The Nickel Game

“What would you pay for a nickel?”
   The question came from a professor in my MBA finance class at Southern Methodist University. I was bidding on the nickel against one of my classmates.
   “Four cents,” I said confidently, leering at my opponent.
   “Five cents,” he said in a condescending tone.
Hmm, I thought. I really wanted to win, but six cents for a nickel? The class was hushed, the suspense unbearable. I took a deep breath.
   “Yours,” I said, swallowing my pride.
   My competitor grabbed the coin, but now it was his turn to bid first.
   “Four cents,” he said.
   “Five cents,” I responded, quickly jumping on the opportunity. I wouldn’t want my competitor to win both nickels and make a penny to boot.
   My professor shook his head. “I expected more from the two of you,” he said. “You both lose the nickel game.”
My jaw dropped.
   The teacher then showed us how the nickel game was played. First, he bid a penny on the nickel. His opponent let him buy the coin. Then she bid one cent on the next nickel. The teacher graciously gave her the nickel and the same four-cent profit.
   “That’s how to win the nickel game,” he said. “The object is to pay as little as possible for the nickel. Too many of you think the object is to win the coin. But if you pay too much for the coin, you lose.”
   In the real world, this cooperation to maximize the profits of both parties is called price-fixing or an antitrust violation. But this was finance class. Business law was next period.
   Price-fixing aside, the nickel game is one of the most valuable lessons I retained from grad school (the other is to check for food in my teeth before an interview).
   I like simple things, and the nickel game is based on an extremely simple concept. If you’re operating a business, you should never pay a nickel for a nickel. To win the game, you must be able to maximize your profits.
  Unfortunately, when it comes to the nickel game, many scrap processors come up losers. The main problem is that too many of them want the nickel at any cost. Simply put, scrap processors often lose the nickel game because they pay too much for scrap. Buying scrap doesn’t guarantee profits. Buying right does.
   Now, imagine you’re a finance professor back at good ol’ SMU (or your own alma mater). Let’s look at our scrap processor students as they play the nickel game.

GAME 1—An Egocentric Decision
  “He’s going after the Smith account, Bill,” says Fred, salesman for Cinco Scrap & Co., a Midwestern processor. “I don’t know how he can pay this guy so much for that garbage. We find all kinds of junk in those boxes. It takes our guys forever to sort.”
   “We’ve had that account for 17 years,” answers Bill, the owner. “My dad brought those guys in. We can’t let ’em go, and    I won’t let that aggressive jerk steal my customers. Pay ’em more.”
Bill just lost the nickel game. The lesson to be learned is this: If you can’t make a reasonable profit margin from a scrap supplier, let them go. Don’t pay five cents for a nickel.
   Outside our classroom, this scenario happens all the time. The real winner is the guy who sells the nickel—in this case, the scrap supplier. The supplier receives a higher price than he’d get if the two processors stayed focused on maximizing their profit margins. The “winning” processor ends up paying too much to keep the account. Bill may lean back in his chair and smoke a cigar to celebrate his win, but it had better be a cheap cigar. His business—not his competitor’s—is the real loser.

GAME 2—Investing in a Quick-Fixed Asset
   “I saw a shear going in over there today,” says Anton of Funf Metal, a Southern recycler, referring to the competing scrap operation up the road. “Now he’ll grab all that business from us. We can’t let that happen. Y’all call the shear salesman right now. We’re a month behind already. We gotta get a shear put in right quick.”
   Sorry, Anton. See what happens when you attend NMU! We would’ve taught you better down here at SMU. You lose the nickel game.
   Your competitor didn’t order that shear on a whim. If the competition knew the nickel game, they added the equipment to reduce costs, add value to their business, and maximize profits. If Funf Metal steps in to add another piece of equipment just to offer the same services as the guy up the road, that decision is based on the wrong logic.
   Perhaps there isn’t enough scrap to support two shears in the same town. Now Anton, you’ve certainly hurt your competition, but you’re also hurting yourself. You now may own a piece of equipment that may not pay for itself. In other words, you may have paid six cents for the nickel.

GAME 3—Variable Your Profits
   “I know we can add volume here, dude,” says Nick, the salesman from Pede Recycling, a West Coast firm. “We’re doing enough business to cover our fixed costs, so every extra pound we process is gravy. We can pay more for this extra scrap because the hurdle we jump is our variable costs. Cool!”
   We scratch our chins as we contemplate this version of the nickel game. This game is just beginning. You may think you won the nickel, Nick, but you’ll soon recognize your losing ways. Let us explain.
   Fixed costs are the expenses faced every month, such as rent, electricity, interest on loans, leases, and so on. Variable expenses are incurred directly related to the volume of the business. Each additional unit of volume adds to variable expenses but not to fixed expenses.An example will more clearly illustrate the loss. This is the plan in dollar and volume terms:

Before Nick’s Plan
Fixed expenses $20,000/month
Gross profit on 500 tons of scrap (9 cents/pound) $90,000/month
Variable costs (5 cents/pound) $50,000
Profit $20,000

Nick’s Plan
Fixed expenses $20,000/month
Gross profit on 500 tons of scrap (9 cents/pound) $90,000/month
Variable costs (5 cents/pound) $50,000
Gross profit on 300 tons of additional business at higher buy prices (7 cents/pound) $42,000
Additional variable costs (5 cents/pound) $30,000
Profit $32,000

  At first, Nick looks like a winner of the nickel game. After all, he has added $12,000 to his profits. But a closer look reveals that he has hurt his profit margin. Nick breaks the nickel game into two parts. In his current business, where he maintains higher profit margins, he wins the game. But the marginal business—the added volume at lower margins—loses and can bring down the winning side.
   Now let’s take Nick’s plan to the next logical step. To carry the plan forward, we’ve added two elements Nick didn’t consider—the competition and the high-margin scrap accounts. The competition, with their lack of understanding of the nickel game, won’t stand still. They don’t want to lose customers, so they’ll react. Perhaps a rival will raise its buying prices. Perhaps another will chase Nick’s customers. Nick may lose high profit margin suppliers to a competitor. His fixed-cost accounts are vulnerable.
   And what about those high profit margin accounts? Will they get wind of the higher prices Nick is paying to his other customers? If they do, they may demand more or be easy pickings for the competition. Now the numbers may not appear as Nick planned. Let’s see:
   
After Nick’s Plan
Fixed expenses $20,000/month
Gross profit on 400 tons of scrap (8 cents/pound) $64,000/month
Variable costs (5 cents/pound) $40,000
Gross profit on 150 tons of additional business at higher buy prices (7 cents/pound) $21,000
Additional variable costs (5 cents/pound) $15,000
Profit $10,000

   Notice that Nick has decreased his profit margins and lost volume from his original customer base. He added new customers but with this unintended effect—now Pede Recycling makes less profit ($10,000 versus $20,000) through more volume and lower margins. He’s below his starting point. 
   Sorry, Nick, you lose the nickel game.
 
GAME 4—An Edgy Mistake
"Did youse see?" asks Sally of Hamaesh Junk, a Northeastern processor. “Copper is down another two cents. Don’t we have a high-priced order we haven’t covered?”
   “Yeah,” replies Don, the yard manager. “And Chuckie offered me a load of copper five minutes ago. Should I buy it from him?”
   “Yeah,” says Sally. “We’re ahead four cents on the order. Offer him two cents above the market, and we’ll lock in our trading profit.”
   Poor Sally. She just lost the nickel game, but she’s so happy with her profit, she doesn’t even know it. 
   Sally gave up the edge—part of the extra profit she gained from the market’s movement in her favor. She was willing to give up part of her four-cent profit to quickly buy the metal needed to fill the order. But she should consider this: Would the supplier have covered Sally’s loss if the market moved against her order?
   Assuming markets are efficient (remember, you’re playing the role of a finance professor), the market will go up 50 percent of the time and move down the other 50 percent. Half of the time, the scrap recycler will make money on market moves, and he’ll lose money the rest of the time. If the recycler gave up some of his profitable trades and kept all of his losers, he’d finish a loser. The losing trades would outnumber the winners.
   To win the nickel game, Sally should have kept all the winnings for her company. She’s entitled to the profit. She took the risk.

Factoring in the Competition
You’ve now finished the classroom portion of our assignment. We now take the simple lessons learned in the nickel game into the scrap business. But, during our internship in the real world of scrap, we’ve discovered an added complexity—the competition.
   The competition can really screw things up. They overpay to win accounts. They may work on smaller margins, have no borrowing costs, or be ethically challenged. Their shenanigans mess up prices. These challenges can push us into losing the nickel game.
   To avoid losing the game, keep your focus on the simple to overcome the competition. If they play the nickel game, make sure they’re the loser. Let them or force them to pay too much for scrap. Go after the high profit margin accounts. Don’t complicate what’s simple: Maximize profit by paying as little as possible for your scrap. Keep your buying prices as low as possible.
   But what if the competition understands the nickel game? How refreshing! Imagine a competitor hearing your buying prices are three cents lower than his and lowering his buying prices to match yours. You both win.
   Congratulations, you’ve now learned the simple secret behind the nickel game. Its simplicity is its beauty. Look for it in your everyday profit decisions. At every opportunity, try to buy the nickel for one cent.
   And if you’re really lucky, someone who hasn’t caught on to the rules of the game may pay you six cents. •