Thursday, March 8, 2012

Profit Margins and Profits

The Lehmann Letter (SM)

Yesterday the Bureau of Labor Statistics confirmed the slowing pace of productivity growth last year:

Don’t confuse productivity growth with production growth. The former measures efficiency; the latter measures output.

Productivity growth = Output growth / Labor input growth.

That’s why efficiency is a synonym for productivity. Both words indicate the rate at which output improves compared with the rate at which labor input increases. Productivity grows when output gains more rapidly than labor-time. More output per hour-of-work means more output per capita: The key to per-capita gains in income.

Productivity advanced during the slump and early recovery as employers shed workers more rapidly than output fell. Now employers must hire workers more workers to achieve additional output gains and, as labor growth catches up with output growth, productivity-growth suffers.

You can imagine that improved productivity benefits profit margins. Efficiency has a nice ring to it. Sure enough: The top chart illustrates recent strong profit-margin gains.

Ratio: Implicit Price Deflator to Unit Labor Costs
(Click on chart to enlarge)

(Recessions shaded)

But profit-margin gains have begun to stall as productivity gains have slowed. The ratio in the chart above, after improving for 20 years, may have reached its limit. Don’t expect further profit-margin improvement.

After-tax Corporate Profits
(Click on chart to enlarge)

(Recessions shaded)

Total profits are the product of profit margins multiplied by sales volume (profit margins X sales volume). Since it appears that profit margins have risen to their limit, sales volume must now grow strongly for earnings to continue their upward march. If sales growth is not robust, most of the biggest profit-gains (see the bottom chart) are behind us.

Can we reasonably expect strong sales growth in an economy with a weak residential-real-estate sector? That’s a question stock-market investors should keep in mind.

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© 2012 Michael B. Lehmann

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