What's behind the rise in U.S. corporate profits?

Globalization, technological innovation, and supply chain efficiency explain the current resilience of U.S. corporate profits—one of the few drivers of the U.S. economy at the moment. The U.S. Department of Commerce recently reported that corporate profits (which includes both domestic and foreign profits) now make up the largest percentage of the country's gross domestic product (GDP) since the 1950s. This ratio currently stands at just under 13 percent of GDP, amounting to a total of US $1.9 trillion (see Figure 1). However, wage and salary disbursements have been slowly trending downward from 47 percent of GDP in 1985 to 44.4 percent in the second quarter of 2011 (see Figure 2). These trends seem to point to increased inequality between workers and managers, driven to some extent by the outsourcing of lower-skilled jobs to Asia.

U.S. domestic corporate profits—defined as American corporations' profits generated from operations in the United States—trended downward from the 1950s through the mid-1980s. But then that trend reversed, with profits experiencing wild swings during recession cycles. In the 1960s, domestic corporate profits were slightly less than 11.0 percent of GDP, falling to 7 percent by 1985.

Article Figures

[Figure 1] Corporate profits as percentage of U.S. GDP Enlarge this image

[Figure 2] Wage and salary disbursements as percentage of U.S. GDP Enlarge this image

Currently, domestic corporate profits stand at 10.1 percent of GDP. Analysts have been amazed at the rate at which domestic corporate profits have been able to spring back following the "Great Recession" (December 2007 to June 2009). Indeed, domestic corporate profits as a percentage of GDP fell to their lowest point in over 60 years during the recession and then rebounded to their pre-recession levels in just over one year. One reason why is that greater supply chain efficiency is allowing domestic companies to maintain lower inventories and avoid overshooting (accumulating inventory) when a slowdown occurs. This helps corporate profits to snap back more quickly. Inventory-tosales ratios adjusted for inflation have been trending down for the retail and wholesale trade over the past 15 years.

The innovation of business-to-business e-commerce has also changed the cost and profit picture for many companies. In 2003, approximately 21 percent of U.S. manufacturing sales and 14.6 percent of wholesale sales were e-commerce-related. By 2008 those percentages had increased to almost 40 percent for manufacturing and 16.3 percent for wholesale trade.

A major game changer in the last couple of decades has been the increasing influence of foreign profits—the profits U.S. corporations earn from overseas receipts. In the mid-1960s, U.S. corporations were making approximately 6.5 percent of their profits from foreign operations, which translated to less than 1 percent of GDP. By the mid-1990s, foreign profits started playing a stronger role in overall corporate profitability. Foreign profits are now slightly less than 4.3 percent of GDP—up more than four-fold from the mid-1980s—and American corporations now make 30 percent of their profits from foreign sources.

Comparative advantage comes into play
One of the central concepts behind the idea of "comparative advantage" advanced by British economist David Ricardo (1772-1823) is that countries specialize in what they do best (that is, most efficiently and cost-effectively), and trade is the central mechanism for exchanging those goods and services. Thus, globalization, trade liberalization, and free trade benefit all nations. Domestic and foreign profits benefit from increased globalization in different ways, and today technological and supply chain innovations are making world trade more profitable in ways David Ricardo could not have imagined.

U.S. and European companies have discovered the advantages of outsourcing low value-added production and service operations to countries with an abundance of productive yet low-wage laborers. Call centers in India and assembly plants in China are just two of many examples. (Approximately 60 percent of Chinese exports, in fact, are sanctioned by U.S. and European corporations.) Outsourcing enables companies to retain the more skilled and higher value-added distribution, design, and technical production processes in their home countries while importing services and goods with lower valued-added components. By doing so, they are optimizing their production cycles and minimizing their costs, thereby improving margins.

As emerging countries continue to develop, demand for high value-added exports from the United States and Europe is growing. Oddly, 30 percent of current U.S. exports are services. This is in addition to domestic corporate profits and makes them more resilient in times of domestic recession. There is considerable anecdotal evidence suggesting that service exports have higher margins than goods and material exports because there are no inventories to worry about and transportation costs (if any) are lower.

Foreign corporate profits have been a blessing for U.S. companies, since the global slowdown in 2008 through 2009 in China, Brazil, and India was relatively mild while U.S. and Western European economies were still dragging. Increasing consumer spending in foreign markets, especially Asia, continue to play a major role in improving U.S. corporate profitability by helping to prop up profits when U.S. domestic consumer spending is anemic.

Protect your profitability
Early in her political career, the British Prime Minister Margaret Thatcher often said that "there is no alternative" to trade liberalization, free trade, and globalization. That appears to be true for U.S. corporations, whose performance is becoming increasingly dependent on overseas operations to bring higher and more stable profits. However, the rising productivity of many Chinese and Indian industries is placing considerable wage and price pressure on U.S. companies' outsourcing operations. Many countries want to move up the value-added chain. In addition, the extensive, very specialized production concentrations that have developed due to some countries' comparative advantage have created considerable supply chain risks from such factors as natural disasters or political instability. Companies might want to think about building a few redundancies in their supply chain networks in order to hedge against events that may be improbable, yet if they happen—and unfortunately they do, as we saw in Japan earlier this year—can make the difference between profit and loss.