Tesla deserves its high market cap only if it can reach profitability – preferably in the next four years. Musk has long stated that the path to success was to start at the high end of the market with cars like the Model S and X and then move down market, producing more affordable cars like the Model 3. But if Tesla can’t make money on expensive vehicles as some analysts suggest, the obvious question is: can they make money selling cars at half the price?
The answer? Absolutely. Tesla’s improvement in cost per vehicle shows Tesla is making money on the Model S and will likely make solid profits on the Model 3. Let us explain. One of the tools of any strategist is a scale (or experience) curve. A scale curve calculates how rapidly the cost per unit (in this case, vehicle) decreases with every doubling of unit volume.[1] This analysis is useful for projecting how Tesla’s costs per unit will change going forward based upon its history.
The answer? Absolutely. Tesla’s improvement in cost per vehicle shows Tesla is making money on the Model S and will likely make solid profits on the Model 3. Let us explain. One of the tools of any strategist is a scale (or experience) curve. A scale curve calculates how rapidly the cost per unit (in this case, vehicle) decreases with every doubling of unit volume.[1] This analysis is useful for projecting how Tesla’s costs per unit will change going forward based upon its history.
A scale curve analysis on quarterly cost and production data from 2012-2014[2] shows Tesla’s cost of production per Model S at the end of 2014 was around $50,000 per vehicle (See Figure 1). This is actually quite good for a Model S with an average selling price of about $85,000. It means Tesla’s losses are a result of significant investments in sales and R&D to launch Models S, X and 3, and to build the battery Gigafactory. It also shows Tesla’s cost per unit has been dropping roughly 20% with each doubling of unit volume.
The bottom line is that sustaining Tesla’s lofty stock price depends on Model 3 volume. Musk was right when arguing that Model S and X were key to launching Model 3—the car that can drive the firm to profitability. If Model 3 generates 400,000 orders per year (the number of current reservations), the lofty stock price makes sense. If not, that’s obviously a very different ending to the story.