by
Dr. V. Laxmanan
Email: vlaxmanan@hotmail.com
Summary
A simple linear law y = hx + c, where x is revenues and y is profits, is
shown to describe the relationship between profits and revenues for both
Ford and the new GM. Its implications are discussed briefly. A new
measure of profitability, the marginal profit rate (MPR), which is similar to
the marginal tax rate in economics, is suggested by this analysis.
Introduction
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Profits = Revenues – Costs ..........(1)
P = [ (k – b)/k ] R – a ..……..(2)
Also, from equation 2, it is easily shown that for this simple model, the
revenue at the breakeven point, when P = 0, is given by
R0 = ak/(k – b) ……..(3)
The profits and revenues data for Ford Motor Company, for the nine most
recent consecutive quarters, obtained from their quarterly earnings
releases, is summarized in Table 1. A graphical representation of this data
reveals a lot of scatter, see Figure 1. Ford reported a loss for one of these
quarters Q1 2009 (24.2, -1.427) and was barely profitable for another, Q4
2010 (32.5, 0.19), compared to the recent quarter Q1 2011 with a profit of
$2.55 billion but with a somewhat higher revenue of $33.1 billion. This
suggests that Ford has been operating at or close to the breakeven point in
these most recent quarters.
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Quarterly Profits, y [$, billions] 3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
0 10 20 30 40
Quarterly Revenues, x [$, billions]
Figure 1: Graphical representation of Ford’s quarterly earnings data for the nine
consecutive quarters ending Q1 2011 (from Q1 2009 to Q1 2011).
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Figure 2: Graphical representation of Ford Motor Company’s profits-revenues
data for the nine consecutive quarters through Q1 2011. The trendline suggested
here is the one with the highest slope, passing through the data points Q1 2009
(24.4, -1.427) and Q2 2010 (31.3, 2.599). The large scatter in the data as observed
here does not permit a linear regression analysis (see also appendix 1).
Notice that for the last two consecutive quarters, Q4 2010 and Q1 2011,
the profits increased by $2.36 billion with only a very small increase in the
revenues: $0.6 billion. A higher revenue increase, $2.3 billion, between the
same two quarters in the two previous years, Q4 2010 and Q4 2009, on the
other hand, produced a much smaller increase in profits, $0.696 billion.
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intercept c = 2.599 – (0.583*31.3) = - 15.664. This trendline, with the
highest slope, also passes close to the data point for Q3 2009 (29, 1.687).
The rest of the scatter here suggests both operational and/or market sales
related variability in the automotive sector during this period of economic
downturn and recession.
The results for Ford Motor Company may now be compared with the most
recent data available for the new GM, see Figure 3, which has been
discussed in more detail, in a separate analysis; see the link given below.
http://www.scribd.com/doc/54996915/GMRPAnalysis-2R
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Figure 3: Graphical representation of the Profits-Revenues data for the new
GM for five consecutive quarters ending with first quarter of 2011. A nice
linear relationship, as suggested by the classical breakeven analysis, is
revealed here, if we take the Q4 2010 data as an outlier. The regression
coefficient r2 = 0.959 which indicates a very high and positive correlation
between profits and revenues.
The classical breakeven analysis considers just one single product, with a
simple linear relationship between costs C, revenues R, and units sold N.
The linear relationship between profits and revenues implied by this
classical analysis, however, seems to extend to more complex real-world
situations, as seen in Figure 3 for the new GM, with many different
products each with its own value of the constants, a, b, and k.
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In spite of the many complexities inherent in the system that we are
analyzing here – manufacturing and design issues, marketing issues, tax
issues, economic uncertainties, product quality and customer acceptance
and perceptions – a very simple linear law applies, akin to the simple laws
that often describe the behavior of many complex systems that we
encounter in the “hard” sciences such as physics, chemistry, and biology.
Amazingly, for both Ford and the post-bankruptcy GM, nearly 50% to 60%
of the additional revenues, beyond the breakeven value, will translate into
profits. The US economy is still in a recession mode, with a paucity of jobs,
especially well-paying jobs, with automotive sales well below their historic
highs witnessed just a decade ago. Nonetheless, the automotive sector
clearly seems to be well positioned, at least for the near term, to reap the
benefits of a post-recession resurgence of sales. Indeed, it can once again
become the engine that powers the whole US economy.
Conclusions
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2. The widely used measure of profitability of a company, the familiar
profit margin, is the ratio y/x, the ratio of profits to revenues,
expressed as a percentage. The universal law revealed by this
analysis explains why a doubling or tripling of profits is almost never
associated with a doubling or tripling of revenues. The profit margin,
the ratio P/R = y/x = h – a/R = h + (c/x) is not a constant and will
increase or decrease as revenues increase or decrease since the
fixed cost (reflected in the constant c = - a) cannot be eliminated and
is always nonzero. The apparent unpredictability in profit margin
variations is thus related to the fluctuations in revenues (or sales).
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Appendix 1
Further analysis of the Ford’s Revenue-Profits data
Figure A1: The best-fit line through the three data points in Table A1.
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Table A1: Revenues-Profits data for Ford Motor Company
from quarterly earnings releases
Quarter Revenues, $ billions Profits, $ billions
Q1 2009 24.4 -1.427
Q3 2010 29 1.687
Q2 2010 31.3 2.599
The equation of the best-fit line through these points is y = 0.597x – 15.898
and the regression coefficient r2 = 0.987, see Figure A1. The breakeven
revenue R0 = $26.637 billion. The constant h, the marginal profit rate
(MPR), is slightly higher than h = 0.583 estimated earlier using just two of
the three points, with roughly the same value for the breakeven revenue.
Now, let us consider the data for the three quarters in Table A2. Again,
profits increase with increasing revenues.
The equation of the best-fit line through these points is y = 0.450x – 12.465
and the regression coefficient r2 = 0.994, see Figure A2. The breakeven
revenue R0 = $27.696 billions. The constant h, the marginal profit rate
(MPR), is significantly smaller than h = 0.583 estimated earlier but the
breakeven revenue is higher.
A regression analysis using all the data points is clearly not recommended
in view of the large scatter. Such a selective analysis, based on heuristic
arguments, is preferable to a “blind” statistical analysis where one is
supposed to include all available data points to eliminate any perceived
bias. The heuristic approach is justified because the fundamental principle
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of profits increasing with increasing revenues is a sound one and cannot be
refuted. The law relating profits and revenues, as shown here, is of the
form y = hx + c and one is then merely left with the task of arriving at the
best estimates for h and c.
Figure A2: Best-fit line through the three points in Table A2.
Now, if a fourth data point is added, to the set in Tables A1 or A2, the
regression equation again changes. Adding Q1 2010 to Table A1, yields a
linear regression equation with very nearly the same slope, with a smaller
intercept, whereas adding it to Table A2 yields a regression equation with a
smaller slope. These two regression equations are given below.
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The three data points, for Q1 2009 (24.4, - 1.427), Q1 2010 (28.1, 2.085)
and Q3 2010 (29, 1.687), on the other hand, can be shown to yield a
regression equation with the highest slope, y = 0.623 x -16.149 with r2 =
0.891 and a breakeven revenue of $25.91 billion. An even higher MPR is
suggested if we consider only the two points Q1 2009 and Q1 2010, which
yields y = 0.677x – 17.944, with the breakeven value of $26.5 billion.
Figure A3: The Ford Profits-Revenue data with the best-fit line.
Finally, the x-y scatter graph, with all the five data points from Tables
A1 and A2, with the best-fit line superimposed on to the data, is
illustrated in Figure A3. Also, included is the point Q1 2010 (28.1,
2.085). The four remaining points, from Table 1 in the main text, fall
away from this best-fit line and only increase the scatter, see Figure 2.
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Appendix 2
Lost Profits Opportunity
The scatter in data and deviations from the best-fit line
Figure A4: Profits-Revenue data for all the nine consecutive quarters with the
best-fit line superimposed on to the data.
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If we accept the basic principle of increasing profits with increasing
revenues, considering any two pairs of data points in the set, the change in
profits is y = (y2 – y1) and the change in revenues is x = (x2 – x1). The
rate of change in profits, for a unit change in revenue, is the slope h =
y/x = (y2 – y1)/(x2 – x1) of the straight line connecting the two points. This
slope must necessarily be less than unity (1.000), since the increase in
profits cannot exceed the increase in revenues.
Also, profit maximization means that one must seek the highest change in
profits for the same change in the revenues. Many different values of the
slope h can thus be determined and rejected after careful consideration.
This leads us to the best-fit equation given above which has now been
superimposed in the graph of Figure A4 with the entire data set.
We observe both positive and negative deviations from the best-fit line.
Both of these must be carefully scrutinized and understood to improve the
financial performance of this operation. The negative deviations, in
particular, represent a lost opportunity for profits, see Table A3. For the
period under consideration, the total cumulative lost profits
opportunity is estimated at nearly $10 billion.
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Appendix 3
Linear Regression with purely statistical arguments
For completeness, the profits-revenue data for all the nine consecutive
quarters from Table 1 of the main text was reanalyzed to determine the
linear regression equation, using purely statistical arguments, see Figure
A5 below. The scatter in the data is even more obvious now. This provides
further support for the heuristic arguments noted in appendix 1 and 2 to
determine the best-fit line.
The sum of all the negative deviations from this best-fit line, which again
represents the lost profits opportunity, is now $4.85 billion, almost one-half
of the earlier estimate based on the principle of profit maximization, which
also implies that we must seek the highest positive slope h.
Figure A6: Graph of linear regression equation deduced without the data for the
single quarter Q1 2009 when Ford reported a loss (24.4, -1.427).
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Finally, if one were to ignore the data for the single recent quarter when
Ford reported a loss Q1 2009, purely statistical arguments may be shown
to yield a regression equation with a negative slope (r2 = 0.145), with profits
decreasing with increasing revenues, see Figure A6. Such an inference is
obviously not justified and does not reflect the reality of the efforts being
made at Ford to increase profitability. Indeed, extrapolating to higher
revenues, this regression equation implies that if quarterly revenues
exceed about $45 billion, Ford should start reporting losses consistently!
Or, extrapolating all the way back to zero revenues, this would also imply
that Ford would actually report a handsome profit of nearly $5.5 billion with
zero revenues, i.e., without selling a single vehicle!
Clearly, the scatter in the data for the most recent profitable quarters at
Ford must be scrutinized more carefully to further improve their operations.
To summarize, the main arguments that have been used to determine the
slope h and intercept c of the best-fit line and/or the trendline are:
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Appendix 4
Costs versus Revenues
An alternative approach to determining the Profits-Revenue Equation
From the basic equation, Profits (P) = Revenues (R) – Costs (C), it follows
that costs C can be estimated for each of the nine quarters. This calculation
is presented in Table A4 below.
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Figure A7: Quarterly “effective” cost C can be estimated from the profits and
revenues data using the basic equation P = R – C. The graph of C versus R shows
a remarkably upward trend with hardly any scatter. The linear regression equation
deduced in this manner is C = 0.873 R + 2.497 which then yields the P-R equation
when P is recalculated. This yields P = 0.127R – 2.497 which is exactly the same
as the regression equation for P and R deduced earlier when purely statistical
arguments were used without any attempt to introduce the notion of profit
maximization.
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Figure A8: The Costs-Revenues graph with the dashed line C = R superimposed on
to the best-fit line C = 0.873 R + 2.497. A profit is reported only when the data
point falls below the dashed line C = R.
The positive intercept means that there is a nonzero fixed cost even if
revenues go to zero (R = 0, C = 2.497). The profits-revenue equation can
now be deduced using the basic relation P = R – C = R – 0.873R – 2.497.
Hence,
The author obtained his Master’s (S. M.) and Doctoral (Sc. D.) degrees in Materials
Engineering from the Massachusetts Institute of Technology, Cambridge, USA. He then spent his
entire professional career at leading US research institutions (MIT, NASA, Case Western
Reserve University, and General Motors R & D Center, in Warren, MI). He holds four patents in
advanced materials processing, has co-authored two books, and has published several scientific
papers in leading peer-reviewed international journals. His expertise includes developing simple
mathematical models to explain the behavior of complex systems. He can be reached by email at
vlaxmanan@hotmail.com
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