Chapter 7 Profits and Raw Material Costs

 

Raw Material Costs -- Results of Empirical Studies:

 

  1. For the periods 1920’ – 1930’s and the 1970’s to 1991: The work of Wesley Mitchell (1951), Frederick Mills (1946) and Moore (1962 and 1983) all conclude the following price fluctuations over the business cycle are typical:

 

There are two reasons for this pattern: 1. an increase (decrease) in the growth of demand for finished goods and services results in a greater percentage of growth in the demand for raw materials (there is an accelerator), and 2. the supply of raw materials is much harder to change than the supply of finished goods.  In an expansion, the quantity of raw materials expands more slowly than the quantity of finished goods, and in a contraction the quantity of raw materials cannot be reduced as fast as the quantity of finished goods.

 

2.      The general pattern is:

·        the prices of raw materials (and goods bought for resale) rise faster than selling prices

·        selling prices rise in an expansion

·        the prices of labor and overhead lag behind selling prices in an expansion -- vice versa for contraction

 

Raw material prices rise early in an expansion and continue to rise throughout the expansion.  By the middle of expansion, rising raw material prices are definitely a negative factor for profits.  In a contraction, raw material prices decline early and continue to decline throughout the contraction and are a positive for profits. 

 

3.      For the period 1950’s to 1960’s, the long-term decline in raw material costs versus finished goods dominated the cyclical changes.

 

4.      For the period 1970-1991: in expansions, the prices for crude and intermediate materials rose 2.1% per quarter while the consumer price index rose 1.7% per quarter.  In contractions, prices for crude and intermediate materials fell by 3.1% per quarter (despite the high inflation rate of the 1966 to 1982 period) while the consumer price index continued to rise by 2% per quarter (due to the long-run high inflation rate).

 

5.      The capacity utilization rate is strongly pro-cyclical, so is the ratio of crude and intermediate material prices to the consumer price index.    This can be seen in the figure below.

 

6.      latest data releases:       http://www.bls.gov/ppi/

http://www.bls.gov/cpi/

historical data:               http://research.stlouisfed.org/fred/

data on raw industrials http://www.crbtrader.com/crbindex/crbdata.asp

                                                Just industrials, no energy, no precious metals

Because prices are so volatile, there are large futures markets for suppliers and vendors to hedge risks.

                                                           

 

 

Since this table is the ratio of raw material costs to selling prices, it shows that profits will probably be very cyclical also.


Profits (and expectations of profits):

 

We have previously encountered 3 areas that would lead us to conclude that profits are very important to the business cycle.

 

1. Profits equal revenue minus costs.  Revenue consists of consumer spending, investment spending, government spending and net exports.

 

We have a model of consumption – the Keynesian A.P.C. and M.P.C. theories of the business cycle and the functional income hypothesis of the business cycle.  Consumption spending rises and falls slower than incomes and it depends on the distribution of labor and property income (and credit).

 

c=c1(labor inc) + c2(property income)

                                    or

                        c=c1(national income) + c2(labor share).

 

We have a model for investment:           ig = in + ir = DKE(y,C,P) + k

(where “KE” is equilibrium capital stock and y is change in output)

 

                        *KE/Y>0  ,  KE/P >0  ,  KE/C<0

                        C = PI(r-I+) brings interest rate into the picture

r = wrerre + wDrD + were

profit level enters the picture because of C and P.  Since P is relatively more stable, it is C that fluctuates the most, and it is r that fluctuates the most within C (rre < re or rd).  

Also accelerator function:

                                    ig = (Dy)/c + k  (where c is real user cost)    c=C/P

 

So, new investment fluctuates much more than consumption over the business cycle.

 

2. The ratio of crude and intermediate materials to consumer prices is strongly pro-cyclical.  This is a ratio of costs to prices.

 

3. The labor share declines early in an expansion and rises early in a contraction because productivity rises rapidly early in an expansion and declines rapidly early in a contraction (the last chapter w/y = (w/n)/(y/n)).

 

 

An Empirical Review of Profits:

 

  1. Profits and the profit rate are strongly pro-cyclical.  Profits are a leading indicator even thought the lead time is often very short.

 

  1. There is no long-term trend to profit rates.

 

  1. The wide swings in investment are the most immediate and direct cause of the business cycle, and profit (actually, profit expectations) determine business investment. The proper forms of P and C in our investment model are expectational.

 

  1. Investor’s profit expectations may be formed from recent changes in actual profits with a time lag – maybe as short as 3 – 4 months (Philip Klein and Geoffrey Moore, Monitoring Growth Cycles in Market Oriented Countries, 1985.

 

  1. There are two ways profits affect investment:  profits lead to profit expectations which are the motivation for making an investment (R.O.I. or R.O.S.), and profits provide the cash flow to fund the investment (or the cash flow to fund the credit).  Most business cycle analysis can be done with either.

 

  1. We are not talking about profits reported by corporations and their accountants as GAAP earnings.  These have become problematic because of shifting definitions of operating profits.  There are three sources of profit reports:

 

1. Publicly reported profits – quarterly and annual shareholder and SEC reports

 

2. N.I.P.A. National Income and Product Accounts – prepared by the Department of Commerce as part of the quarterly GDP reports.  The Department of Commerce also prepares monthly estimates of these profits. http://www.bea.doc.gov/bea/dn1.htm

 

Measures the earnings of domestic corporations arising from current production that is distributed to residents of US.

Operating profit –   profits before taxes without adjustments

profits before taxes with adjustments for IVA and CCA for financial and non-financial corporations(financial corp profits – also include profits of the Federal Reserve system and contributions less payouts of non-insured corporate pension plans.)

corporate profits before and after taxes by industry

R.O.W. profits.

 

3. Profits Reported for Tax Purposes – very comprehesive, but released in an annual report by the IRS Statistics of Income – Corporate Income Tax Returns which is not available until several years after the end of the tax year.  This is only useful for research purposes. http://www.irs.gov/taxstats/content/0,,id=97507,00.html

 

The chart below is prepared using Profits from the NIPA reports (total corporate profit with IVA) and the Profit Rate on Capital from the IRS income tax returns (the ratio of profits after taxes to stockholder’s equity for all manufacturing corporations, quarterly and seasonally adjusted).

 

 

 

 

 

 

 

 

 

The use of profit rate rather than profits leads to an interesting analysis by Thomas Weisskopf, “Marxian Crisis Theory and the Rate of Profit in the Postwar U.S. Economy”. Cambridge Journal of Economics 3 (December 1979): 341-378.

 

*  /k = (/y)(y/z)(z/k)

 

where:        = real profits

                  y = real national income

                  k = real capital

                  z = potential output

profit rate = (profit share of income) x (capacity utilization ratio) x (ratio of potential output to capital)