Why Are SUVs More Profitable?

Many discussions of auto company economics include the assertion that SUVs and pickup trucks are more profitable than small cars, and so a shift from the former to the latter – as discussed by Felix Salmon, for example – will not be good for the auto companies, particularly GM and Chrysler (since they are in the news these days). I accept that as a historical statement, but I don’t understand why that is the case.

Textbook micro tells you that price equals marginal cost, so the gross margin on every product is zero; that’s clearly no help here. Profit margins should be higher in product segments with less competition, but basically every manufacturer makes a small, midsize, and large SUV, so I don’t think that’s the explanation.

I can think of a few other possibilities:

  1. Small cars help manufacturers meet their CAFE targets, and so manufacturers are willing to accept lower profit margins on them. That is, each small car allows them to sell one more big car, so the marginal benefit of selling the small car includes the profit on the big car. There may be something to this, but not as much as you would think, because CAFE targets are scaled by vehicle footprint (length x width), so big cars have lower fuel economy targets; the more big cars you sell, the lower your overall target. It’s possible that the targets are carefully engineered so that, all other things being equal, it is easier for small cars to hit the small-car targets than for big cars to hit the big-car targets; if so, that would lead to manufacturers accepting lower profits on small cars.
  2. The customer lifetime theory: The goal is to get a loyal customer for life and upsell him to bigger and bigger cars – you sell him a Civic out of college, an Acura RSX when he gets his first bonus (oh, wait, no more bonuses . . .), an Accord when he gets married, an Acura MDX when he has kids, and an S2000 when the kids go to college. In that model, the Civic can be a loss leader, because it pays for itself with the later models.
  3. There’s more scope for differentiation with big cars. The bigger the car, the more bells and whistles you can throw in. Differentiation from the competition creates pricing power.
  4. Big-car buyers are less price sensitive; they are buying the cars with their bonuses (sorry, forgot about that) or their home equity lines (whoops, none of those, either), while small-car buyers are saving up tips from waiting tables.

However, except for #1, all of these theories just say that you get higher profit margins on cars that you sell to people later in life (2), that are fancy (3), and that are expensive (4). And I don’t see any reason why these have to be big. You can imagine a world in which most cars are small-to-medium-sized, but they range from undistinguished ones like a low-end Honda Fit to expensive luxury cars with all the bells and whistles, like self-parking systems and haptic warnings when a car is in your blind spot, and with the latest fuel-efficiency technologies. In that world, manufacturers could rake in the profits on the high-end small-to-medium cars.

Anyway, is it really all about CAFE standards? Or is there another reason why big cars are inherently more profitable than small ones? I figure someone out there must know.

About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

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