A widget maker has a dilemma.  Back in the heyday, he purchased the raw materials to make 100 widgets at a cost of $10 per widget.  Adding in labor, administrative costs, and depreciation, his unit cost was $15 per widget.  Normally, his widgets sell for $20, netting him a handsome 25% profit on every widget sold.

But, haven't you heard?  These are tough economic times!  Widget sales are off dramatically.  In fact, the widget maker estimates the most he could sell his inventory for is $14 per unit, a loss of $1 on every unit sold.

So, here's the widget maker's dilemma:  He's got $1,500 in sunk cost tied up in these widgets.  Should he sell them at $14, recouping $1,400?  Or, should he allow the inventory to pile up until the widget market rebounds?

Of course, the dilemma isn't just centered on the widget maker's factory.  Retailers, who could sell widgets all day long at the lower price, are scrambling for inventory.  Materials suppliers, who are hearing the same, sad story from widget makers around the world have seen their sales drop to almost zero.  Who wants to buy raw materials when inventory is piling up in the warehouse?

In fact, his suppliers are willing to give deep discounts of 30% off the previous price.  The widget maker punches some numbers in his trusty calculator and figures his new unit cost at $12 so, without any other changes, he could make a profit of $2 per widget.  That's not the previous 25%, but at least it's positive cash flow.

But, there are already 100 widgets, sitting in the warehouse, that need to be sold before he can produce and sell more widgets at the new prices.  If he were to sell current inventory at a loss and produce another batch of widgets, what would his income statement look like?

 

                            Period 1    Period 2

Sales                    1400          1400

  Cost of Goods    1000           700
Revenue            $   400       $  700

Expenses           $  500        $  500
Net Income        $(100)        $  200

Gee, that doesn't look too bad.  By period 2 he would recoup his loss and be back in the black.  So, what would the proforma cash flow statement look like?

                            Period 1    Period 2
Operations
  Net Income          (100)            200
  Inventories            300                0
Cash from Ops    $  200        $   200

Previous Period             0            200
Change                      200            200
Cash on Hand        $  200        $  400

Because the new inventories are cheaper to produce at the new prices, the widget maker would actually realize a positive cash flow in the first period, the very period where the income statement would show a loss.  Given the dire straights the widget maker was facing, this would seem to be all good news.  So, why wouldn't the widget maker sell existing inventories and get on with the business of making widgets?

There is only one reason.  Given his own time preferences, for some reason the widget maker believes that, sometime in the future, he will be able to sell existing inventories for a greater profit than if he sold them immediately.

Hopefully, by now, you've realized that the widget maker's dilemma is not-so-hypothetical.  Here are two recent headlines:

Toyota, Honda Slash Global Production as Recession Cuts Demand

January auto sales expected to drop 30%

And, here are some photos the Guardian published last week of auto inventories piling up at the ports and other lots:

Keep in mind that those photos are not of “assets”, but of liabilities.  Every day those vehicles spend in those lots the manufacturers are paying to store and insure them.  Every day those cars go unsold, interest is mounting on any loans outstanding.  Administrative costs are increasing in a period where workers on the line are being laid off, and auto makers are begging their governments for bridge loans.

Perusing the CPI data from December 2008, we see that car and truck prices dropped 5.7% in the last quarter of 2008, compared to a 12.7% decrease in all goods (led and distorted, of course, by the drop in gas prices).  Cars, trucks, and civilian airplane prices are up on the Producer Price Index even while almost all other finished goods are down dramatically, and intermediate and crude goods prices have fallen off a cliff.

Meanwhile, the automakers who begged President Bush for bridge loans have until March to show some progress.  At the time the loans were made, everyone merely assumed that the automakers would be back to Washington panhandling in March.

So, rolling it all up, the bottom line is the price of cars and trucks is increasing compared to all other goods even as inventories pile up in lots, production costs are down, and at least a couple auto manufacturers have a very short time horizon.  Given all that, why won't the automakers drop their prices, liquidate current inventories, and get back to the business of making cars like our widget maker?

There can be only one reason.  Automakers, for some reason, believe that they will be able to sell those inventories in the future at a greater profit than they can by selling them immediately.  That's quite a belief, given the current state of world economies and the very short time preferences they have right now.

In other words, the automakers have reason to believe that the deflation of current prices will not last very long.  In fact, they're making bets based on an expectation of very rapid price inflation, very soon.

Remember that driver's ed film we had to watch, Highways of Agony?