Monday, September 27, 2010

Profit Margins

The Lehmann Letter ©

Why is the stock market climbing although the economy is slack?

Record profit margins should be part of any answer.

Think of profit margins as the ratio between the price of the product divided by the cost of producing it. If the number rises, profit margins are rising as the gap between price and cost grows. If the number falls, profit margins are falling as the gap shrinks.

The chart shows profit margins for the whole economy. You can see that they now stand at a post-World War II high.

Chart 2.3 Profit Margins

(Click on image to enlarge)

Recessions shaded

Business now enjoys this good fortune because the cost of producing each unit of output has fallen while prices have held steady. During the recession employers reduced their workforces more than output fell. The employees who survived the mass layoffs now produce more per hour of work because workforce reduction exceeded output reduction. That means less labor time is required to produce each unit of output. Consequently unit labor costs (the cost of producing a unit of output) have fallen. The chart shows record profit margins as prices held steady while costs fell away.

But record profit margins by themselves can’t keep boosting total profits. Growing profits also require growing sales volume. (Total Profits = Profit Margins X Sales Volume) That’s why the economy’s recovery and improvement are also important.

(The chart was taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

© 2010 Michael B. Lehmann

No comments: