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Why GM Failed

Posted December 05, 2010 by FinanceDog Staff

Although there are lots of opinions as to why GM failed, one thing is clear - GM failed because they hadn't made a profit since 2005. Why? Because as sales went down, their costs didn't go down, as would happen in most manufacturing companies.

Here's a question from a reader.

Rammohanpotturi asks:

I have a very specific question for both of you. Why do you think GM collapsed? A company which was started in 1909 went on to stay well ahead in the automobile industry for 100 years collapsed. I understand it is not all of sudden. What happened to their financial management?

GM is a very interesting case. Yes, it is certainly one of the great titans of U.S. industry and it's not any fun to see them go into bankruptcy.

There have been several opinions put forward at to why this all happened:

  GM makes cars people don't want

  GM is too slow to innovate because of its size

  GM is too bureaucratic and unable to adjust to changing markets

  GM's dealer network is too large

  GM sold off its formerly profitable financing business GMAC

To us the problem with GM is very simple. GM stopped making a profit. The reason any company exists is to make a profit. When companies stop making a profit they fail. We measure profit using the income statement. The income statement simply takes what you sold in a period and subtracts the costs in the business during the same period. If sales are greater than costs or expenses then there is profit. If sales are less than costs then there is a loss.

GM stopped making profit in 2005. Since that time GM lost more than $90 billion through the 1st quarter of 2009. As Joe says in his classes, "In finance we learn that losing money is bad." GM has been very, very bad for several years. The next question, then, is, "why did those losses happen?" From our perspective, even though all of the above may be good points, the key to GM's losses has to do with sales and fixed costs.

I (Joe) have owned a small business with partners for several years. We have learned that to survive in tough times (BTW the definition of tough times in business is a drop in sales) we had to cut costs. Cutting cost is the most painful thing you have to do as an owner because it usually means having to cut jobs.

The problem for GM was that when the sales slowed down, they had trouble cutting costs because most of their costs were fixed. In other words, a lot of their costs did not go down as their sales went down. In most manufacturing companies, when sales go down, some of the bigger costs go down as well (if you aren't selling as much of your product, then you cut back on manufacturing through layoffs, through reductions in material purchases, and so on). GM has tremendous fixed costs related to their union contract. Closing a plant, for example, did not necessarily mean the workers lost their jobs. Company pensions and legacy health care costs were fixed as well. So when sales went down, many costs stayed fairly constant. And that led to losses.

As the losses mounted and the economy struggled, these losses became so significant that GM could not survive as a viable business. In spite of billions of dollars of government support, the only solution for GM is to declare bankruptcy and try to lower those fixed costs through a court process.

Thanks for the questions. Keep them coming.

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