Automobile Accounting

Stories have been circulating this week about the production costs of the Chevy Volt hybrid automobiles. The numbers are astounding! According to a Reuters article in the National Post story, it costs US$89,000 to produce a car that sells for US$39,995. GM is losing US$40,000 per car. Yet GM continues to produce and market these vehicles. There is something seriously wrong with the management at GM, or there is something wrong with these numbers.

Basic economic theory suggests that a firm will be willing to sell its product for any price greater than the marginal cost of production, provided that the price is higher than the minimum average variable cost. The same economic theory tells us that “sunk costs” are irrelevant for decision making. A sunk cost is a fixed cost that has been incurred that can never be recouped. An example would be research and development costs. These costs certainly effect profits, but not the profit making decisions.

The article referenced above suggests that the $1.2 billion spent by GM should be divided up among the number of Volts that have been sold. While an accountant might agree with this, an economist certainly would not. The R&D money is a sunk cost. It can never be recovered. It reduced profit by $1.2 billion dollars. That money is an investment in a technology that is still developing, and will be used in other models in the future. The patents are intellectual property of GM and could, in theory, be sold to other automobile manufacturers.

The costs that are relevant to the production of the Volt, are the materials, labour and equipment used to produce each vehicle – the marginal costs of production. We haven’t asked GM for their cost figures, and we suspect that the batteries add significant costs over internal combustion engines, but to suggest the marginal cost of producing a Volt is US$89,000 is ridiculous.

Another issue surrounding the Volt, as reported by CBS news, is the lackluster sales of the Volt. GM has recently reduced the price of the volt (increasing the loss per vehicle reported by the industry analysis in the Financial Post article) in an attempt to increase sales. Demand curves are downwards sloping, so a reduction in price should increase the number of vehicles sold. The biggest problem that electric vehicles face is that oil prices, and therefore gasoline prices have fallen. Electric cars are a substitute for gasoline fueled cars, and a drop in the cost of operating a gasoline vehicle reduces the demand for electric cars. On our road trip through the western states this summer, we were able to purchase gasoline for about the equivalent of C$0.90 per litre. At this price, electric cars don’t make economic sense.

At some point in the future, oil prices will be high enough and the technology used in electric cars will be efficient enough that we will see more electric cars on the road. Until then, we’re investing in the oilsands.