In an increasingly interconnected world, the flow of goods across borders is a constant. However, when governments impose tariffs, a form of trade barriers, which have been proposed and imposed by the US government in recent months, the seemingly straightforward journey from factory to consumer can become considerably more complex.
Understanding how these tariffs ripple through the supply chain and ultimately influence the price level we see on store shelves is crucial in today’s evolving economic landscape.
It’s easy to assume a direct, one-to-one relationship: a 10% tariff equals a 10% price increase. However, the reality is far more nuanced. The journey of a tariff from its imposition at customs to its potential impact on your wallet is shaped by a multitude of factors, making it less of a simple calculation and more of an intricate dance within the global economy, influenced heavily by trade policies.
At the heart of this process lies the price associated with the product when it arrives at customs. Typically, this will be the CIF price, which stands for the cost of the goods, plus insurance and freight charges; however, this Incoterm can differ.
Once customs duties are applied to the CIF price, depending on applicable tariff rates, this total becomes the ‘landed cost’, the initial cost for the importer to bring the goods into the country. But this is just the first step in a chain that involves manufacturers, distributors, and retailers, each making their own decisions that ultimately shape the final price level you pay.
The Journey Through the Value Chain: A Running Shoe Example
There is a limit to how much of the tariff cost a company can absorb before the hit on profit margin becomes too much. So, it gets passed on. To illustrate, here is the estimated value chain cost structure of a $100 running shoe through the eyes of the producer and the retailer.
In this example, tariffs apply to the CIF price, which stands for the cost to produce, insurance, and freight at the point where the product lands at customs. The CIF price plus customs duties becomes the “landed cost”.
If the shoe’s production cost is $22 and the retailer buys from the producer/OEM at $50, the producer’s profit is approximately $5. The historic landed cost equals $27, which includes CIF plus customs duty. An additional ‘ad valorem’ tariff would apply to the cost to produce, plus insurance and freight elements, which we can estimate to be around $25 (+$2 legacy customs duty).
The 145% tariff example shows that the landed cost increases from the historic $27 to $63.25, $36.25 of which is the cost of the tariff. Passing this down the chain goes like this:
• The producer/OEM sale price to the retailer increases from $50 to $86.25
• The retailer, operating on a 100% markup, increases the customer sale price from $100 to $172.50
While the legacy profit numbers ($5 for the producer, $6 for the retailer) allow for a minor tariff impact, they cannot support a 145% tariff, resulting in a greater proportion being passed on to the customer.
Factors Influencing the Final Price
It’s not an exact science how a tariff will land within a total purchase price because of the cost composition of products and sales. The landed cost can vary according to how a manufacturer sets up their supply chain. The final purchase price can vary according to how the Original Equipment Manufacturer (OEM) or importer structures and allocates their operations and operating costs. Several key factors can amplify, diminish, or otherwise alter how the initial tariff cost translates into the final price for consumers:
Supply Chain Structure and Efficiency
Complexity
Longer and more complex supply chains with multiple intermediaries might see a greater cumulative impact of tariffs as each entity adds their markup to the increased cost.
Absorption Capacity
Companies with efficient supply chains and lower operating costs might have more capacity to absorb some of the tariff costs without passing them entirely to consumers, at least in the short term.
Sourcing Alternatives
Businesses with the flexibility to quickly shift their sourcing to foreign countries not subject to the tariff might mitigate price increases. However, this often involves time, investment, and potential quality or logistical adjustments.
Category Dynamics and Price Elasticity
Price Sensitivity
For product categories where consumers are highly price-sensitive (elastic demand), retailers and manufacturers might be hesitant to pass on the full tariff cost for fear of losing significant sales volume. They might opt to absorb a larger portion of the cost or look for ways to reduce other expenses.
Availability of Substitutes
If consumers can easily switch to alternative products, either domestic products or goods from countries without tariffs, businesses importing tariffed goods might be unable to raise prices significantly.
Necessity vs. Luxury
Tariffs on essential goods might see a higher pass-through to consumers as demand is less likely to decrease drastically. In contrast, tariffs on luxury items might be absorbed more to avoid deterring purchases.
Brand Positioning and Pricing Power
Premium Brands
Brands with strong customer loyalty and perceived high value might have more leeway to increase prices without significantly impacting demand.
Value Brands
Brands competing primarily on price might have to absorb more of the tariff to remain competitive, even if it impacts their profit margins.
Market Share Leaders
Companies with significant market share might be able to influence pricing trends and pass on costs more easily than smaller players.
Commercial Agreements and Contracts
Existing Contracts
Pre-existing agreements between suppliers and retailers might dictate pricing for a certain period, potentially delaying or limiting the immediate impact of baseline tariffs on consumer prices.
Negotiating Power
The relative bargaining power of different entities in the supply chain can influence how the tariff burden is shared. Large retailers, for example, might be able to negotiate better terms with suppliers to absorb more of the cost.
Competitive Landscape
Domestic Competition
The presence and pricing strategies of domestic industry producers (who are not subject to import tariffs) will influence how much importers can raise their prices for customers.
International Competition
The pricing of goods from countries not subject to the same tariffs will also create competitive pressure, limiting the ability of businesses importing tariffed goods to increase prices significantly.
Tariffs imposed by one country may also lead to retaliatory tariffs from trading partners, further influencing market dynamics. In such cases, retaliatory tariffs can compound the effects on price levels and consumer choice.
Currency Fluctuations
Exchange Rates
Changes in exchange rates can either offset or exacerbate the impact of tariffs on import costs. A weakening domestic currency would make imports more expensive, potentially compounding the effect of a tariff.
Government Policies and Regulations
Subsidies or Tax Breaks
Governments might implement policies on taxes to offset the economic impact of tariffs on certain industries or consumers, aiming to protect economic growth.
Price Controls
In some cases, governments might impose price controls to limit how much businesses can increase prices on essential goods.
