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A Fresh Look at Microsoft after its first Quarterly loss

Microsoft CEO Steve Ballmer comments on the Windows 8 operating system before unveiling Surface, a tablet computer to compete with Apple's iPad. ?t=1342733984&s=51
We delivered record fourth quarter and annual revenue, and were fast approaching the most exciting launch season in Microsoft history, said Steve Ballmer, chief executive officer of Microsoft. Over the coming year, well release the next versions of Windows, Office, Windows Server, Windows Phone, and many other products and services that will drive our business forward and provide unprecedented opportunity to our customers and partners. The combination of solid revenue growth and rigorous cost discipline drove doubledigit operating income growth for the quarter, adjusting for the goodwill impairment and deferred revenue, said Peter Klein, chief financial officer of Microsoft. We are focusing our resources in strategic areas that will deliver shareholder value and long-term growth opportunities. From the FY12 Q4 Earnings Release.

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Table of Contents
No. 1. 2. 3. 4. 5. 6. 7. 8. Topic Executive Summary Introduction A simple universal profits-revenues law Microsoft Profits-Revenues Analysis Summary and Conclusions Appendix I: Three types of Companies Appendix II: Extending Einsteins work function beyond physics Appendix III: Bibliography list of related articles Page No. 3 4 5 10 18 19 27 31

LOS ANGELES, CA - JUNE 18: Microsoft CEO Steve Ballmer shows the new tablet called Surface during a news conference at Milk Studios on June 18, 2012 in Los Angeles, California. Photo by Kevork Djansezian/Getty Images eal_lesson_is_that_innovation_is_hard/146537702.jpg.CROP.rectangle3-large.jpg

Note: Tables of all the raw data analyzed are provided to permit readers to do their own analysis and prepare their own plots to verify all the findings reported here. The following Second Look article provides a brief treatment and may be reviewed before returning to this article. , Published July 30, 2012.
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1. Executive Summary
The present analysis is prompted by the recent announcement of the first ever quarterly loss since Microsoft became a public company 26 years ago. However, Microsoft also reported record revenues of $18.06 billion for Q4 2012 and $73.723 billion for FY2012 and a profit of $16.978 billion for FY2012. What has been lost in the discussion about significance of this historic loss is the fact that profits decreased in 2012, compared to 2011, although revenues have increased. Revenues increased by x = $3.780 billion. Profits decreased much more, by y = - $6.172 billion. In other words, on the profits-revenues graph, the line joining these two points has a very steep negative slope h = y/x = -1.633 > -1. A careful review of the historical profits-revenues data for Microsoft for the last two decades (1993-2012), with the aid of x-y profits-revenues diagrams, shows that Microsoft has been essentially operating along a series of three roughly parallel lines, with the general equation y = hx + c, with a positive slope h > 0 and a negative intercept c < 0. These are called Type I lines. Microsoft was first operating along Line A and then made a transition to the parallel Line B, operated on line B and then transitioned to Line C. During the transition, profits and revenues increased at a much lower rate as revealed by the transitional (x, y) pairs. The transitional line, called the Type II line, and has smaller slope h and a positive intercept c (also opposed to the negative intercept for the Type I operating line). It is interesting that when both profits and revenues decreased between 2008 and 2009, Microsoft essentially retreated back along the Type I Line C that it was operating on and profits and revenues returned to close to the Type II transition line. It then jumped back to the Type I line C in 2010 and 2011. And now, amazingly, when profits have decreased, with increasing revenues, between 2011 and 2012, Microsoft has once again essentially returned to the extension of EXACTLY the same Type II transitional line! So, all is well with Microsoft. Onwards now to higher profits and revenues and a new Type I Line D or a return to Type I Line C of recent years.

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2. Introduction
The main purpose here is to take a fresh look at Microsofts profits-revenues performance over the two decades (1993-2012). As we all know, on July 19, 2012, Microsoft has reported its first ever loss since it became a public company 26 years ago. However, this was only a QUARTERLY loss. For the fiscal year ending June 30, 2012, Microsoft reported a profit of $16.978 billion, see Table 1.

Table 1: Cumulative Revenues and Profits in Fiscal Year 2012

Quarter 1Q2012 2Q2012 3Q2012 4Q2012 Revenues, x $ Billions 17.372 20.885 17.407 18.059 Profits, y $, billions 5.738 6.624 5.108 -0.492 Cumulative Revenues, R 17.372 38.257 55.664 73.723 Cumulative Profits, P 5.738 12.362 17.47 16.978

The 4Q loss was attributed to a write-off ($6.2 billion accounting adjustment) Microsoft was taking for the entire value of aQuantive, an online advertising company that it had bought in 2007. This online services division had become a financial drag on the company. Some reports have pointed out that the quarterly loss is not entirely due to this transaction alone and that Windows sales looked much worse than reported, see Refs. [3,4] in the list below. 1. eleaseAndWebcast/FY12/Q4/default.aspx (see extract on next page). 2. 3. 4. ws%2F240004106 . The announcement, however, does not seem to have ruffled too many feathers, or affected, its share price. Investors took the news in its stride and Microsofts CEO
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INCOME STATEMENTS (Extracted from 4Q2012 Release) The following is obtained from

(In millions, except per share amounts) (Unaudited) Three Months Ended June 30, Twelve Months Ended June 30, 2012 1. 2. Revenue, x Operating expenses $ 18,059 4,163 2,594 3,781 1,136 6,193 17,867 192 167 359 851 (492) 2011 $17,367 3,708 2,393 3,916 1,179 0 11,196 6,171 148 6,319 445 5,874 2012 $ 73,723 17,530 9,811 13,857 4,569 6,193 51,960 21,763 504 22,267 5,289 16,978 2011 $ 69,943 15,577 9,043 13,940 4,222 0 42,782 27,161 910 28,071 4,921 23,150

a. Cost of revenue b. Research and development c. Sales and marketing d. General and administrative e. Goodwill impairment f. Total operating expenses 3. Operating income 4. Other income 5. Income before income taxes 6. Provision for income taxes 7. Net income (loss), y

The line item 2.f Goodwill impairment was $0 in 2011 and $6,193 in 4Q2012 and for FY2012. This is the write-off and the main reason for the quarterly loss of $492 million. Without the Goodwill Impairment (GWI), Operating income increases to $6,385 and net income for the quarter is $5701 and for FY 2012, the net income will be $23, 171. The analysis presented here considers only the line items 1 and 7: Revenues x and Profits y (or net income). Everything in between is of no interest. The universal law y = hx + c relates these two important line items, for all companies, even when exceptional situations that led to Microsoft historical quarterly loss arise.

****************************************************************** Ballmer emphasized the launch of Windows 8 (in October) and other exciting products in the coming year. The company has still delivered a record fourth quarter revenue of $18.06 billion, Table 1. For FY2012, ending June 30, 2012, revenues were $73.723 billion and profits were $16.978 billion, see Table 2.

3. A simple universal profits-revenues law

As we see from the annual profits-revenues data summarized in Table 2 for the last two decades, while revenues, in general, have increased year-after-year, Figure 1, there has been some fluctuation in the level of profits reported, Figure 2. Let x be revenues and y the profits. The slope of the various line segments on these two
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graphs is proportional to the magnitude of the change in revenues x and profits y between consecutive years. Is there a simple relation between profits and revenues? We expect profits y to increase with increasing revenues x. This is confirmed by the cumulative increase in both revenues and profits during the fiscal year, see Table 1, with the exception of Q4 2012. Is there any law that tells us how profits grow with increasing revenues?

Table 2: Annual Profits-Revenues data for Microsoft (1993-2012)

Year 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 Revenues, x ($, billions) 73.723 69.943 62.484 58.437 60.420 51.122 44.282 39.788 36.835 32.187 28.365 25.296 22.956 19.747 15.262 11.936 9.050 6.075 4.714 3.786 Profits, y ($, billions) 16.978 23.150 18.76 14.569 17.681 14.065 12.599 12.254 8.168 7.531 5.355 7.346 9.421 7.785 4.462 3.454 2.195 1.453 1.146 0.953 Change, x 3.780 7.459 4.047 -1.983 9.298 6.840 4.494 2.953 4.648 3.822 3.069 2.340 3.209 4.485 3.326 2.886 2.975 1.361 0.928 3.786 Change, y -6.172 4.39 4.191 -3.112 3.616 1.466 0.345 4.086 0.637 2.176 -1.991 -2.075 1.636 3.323 1.008 1.259 0.742 0.307 0.193 0.953 Slope, h = y/x -1.633 0.589 1.036 1.569 0.389 0.214 0.077 1.384 0.137 0.569 -0.649 -0.887 0.510 0.741 0.303 0.436 0.249 0.226 0.208 0.252

The profits and revenues data compiled here were obtained from historical data available at the Microsoft website, see links provided earlier.

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Revenues, x [$,billions]

70 2008 60 2009 50 40 30 20 10 0 1990






Time, t [Calendar year]

Figure 1: Steady increase in revenues for Microsoft between 1993-2012, with one exception (2008 and 2009).
25 2011 20 2008 15 2012 2009

Profits, y [$, billions]



5 2002

0 1990






Time, t [Calendar year]

Figure 2: Up and down fluctuations in the level of profits is seen here for Microsoft between 1993 and 2012.
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Cumulative Profits, y, [$ billions]



20 15

y = hx + c = 0.306x + 0.42

3Q2012 4Q2012



0 0 10 20 30 40 50 60 70 80 90

Cumulative Revenues, x, [$ billions]

Figure 3: The cumulative growth of profits and revenues during the fiscal year. This is the graph of the Microsoft data for FY2012. Such graphs can be prepared to test this linear law for other years, and for several companies. We invariably see a nice linear relation. Now compare the extrapolated profits (blue dot) with the actual profit and the goodwill impairment expense! Do profits increase linearly with increasing revenues, following a simple linear law y = hx + c? Or, do they increase at an accelerating or decelerating rate, as described by the power-law relation, y = hxn + c. For n = 1 this reduces to the linear law. For n > 1, profits will increase faster than revenues do, i.e., at an accelerating rate. For n < 1, profits will increase at a decelerating rate. This can be seen by computing the derivative dy/dx = y/x = n(y c)/x. The formula for the derivative of the function y = xn, dy/dx = nxn-1, is the very first formula we learn in our elementary calculus courses. The derivative dy/dx equals the slope of the profits-revenues curve and gives the rate of increase, or decrease, of profits (y) with increasing or decreasing revenues (x). For a straight line, n = 1 and the derivative dy/dx = (y c)/x = h, the slope of the line.
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The preponderance of the empirical evidence for all companies, such as the cumulative profits-revenues data for Microsoft in Table 1, suggests a simple linear relation between profits and revenues as seen in Figure 3. The straight line joining the 1Q2012 and 3Q2012 has the equation y = hx + c = 0.306x + 0.4155. The 4Q2012 falls below this line and the 2Q2012 data point falls right on this line. The slope h = 0.306 > 0 and the intercept c = 0.4155 has a very small positive value. What is the significance of this slope and intercept? Can we explain the 4Q2012 drop off based on this information and other information about the profits and revenues performance for Microsoft? As we will see, it is indeed possible to explain the extraordinary offset between the 4Q2012 data and the rest of the data in Figure 3 using a simple (and well known but not yet fully appreciated) theoretical model to justify the linear law y = hx + c. (Extrapolate to revenues x = 73.723 and profits y = 23.00, value at blue dot. This is $6.02 billion more than the reported profit of $16.98 billion!) Consider the simple case of a company making and selling N units of a single product. The total cost C of producing these N units is the sum of the fixed cost a and the variable cost which varies with the number of units sold. Thus C = a + bN where b is the fixed unit variable cost. If p is the unit price, the revenues generated is R = pN. Thus, the profits P = R C = pN bN a = (p b)N a. Or, eliminating N using N = R/p, we get P = [(p b)/p] R a = hR - a. This classical breakeven analysis thus implies a simple linear relation between profits P and revenues R, which can be rewritten as y = hx + c = h(x x0). Slope of P-R graph Intercept of P-R graph h = (p b)/p = 1 (b/p) . Depends on b and p c=-a . Depends on a, fixed cost

This is what we see in Figure 3. The quarterly profits and revenues data for Microsoft are discussed further in Appendix 1 so as not to distract from the main discussion here. The applicability of this simple linear law to many companies, big and small, has also been discussed in several recent articles, see bibliography list
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provided at the end of this article. Some single product companies, the so-called one-trick ponies (Google has also been included in this category), are shown to follow this simple linear law. Also of particular interest is Kia Motor Company. In the automotive industry, the number of vehicles sold (the units N) is also reported along with profits and revenues. Although not a single product company, we find a stunning confirmation of this simple linear law. The R-N, P-N and P-R graphs can all be shown to be perfectly linear. Indeed, one can deduce the number values of the three constants (a, b, p) that enter into the breakeven analysis. The same conclusions apply for many other successful companies of the modern era, like Apple, Google. The profits-revenues graph for Apple can be shown to be a PERFECT straight line. Also, it appears that we can deduce the effective values the triplet (a, b, p) for Apple by defining units N of product sold as being simply the sum of the number of iPhones, iPads, iPods, and Macs sold by the company. (This will be published soon.) Furthermore, since a simple linear law seems to apply, this also means that there are at least three different possibilities depending on the numerical values of h and c in this linear law. This gives rise to what has been called Type I, Type II, and Type III companies. Examples of ALL three types of behavior can be found in the real world. We also see transitions between these three types of behaviors. The significance of such transitions has also been discussed and the reader is referred to the articles cited at the end of the present one. A brief discussion of the three types of companies may be found in Appendix 1 at the end of this article. With this background, let us reconsider the profits-revenues data for Microsoft for the last two decades.

4. Microsoft Profits-Revenues Analysis

Notice that Microsoft reported increasing revenues but decreasing profits between 2000 and 2002. Revenues increased from $25.296 billion in 2001 to $28.365 billion in 2002, giving x = 3.069, see column 4 in Table 2. The numbers in each row of this column give the change in revenue between consecutive years.
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The change in profits y between successive years is given in column 5. For 2002, y = -1.991. The same conclusion of positive x but negative y also holds true for 2001 and 2000. Both profits and revenues decreased between 2008 and 2009, yielding a positive value for the slope h although both x < 0 and y < 0. Also, between 2007 and 2008, revenues increased by x = $9.298 billion and profits increased by y = $3.616 billion, yielding a slope h = 0.389 < 1. Some of the slopes h > 1 which means that profits increased even more than revenues did for those two years. A good example is 2005, when revenues increased by $2.953 billion but profits increased even more, by $4.086 billion, giving h = 1.384. Hence, it appears that the significant story is NOT the first ever quarterly loss, or the record quarterly revenue in 4Q2012, or that FY2012 resulted in an overall profit of $16.978 billion and a record revenue of $73.723 billion. The significant story, it appears is what has been overlooked so far: the decreasing profits with increasing revenues between 2011 and 2012. Table 3: Profits-Revenues for 2012 compared to 2011 with and without GWI Year Revenues, x Profits, y Comment $, billions $, billion 69.943 23.150 2011 73.723 16.978 x but y 2012 (with gwi) 73.723 23.171 x profits flat 2012 (without gwi) Operating income $27,161 in 2011 and $28,496 in 2012, w/o GWI, is also flat. Notice that although revenues increased between 2011 and 2012, for x = $3.780 billion, profits have decreased even more, giving y = -$6.172 billion and a slope h = y/x = - 6.172/3.780 = - 1.633. This is the largest negative slope and is also obvious in Figure 2 which reveals the largest negative change in y. Notice that all the other slopes h calculated from the annual changes in profits and revenues (except for 2001 and 2002, mentioned earlier) are positive.

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It is this change in revenue and profits between successive years, especially the significance of the rather high negative value of h = -1.633 that must be analyzed to see if there is a longer-term pattern (considering the goodwill impairment expense as a normal part of business operations, companies routinely write-off certain expenses incurred!). The easiest way to do this is to prepare a x-y diagram for revenues and profits, see Figure 4. The straight line joining the 2011 and 2012 data points has been included here to highlight the most recent quarterly loss which manifests as a steep decline in the profits on this graph.


y = -1.633x + 137.35 = - 1.633 ( x 84.12)


Profits, y [$, billions]




0 0 20 40 60 80 100

Revenues, x [$, billions]

Figure 4: The profits-revenues diagram for Microsoft (1993-2012). A generally upward trend is observed here which can be described by the simple linear law y = hx + c but the slope h and intercept c will vary for different time periods (or equivalently, different revenues levels). The most recent and relevant line segment with the slope h = -1.633 between 2011 and 2012 is highlighted here. The equation of this line is y = -1.633 + 137.35 = -1.633(x 84.12). The intercept c in the equation y = hx + c can be fixed since h = -1.633 and the line passes through both
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the (x, y) pairs for 2011 and 2012. Hence, we know x, y and h can c is fixed. Notice that the extrapolation yields a finite positive x0 = - c/h = -137.35/ (-1.633) at which the graph will cut the revenues axis. This cut-off value when profits goes to zero is x0 = 84.12, as seen on this graph. The decline in the profits between FY 2012 and 2011 is also a part of a natural variation, or fluctuation, that all companies must go through. What should be interest is the magnitude of the decline and the numerical value of h = -1.633 deduced here. The linear law is a universal law that holds even under these exceptional circumstances. What we must be concerned about is the extent of the fluctuation in the profits, as revealed by the change in the constant c, not just the change in the numerical value of the constant h.
30 25

Profits, y [$, billions]

15 10 5 0 -5 -10 0 20 40 60 80 100 Line A, y = 0.644x 5.37 = 0.644(x 8.34) Line B, y = 0.603x 11.78 = 0.603(x 19.5) Line C, y = 0.574x 17.02 = 0.574 (x 29.63)

Revenues, x [$, billions]

Figure 5: The dominant characteristic of Microsofts profits-revenues graph is the Type I behavior (h > 0, c < 0) revealed here. The general equation is y = hx + c = h(x x0) where x0 is the minimum, or cut-off, or the breakeven revenue needed before the company can report a profit.
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The dominant characteristic of Microsofts profit-revenue graph is NOT the negative slope h = -1.633 established between 2011 and 2012 (mainly due to the GWI write-off). The over-riding characteristic is the rising profits with rising revenues and rising profit margins, or what has been called Type I behavior (see Appendix I), which is revealed by the rest of the data. The three upward sloping straight lines in Figure 5, which are seen to be roughly parallel to each other, are deduced by considering various (x, y) pairs. Line A is the straight line joining the 1998 and 2000 data. The profits were higher than predicted by this line in the earlier years, see bottom left of the graph and Microsoft then started operating on this line with profits increasing with increasing revenues.
30.0 25.0

Profits, y [$, billions]

20.0 15.0 10.0 5.0 0.0 -5.0 0

Type II transition line y = 0.124x + 7.31 2005-2007, 2009, 2012?



Type I (2008, 2010, 2011) y = 0.574x 17.02 = 0.574 (x 29.63)











Revenues, x [$, billions]

Figure 6: The dashed line, y = 0.124 x+ 7.31, with a positive slope h > 0 and a positive intercept c > 0 joins the Type I lines B and C in Figure 4. The slope h = 0.124 was fixed from the (x, y) pairs for 2005 and 2009.

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Then profits declined in 2001 and 2002 and Microsoft essentially moved, or jumped, from line A to line B and continued to operate along line B for a while, before a slow transition to line C, which occurred between 2005 and 2007 as seen by the data points that fall between the lines B and C. The transition between lines B and C is a Type II transition and is highlighted in Figure 6. Microsoft has been operating on line C. Now, we see the drop in profits between 2011 and 2012. What is the significance of these transitions although Microsoft has continued to exhibit Type I behavior throughout the last two decades. Type I behavior is characterized by a positive slope h > 0 and a negative intercept c < 0, which is equivalent to a finite positive intercept x0 = - c/h on the x-axis, i.e., the revenues axis. If revenues are less than this critical level, there will be no profits reported. This is essentially the lesson learned from the simple breakeven analysis discussed in 2. The cut-off revenue x0 is like the breakeven revenue for a single product company but now we see its applicability in the real world, even with a company like Microsoft when many complex revenue streams. (As discussed elsewhere, it also applies to many companies like Apple, Google, or real one-trick ponies!). When the revenues x > x0, profits appear. However, not all of the revenues will appear as profits. This is also evident from the simple breakeven analysis. Once the fixed cost a is exceeded we must still account for the variable cost. Hence, only the difference (pN bN) will appear as profits and profits will increase as more and more units N are sold. Likewise, in the real world, as revenues increases profits increase at a fixed rate h. When revenues increase by x profits increase by the same fixed amount y = hx, where the slope h = 1 (b/p) reflects the combined effects of the unit variable cost b and the unit price p. The slope h will change if the unit variable cost changes and/or the unit price p changes. Hence, the transitions between the three roughly parallel lines A, B, and C imply that the fixed costs a, as reflected by the increasing x0 = -c/h, have been going up slowly and steadily at Microsoft. Also, notice that the three lines, although roughly parallel, suggest a slow decrease in the numerical value of h with the passage of time. This means that the unit variable costs b has been rising and/or that the unit price p has been falling (due to competitive pressures felt, such as the recent deferred revenues allowing users to upgrade to Windows 8). The sudden drop in
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the profits between 2011 and 2012 should be viewed in this overall context. It is NOT a one-time effect alone, although the one-time effect has exacerbated the decline. It is really the general nature of operating a business and such transitions occur over time. Microsoft has only shown a slow transition from one Type I line to another Type I line. Other companies have done much worse. They have made the transition from Type I to Type III, or from Type I to Type II to Type III and reported consistently decreasing profits with increasing revenues. A sustained period of time, when revenues increase but profits decrease (h < 0) is called Type III behavior. Some companies like Air Tran, Yahoo, etc. have moved back and forth on a Type III line. General Motors operated on a Type III line for many years before it filed for bankruptcy in June 2009. Air Tran also could not sustain an extended period of Type III and the transitions from Type I, to Type II to Type III mode, all of which were observed, before its merger (in March 2011) with Southwest Airlines. The dip in profits between 2011 and 2012 and the first ever quarterly loss for Microsoft should be viewed in this broader context of the successful transitions it has made from one Type I line to another Type I line. Perhaps, Microsoft will return quickly in 2013 to line C. Or, it might settle on to a new line D, with Type I behavior, but with a much higher x0. Actually, with the 2012 data point, Microsoft can be seen to fall right smack on to the extension of the Type II transition line when it moved from Line B to Line C in Figure 4. This is illustrated in Figure 5. When revenues dropped between 2008 and 2009 (see Figure 1) and profits also dropped (see Figure 2), no one paid any attention! It is amazing, since this was the first time both profits and revenues decreased simultaneously (yielding a positive slope h) in all the years being reviewed here. The (x, y) pair had essentially retreated along Line B but the revenues were slightly higher in 2009 and so the 2009 (x, y) pair was to the right of line B. Now, when profits have fallen again between 2011 and 2012, everyone is paying attention. However, Microsoft has essentially returned to the earlier Type II transition line.

Amazing, but true!

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This really has nothing to do with any special one-time write-off that most financial analyses focus on. It is ALL in the natural course of business operations. The linear law y = hx + c, and all of its myriad manifestations, as being discussed here with Microsoft as the example, indeed embodies something like the genetic code of a company. The constant h and c, and even how they change over time, has a lot to do with something unique about the operations of the company, its management, its employees, its customers, its products, and how all of this interacts with the so-called market place. This is the reason for the amazing coincidence observed here. The longer term profitability of Microsoft is not in doubt. However, profitability can be greatly improved by paying attention to the basics, especially the (a, b, p) triplets highlighted here and the powerful message of the profits-revenues diagrams. This should become a standard tool for analysis of the profits-revenues data for a company, not just the familiar ratios like the profit margin y/x, or the earnings per share, or other ratios related to assets, liabilities and shareholder equity. A successful company must continue to exhibit Type I behavior like Microsoft has over the last two decades considered here. The EPS and other business and financial ratios will take care of themselves once the company learns to operate in the Type I mode.

In summary, all is well at Microsoft. Onwards now to higher profits and revenues and a new Type I line or a return to Type I line of recent years. Even better, learn more about the fundamental (a, b, p) triplet to enhance profits even more in coming years.

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5. Summary and Conclusions

A review of the profits-revenues data for Microsoft, for the last two decades (19932012) shows that it has been operating on three roughly parallel lines (the Type I lines) with profits increasing with increasing revenues along these parallels. During the transition between these parallels, profits and revenues increase at a lower rate following a Type II transitional line. When profits and revenues decreased between 2008 and 2009, Microsoft was operating along one of these Type I lines and its profits and revenues fell back to the Type II transitional line. Now, amazingly, when profits have decreased, with increasing revenues, between 2011 and 2012, following the historic quarterly loss, Microsoft has once again returned to the extension of the same Type II line. Hence, we conclude that, as in earlier years, Microsoft will return again to the same Type I line or reestablish a new Type I line that is roughly parallel to the three lines on which it operated between 1993 and 2012. This indeed is an eloquent confirmation of the basic idea of a work function in the business and economic world, akin to the idea of work function in physics, invoked by Einstein to explain the photoelectric effect. (The idea of a work function has been discussed in detail in other articles mentioned in the bibliography list.)

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6. Appendix 1: Three Types of Companies General Background and Introduction

It has not yet been generally appreciated that all businesses follow the same, very simple, mathematical law, see bibliography list where a detailed discussion of the behavior of several companies may be found. It is actually a universal law, which can be shown to be a consequence of the classical breakeven analysis for the profitability of a company. In the real world, this manifests itself as a simple linear law y = hx + c = h(x x0) where x is revenues and y is profits and h and c are constants that can be deduced from the financial data, as just discussed, for example with the Microsoft annual and quarterly data. The constant c can be related to the fixed costs and the constant h to the unit variable cost in the breakeven model. Note also that x0 = - c/h which depends on both the slope h and the intercept c, represents a critical revenue below which no profits will be reported and is essentially the same as the breakeven revenue in classical profitability analysis. Depending on the numerical values of h and c (positive or negative), we can observe three types of profits-revenues graphs, which lead to what may be called Type I, Type II, and Type III behavior. Thus, ALL businesses can be evaluated in terms of three basic types of profits-revenue graphs. Examples of these three types of behavior have been provided in recent articles on this topic (all written since the Facebook IPO on May 18, 2012) that are available on the Internet, see link below. (see bibliography compiled in Appendix II). Consider a company making and selling N units of a product. Let a denote the fixed costs and b the unit variable costs. The total costs C is the sum of the fixed and the variable costs and is given by C = a + bN. If p is the unit price, the total revenues R generated by the sales is given by R = pN. This also means N = R/p, a relation we will use shortly.

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The Profits P can now be deduced using the universal statement that applies to all companies, big and small, viz., Profits = Revenues - Costs. Thus, we get, P = R - C = pN - bN - a = (p -b)N - a = [(p - b)/p] R - a = hR - a This implies a linear relation between profits P and revenues R, and follows when we eliminate N using N = R/p. It can be rewritten as y = hx + c where x is revenues and y is profits and h and c are constants whose values can be deduced from the (a, b, p) triplet for each product. More generally, the numerical values of h and c can be deduced from the financial statements (the 10-K and the 10-Q) filed with the SEC every quarter and also readily available at various internet sources, such as MSN Money, Yahoo Finance, etc.

Slope h = 1 - (b/p) Determined by the unit variable cost b and unit price p Intercept c = - a Determined by the fixed cost, a

The linear law y = hx + c, quite interestingly, also suggests three different possibilities, depending on the numerical values of the constants h and c. This gives rise to what may be called Type I, Type II, and Type III companies. Examples of all three behaviors may be found in the real world, and have been discussed in the articles just mentioned (see The three types can be described, briefly, as follows: 1. Type I (h > 0, c < 0, positive slope, negative intercept which also means a positive intercept on the x-axis, or the revenues-axis). Both profits and profit margins increase with increasing revenues. This is usually the case for all companies in the very early stages of growth and emergence into profitability. (We encounter an unusual INVERSE Type I with RIM, Limited; revenues and profits going down together yielding h > 1.) 2. Type II (h > 0, c > 0, positive slope, positive intercept). Profits increase but profit margins decrease with increasing revenues. Also, profits increase at a lower rate than in the Type I stage. 3. Type III (h < 0, c > 0, negative slope, positive intercept, and yes, very rarely also with negative intercepts on both axes). Profits decrease with increasing revenues, or vice versa, i.e., profits can also increase with
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decreasing revenues. Correspondingly, profit margins can either go down with increasing revenues, or up with decreasing revenues. Also, as shown elsewhere, the profits-revenues data for a single company shows the transitions between Type I to Type II to Type III behavior, over a period of time. Microsoft is a good example of a company that has made the transition from Type I to Type II and then back again to Type I. This is discussed separately (see bibliography). Google is another example but there is a huge difference between what happened at Microsoft and what happened at Google. Apple illustrates a near PERFECT Type I behavior. Quite surprisingly, that totally confusing Type III behavior, described under no. 3 above, also appears to be quite common and is observed with several companies in the Fortune 500 list of 2012. The consequence of these three types of behavior, taken together, is the maximum point on the profits-revenues graph of a company. This too has been observed with several companies, but alas, is not widely known as of this writing in the business community. It has also, surprisingly, escaped the attention of economists and the academic scholars in the financial world. The most important and the largest of such companies is Ford Motor Company. Others are Verizon Communications, Yahoo, Kroger, Southwest Airlines and Air Tran (which was acquired by Southwest Airlines in 2011). General Motors also showed a Type III behavior, for an extended period, and was operating past its maximum point, before its historic bankruptcy filing in June 2009. That is a total of 6 out of 24 (give and take) companies that I have studied recently (since May 18, 2012, the date of the Facebook IPO.) We must also add RIM to that list of companies that reveal a maximum point on the profits-revenues graph. This is an unusual maximum point arising from a transition from Type II to Type III behavior on the cumulative quarterly profits-revenues data. We will now discuss the quarterly profits-revenues data for Microsoft. The data have been compiled in Tables 4 and 5. There are two ways of considering the quarterly data. We can simply consider the data for each quarter separately over a single year or many years, Table 4. Or, we can consider the cumulative quarterly
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revenues and profits during the course of a single year (as was done in Table 1 for FY 2012), see also Table 5. The quarterly profits-revenues data for Microsoft, for 16 consecutive quarters, from FY2009 to FY2012 reveals an amazingly linear relation with all the data, with the exception of the 4Q2012 data, falling between two parallels, see Figure 7.

Table 4: Quarterly data for Microsoft (FY2009-2012)

Quarter ending 30-Jun-12, 31-Mar-12, 31-Dec-11, 30-Sep-11, 30-Jun-11, 31-Mar-11, 31-Dec-10, 30-Sep-10, 30-Jun-10, 31-Mar-10, 31-Dec-09, 30-Sep-09, 30-Jun-09, 31-Mar-09, 31-Dec-08, 30-Sep-08, 4Q2012 3Q2012 2Q2012 1Q2012 4Q2011 3Q2011 2Q2011 1Q2011 4Q2010 3Q2010 2Q2010 1Q2010 4Q2009 3Q2009 2Q2009 1Q2009 Revenues, x $, billions 18.059 17.407 20.885 17.372 17.367 16.428 19.953 16.195 16.039 14.503 19.022 12.920 13.099 13.648 16.629 15.061 Profits, y $, billions -0.492 5.108 6.624 5.738 5.874 5.232 6.634 5.410 4.518 4.006 6.662 3.574 3.045 2.977 4.174 4.373

The equation of the top line A, y = 0.506x 2.96 = 0.506 (x 5.86) is deduced from the (x, y) pairs for quarters ending 30 Sep 2009 (1Q2010) and 31 Dec 2009 (2Q2010). The positive intercept on the revenue axis x0 = $5.86 billion. The equation of the lower line B, y = 0.504x 3.901 = 0.504 (x 7.74) is deduced from the (x, y) pairs for quarters ending 31 March 2009 (3Q2009) and 31 Dec 2011 (2Q2012). The positive intercept made on the revenue axis x0 = $7.74 billion. Notice that the slope h is virtually identical but the intercepts x0 differ.

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As discussed already, according to the classical breakeven model, revenues must exceed a minimum value before profits can be reported. Hence, if revenues x < x0, which is equal to the effective fixed costs for a company like Microsoft, no profits will be reported. However, when x > x0 profits increase at a fixed rate given by the slope of the line h. If revenues increase by a fixed amount x profits will increase by the fixed amount y = hx. Amazingly, for Microsoft, the high value of the slope h 0.50 means that it is able to convert nearly 50% of the additional revenues, beyond the breakeven point, into profits. At least this is the recent trend for the last 16 consecutive quarters.

Quarterly Profits, y [$, billions]

10.0 8.0 6.0



-2.0 0.0 5.0 10.0 15.0

4Q2012 20.0 25.0

Quarterly Revenues, x [$, billions]

Figure 7: Quarterly profits and revenues data for 16 consecutive quarters, from 1Q2009 to 4Q2012 is plotted here. The data again reveals a nice linear relation. All of the data follows the two PERFECTLY parallel lines deduced from the (x, y) pairs. Only the 4Q2012 data point falls off these lines.

The slightly different values for x0 that the fixed cost has not been constant and has fluctuated slightly varying from $5.84 billion on line A to $7.74 billion in
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line B. This fluctuation accounts for $1.9 billion in revenues that will not be converted into profits, or an additional fluctuation in profits of about $1 billion between quarters. Now we are ready to rationalize the huge drop in profits in 4Q2012 and the drop in the profits for FY2012. We are simply using the following principle in what follows here. If a point (x, y) of interest to us does NOT lie on the straight line A, y = hx + cA (like the 4Q2012 data in Figure 3, or the FY 2012 data in Figure 5), it can always be imagined to lie on a parallel B to the line A. The parallel B has the equation y = hx + cB. Thus, the offset equals the change in the intercept. It is important to think in terms of changes in intercept since this has to do with changes in the fixed cost, or changes in x0 = -/ch, the cut-off revenue. Consider the cumulative profits and revenues graph presented in the main text in Figure 3. The straight line joining the 1Q2012 and 3Q2012 data has the equation y = 0.306x + 0.4155. The graph is almost passing through the origin since the intercept c has a very small positive value (instead of the expected negative value). We know that profits increase with increasing revenues and it appears that about 30% of these revenues appear as the quarterly profits. Now, imagine a line parallel to this line and passing through the 4Q2012 data point with y = 18.059 and x = 73.723. Since h = 0.306, we compute the intercept c = y hx = 18.059 (0.306 73.723) = -5.609. Now take the difference between the intercepts made by the two parallel, which is the amount by which profits will fall as the company moves between the parallels. The difference 0.416-(-5.609) = 6.025 and we have been able to account for the missing $6 billion. This shows that the movement between parallels on the profits revenues diagram can indeed be explained and even one-time write-off like the one Microsoft took now can be properly accounted. Indeed, the law y = hx + c like the genetic code of a company. Once the slope h is fixed using good data and sound arguments, the rest of the data can be explained simply as a movement along and between parallels. The same considerations also apply to Figure 7 where we are looking at the quarterly data from several years (in Figure 3 we looked at a single year). The
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intercept c = -9.593 for a parallel through the 4Q2012 data (18.059, -0.452) if we consider line B and c = - -9.631 if take line A as our reference line. Although the lines are almost perfectly parallel, we see differences in the computed intercepts. Now compute the difference in the intercepts and we get 5.692 (with reference to line B) and 6.666 (with reference to line A) or an average of about $6 billion, the amount of the write-off loss claimed by Microsoft. Thus, the simple linear law, deduced using the breakeven model provides a satisfactory explanation for the observations, including such historic one-time event as the recent first-ever quarterly loss by Microsoft.

Table 5: Cumulative Revenues and Profits for FY 2010-2011

Quarter Revenues, x Profits, y Cumulative Cumulative $ Billions $, billions Revenues, R Profits, P 12.920 3.574 12.92 3.574 1Q2010 19.022 6.662 31.942 10.236 2Q2010 14.503 4.006 46.445 14.242 3Q2010 16.039 4.518 62.484 18.76 4Q2010 The line joining 1Q and 4Q, y = 0.3064x 0.385, slope h as in Table 1. 16.195 5.410 16.195 5.41 1Q2011 19.953 6.634 36.148 12.044 2Q2011 16.428 5.232 52.576 17.276 3Q2011 17.367 5.874 69.943 23.15 4Q2011 The line joining 1Q and 4Q, y = 0.330x + 0.0647

Finally, let us consider the cumulative profits and revenues for the FY2010, FY2011 and FY2012, see Table 5, i.e., we plot the 3-month, 6-month, 9-month, and 12-month revenues and profits for each of the three years on a single plot. The following linear equations can be deduced from the data for each year separately. For FY2010: y = hx + c = 0.3064x 0.385 (line joining 1Q and 4Q) For FY 2011: y = hx + c = 0.330x + 0.065 (line joining 1Q and 4Q) For FY2012: y = hx + c = 0.3064x + 0.416 (line joining 1Q and 3Q) Notice that the slope h = 0.0364 is EXACTLY the same for both FY2010 and FY2012, if we overlook the 4Q2012 data. (The slopes are 0.306392 for FY2010
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and 0.306383 for FY2012 differing only in the 4th and 5th decimals.) However, the intercept c has changed from a small negative value in FY2010 to a small positive value in FY2012 with a nearly zero intercept for FY2011. (It is small in relation to the minimum and the maximum revenues and profits being considered, which is of the order of several billions.) The composite plot is illustrated in Figure 8 below.

Cumulative Profits, y [$, billions]

35 30 25 20 15 10 5 0 0 20 40 60 80 100

Cumulative Revenues, x [$, billions]

Figure 8: Composite plot of the cumulative revenues and profits for the FY2010 (blue dots), FY2011 (red squares) and FY2012 (diamonds). The straight line connecting 1Q2011 and 4Q2011, y = 0.330x + 0.065 is included here to reveal the general trend. It practically passes through the origin (0, 0). The movement of the profits and revenues data along essentially parallels lines (with Microsoft quarterly data, we actually find EXACTLY parallel lines), supports the idea of a work function, which has been discussed already in detail in other articles (see for example, the Google article, Ref.[12] and the Kia, Ref. [15] and RIM, Ref.[14] articles). This is actually borrowed from Einsteins idea of a work function which was introduced into physics in 1905 to explain the photoelectric effect.
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7. Appendix II
Extending Einsteins Work Function Beyond Physics
A brief discussion of the photoelectric effect and Einsteins work function is provided in what follows here because of the amazing confirmation of these ideas that we find now with Microsoft profits-revenues data, see also other references cited in the bibliography. During the course of his 1887 experiments aimed at the laboratory production of electromagnetic waves, as predicted by Maxwells theory of electromagnetism, Hertz noticed a curious spark in his apparatus. Hertz had to focus his attention on producing what we now call radio waves. Others, notably Lenard and Hallawachs, followed up on Hertzs observations. (Lenard was Hertzs assistant and received the Nobel Prize in 1905 for this and many of his other studies on cathode rays). Lenard found that when light (of different colors) shines on the surface of a metal, electrons are ejected, which can be collected and made to flow in an external circuit thus producing a photoelectric current. There was cut-off frequency below which no electrons are produced. Increasing the intensity of light seemed to make no difference. These results could NOT be explained by the wave theory of light. That same year, in 1905, when Lenard was honored with the Nobel Prize, a very young Einstein, who would publish several papers which revolutionized physics, proposed the radical idea of light being made of up a stream of particles (now called photons), each having a fixed energy E = hf. Einstein was essentially extending Plancks idea of an elementary energy quantum (invoked to explain blackbody radiation) to light. When a stream of photons strikes the surface of a metal, some of the energy E is transferred to an electron within the metal surface. If the photon energy E is greater than a critical value, the electron is ejected to produce the photoelectric current. If the energy E is less than the critical value, no electrons will be observed. The minimum energy E needed to produce the electron depends on the characteristics of the metal on which light shines. Some work W must be done to overcome the forces that bind the electron to the metal and hence the minimum energy, depending on the metal substrate.
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After discussing the notion of entropy of light, from which he was able to deduce that light can be treated as particles with energy E = hf, Einstein applies the particle idea to provide a remarkably simple solution to the observations of Lenard and the cut-off frequency. Einstein says that the maximum (kinetic) energy of the electron K = E W = hf W = h(f f0). This immediately explains the existence of the cut-off frequency f0 = W/h. If W = 0, there is no cut-off frequency. Lenards cut-off frequency is thus a manifestation of the work function W, or the minimum energy that must be given up to produce the electron. If f < f0, no electrons, or photocurrent, will be observed since K < 0. Also, if one can determine this maximum kinetic energy K of the electron as a function of the frequency f, the K-f graph will be seen to be a straight line with a slope which is exactly equal to h, the Planck constant. Furthermore, if we conduct experiments with different metals, the K-f graph will be a series of parallels all with the same fixed slope h but with different intercepts due to the different work functions. With a little reflection, it is easy to appreciate that what we are witnessing here is exactly analogous to the observations on the photoelectric effect with different metals having different work functions W. Energy in physics is just like money in economics or the business and the financial world. Einsteins photoelectric law is also a linear law, y = hx + c = h(x x0). The cut-off frequency f0 is exactly similar to the cut-off, or breakeven, or minimum revenue x0 that must be exceeded before a company can produce profits. When revenues x < x0 all the revenues are absorbed as costs and no profits appears, as when the energy of the photon E < W. Once E > W, the kinetic energy of the electron K, increases with the frequency f, at a fixed rate determined by the Planck constant h. When the frequency of light changes by a fixed amount f, the kinetic energy of the electron changes by the same fixed amount K = hf. Likewise, once the cut-off revenue x0 is exceeded the additional revenues are converted into profits at the fixed rate h. When the revenue increases by a fixed amount x, the profits always increase by the same fixed amount y = hx. The terms such as photon energy, kinetic energy of electron, work function, are exactly

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analogous to the terms revenues, profits, and costs in the financial world. Energy in physics is just like money in economics. The movements of the Microsoft profits-revenues data along PERFECTLY parallel lines is eloquent confirmation of these ideas. The financial data for Kia Motor Company are also noteworthy in this context. The readers attention is also called to the discussion of the unemployment data where the same analogy is applied, Refs.[18-24]. The labor force x must exceed a critical value x0 before we see any unemployed y since the law relating x and y is again y = hx + c = h(x x0). Also, the careful study of the unemployment data for US, Canada, and Japan shows that a single universal value of h can be used to describe the unemployment data for all three countries. The single universal value of h = 0.0956 for the unemployment problem was deduced by considering UNIQUE points in the historical data, such as the (x, y) pairs (where x is labor force and y the number of unemployed, when the unemployment levels were at their record highs or record lows. This is similar to the situation in physics. The Planck constant h could only be deduced from the photoelectricity experiments when the maximum kinetic energy K was determined accurately. Likewise, with a company like Microsoft, which has become a standard for excellence in the business world, we see an exact movement along parallels on the profits-revenues diagram. Furthermore, the numerical value of h deduced for several leading companies (like Microsoft, Apple, Google) also appear to be roughly similar. More careful studies will be required, analogous to Millikans efforts to determine the Planck constant h, before one can conclude that a single value of h can be applied to describe the profits-revenues data (see Line of Excellence discussion in the Google article, Ref. [12]). Nonetheless, the preponderance of the empirical evidence accumulated by the present author over the past couple of months (since the Facebook IPO on May 18, 2012) and in the last couple of weeks (since the July 4th holiday weekend in the US, when discussions on the US unemployment situation began during the US Presidential campaign) points to both the existence of a work function well
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beyond physics and also a universal value of h in the simple law y = hx + c that can be used to explain many problems in many different situations. In summary, the quarterly data for Microsoft (Figures 7 and 8) shows that the company is moving along PERFECTLY PARALLEL lines in profits-revenues space. a) The cumulative profits-revenues diagrams for FY2010 and FY2012 (with the exception of 4Q2012 loss) yield EXACTLY IDENTICAL slopes h which differ only in the 4th and 5th decimal places. b) The quarterly data for 16 consecutive quarters also shows that Microsoft is moving along EXACTLY parallel lines. And, with the unemployment data, a single value of h in the law y = hx + c, has been shown to apply for the US, Canadian, and Japanese economies. This single value of h was deduced from UNIQUE POINTS in the historical unemployment data for each economy - the three points for the US with the highest unemployment levels, several points for Canada at the lowest unemployment levels and some at the highest, and likewise for Japan. One cannot think of a more eloquent proof for the idea of a work function beyond physics.

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8. Appendix III: Bibliography

Related Internet articles posted at this website Since the Facebook IPO on May 18, 2012
1. Current article with all others above cited for completeness, Published June 4, 2012 with several revisions incorporating more examples. 2. Basic discussion of three types of companies, Published May 24, 2012. Examples of Google, Facebook, ExxonMobil, Best Buy, Ford, Universal Insurance Holdings 3. Detailed discussion of Apple Inc. data. Published June 7, 2012. 4. Ford Motor Company graph illustrating pronounced maximum point, Published May 29, 2012. 5. Generalization of Plancks law, Published May 30, 2012. 6. Facebook and Google data are compared here. Published May 21, 2012. 7. Published May 19, 2012 (the day after IPO launch on Friday May 18, 2012). 8. Discussion of the meaning of entropy (using example given by Boltzmann in 1877, later also used by Planck to develop quantum physics in 1900). The example here shows the concepts of entropy S and energy U (and the derivative T = dU/dS) can be extended beyond physics with energy = money, or any property of interest. Published June 3, 2012. 9. The Future of Southwest Airlines, Completed June 14, 2012 (to be published).
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10.The Air Tran Story: An Important Link to the Future of Southwest Airlines, Completed June 27, 2012 (to be published). 11.Annies Inc. A Single-Product Company Analyzed using a New Methodology, Published June 29, 2012 12.Google Inc. A Lovable One-Trick Pony Another Single-product Company Analyzed using the New Methodology., Published July 1, 2012. 13.GT Advanced Technologies, Inc. Analysis of Recent Financial Data, Completed on July 4, 2012. (To be published). 14.Disappearing Brands: Research in Motion Limited. An Interesting type of Maximum Point on the Profits-Revenues Graph Published July 5, 2012. 15.Kia Motor Company: A Disappearing Brand, Published July 6, 2012. 16.The Perfect Apple: Taking A Second Bite: A Simple Methodology for Revenues Predictions (Completed July 8, 2012, To be Published) 17. Microsoft after the quarterly loss, published July 25,, 2012. 18. Single universal value of h for US, Canada and Japan in the unemployment law y = hx + c, Published July 24, 2012. 19., Published July 24, 2012. 20. Published July 24, 2012.
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21., Published July 22, 2012. 22. , Published July 19, 2012. 23. , Published July 12, 2012. 24. , Published July 10, 2012.

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About the author V. Laxmanan, Sc. D.

The author obtained his Bachelors degree (B. E.) in Mechanical Engineering from the University of Poona and his Masters degree (M. E.), also in Mechanical Engineering, from the Indian Institute of Science, Bangalore, followed by a Masters (S. M.) and Doctoral (Sc. D.) degrees in Materials Engineering from the Massachusetts Institute of Technology, Cambridge, MA, USA. He then spent his entire professional career at leading US research institutions (MIT, Allied Chemical Corporate R & D, now part of Honeywell, NASA, Case Western Reserve University (CWRU), and General Motors Research and Development Center in Warren, MI). He holds four patents in materials processing, has co-authored two books and published several scientific papers in leading peer-reviewed international journals. His expertise includes developing simple mathematical models to explain the behavior of complex systems. While at NASA and CWRU, he was responsible for developing material processing experiments to be performed aboard the space shuttle and developed a simple mathematical model to explain the growth Christmas-tree, or snowflake, like structures (called dendrites) widely observed in many types of liquid-to-solid phase transformations (e.g., freezing of all commercial metals and alloys, freezing of water, and, yes, production of snowflakes!). This led to a simple model to explain the growth of dendritic structures in both the ground-based experiments and in the space shuttle experiments. More recently, he has been interested in the analysis of the large volumes of data from financial and economic systems and has developed what may be called the Quantum Business Model (QBM). This extends (to financial and economic systems) the mathematical arguments used by Max Planck to develop quantum physics using the analogy Energy = Money, i.e., energy in physics is like money in economics. Einstein applied Plancks ideas to describe the photoelectric effect (by treating light as being composed of particles called photons, each with the fixed quantum of energy conceived by Planck). The mathematical law deduced by
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Planck, referred to here as the generalized power-exponential law, might actually have many applications far beyond blackbody radiation studies where it was first conceived. Einsteins photoelectric law is a simple linear law, as we see here, and was deduced from Plancks non-linear law for describing blackbody radiation. It appears that financial and economic systems can be modeled using a similar approach. Finance, business, economics and management sciences now essentially seem to operate like astronomy and physics before the advent of Kepler and Newton.

Cover page of AirTran 2000 Annual Report

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