What Manufacturing Profits Don't Tell Us: A Response to Perry

by: Michael Mandel

Mark Perry, who I recently had the pleasure of meeting and who seems like a nice guy, replies to my manufacturing revival post by focusing on profits. He writes that

… real manufacturing profits have completely recovered from the recession, and reached an all-time high in the fourth quarter of last year

He then goes on to conclude:

In the end, it's profitability that's the most important gauge for the health of a company or industry, not the amount of shipments, output, or employment levels

With all due respect, Mark misses the point. First, the measure of profits that he is using includes the profits from foreign subsidiaries of U.S. companies, so his measure of profits could be going up because factories in other countries are expanding, By comparison, I am looking at the shipments by factories in the U.S. I think my scope better fits what people mean by the revival of American manufacturing.

Here's a chart of real "domestic" profits in manufacturing.* In fact, we see that 2010 real ‘domestic' profits are about 20% below the latest peak in 2006. So much for all-time high.

(Click to enlarge)

But I'm not done yet. Why do I keep putting "domestic" in quote marks? It's because "domestic" profits don't really mean what you think they do. Suppose that a large manufacturer closes a U.S. factory that makes parts, and starts buying from a foreign supplier that offers lower prices. In this situation, the entire gain in corporate income is counted as an increase in domestic profits, even though manufacturing production was actually decreased in the U.S.

Or consider this example. A U.S. manufacturer is buying components from a Japanese supplier for use in a domestic factory. The manufacturer shifts sourcing of the components to a Chinese supplier which offers a lower price. As the result of this change – which affects absolutely nothing about production in the U.S. – domestic profits rise

In other words, domestic profits can be affected by changes in the global supply chain that have nothing to do with production in the U.S. In general, in a supply chain world, domestic profits don't give you a clear measure of the health of domestic manufacturing, in the conventional sense.

Added: See also FT Alphaville's quick note.

*Domestic manufacturing profits from table 6.16D in the national income accounts, deflated by the GDP deflator.