Let us imagine a time when I bought steel for $400 per ton and sold it for $500 a ton, making a $100 a ton profit or 20% ($100/ $500). The markup would be 25% ($100/ $400).
From that $100 I have to cover all of my payroll and expenses which, let’s imagine cost $90 per ton leaving me with a $10 per ton net profit. If I sell 20,000 tons I make $200,000 after all expenses.
Now suppose that the replacement cost just shot up to $600 per ton. If I continue to sell my old existing inventory at $500 a ton, I will be $100 per ton short when I have to replace that inventory. So in order to be sure I have the cash to replace my inventory I price based on the replacement cost. I add $100 per ton to the replacement cost of $600 per ton and now sell for $700 per ton.
But wait; that old inventory that I bought for $400 now gets a $300 margin, triple what I got before. My income goes up dramatically. This is called an ‘inventory profit’; I benefited not by better selling or management, but by uncontrollable (by me) price increases. The additional $200 is needed pay the higher replacement cost but for a short time it is added to my bottom line.
Actually I need more than that $200 to cover the higher tax costs and interest costs.
Now some would accuse me of gouging or “excess profits” because they do not understand the economics of commodity products and pricing.
The reverse happens when prices fall. My cash flow improves but I will be selling product for below my costs and my profits will quickly become losses.
Explain that to your banker when it happens. You had better hope they understand basic economics much better than our elected officials, and certainly much better than the morons who report on the economy in much of our media.
Pricing mechanisms serve a clear function: keeping product available and suppliers viable. When the government with its populist stupidity tries to interfere with that function, the financial viability of the supplier and the consistency of the supply stands to suffer.