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Comment by highfrequency | Hacker News Reader

Could someone explain the core example about prepaying restaurant vendors?

(Kokonas again): That’s what I said! I went, “I’ll pay you $20 if you tell me why.” And he said, “Well, it’s very simple. I have to slaughter the cows, then I put the beef to dry. For the first 35 days I can sell it. After 35 days there’s only a handful of places that would buy it, after 60 days, I sell it $1 a pound for dog food.” So his waste on the slaughter, and these animals’s lives, and the ethics of all of that, are because of net-120! Seems like someone should have figured this out! As soon as he said that, everything clicked, and I went “We need to call every one of our vendors, every time, and say that we will prepay them.”

It seems like the value to the beef vendor is not from actually receiving the cash flow earlier, but rather from just knowing the order quantity in advance to optimize inventory.

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Part of the reason is because it's a set order. Consider that in pricing his beef normally, the vendor has to account for three things:

1. Beef that sells within 35 days at regular price 2. Beef that sells within 60 days as a discounted price 3. Beef that sells after 60 days for a loss.

The beef's regular price has to be somewhat higher than in an efficient market because some of it will be sold at a loss.

Getting an order for a set amount per week allows him to disregard the losses he normally has from beef that has to be sold for dog food, because the purchaser is guaranteeing their quantity, smoothing their expectations on how much beef to purchase in the future.

It's possible that at $18 a pound, without any waste, he's making the same margins/profit as he would at $34 with some waste.

Right. So the value add here is not actually about moving cash flow forward in time through reservation deposits, but rather just having a predetermined order size. Am I misunderstanding, or is this a complete non-example for the point of the article?

I'd guess in the restaurant game, net-120 also has the risk of the restaurant going out of business, so any "predetermined order sizes" are less than guaranteed (a very long way from the guarantee the pre paying gives).

By the restauranteur having reservation deposits which allow them to offer to pay upfront (moving that cash flow 120 days earlier) - the wholesaler reduces both uncertainty (I wonder how much beef I need to order and how much extra I should add that I'll later sell for a loss to make sure I don't run out if sales increase?) as well as risk (What if this restaurant shuts down owing me for 4 months worth of beef?)

This doesn't really add up though because in reality the butcher would just use invoice finance to get the money ahead of time at a way lower cost than a 50% discount he's offering, which would probably include some insurance if the restaurant went under. It doesn't make sense. Invoice finance might cost 5-15% of the invoice. Why wouldn't you do that rather than giving customers 50% off? I can get a small discount but half price doesn't seem realistic.

The point is that improving the cash position of the restaurant (traditionally a low float, low margin business), by moving customers payments forwards in time, allows them to improve their margins by pre-paying their food vendors. This is in contrast to the example right before, where speedy deliveries from a lean manufacturer motivates downstream distributors to switch suppliers, despite taking a margin hit, because they can improve their cash position by doing so.

So why isn't there a futures market for selling these meats?

The farmer/producer would like certainty of sale, at a certainty of price. This is exactly what a futures option gives them - they can offload the risk of price fluctuations (and demand reduction/changes) in the future, and someone else can speculate on this (and make more profit, or loss).

It seems stupid for a farmer/producer to take on this risk, rather than sell these futures.

Futures markets work for commodities where what you get from one seller is essentially interchangeable with what you get from another seller.

There are futures markets for livestock, but that's not going to cut it for the high-end restaurant market that this example comes from--the restaurants this story is about are internationally famous and will have exacting food quality standards that are hard or impossible to meet from a futures market. The suppliers they work with are in turn focused on supplying high-quality meat and produce that isn't really interchangeable enough for a futures market.

Farmers who grow commodity crops (corn, soybeans, etc.) or commodity livestock often do use futures markets in the way you describe, or work with financiers who essentially do it on their behalf.

Because it is not a set commodity that any producer can make . This is how things work for corn, wheat, and so on.

I assume the beef vendor doesn't have much cash on hand. So he can take the prepayment and give it directly to the cow farmer who also doesn't have a lot of cash and is happy to prioritize the preorder.

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