Cost-Of-Goods-Sold (COGS) is the basis for all pricing. In very general terms, COGS is made up of:
- Indirect Overheads
- Direct Processing
- Direct Labor
If you are not in industry, you might be surprised to learn that labor often accounts for less than 10% of COGS. You might also be surprised that in some industries — for instance, machining — it is not unusual for material to comprise 50% or more of the COGS. Raw materials are usually worldwide commodities and should — at least theoretically — cost the same for everyone regardless of the country they are bought in. And while wages are lower in some countries compared to the U.S., they don’t really move the needle much, relative to overall cost. If that’s the case, you might ask, why are Original Equipment Manufacturers (OEMs) sourcing so many parts overseas?
The answer to this question can be quite complicated.
For a detailed account of how manufacturers in some countries can offer OEMs significantly lower prices than domestic sources you may want to refer to my Industry Week article “Why U.S. Government Needs to Be Engaged in Economic Development,” which I wrote during my time as a contributor to their website and which significantly supplements this discussion.
The Consequences of New Steel and Aluminum Tariffs
There is really no question whether enacting a tariff on raw steel and aluminum will help U.S. steel and aluminum corporations financially. It will. The question remains, however, how those tariffs will impact our small and medium-sized manufacturers (SMEs). I believe the answer to this question centers around the issue of COGS. To understand this better let’s look at a possible scenario.
For this example, assume the following:
- The part in question is processed exclusively from imported raw steel with 50% of the COGS coming from the cost of that raw material.
- The current COGS is $1.00 per part.
- A 25% tariff on imported steel has been put in place.
The tariff would cause the material contribution to the COGS to increase from 50% to 55.5%, and the overall COGS to increase 12.5% to $1.125. A supplier operating under this scenario would need to raise their piece price to (at least) $1.125 in order to maintain its’ current profitability. How do you think that will go over with the OEM customer?
Based on this, you can be sure that the SME would be searching for a domestic steel source to buy their raw material from more cheaply, right? What would that search yield them? First, a shortage of available steel. Why? Because currently, domestic mills no longer have capacity to immediately replace the portion of domestic steel consumption that imported steel is filling. So you’ll have SMEs likely coming up short relative to the material they need to support customer schedules. That won’t make their OEM customers happy, either.
“Currently, domestic mills no longer have the capacity to immediately replace the portion of domestic steel consumption that imported steel is filling.” –
Added to that, history shows that when tariffs are applied, mills do not maintain current pricing. In fact, they raise their prices to be marginally below new tariff-loaded foreign pricing. This means that even if they can get their hands on domestic raw material, SMEs are probably looking at a significant increase in material cost here, too. Again, because the price of non-tariffed domestic steel won’t significantly dampen the increase SMEs will see on imported material, OEM customers won’t be happy.
Backing OEMs Into a Corner
What do OEMs do when they are not happy with current supplier pricing proposals? It’s very simple. First, they first push back, asking the supplier to absorb the increased material pricing. Second, if this doesn’t work, they look for another source. OEMs certainly don’t want to raise the prices of their own finished goods since this would affect their competitiveness. If they do raise prices, they will likely see sales drop since fewer customers will be able to afford their products. I can tell you that very few SMEs are getting rich today selling to OEMs. If they are good business people they probably make what would be judged a reasonable profit on their investment and labor. So, I suspect not many suppliers will be looking to absorb an increase in their material costs, particularly if it represents a double-digit percentage contribution of their COGS.
A Neatly Packaged Advantage Over American Manufacturing
Based on this and their need to remain competitive, the introduction of more or increased tariffs on steel and aluminum will force many OEMs to either re-source business from domestic suppliers or turn to the only place where they can get parts with lower-cost raw steel — namely overseas sources. For instance, South Korea is a big exporter of parts, assemblies and finished product to the U.S.A. The biggest steel supplier to South Korea (by far) is China, and U.S. tariffs on Chinese steel will not increase the price they pay for their needed raw steel. This means that, South Korean manufacturers will enjoy an increased competitive advantage over U.S. manufacturing — provided directly by the U.S. government.
Unfortunately, the recently announced updated trade agreement with South Korea does not address this issue! Hmmm.
Second, OEMs with manufacturing plants outside of the United States will think again about bringing them back in-country since it would increase their cost of steel. And others may consider setting up out-of-country manufacturing. Again, hmmm.
“The introduction of more or increased tariffs on steel and aluminum will force many OEMs to either re-source business from domestic suppliers or turn to the only place where they can get parts with lower-cost raw steel — namely overseas sources.” –
This will not bode well for the impacted SMEs, and many will likely struggle to stay in business. It will also not bode well for increased OEM employment in the United States. The U.S. needs a strong steel and aluminum industry, but I also feel that the worldwide economy is so complicated that we probably won’t get what we want by acting like a bull in a china shop, i.e., being a bully. Instead, we can expect damage to our domestic economy as a result of these general, stand-alone tariffs.
If the problem were simple to resolve it would have been addressed a long time ago. There are no simple answers, and people that think there can be aren’t being realistic.
So, what’s the solution?
Again: The U.S. Government Needs to Be Engaged in Economic Development
In order to compete effectively on a worldwide basis, the U.S. needs to realize that in many places free enterprise is the exception, not the rule. One of the reasons why our competitive issues haven’t been addressed is we continue to elect to Congress a large number of what I call “Uber Free Marketeers,” who will not allow our government to take an active role in protecting U.S. manufacturing. For instance, there has been persistent pressure over recent years by these “Uber Free Marketeers” to eliminate the Import-Export Bank, which helps foreign firms and countries finance purchases from U.S. manufacturers. Elimination of that institution would result in a competitive advantage for the foreign governments that continue to maintain them. And, by the way, most of the world’s top manufacturing countries have one.
“Left to itself, a solely free market strategy will require SMEs in small-town U.S.A. to compete not only against foreign sources but also against their own governments.” –
Instead, the Uber Free Marketeers want to adhere to a strict government “hands-off” approach, believing that, in the end, a free market itself will take care of everything. The rise of China’s economy and our current competitive situation shows that a global free market doesn’t actually exist. This means that, left to itself, a solely free market strategy will require SMEs in small-town U.S.A to compete, not only against foreign sources but also against their own governments. Lordy, Lordy, this type of idealistic thinking drives me nuts.
The main point I’m trying to make is that there are realities of international business that need to be recognized and that without our federal government taking a more proactive and holistic role in addressing them, our manufacturing sector will continue to diminish. It might be true that, “Without a steel industry you don’t have a country,” as has been said. But it’s even more evident that, “Without manufacturing, you really don’t have a country,” and we need to start recognizing that.
My next article will discuss the OEM Payment terms.
Learn more about Paul Ericksen and his over 40-years in the manufacturing industry here.