By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

15 March 2015

Suppose you are offered an opportunity to get into one of two business: the first can make you a profit of Sh5,000 per month and the second Sh10,000; which would you choose?

If you picked the first one, you are wrong. If you chose the second one, you are also wrong! If you ever came across such a situation, don’t make a choice until you are told how much money you are expected to put into each business.

It might turn out that you need to put Sh25,000 in the first business and Sh100,000 in the second one. The returns on investment are 20 per cent 10 per cent. That changes the scenario dramatically: anyone who understands basic finance will go for the first business.

Now, imagine you run a shop and you are offered two products to sell – the two have equal demand in the market. The first one will cost you Sh96 and you can sell it for Sh100 making a profit of Sh4. The second one costs you Sh76 and you can sell it at Sh80 also making Sh4. Which of the two would you prefer?

This is the situation that oil marketers in Kenya find themselves in. The petroleum pricing formula allows a fixed shilling amount as the profit margin – Sh6 for wholesalers and Sh3 for retailers. Whether the price is Sh150 per litre or Sh50, the dealers get only Sh6 and Sh3 per litre, respectively.

So, if you were in the petroleum business, what would you prefer: high or low prices? Contrary to popular opinion, oil dealers actually make more money per litre of petrol when prices are low than when they are high.

The reason for this is the cost of finance: the higher the price of petrol, the higher the cost of financing the business. To illustrate this, suppose a retailer needs bank finance for 100,000 litres in a month.

If the retail price is Sh100, it means that he buys his product at Sh96. Therefore, he needs Sh9.6 million to purchase this stock. If the bank interest is 15 per cent per annum, the finance cost for one month comes to Sh120,000. But the gross profit margin is Sh3 per litre, that is, Sh300,000 for the 100,000 litres. Therefore, the profit after finance costs is Sh180,000.

This Sh180,000 is what will cover other running costs that do not depend on the selling price (for example, salaries). Whatever remains after that is the dealer’s net profit before taxation.

If the retail price is Sh75 per litre, the dealer will get the product at Sh72. So now he needs Sh7.2m which will cost him Sh90,000 in bank interest. This now leaves him with Sh300,000 – Sh90,000 = Sh210,000.

Clearly then, it is NOT in the interest of petroleum marketers in Kenya to have high prices. In deed, I see the possibility of prices going so high that it becomes unprofitable to operate the business!