CHAPTER NINE

The Delusion of Profits

BUSINESSMEN HABITUALLY COMPLAIN about the economic illiteracy of the public, and with good reason. The greatest threat to the free enterprise system in this country is not the hostility to business of a small, strident group, but the pervasive ignorance throughout our society in respect to both the structure of the system and its functioning.

But the same businessmen who so loudly complain about economic illiteracy are themselves the worst offenders. They don’t seem to know the first thing about profit and profitability. And what they say to each other as well as to the public inhibits both business action and public understanding.

For the essential fact about profit is that there is no such thing. There are only costs.

What is called “profit” and reported as such in company accounts is genuine and largely quantifiable cost in three respects: as a genuine cost of a major resource, namely capital; as a necessary insurance premium for the real—and again largely quantifiable—risks and uncertainties of all economic activity; and as cost of the jobs and pensions of tomorrow. The only exception, the only true surplus, is a genuine monopoly profit such as that now being extorted by the OPEC cartel in petroleum.

1.

All economists have known for two hundred years that there are factors of production, that is, three necessary resources: labor, land (i.e., physical resources), and capital. And all of us should have learned in the last ten years that there are no “free” resources. They all have a cost. Indeed, the economists are way ahead of most businessmen in their understanding and acceptance of a genuine “cost of capital.” Some of them, such as Ezra Solomon, a former member of the Council of Economic Advisers now back at Stanford University, have worked out elegant methods both for determining the cost of capital and for measuring the performance of a business in earning it.

We know that in the post-World War II period, until the onset of global inflation in the mid-sixties, the cost of capital in all developed countries of the Free World ran somewhat above 10 percent a year (it is almost certainly much higher in Communist economies). And we know that very few businesses actually earn enough to cover these genuine costs. But so far only a handful of businesses seem to know that there is such a cost. Fewer still seem to know whether they cover it or not. And even these few never talk about it and never in their published accounts subject their own performance to the test. Yet not to earn the cost of capital is as much a failure to cover costs as not to earn the costs of wages or of raw materials.

2.

Economic activity is the commitment of existing resources to future expectations. It is a commitment, therefore, to risk and uncertainty—in respect to obsolescence of products, processes, and equipment; in respect to changes in markets, distributive channels, and consumer values; and in respect to changes in economy, technology, and society. The odds in any commitment to the future are always adverse; it is not given to human beings to know the future. The odds, therefore, are always in favor of loss rather than gain. And in a period of rapid change such as ours, the risks and uncertainties are surely not getting smaller.

These risks and uncertainties are not capable of precise determination. But the minimum of risk in these commitments to the future is capable of being determined, and indeed quantified, with a fair degree of probability. Where this has been attempted in any business—and in both Xerox and IBM, for instance, it is known to have been done for years in respect to products and technologies—the risks have proven to be much higher than even conservative “business plans” assumed.

The risks of natural events—fire, for instance—have long been treated as normal business costs. A business that failed to set aside the appropriate insurance premiums for such risks would rightly be considered to be endangering the wealth-producing assets in its keeping. Economic, technological, and social risks and uncertainties are no less real. They too require an adequate “insurance premium”—and to supply it is the function of profit and profitability.

Therefore, the proper question for any management is not “What is the maximum profit this business can yield?” It is “What is the minimum profitability needed to cover the future risks of this business?” And if the profitability falls short of this minimum—as it does in most companies I know—the business fails to cover genuine costs, endangers itself, and impoverishes the economy.

3.

Profit is also tomorrow’s jobs and tomorrow’s pensions. Both are costs of a business and, equally, costs of the economy. Profit is not the only source of capital formation; there is also private savings, of course. But business earnings, whether retained in the business or paid out (returned to the capital market), are the largest single source of capital formation for tomorrow’s jobs and, at least in the United States, the largest single source of capital formation for tomorrow’s pensions.

The most satisfactory definition of “economic progress” is a steady rise in the ability of an economy to invest more capital for each new job and thereby to produce jobs that yield a better living as well as a better quality of work and life. By 1965, before inflation made meaningful figures increasingly difficult to obtain, investment per job in the American economy had risen from $35,000 to $50,000. The requirement will go up fairly sharply, for the greatest investment needs and opportunities are in industries: energy, the environment, transportation, health care, and, above all, increased food production, in which capital investment per job is far higher than the average in the consumer goods industries, which have dominated the economy these last twenty-five years.

At the same time, the number of jobs required is going up sharply—the aftermath of the “baby boom” between 1948 and 1960. We will have to increase the number of people at work by 1 percent, or almost a million people, each year until the early eighties to stay even with the demographics. At the same time, the number of people on pensions will also increase, if only because workers reaching retirement age will live longer, and so will the income expectations of the pensioners. Any company which does not produce enough capital, i.e., enough earnings, to provide for this expansion in jobs and pensions fails both to cover its own predictable and quantifi able costs and the costs of the economy.

These three kinds of costs—the costs of capital, the risk premium of economic activity, and the capital needs of the future—overlap to a considerable extent. But any company should be expected to cover adequately the largest of these three costs. Otherwise it operates at a genuine, certain, and provable loss.

There are three conclusions from these elementary premises:

1. Profit is not peculiar to capitalism. It is a prerequisite for any economic system. Indeed, the Communist economies require a much higher rate of profit. Their costs of capital are higher. And central planning adds an additional and major economic uncertainty. In fact, the Communist economies do operate at a substantially higher rate of profit than any market economy, no matter that for ideological reasons it is called “turnover tax” rather than “profit.” And the only economies that can be considered as being based on profit planning are precisely Communist economies in which the producer (state planner) imposes the needed profitability in advance rather than let market forces determine it.

2. The costs which are paid for out of the difference between current revenues and current expenses of production and distribution are fully as much economic reality as wages or payments for supplies. Since a company’s accounts are supposed to reflect economic reality, these costs should be shown. They are, to be sure, not as precisely known or knowable as the accountants’ “costs of doing business” supposedly are. But they are known and knowable within limits that are probably no wider or fuzzier than those of most cost accounting or depreciation figures—and they may be more important both for managing a business and for analyzing its performance. Indeed, it might not be a bad idea to tie executive bonuses and incentives to a company’s performance in earning adequately these genuine costs rather than to profit figures that often reflect financial leverage as much as actual economic performance.

3. Finally, businessmen owe it to themselves and owe it to society to hammer home that there is no such thing as profit. There are only costs: costs of doing business and costs of staying in business; costs of labor and raw materials, and costs of capital; costs of today’s jobs, and costs of tomorrow’s jobs and tomorrow’s pensions.

There is no conflict between profit and social responsibility. To earn enough to cover the genuine costs, which only the so-called profit can cover, is economic and social responsibility—indeed it is the specific social and economic responsibility of business. It is not the business that earns a profit adequate to its genuine costs of capital, to the risks of tomorrow and to the needs of tomorrow’s worker and pensioner, that “rips off” society. It is the business that fails to do so.

(1975)