Preface: When inventory costs catapult, a business owner may find himself in the strange position of making higher profits but having less cash.
Credit: Jacob M. Dietz, CPA
Catapult on the Job Site
Imagine Abner’s hammer crash into another nail as he fastens another 2X4 to connect another truss on another building. Abner is simply doing his honest work. He has done this for years. His father started the business, and he has been building even longer than Abner. The gentle breeze blows across his sweated face and tugs at his hat.
Now, imagine someone installing a small catapult in the middle of the building that is being constructed. Abner and his dad stare in disbelief at the catapult. Neither of them has ever seen a catapult come to a job site before. The catapult flings a stone up through the trusses. The stone sails mere inches away from Abner’s hat on the way up, and it almost hits Abner’s dad as it descends. The stone could hurt Abner on the way up as the catapult propels it away from the earth, and it could hurt Abner or his dad on the way down as gravity hurls it towards the ground.
Business owners might stress if catapults started flinging stones at their builders, but fortunately I have not heard of any construction companies coming under catapult attack. Some companies, however, have been threatened by catapulting costs. Some fluctuations in costs may be a normal part of business, but unfortunately some costs have fluctuated in recent times in ways that current business owners, and perhaps their fathers too, have never experienced. Although the business owners might desire to be able to simply work a normal day without catapulting costs, unfortunately the catapult has come to the industry. How do catapulting costs threaten businesses?
First, catapulting costs could hammer a company’s bottom line if the company cannot raise prices enough to compensate for their increased costs. Imagine Abner’s building company normally pays $35 in lumber for every $100 of sales. That left them with $65 for every $100 in sales to pay labor, subcontractors, and other expenditures and still have some left over for a profit. Net profits vary from business to business and industry to industry, although for this example we will assume that the company normally kept $15 of profit for every $100 of sales. If the cost of lumber suddenly doubles on the company, and they failed to raise their prices or make any other adjustments, then lumber would cost them $70 for every $100 in sales. Instead of making $15 on every $100 of sales, they would lose $20 on every $100 of sales. The catapulting prices hit this hypothetical company on the way up.
Now suppose the company realized that lumber was shooting up, and they adjusted their prices to make the same profit. Now they should not lose money for each $100 of sales. There could still be other challenges, however.
One challenge is figuring out how much to raise prices. First, let’s assume that lumber doubled, so Abner reacted by doubling his prices. If Abner still sold the same number of jobs, his profits likely will more than double, since his sales price doubled, and his lumber doubled, but his other costs did not double. Depending on the market, doubling prices when one cost doubles might price yourself out of the market.
Imagine Abner realized that his market would not allow him to double his prices, so he only increased his sales price by the same amount that this lumber increased. Abner might find that he is less profitable. One reason is if Abner gives discounts off the total sales price to some customers. For example, if Abner gives a 2% discount for timely payment, and if he increases his sales price, then 2% of the new sales price is more dollars and cents than 2% of the old sales price. What if Abner gives discounts to certain other businesses that are even more than 2%? Those discounts could be even more dollars and cents after Abner increased his prices. Also, even if Abner were able to maintain the same profit in dollars after increasing prices only enough to offset the increase in lumber, his net profit percentage would decrease, because as a percentage his profits would be lower. It would be the same profits (numerator), but a higher sales number (denominator).
Another way the cost catapult could hurt Abner’s business is by increasing inventory costs. Assume that Abner has X quantity of inventory in stock. Now, assume that the cost of that inventory doubles. If Abner counts the quantity of inventory, it is the same as it always was. The money that Abner has tied up in inventory, however, may have doubled along with the cost. Abner therefore needs more capital to simply sustain his normal inventory.
When inventory costs catapult, a business owner may find himself in the strange position of making higher profits but having less cash. How is this possible? If the business owner increases prices enough, there might be more profits. The profits might need to go to fund the higher cost of inventory.
Increasing Lead Times
Abner may need more capital to sustain his inventory with normal lead times if costs rise. It is even possible that Abner might increase his inventory quantity if he is having trouble getting product in time. Increasing the quantity of inventory that has already increased in price can be quite capital intensive. Abner may want to consider these capital needs when he considers how much to charge his customers. He might also want to consider negotiating with vendors for payment terms, and he might consider talking with his banker.
Catapulting a stone causes danger on the way up. Gravity also poses a risk as the stone hurls earthwards. What would happen to Abner’s company if suddenly the cost of his inventory fell drastically, after he stocked up on inventory at a high price? Would the market force him to sell some of the inventory at a loss? Abner may want to ask himself if he has enough financial margin to sustain the business if his costs of materials drop significantly, potentially forcing him to cut his prices.
If a real catapult suddenly showed up at work and started flinging stones, it would get the attention of the business. Action might be taken to mitigate the risk.
Fortunately, real catapults don’t normally show up at jobsites. However, catapulting prices have affected the economic landscape recently. Are you paying attention to your costs and your prices? Are they healthy?
Proverbs 27:23 Be thou diligent to know the state of thy flocks, and look well to thy herds.
This article is general in nature, and it does not contain legal advice. Contact your advisors to discuss your specific situation.