the preannouncement

As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings.  The main culprit?  …worldwide general economic slowdown.

The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago.  The gross margin will come in at 62% instead of 63%.  Virtually all other cost items will remain the same.

looking at leverage

This isn’t much data.  But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.

manufacturing leverage

two kinds of costs

In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build.  So, in a sense these are indirect costs of manufacturing.  In the short run, they’re relatively fixed.

In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips.  These are direct costs.   Their total in any period is variable, depending on how many chips get made.

Accountants assign each chip a total cost that depends on two factors:  the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.

gross margin

Total cost ÷ sales price = gross margin.

separating the two

Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter?  In INTC’s case, yes.

Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point.  That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips.  (It’s a little more complicated than that, but not a worry in this case.)

Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips.  If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.

Here we go:

$13.2 billion x .62  =  $8.18 billion in gross profit

$14.3 billion x .63  =  $9.01 billion in gross profit

The difference is $.83 billion, the gross profit lost from lower sales.   This gross profit   ÷ $1.1 billion in lost sales   =  75.5%.

Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter.  That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.

Note, too, that the new operating profit is 9.1% less than the original estimate.  That compares with a 7.7% drop in sales.  So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.

SG&A leverage

INTC has two types of SG&A.  One is R&D.  The other is the typical SG&A that any industrial company has. The two items are roughly equal in size.  This quarter they’ll amount to $4.6 billion.

Let’s subtract that from both the original gross profit estimate and the new guidance.

$8.18 billion  –  $4.6 billion  =  $3.58 billion in operating income

$9.01 billion  –  $4.6 billion  =  $4.41 billion in operating income

Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.

It’s 18.8%!

To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits.  Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.

In other words, the operating leverage at INTC is coming from SG&A, not manufacturing.  If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.