The New GM versus Ford

Introducing a New Measure of Profitability Analysis of the Revenue-Profits data for most recent consecutive quarters ending Q1 2011 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 A careful examination of the quarterly earnings releases for any company reveals that profits will generally increase if revenues increase. A doubling or tripling of profits is, however, almost never associated with a doubling or tripling of revenues! A good example is the new GM which recently reported a tripling in quarterly profits for Q1 2011 compared to the same quarter last year but with only a 15% increase in revenues. Why? The reason, quite simply, lies in the costs, especially the fixed costs, associated with a company’s operations. Indeed, the following statement may be taken as a universal law governing the operation of the financial world.
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Profits = Revenues – Costs

..........(1)

If N is the number of units sold and/or manufactured, e.g., vehicles in the case of an automotive company, and k is the unit price, the total revenues generated from sales R = kN. The total costs C = Fixed costs + Variable Costs = a + bN and hence profits P = (R – C) = kN – a – bN = (k – b)N – a which can be rewritten as: P = [ (k – b)/k ] R – a ..……..(2)

Equation 2 is obtained by eliminating N, using R = kN, and suggests a simple linear relationship between profits P and revenues R. Hence, as revenues x increase, profits y will also increase following a simple linear law y = hx + c where h = (k – b)/k and c = - a. The breakeven point, where R = C, or P = 0, can therefore be readily determined by preparing a x-y scatter graph and examining the underlying trend. 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 breakeven revenue R0 may thus be thought of as a “modified” fixed cost, modified by the factor k/(k – b) multiplying fixed cost “a”.

Ford’s quarterly earnings data 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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3.0

Quarterly Profits, y [$, billions]

2.5 2.0

1.5
1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0

0

Quarterly Revenues, x [$, billions]

10

20

30

40

Figure 1: Graphical representation of Ford’s quarterly earnings data for the nine consecutive quarters ending Q1 2011 (from Q1 2009 to Q1 2011).

Table 1: Revenues-Profits data for Ford Motor Company from quarterly earnings releases
Quarter Q1 2011 Q1 2010 Q1 2009 Q2 2010 Q2 2009 Q3 2010 Q3 2009 Q4 2010 Q4 2009
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Revenues, $ billions 33.1 28.1 24.4 31.3 26.8 29 30.3 32.5 34.8

Profits, $ billions 2.551 2.085 -1.427 2.599 2.261 1.687 0.997 0.19 0.886

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. The overall data trend is revealed by superimposing the upward sloping line with the equation y = hx + c, see Figure 2, where the constants h and c were deduced by considering the two data points (24.4, -1.427) and (31.3, 2.599). The slope h = [2.599 – (-1.427)] / (31.3 – 24.4) = 0.583 and the
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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 breakeven revenue, on a quarterly basis, is thus about $27 billion to $31.5 billion, depending on whether one uses the trendline with the highest slope or the least slope, i.e., between points (24.4, -1.427) and (32.5, 0.19). The straight line passing through the latter two points has the equation y = 0.1996x – 6.298 with a breakeven revenue of $31.5 billion. Further justification for the methodology used here to determine the correct trendline may be found in the appendix. The main arguments that have been used to determine the slope h and the intercept c of the best-fit line and/or the trendline are: 1. While an increase in quarterly revenues might not always be associated with an increase in profits, an increase in profits must necessarily be associated with an increase in revenues. 2. The change in profits between any two quarters cannot be greater than the change in the revenues. 3. The principle of profit maximization implies that the slope h must be the maximum value consistent with the two points noted above. 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.

Comparison with the new GM 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. The slope h in the universal law, y = hx + c, relating profits and revenues, is like the well-known marginal tax rate in economics. The marginal tax rate is the additional tax paid on each additional unit of taxable income. Likewise, the slope h here tells us about the additional profit made with each additional unit of revenue. The analysis here suggests that once the breakeven revenue is reached, profits increase rapidly. It is suggested that the term marginal profit rate (MPR) be used to describe this new measure of profitability. 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 1. As noted in the earlier analysis of the new GM earnings data, it appears that the simple linear equation y = hx + c, where x is revenues and y is profits can be elevated to the status of a universal law describing the financial behavior of all companies, large and small, operating in all sectors of the economy and in many different economic, political, and social (or tax!) environments.

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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). 3. The slope h = dy/dx, in the universal law y = hx + c relating profits and revenues, is like the well-known marginal tax rate in economics. The marginal tax rate tells us about the additional tax paid on each additional unit of taxable income. Likewise, the slope h tells us about the additional profit made with each additional unit of revenue. Perhaps, the term marginal profit rate (MPR) should be used to designate this new measure of profitability. 4. If revenues increase and exceed the breakeven value, which equals R0 = ak/(k – b) in the simple model, profits will automatically increase. Hence, it would seem that companies should focus their efforts on revenue enhancements, instead of merely being focused on costcutting that seems to have been the dominant management strategy in recent years – with all its attendant social and political turmoils, as evidenced by the ongoing economic struggles still being experienced throughout the US economy, following its near total collapse in 2008.

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Appendix 1 Further analysis of the Ford’s Revenue-Profits data
The estimates of the breakeven revenue and the Profits-Revenue equation can be further refined as follows but do not significantly affect the conclusions presented in the main text. With revenues of $24.4 billon Ford reported a loss of $1.427 billion in Q1 2009. However, with higher revenues in other quarters Ford was able to report a nice profit. Let us consider the data extracted for the three quarters in Table A1. We see profits increasing with increasing revenues.

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 Q1 2009 Q3 2010 Q2 2010 Revenues, $ billions 24.4 29 31.3 Profits, $ billions -1.427 1.687 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.

Table A2: Revenues-Profits data for Ford Motor Company from quarterly earnings releases
Quarter Q1 2009 Q3 2009 Q1 2011 Revenues, $ billions 24.4 30.3 33.1 Profits, $ billions -1.427 0.997 2.551

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. y = 0.592x – 15.456 with r2 = 0.877 y = 0.409x – 10.797 with r2 = 0.715
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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 As noted already, the graphical representation of the profits-revenues data for Ford Motor Company, for the most recent nine consecutive quarters, reveals a significant scatter. Although it seems arbitrary to choose just three points from this data set, as discussed in appendix 1, to determine the best-fit line, a careful examination of the entire data set reveals that the choice of the best-fit line yb = 0.597x – 15.898 is eminently justified. Very briefly, the justification is as follows.

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. Table A3: Lost profit opportunity based on best-fit equation Best-fit line Deviation Quarter Revenue, x Profit, y prediction, from best-fit yb line, (y - yb) Q1 2009 24.4 -1.427 -0.092 -1.335 Q2 2009 2.164 26.8 2.261 0.097 Q1 2010 1.212 28.1 2.085 0.873 Q3 2010 0.276 29 1.687 1.411 Q3 2009 -1.189 30.3 0.997 2.186 Q2 2010 31.3 2.599 -0.184 2.783 Q4 2010 -3.309 32.5 0.19 3.499 Q1 2011 -1.307 33.1 2.551 3.858 Q4 2009 -3.986 34.8 0.886 4.872 The best-fit line is yb = 0.597x – 15.898 and the breakeven revenue R0 = 26.637 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.

Figure A5: Linear regression equation relying on purely statistical arguments including the data for all nine quarters from Table 1. The breakeven revenue, when profits y = 0, is R0 = -c/h = -(-2.497)/0.127 = 19.678. The linear regression
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coefficient r2 = 0.101 also has a small value and one might even conclude, if we did not know better, that there is no significant positive correlation between revenues and profits. 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: 1. While an increase in quarterly revenues might not always be associated with an increase in profits, an increase in profits must necessarily be associated with an increase in revenues. 2. The change in profits between any two quarters cannot be greater than the change in the revenues. 3. The principle of profit maximization implies that the slope h must be the maximum value consistent with the two points noted above.

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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.

Table A4: “Effective” cost C from the Profits-Revenues data Quarter
Q1 2009 Q2 2009 Q1 2010 Q3 2010 Q3 2009 Q2 2010 Q4 2010 Q1 2011 Q4 2009

Profit, P
-1.427 2.261 2.085 1.687 0.997 2.599 0.19 2.551 0.886

Revenue, R Cost, C Best-fit C
24.4 26.8 28.1 29 30.3 31.3 32.5 33.1 34.8 25.827 24.539 26.015 27.313 29.303 28.701 32.31 30.549 33.914 23.801 25.896 27.031 27.817 28.952 29.825 30.8726 31.396 32.881

The cost C calculated in this fashion is an “effective” cost, not directly reported in the financial statements, and accounts for ALL of the costs, including taxes paid, to produce the revenues. Instead of preparing a graph of profits P versus revenues R, consider instead the graph of costs C versus revenues R. Costs C always go up as revenues go up. The large scatter seen in the P-R graph is not seen in the C-R graph. Indeed, a nice upward trend is revealed, see Figure A7, suggesting a strong positive correlation between costs and revenues. The linear regression equation relating costs C and revenues R is easily deduced and is given below. C = 0.873 R + 2.497 with r2 = 0.842 ……….A4.1

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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, P = 0.127 R – 2.497 ……….A4.2

Amazingly, equation A4.2 above relating P and R is exactly the same as the linear regression equation deduced earlier and graphed in appendix 3.
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The upward sloping dashed line in Figure A8 is the graph of C = R. The revenues are equal to costs on this line. Hence, when the data point falls above this line, the company would report a loss, for example in Q1 2009; see also the calculations in Table A4. The data points that fall very close but just below the line C = R represent quarters when the company just barely reports a profit. The procedure described here is an alternative approach to determining the profits-revenues relation and is based on purely statistical arguments. It does not employ the principle of profit maximization as discussed in appendix 3.

About the author
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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