

More tariffs! This time a 25% tariff on steel and aluminum! While I understand the need for specific tariffs (critical industries where we have a large infrastructure in place or against "enemy" states), they are not an effective long-term tool.

I will 100% admit that I am not the smartest person in the room; sometimes I rank behind one or both of my dogs but if I can see the dangers of these policies, it scares me to think that people that are making this happen don't see it. If you read this and find an error (not a difference of opinion, but an actual fact based error), please let me know.

Rather than use pet food or a specific industry, I'll use the example of The World Famous "Widget". For this particular widget, our Company retails it for $250. Included in this SRP are raw material costs, manufacturing costs, labor costs, distribution costs and overhead expenses. We also need to add in the Company's target profit margin to get to the selling SRP.

SRP = Materials + Manufacturing + Labor + Distribution + Overhead + Profit

Companies are in business to make a profit. To that end, employees either add to revenue or reduce costs so that profit margins can be maximized. I personally believe everyone is a cost center but that is for another day.

OK, back to our "widget". Our US based company is able to domestically source all the raw materials for $90. The actual cost to manufacturer our "widget" is $40. The hourly wage rate is $25/hour and our distribution and overhead costs (including testing, certification, paper work) adds $30 per piece. The landed cost of the "widget" is $185 and the manufacturers profit margin is 26%. This means the SRP is $250.

$250 = $90 + $40 + $25 + $30 + $65 (Profit Margin = 26%)

The goal of the company is now to drive costs out of the system so as to increase the 26% margin. This can be the use of less expensive foreign raw materials; automation of the factory to improve efficiencies, reducing the number of FTEs (full time equivalents; we don't want to call them "people") or outsourcing the manufacturing (in part or in whole) to a foreign entity. The biggest "buckets" we can target for reductions are raw material costs and manufacturing costs.

REDUCING COSTS - Normally we would look domestically and try to find better, more lucrative pricing. Depending on the maturity of the market, number of competitors, etc we may be lucky and find a 4-6% cost reduction. So we start by saving about $5 which adds to our profits. As for production, we may want to look at automation but the CapEx is probably higher than we can fund/finance. Instead of taking on that project, we can drive efficiency through innovations and proven techniques (JIT, TQM, Kaizen, etc). Maybe we drop another $5 in cost. We can also look at streamlining our labor costs by bringing in temps. Overall we reduce our average hourly costs from $25/hour to $20/hour. Another $5 to profit!! So we have avoided a massive capital expenditure and cut our costs by $15!! Our profit has jumped from $65 per widget to $80 per widget or a profit margin jump from 26% to 32%. A lot of work! Bonuses all around!!

$250 = $85 + $35 + $20 + $30 + $80 (Profit Margin = 32%)

So what's next? Well, we discover that we can source all the raw materials from a foreign country for $70. If all other variables remain the same, we have just INCREASED our profits another $15. After a sight visit, we learn that the cost of foreign labor to produce our widget is $7/hour!! That just boosts our profits another $13! We are able to negotiate with the same foreign based company to manufacture our widgets for almost half the cost of our US based operations ($20). We have now increased our dollar profits 42% (an impressive year over year "savings/growth". Time to buy the big house and plan the family vacation!

$250 = $70 + $20 + $7 + $40 + $113 (Profit Margin = 45.2%)

BLINDING SHORT TERM PROFITS - We started out making $65 in profits and with some efficiencies and offshoring, we have increased our profits to $113 per unit. Our US based factories are now dormant and an albatross around our necks. Rather than refurbish or reallocate the facilities for something else, we shutter the buildings and layoff the local employees. We do hire some new employees to help us manage our new business model but we have, in essence, changed from a US manufacturing company to a globally sourced business entity. Far too many variables are no longer in our control. Fewer people are employed by us, the concentration of wealth in our Company is held by a smaller group and the gap in pay from "rank and file" to Executive is massive.

The people in the community will be angry; they will organize and speak to their elected officials about how foreign business and trade deficits are killing Smalltown USA. Since we are ALWAYS in an election cycle, the government responds with a tariff of 30%. Instead of paying $137, the Company now has to pay $178 with $41 of that paid by our CFO directly to the US Treasury. Our profits drop from $113 to $72. While better than where we started, this decrease is completely unacceptable to our Executives, The Board and all of our shareholders. We decide that we will pass the increased costs to the consumer. The widget now will cost them $299.99, a 20% increase. Through some "Marketing Magic", we convince our consumers that while it may be a 20% price increase to them, WE are paying a full 30% tariff. Hell, we'll even drop the price to $299.99. The crazy part, our profits have actually INCREASED.

$299.99 = $70 + $20 + $7 + $40 + $41 + $120.99 (Profit Margin = 40.5%)

What happens with our consumers? I imagine they would be upset and rightfully so! They will buy fewer widgets because they are now unemployed and the price has increased 20%! The Company's response...more layoffs through a reduction in force (RIF)! We have no other choice, we must protect our margins; the future of the Company depends on it.

AN ALTERNATIVE SCENARIO: SUBSIDIES - Remember "way back" when I said we couldn't afford a major CapEx project? What if we could and we did? Instead of offshoring, what if we decided to go to our elected officials and promised to "create more jobs" and help them get re-elected? In exchange for these new vote earning jobs, we ask them for a subsidy so that we can bring in automation, thereby lowering our manufacturing costs. We also ask for money to cover our losses while we work to become more competitive. Granted, the jobs won't be the same. Instead of line workers, we will need more contractors, engineers and safety folks to build, service and maintain the automation.

Along with the subsidies, a lot of money will be spent (both by the company and the government) on tariffs to "level the field". The purpose is to make it cost prohibitive for companies to do business with these foreign countries and (hopefully) bring back jobs to American companies. The subsidies are offered to build more competitive manufacturing facilities, lower the Companies tax liabilities and improve their profitability (sometimes, just to keep them near "breakeven"). This may work for some time but eventually, the subsidies will stop. We will need Cost of Living Adjustments (COLA) for our employees; we will need to structure our debt appropriately. We will again look to RIFs; unemployment and inflation will start to rise putting us in a downward spiral. We will have "lived up" to our subsidized financials and we will have been protected from actually becoming efficient by the tariffs. Once those go away, many companies will find themselves in dire straits and will either sell some or all of their assets. For the most unfortunate, they will go out of business and take all the jobs down with them.

DEEP THOUGHTS - If US corporations "walked away" from an industry, you have to first understand the dynamics behind WHY? The answer is usually a cornucopia of things like the material, product and/or labor costs are cheaper elsewhere. "Unfair" regulations in the US won't allow us to compete with the world. Lots of things! What will it take to create, acquire and manufacturer at competitive costs? It shouldn't be about big donors or mobilizing the electorate to put you in office. During Trump's first Administration, the US spent nearly $80 BILLION in subsidies to aid farmers that got hurt with the agriculture trade war and tariffs with China. The money was never appropriated by Congress. It was funneled through USDA's Commodity Credit Corporation which was created during the Depression-era to "stabilize" the farmer economy. Under the category of "things that make you go HMMM", here is the Electoral Map from 2024 and the largest agricultural/farming communities that benefitted most from the subsidies and tariffs. HMMMM...