What’s Better: Scaling Up or Down?

As more and more news comes in on the U.S.–China trade tariffs, it can be difficult to know what to expect — let alone plan for. Most recently, both countries reached an agreement that provides some tariff relief, but the execution and ultimate impact remain uncertain. While this was a positive sign, manufacturers, distributors, and other organizations are left wondering how to respond to the tariffs, knowing that they can’t base their inventory strategy and other operational decisions solely on the most recent headlines.

While the volatility of these trade negotiations has left many manufacturing and distribution organizations with a feeling of uncertainty, it is important that companies do not become paralyzed as a result. Action is needed, but the question is, what should that action be?

While a common reaction has been to raise prices to account for the tariffs, this has shut down a great deal of consumer demand. For many manufacturers and distributors, demand is what drives volume. But with rising production and material costs and declining consumer demand leading to an erosion of margin and profit, how can they determine the appropriate approach to handling tariff challenges? This depends on whether they think that tariffs will increase or decrease in the future.

Those that believe that the tariffs will increase or remain in effect for a long time are struggling with whether they should build up inventory now to avoid higher costs in the future. While this means more expense to the business now in securing inventory, operations can continue and profitability — hopefully — can be preserved. But this is a gamble in that the company may over-invest in inventory only to see the tariff decrease. And what happens if consumer demand doesn’t pick up?

Those thinking that tariffs will decrease are holding off on bulking up their inventory to avoid the current tariff and maintain their profitability, but this comes with several challenges. Inventory will continue to decline — leading to potential shortages and potentially forcing the company to replenish their inventory at the higher cost they were hoping to avoid. Shortages can also mean service problems, which bring about their own costs and difficulties.

Both scenarios are incredibly difficult, and it’s understandable that they would leave many companies feeling paralyzed. But in order to best know how to handle tariffs, companies should first look to areas where they can reduce costs.

Descaling Through Cost Reduction

There are two high-level areas where manufacturers and distributors can look to reduce costs as a solution for how to handle tariffs: variable costs and fixed costs. Variable costs are costs that change with business output, whereas fixed costs don’t. While it can be easy to put together a list of such costs that can be reduced, it’s important that these reductions are done in such a way that organizations can quickly scale back up when needed.

Variable Cost Reductions

Variable costs are expenses that generally trend in relation to sales volume. As an organization sells more goods, it follows that other costs increase in order to meet demand and to help an organization get into a position to increase sales even more. Examples of variable costs include basic raw materials, component parts, salesperson commissions, hourly labor, delivery and shipping charges, and advertising.

When planning for how to handle tariffs, adjusting variable costs is often the first step organizations take because those costs are directly tied to sales. If sales are down, the costs associated with the business must go down as well. Variable costs can also be adjusted more quickly than fixed costs. For example, canceling an advertising campaign or reducing orders of raw materials would not be as time-consuming as eliminating personnel or moving to a new facility.

If the tariffs were to increase, adjusting variable costs gives organizations a faster way to preserve their margin or at least withstand the immediate impact of the tariff increase while finding other ways to reduce costs and maintain operations. If the tariffs were to decrease, the very nature of variable costs means they can be scaled back up to meet increasing demand.

Fixed Cost Reductions

Whereas variable costs are tied to business sales, fixed costs are expenses that are incurred regardless of fluctuations in sales. Sales supports these costs, but they will not change alongside reduced demand or higher production costs. Fixed costs are also more difficult to adjust because they are items that often have a longer-term (e.g., 6–12 months or more) commitment associated with them. Examples of fixed costs include facility rent or loan payments, employee wages, equipment depreciation, certain technology platforms, insurance, and so on.

While not all fixed costs can be reduced right away in order to relieve the pressure on margins, some adjustments can be made that will have a positive impact over time. Making efforts to reduce energy usage and non-production-related materials, not hiring any additional staff (as opposed to eliminating personnel, unless the latter is necessary), and so on can help drive down costs going forward while organizations wait on the outcome of the tariff agreements.

If tariffs increase and demand decreases, the ground made up in reducing fixed costs combined with adjustments to variable costs can help to preserve margin. If the tariffs decrease, companies can consider ramping the company back to where it was if desired. Often, fixed cost reductions are an ongoing effort, as such reductions would help a business increase its margin and profit regardless of tariffs. But, this is dependent on the organization and its goals.

When considering how to react to tariffs, the scalability of the cost reductions that are enacted is critical. Remember, while headlines seemingly change with each passing week, so too does the chance for the tariff negotiations to be concluded. If and when that happens, it’ll be important to start scaling back in the direction of where operations were in the pre-tariff environment.

Competition Factors into How to Handle Tariffs

Finally, the choice between scaling up or scaling down and the related cost adjustments play an important role in the competitive space. Not every organization is going to make the same decision as their competitor will make — or make a decision at all for that matter. Taking action now to get into the most advantageous position possible not only helps to preserve margins and profits but also helps companies emerge from this challenging season ahead of their competition.

Remember, addressing the tariffs is not necessarily a gamble on whether to buy more inventory or sit on current inventory levels. It’s about making intelligent decisions that preserve profit margins in such a way that companies can efficiently scale back up to pre-tariff operations when the circumstances permit.

Plan Your Tariff Strategy with Confidence

At River Rock Advisors, we understand that this decision is not one to be made lightly. Our team will work with you to understand your current inventory performance and business objectives and develop a strategy that protects your business now and in the future. If you’d like to learn more about this approach and the recommendations that have been made, River Rock Advisors is here to help. Contact us today to get started or fill out the form below.