Many middle-market companies are feeling the squeeze this year. Even as sales remain steady, their gross margins have shrunk dramatically. In many cases, closer review of the financials reveals the cause to be an increase in material costs, spurred by the ongoing trade wars.
In March 2018, the Trump administration imposed hefty tariffs on most imported steel and aluminum — at 25% and 10%, respectively. While tariffs against some countries have since been lifted, they remain in effect against China. In this climate, manufacturers and distributors that rely on Chinese-made materials have been hit hard.
As margins shrink further, companies face a basic question: Should they raise prices — and risk customer defection — or absorb the material cost increases, under the assumption the tariffs will be temporary?
They’re understandably worried about taking a definitive step in either direction, without knowing the larger timeline. And though the trade wars could end tomorrow, they could also drag on indefinitely.
Lacking a crystal ball, companies are better off assessing how they can weather the current uncertainty.
Common ‘Solutions’ Bring Risks
At the outset, it pays to remember that knee-jerk responses can pose significant risks.
This includes the temptation to acquire materials from another country. Alternate supply networks may not be able to produce comparable quality and quantity of material — or in the expected timeframe, either.
Companies should also be wary of seeking additional lines of credit. As double-digit reductions in gross margins affect already-tight cash flows, it’s logical to mull this option, but assuming debt from a position of weakness is rarely a good strategy.
It also makes little sense to offset material cost increases by cutting staff. Despite currently high U.S. productivity levels, it’s unlikely greater output can occur with smaller workforces. Nor is it practical for most middle-market companies to move their business overseas.
Presented with that range of outcomes, companies may see price increases as the only viable choice.
Before going this route, however, it’s important to assess whether the competition is increasing prices. If so, businesses may pick up market share by preserving current pricing, but some firms may simply be unable to maintain the status quo. So, what then?
Companies can offset the impact of tariffs by cutting costs in strategically wise ways. Here’s a rundown.
1. Focus on ‘Just-in-Time’ Inventory and Favorable Depreciation of Capital Expenditures
Given the material cost increases, this is not the time to stock up on high-cost inventory purchases for the long term. It makes more sense to maintain just-in-time inventory.
So, rather than acquiring inventory for a six-month supply, for example, a company may purchase only the inventory required to fulfill current orders.
But additional purchases are sometimes unavoidable. This is true for industries that rely on high-cost equipment with consistent capital improvement requirements. In such cases, companies should take full advantage of the new tax law’s improved bonus depreciation provisions in place through December 31, 2022. Bonus depreciation then begins to sunset at a reduced rate of 20% a year through 2026.
The provision holds myriad benefits. For example, a scrap metal supplier can find relief from material cost increases by writing off the large capital expenditures it makes each year.
2. Revisit Administrative Costs
Another area worth checking is administrative fees. This includes rent.
In the New York area, for example, rental fees for industrial and retail properties have skyrocketed since the Great Recession. If a business is renting 100,000 square feet, but only needs three-quarters of the space, now might be a good time to right-size operations.
Similarly, companies should revisit health care and utility costs. This means verifying that vendors have provided the best pricing, and if not, whether terms can be renegotiated.
Your CPA can help identify additional cost-cutting opportunities.
3. Communicate with Customers
When there’s no choice but to raise prices, firms should inform customers of their decision in advance. The key is proactive communication.
Companies should not shy away from providing a full explanation, either. For example, if the current trade environment is the cause, the business might say, “The increase in prices is the result of the impact tariffs have had on our materials costs.”
The explanation may also note that competitors are doing the same. But any such assertion must withstand scrutiny. Otherwise a business risks losing credibility with customers, who could view it as a “lone wolf.”
Start by Identifying Cost Trends
The current uncertainty around tariffs requires a new approach.
As a first step, businesses should look beyond basic accounting and tax advice. The right advisor can identify trends in a company’s financial statements. Comparing current-year income statements to prior years should be central to this exercise.
Where decreasing gross profits are identified, the culprit is not always what first meets the eye. For example, overhead costs may not be the reason for the dip. Digging deeper into the financials may instead reveal the cause as material cost increases, triggered by the tariffs. That’s where the conversation should really begin.
Nobody can predict when the tariffs will end, of course. But an expert can help assess the pros and cons of raising prices and help strategize alternate ways to minimize the strain on profitability — until the tariff outlook becomes clearer.