This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
A company turning out a product which requires a long period of manufacture will be compelled to purchase raw materials, pay for labor and other expenses incident to manufacture, and wait for a long period before the finished product is ready to sell. Large amounts of capital will necessarily be tied up in the process of manufacture itself. As an extreme instance, take shipbuilding. To build and equip a large vessel may-require three or four years. The outlay may amount to several millions of dollars. In case the product is not paid for until delivery, and in case several vessels are under construction at the same time, it is clear that the amount of capital invested in raw materials, partly finished products, and other forms of working assets will soon become enormous. Like remarks apply to the erection of large buildings or other important pieces of construction which may require several years' time and the investment of millions of dollars before the product is completed.
In these extreme instances, the problem is solved by throwing a large part of the burden of providing the expenses of construction upon the purchaser. Contracts for construction of all kinds almost invariably provide for inspection and acceptance of the work that has been completed up to given stages or at given intervals, and for payment on account by the purchaser of a proportionate share of the contract price. This arrangement is customary even with comparatively small pieces of construction, such as the installation of bank vaults, the erection of small dwellings, and the like.
Even with this proviso, it is usually the case that construction and contracting firms are called upon to lay out large sums and to wait for a considerable period before they are reimbursed, and it is quite necessary, therefore, that their working capital should be correspondingly ample. There is scarcely any line of business in which insolvencies are more frequent than in contracting. The explanation is nearly always the same; the working capital of the contracting firm is not sufficient to "swing" its undertakings. This is a difficulty which is peculiarly apt to confront all enterprising, progressive, and otherwise successful contractors.
In the extreme instances that have just been cited, the necessity of securing either an exceptionally large working capital or a series of payments on account in advance of delivery of the finished product, is universally recognized. But there are many less extreme cases in which the importance of this factor seems easily to be overlooked. In many processes of manufacture, time is one of the important elements. This is true particularly in handling "green" products such as lumber and hides; in making wines and distilling liquors of good quality; in developing suburban real estate; and so on indefinitely. The moment an effort is made to rush the process of turning out a finished product in any of these lines, the result is either a great increase in expense or an impairment in quality. On the other hand, it must not be forgotten that in slow processes provision for relatively large sums of working capital must be made. And in most cases it is not practicable to secure payment from the purchaser in advance of delivery of the finished product.
Moreover, there is a danger connected with long-process manufacturing, not on contract but for the general market, that fluctuations in prices may diminish or wipe out expected profits. To take care of such fluctuations and to carry the company through periods of distress which may result, it is essential both that the average profits should be high and that the supply of working capital should be ample.
This was one of the main sources of trouble for the United States Leather Company when the combination was first formed; between the date of purchase of green "packer" hides in this country and the actual sale of the finished leather, from six to twelve months usually elapsed. Between the purchase of Argentine hides and the sale to a foreign consumer, this period may be extended to a year and a half or more. At a time of falling prices, the price of hides lags behind that of leather. As a result, in the middle 90's, the United States Leather Company repeatedly sold leather for less than its cost of production.*
Still another handicap to a business in which the period of manufacture is lengthy, is the impossibility of making quick adjustments to market conditions. By way of contrast, consider the case of a company at the other end of the scale - a bread-baking company, which manufactures overnight the product that it sells the next morning. If there were to take place a sudden shifting of demand from one kind of bread to another, or even away from bread altogether toward some other kind of food, the bakers obviously could adjust themselves to the change in short order. The leather manufacturer has no such advantage. He is continually tied up with enormous quantities of hides and of leather in the various stages of manufacture. It is at least expensive, and in many cases impossible, for him to shift from one kind of product to another. He may suffer - and in fact many leather manufacturers have suffered - severe losses due simply to changes in taste on the part of the consuming public.
It is clear that the length of period of manufacture is an important factor in determining how much working capital a corporation will need. A breadmaker does not risk as much in proportion to the volume of his business as does the leather manufacturer; for he has scarcely paid for his flour and labor before the receipts from his sales flow back to him.
One important improvement in automobile manufacturing which within recent years has put it on a safer and more stable basis, is the reduction in the length of time required for turning out finished cars.