So let's walk through an example of how this system works according to the manufacturers and the Frontline episode that spurred this whole discussion.
Shovel Inc. sales rep goes in to meet with Home Depot buyer. The buyer tells the sales rep that they would like to buy 100,000 snow shovels at $13.55 per shovel. This would allow Home Depot to put a 40% markup on these shovels and they have found that $18.97 is the best price to mark their snow shovels for selling. The Shovel Inc. sales rep tells the Home Depot buyer that it is costing them $14.00 per shovel to produce the shovel now and there is no way they can sell it to Home Depot for $13.55. The Home Depot buyer says, OK, we won't buy any shovels from you this year, we'll go with another brand instead. The Shovel Inc. sales rep says no we need the business so we'll do it for $13.55.
Now Shovel Inc. is in a tight situation. They have this order to produce 100,000 shovels to be sold at $13.55 per shovel. Now obviously Shovel Inc. needs to make money on this so if they are going to be selling the shovels for $13.55 per shovel they would like to make 20% per shovel or produce the shovels at $11.29 per shovel. Currently it is costing them $14.00 per shovel so they have to shave off $.45 per shovel just to break even. The first step to cutting costs is to look at alternatives to the raw goods they are using. It just so happens that China is dumping steel on the US market that year and so they decide to buy this cheap Chinese steel instead of the US Steel they've always bought before. This will save them about $.50 per shovel, so enough to break even. They also decide to go with plastic handles instead of wooden handles to save another $.50 per shovel. Of course the first year they make this change there are development costs and so in the end they break even on the shovels.
The next year tariffs are placed on Chinese steel and so Shovel Inc. goes back to Home Depot and says OK we are ready to get you your 100,000 shovels, but with steel prices going up we have to do it this year for $15.00 per shovel. Home Depot says no we would like two things from you this year. We would like 50,000 all plastic shovels at $10.00 per shovel and 100,000 of the plastic and steel shovels at $13.00 per shovel. We hope to sell the $10.00 shovels for only a 10% markup but use that low price to pull in customers. We will keep our other shovels marked at $18.97 and make more profits to makeup the difference. If you can't meet these demands we will look elsewhere. The Shovel Inc. seller again agrees and goes back to his company.
Now they have to invest money to develop an all plastic shovel, and still provide a steel shovel with a plastic handle at a lower cost than they were able to do the year before. They are not going to be able to get their raw materials down enough to make these prices work and actually make profits for the year so they start to look at other ways they can cut costs. There are restrictions on steel imports, but not on importing shovels, so Shovel Inc. decides to bight the bullet and move one of their plants to China. They will lose money this year, but by moving their plant to China they will cut labor costs by 98%. They are currently paying union employees $15.00 per hour, in China they will be paying $.25 per hour. They also will not have to pay insurance, social security, pension, etc. It will also make the cheaper Chinese steel available to them and so even though they will have to ship their shovels into the United States market they will easily make their money back and increase their profits down the road.
Now of course the US plant is shut down and those employees laid off. It also means that US Steel loses the customer for raw goods even though there was protection against steel dumping on the US market. Home Depot gets to increase their profits and Shovel Inc. is now positioned to do the same.
In the next installment we will look at what other factors are involved this process that are missing from the model as presented by Frontline.
