Updated on March 14, 2019 to reflect the agreement between Chinese President Xi Jinping and U.S. President Donald Trump to delay planned tariff increases from taking place on March 1, 2019.
Are you sitting down? Your inventory costs could increase by 25 percent because of tariffs.
The whole tariff situation has escalated rapidly in less than a year and shows no signs of resolution. Just what are tariffs and what can businesses do to protect their margins? We look at the history of tariffs and how business owners can stay afloat in this new wave of protectionism.
What are tariffs?
Tariffs are basically a tax on imported goods at the border.
In theory, tariffs serve two main purposes:
- Allow the government to collect revenue
- Protect domestic industry and products
Tariffs restrict imports by increasing the price of goods and services purchased from overseas, driving consumer demand for domestic products. This can help prevent what’s called a trade deficit—when a country imports more than it exports. A trade deficit can harm domestic industries and employment.
If a country imports more goods from foreign countries than it exports, prices for those goods can go down, which makes it harder for domestic companies to compete—resulting in fewer jobs and lower pay.
It sounds simple and logical, but the outcome of tariffs is more complicated. Here’s why.
The history of American tariffs
The first tariff law was passed in 1789, shortly after the Constitution was ratified, as a way to generate revenue for the new United States government.
Tariffs were the primary source of federal revenue because there were no corporate taxes. Talk about easy quarterly paperwork!
The other goal of tariffs was to protect the fledgling industries of the new country. Prior to American independence, Britain imposed limits on what the colonies could manufacture, in effect keeping the colonies primarily agricultural and not industrialized.
Not surprisingly, these economic limitations helped start the American Revolution.
The first tariffs were levied at only five percent, but by 1820, tariffs were an average of 40 percent.
America was one of the most protectionist nations in the world when it came to trade. Then, two things led to the decline of tariffs:
- American industry grew and needed to expand to foreign markets.
- The Federal government created a different revenue source in 1913: income tax.
After World War I, tariffs were raised again when the Smoot-Hawley Tariff Act was passed in response to the Great Depression.
Canada, Britain, Germany, France and other industrial countries retaliated immediately with their own tariffs and bilateral trade deals. As a result, American imports and exports declined.
Post-WWII, protectionist policies shifted to promote the growth of free trade. Use of tariffs declined rapidly. The General Agreement on Tariffs and Trade was established in 1947, becoming the World Trade Organization in 1995.
The North American Free Trade Agreement (NAFTA), which had bipartisan support, passed in 1993.
Tariffs in the modern age
Tariffs were a simple lever back in 1789.
While materials, which were not subject to tariffs, may have been imported, most manufacturing was completed in a single country.
Supply chains were shorter and the products manufactured were much simpler. Thus, tariffs had a clear cause and effect in this early economy.
For example, if you bought an American-brand vehicle that was one of 1.6 million imported to the U.S. from Mexico in 2016, 40 percent of that vehicle was manufactured in the U.S.
In some instances, a single part of that vehicle crossed the border as many as eight times during its manufacture.
Imagine the cumulative financial effect if a tariff were levied at each of these border crossings.
Given the interdependence of modern supply chains, the value — and impact — of tariffs is far less clear. In some instances, the same industry can both gain and lose with tariffs.
How tariffs have impacted the washing machine industry
Citing “serious injury to domestic manufacturers” the Trump administration imposed its first tariffs on washing machines and solar panels in January of 2018.
“This is, without any doubt, a positive catalyst for Whirlpool.”
-Marc Bitzer, the chief executive of Whirlpool Corp.
Whirlpool’s stock rose by 10 percent along with hiring, supplier orders, and company expectations. Then, China retaliated with its own tariffs on steel and aluminum.
In the six months since the first washing machine tariff was announced, Whirlpool’s share price went down 15 percent. Foreign competitors LG and Samsung have increased investment in their U.S. operations, resulting in some new American jobs.
Globally, appliance manufacturers have margins that average just 3.7 percent. These thin margins left all manufacturers with no choice but to increase prices.
Prices for washers jumped 20 percent and now consumer demand is declining, with an 18 percent drop in shipments in May 2018 alone.
U.S. appliance manufacturing revenue, employment, and wages are now expected to sink for the first time in 10 years.
Ironically, in that same period since the first washing machine tariff, the overall U.S. trade deficit increased by 7 percent.
The situation for washing machine manufacturers highlights how complex tariffs are now, bringing both benefits and losses to the same industry.
One of the few clear winners in this situation? Appliance repair shops.
What new tariffs aim to achieve
A question most of us are asking right now is “why?”
The rationale for the current wave of tariffs is President Trump’s America-first agenda and the administration’s stance on the trade deficit.
The administration’s stance is that China’s acts, policies, and practices related to technology transfer, intellectual property, and innovation are unreasonable, unjustifiable, or discriminatory and burden or restrict U.S. commerce.
The ability for the president to act without receiving approval from Congress is why we’ve seen such rapid escalation on tariffs. And this creates much of the uncertainty for the future.
Where the trade war is headed
Since these first washing machine tariffs, the scale and scope of tariffs have been rapidly increasing as foreign countries respond to U.S. tariffs with their own tariffs.
By early July of 2018, the Trump administration had imposed a total of nearly $100 billion in tariffs on China and other trading partners including the EU.
The actions set in motion a trade war with retaliatory measures from all impacted trading partners, especially China.
U.S. goods initially targeted for tariffs by other countries were both strategic and political in nature: agricultural commodities including soybeans, pork, corn, and wheat; American motorcycles; jeans; and bourbon.
As the trade war escalated, the items on the 475-page “Mega Retaliation Matrix” list now number into the thousands. The industries most impacted by retaliatory (non-U.S.) tariffs are:
- Automobiles and car parts
- Aluminum, steel, and iron (exports)
On July 11, the trade war “went nuclear” with a jaw-dropping additional $200 billion in proposed tariffs on Chinese good—over 6000 line items ranging from nuclear plant parts to sporting goods. U.S. industries that will be most impacted by these tariffs on Chinese imports include:
- Science and education
The Trump administration began levying 10 percent on these targeted Chinese goods on September 24. The rate will increase to 25 percent in March unless China concedes.
If China retaliates, the Trump administration is proposing more tariffs on nearly all imports from China other than a few company-specific exceptions.
Over $500 billion in Chinese imports could be subject to a tariff. There is no resolution in sight.
How enterprise companies are responding to tariffs
A few corporations have negotiated exceptions to tariffs, resulting in a significant competitive advantage.
The majority, however, are starting to feel the pain of tariffs as a decline in their stock prices. They are taking protective measures.
There are four primary responses from enterprise companies:
- Moving production away from China, primarily to Southeast Asia
- Reshoring production to the U.S.
- Moving production outside the U.S. for the products hit with retaliatory tariffs
- Raising prices
These companies, your customers, are looking to their supply chains for collaboration and ways to save costs.
How SMB and mid-market companies can respond to tariffs
So, as a vendor, what do you do if your goods or materials are subject to a tariff?
Like the mixed results for washing machines, it depends a lot on your individual situation.
Buy inventory before prices increase
The latest tariffs are levied at 10 percent, but this cost will increase to 25 percent March 2019.
One option is to fund inventory ahead of price increases. If your customers offer an option to request early payment, you can access your own cash at a discount lower than your cost of capital.
This provides a smart, debt-free source of funds you can use to purchase inventory before your costs increase.
If your supply chain is in China, you may have to find alternative suppliers, raise prices on future shipments, or reduce your operational costs to navigate these changes.
This is easier said than done.
Most companies are beginning the process by reviewing their global import and export data and to understand the potential impact of current U.S. and non-U.S. retaliatory tariffs.
Be sure to review not only the costs of the inventory but logistics costs, transfer pricing ramifications, and tax implications as well as the time it will take to ramp up production with a new supplier.
Stocking up on inventory and assuring you have adequate cash flow now may help you avoid disruption if you need to change suppliers.
Look for other cost savings
It may not make financial sense to change suppliers or may put your business at too much risk.
In this case, you may need to invest in ways to make your business more efficient, streamline operations to save costs, or work with your suppliers to minimize price increases.
Your ability to raise prices will depend on your customers and contracts. If you sell to retail or big box customers, many will not accept price increases on confirmed purchase orders.
This may not be as painful now with tariffs at 10 percent. But, that pain will increase in March when tariffs go up to 25 percent.
Some retailers are collaborating with suppliers in a shared-loss approach, each side absorbing part of the increased cost.
As a manufacturer or supplier, you will need to communicate with your customers and weigh the risk of losing business against absorbing increased costs.
Prepare for an influx of new orders (if tariffs benefit your industry)
Some companies, US steel producers, for example, may benefit from the tariffs with increased orders or new contracts.
It’s a good problem to have, but it comes with a need for increasing cash flow to ramp up production and meet an anticipated increase in demand.
Having outstanding invoices paid early by your customers can give you the cash flow you need without adding debt in this situation, too.
Revisit plans for expansion and other capital investments
It’s been a turbulent year for businesses. Many celebrated the lower corporate tax rates only to have this boon offset by tariffs and supply chain risks.
The uncertainty has a few companies considering delays for expansion plans or purchases of equipment.
The tariff situation does not show any signs of resolution for the near term. You will need a holistic approach to deal with the current situation and prepare for how it evolves.
Depending on your situation, strategies to minimize the impact of tariffs include:
- Identifying the products, parts, or materials that are affected by the tariffs and what the financial impact will be.
- Evaluating your funding options, including your cost of debt which may be rising with interest rates versus non-debt sources of cash flow such as early invoice payments.
- Accelerating invoice payments, then using the cash flow to buy inventory now at lower costs.
- Deciding if you need to change sourcing or manufacturing in the future and plan for how to manage the costs until you can make those changes.
- Reviewing your operations to identify costs savings and work with your suppliers to reduce costs in your supply chain if possible.
- Reviewing your agreements with customers and suppliers for contract dates, hardship exceptions, and terms for price increases related to tariffs.
- Working with your customers and suppliers to identify any shared-loss options.
- Ensuring you have the legal mechanisms in place to switch manufacturers; ensuring there are no restrictions on switching a manufacturer and that you have rights to intellectual property and technical data you need to provide manufacturing instructions to another source on short notice.
- Working with your suppliers and customers to prevent supply chain disruption. Even if you are not impacted by tariffs currently, take this opportunity to identify alternate sources in case the trade war escalates in scope.
- Negotiating price increases if necessary—consider a phased approach.
- Understanding your full cost of inventory including logistics, transfer pricing, and tax implications.
- Following the tariff issue closely for how it will impact your business.
- Diversifying your customer base outside the U.S. to offset the impact of retaliatory tariffs.