The real threat to legacy auto: Tesla’s profit margins

Posted on March 02, 2023 by Charles Morris

Most of the world’s legacy automakers are slowly but surely raising their electrification games, and that’s good news for all concerned—car buyers need more choices, and the industry needs healthy competition. However, they still have a lot to learn, and some painful choices to make, if they hope to catch up to the industry’s trend-setter.

Above: A Tesla service center (Image: Casey Murphy / EVANNEX).

As EV sales volumes have increased, Tesla’s EV market share has—perhaps inevitably—shrunk from absolutely dominant to merely commanding, and many a pundit is predicting that this is the beginning of the end for the brash upstart. Such fears (or hopes) are overblown. Tesla has a few aces up its sleeve, and one of these is a much-misunderstood accounting concept called the gross margin.

Gross margin is defined as the difference between the sale price of a product and the cost to produce that product. It’s the amount a company earns on each unit that it sells. Many of those who pontificate about Tesla’s prospects might be surprised to learn that the young company has by far the highest margins in the auto industry—and has for some years. Back in the days when Tesla dwelt in the Valley of Death, it was common for naysayers to write that the company “lost money on every car it sold.” This was false. Yes, the company as a whole was losing money, but that was because it was investing huge sums in building factories and developing new models. Tesla did, and does, earn a healthy margin on every car it delivered. As other, better-informed pundits pointed out, the company could have become profitable years before it actually did by abandoning its grand expansion plans and focusing on delivering Model S in moderate volumes.

As explained in a recent Reuters article, and illustrated in an infographic from Visual Capitalist, Tesla earns more money for every vehicle it sells than any of its global rivals. A lot more. Reuters calculates that Big T earns an average of $9,574 per vehicle sold, compared to $2,150 for second-place GM, and $1,550 for plug-in powerhouse BYD.

This isn’t just a nice thing to brag about—like a material advantage in a game of chess, it’s a resource that the company can choose to deploy in different ways to defend its position and/or to attack its opponents. A couple of recent stories provide examples.

When Tesla recently announced substantial price cuts, many observers naively saw this sign of flagging demand as the beginning of the end. Other pundits (and the stock market) saw it as the normal working of the Invisible Hand of supply and demand, and a shot across the bows of Tesla’s rivals. Within days, Ford was forced to respond with price cuts on its own EVs, and other shoes may yet drop. And here’s the rub: Tesla still has plenty of room to make further price cuts—its rivals don’t. (According to Reuters, Ford already goes $762 into the red every time it sells a car.)

By most accounts, the main reason for Tesla’s superior margins is lower production costs. EVs are simpler machines than ICE vehicles, and inherently cost less to build, and Tesla is constantly finding ways to refine its manufacturing processes—for example, using giant castings to replace complicated assemblies of smaller parts. As Reuters notes, using production-cost advantages to fund price cuts has a long history in the auto industry. Toyota successfully weaponized its superior margins in the 1980s and 1990s.

Meanwhile, Chinese automakers have started selling their EVs in Europe, and domestic brands fear, with good reason, that they may steal a large part of the market for lower-priced cars, which European EV-makers have largely ignored. Stellantis CEO Carlos Tavares is just one of several industry execs sounding the alarm, and implying that governments need to ladle out more subsidies to help automakers meet the threat.

But there’s a pretty good argument to be made that Tesla is a more immediate challenge to European automakers. For a month or two in 2022, Model Y was the best-selling car (yes, of any kind) in Europe, and that was before the recent round of price cuts. If demand should drop, Tesla could dip into its magnificent margin to drop prices further. Volkswagen (for example) has much less leeway, with its margin of $973. And the Chinese? According to Reuters, Xpeng and NIO are bleeding cash—their margins are each five figures into the red. (It’s true that China is still facing crippling supply chain issues, and furthermore, all these figures are for global sales, so they don’t take regional differences into account.)

As the legacy automakers produce more EVs, they’ll improve their EV-building chops and increase their margins. (Unfortunately, they’ll also be cutting costs via layoffs over the next few years.) Tesla’s advantage may not last. On the other hand, it may—for over a decade, we’ve been told that the dinosaurs would soon get their act together and stomp on the pesky little mammal running between their legs.

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Source: Reuters; Infographic: Visual Capitalist