A longtime friend and reader asked me to explain how tariffs work. Of course, it’s a politically charged topic, but a simple description of how they function should be apolitical and straightforward enough.
I will start with a made-up product, Wakanda’s Widgets, which are imported to the US. My made-up supply chain has three players: the manufacturer in Wakanda, a US importer that also acts as a distributor and the end retailer that puts the widgets on the shelves.
The left-hand column below shows the price of the widget from the initial cost of goods sold of $6 to the final retail sale price of $39. I’ve made up all the numbers, and you can be sure nobody is making this much money on a $39 widget in the real world.
The right-hand column shows a highly simplified profit/loss statement for each company in the supply chain.
Let’s start with Wakanda’s Widgets, which are highlighted in orange. In my example, the raw goods that go into a widget cost $6 to pull from the ground. The company has to pay its workers $1 and spend another $1 on drills, office equipment, etc. If they sell the widget to an importer in the US for $10, that leaves a profit of $2, or 20 percent. For the manufacturer, the left and right columns look similar.
The importer buys the widgets for $10 and pays $1 to transport and insure them during transport. In this example, I’m assuming that the US already charges a 10 percent tariff on goods from Wakanda, so the importer also has a $1 cost. The ‘landed cost’ is $12. Let’s assume the importer can turn around and sell the widgets for $18, a 50 percent markup from the landed cost.
The righthand column looks similar, but there are a few more items because what others say about tariffs is often misleading. For example, others frequently write that the importer has a $6 profit, which is the difference between the sale price and the landed cost. That may be the gross profit, but it assumes that the importer has no costs – no people to facilitate the transport, no offices or computers, etc. So, I’m showing that there are operating costs of $2.40, which leaves the importer with an actual profit of $3.60, or 20 percent of their revenue.
The retailer had to pay $18 for the widgets, and if they used the standard ‘keystone’ pricing markup, they would sell the widgets for $36. Like the importer, people often think that this difference is all profit, but that’s not true, so my mini-income statement on the right shows the retailer’s profits, which are $7.20, or 20 percent of their revenue.
For fun, let’s assume that the US government doubles the tariff from 10 to 20 percent. If I recreated the illustration from above, we’d see the direct hit to the importer because the tariff would go from $1 to $2, taking the landed cost from $12 to $13.
If that were the end of the story, we could quickly answer the question, ‘Who would pay the tariff’s cost?’
It’s not that simple because the importer won’t likely absorb the cost. If they have a contract to sell the widgets to the retailer for $18, then yes, they’ll pay unless they can work something out with the manufacturer.
The importer is more likely to pass on the cost to the retailer than the manufacturer. Retailers might absorb the cost and reduce their profits, but they are more likely to pass on the new cost to the consumer. What once cost $36 to buy might now cost $36 to $39, depending on who in the supply chain can pass on their costs and by how much.
A natural worry is that the tariff’s cost goes straight to the consumer and causes inflation. The tariff could hurt the manufacturer by forcing a price reduction or reducing demand for widgets. The distributor and retailer would likely also see their margins squeezed.
The most likely scenario is that everyone is impacted, from the manufacturer to the consumer and everyone in between. It may be worth it to reduce the deficit or impact other priorities of the country, but it won’t likely be a free lunch.
