You Just Have to Know When

Naomi and Terry were looking at the steel orders for the J-class line. Terry thought money could be saved by ordering in advance. "Now look at this." Terry said. "In the six months ending last December, we ordered steel for a total cost of \$1 600 000. If we had bought this steel at the beginning of July, it would have cost only \$1 400 000. That's a savings of \$200 000!"

"Good observation. Terry, but I don't think buying in advance is the right thing to do. If you think about it, the rate of return on our SI 400 000 would be 200 000/1 400 000 or about 14,3% over six months."

"Yes. but that's over 30% effective interest, isn't it? I'll bet we only make 8% or 10% for money we keep in the bank."

"That's true, but the money we would use to buy the steel in advance we don't have sitting in the bank collecting interest. It would have to come from somewhere else, either money we borrow from the bank, at about 14% plus administrative costs, or from our shareholders."

"But it's still a good idea, right?"

"Well, you are right and you are wrong. Mathematically, you could probably show the advantage of buying a six-month supply in advance. But we wouldn't do it for two reasons. The first one has to do with where the money comes from. If we had to pay for six months of steel in advance, we would have a capital requirement beyond what we could cover through normal cash flows. I'm not sure the bank would even lend us that much money, so we would probably have to raise it through equity, that is. selling more shares in the company. This would cost a lot, and throw all your calculations way off."

"Just because it's such a large amount of money?"

"That's right. Our regular calculations are based on the assumption that the capital requirements don't take an extraordinary effort."

"You said there were two reasons. What's the other one?"

"The other reason is that we just wouldn't do it."

"We just wouldn't do it. Right now the steel company's taking the risk—if we can't pay, they are in trouble. If we buy in advance, it's the other way around—if our widget orders dropped, we would be stuck with some pretty expensive raw materials. We would also have the problem of where to store the steel, and other practical difficulties. It makes sense mathematically, but I'm pretty sure we just wouldn't do it."

Terry looked a little dejected. Naomi continued, "But your figures make sense. The first thing to do is find out why we are carrying that account so long before we pay it off. The second thing to do is see if we can't get that price break, retroactively. We are good customers, and I'll bet we can convince them to give us the price break anyhow, without changing our ordering pattern. Let's talk to Clem about it."

"But, Naomi, why use the mathematical calculations at all, if they don't work?"

"But they do work, Terry. You just have to know when."