The average 20-something I meet knows more about healthy food and how to recycle than they do about how their job works or how innovations are financed in the global economy.

As I teach entrepreneurial thinking to people aged 12 to 80, I am surprised at how little people know about economics, including the important concept of profit.  Even business people!  This is especially true of small business owners and professional service providers, from restaurant owners to doctors and dentists.  But it also strikes the hearts of people running large organizations or trying to start new ones, even people with degrees in business.

While theories of profit fill many books, and debates among experts can rage for pages, here is my much simpler take on the concept.

When the University of Texas asked me to teach a course in entrepreneurship a few years ago, they asked which textbook I wanted to use, so I closely reviewed several of the most widely used texts.  I said, “I cannot use any of these as the main line of teaching, only as supplemental readings.”  My greatest concern was that all the ones I reviewed said that in seeking business opportunities, one should look for good profit margins.  They meant profit as a percent of sales, or “return on sales.”

If the great entrepreneurs and innovators of history had focused on how to make the most profit percent on each sale, we would have no Ford Motor and perhaps no affordable automobiles, we’d have no Walmart, Costco, or Amazon, few brokers or agents, and no wholesalers, a seven trillion dollar industry employing six million Americans according to the 2012 Economic Census.

So even the “best” business professors don’t always seem to have studied economics.

The main mistake is confusing profit as a percent of sales (revenues) with profitability.  The real idea of profit is the return on capital, most commonly called ROI or Return on Investment.  A business can make a high profit on revenues but not be very profitable.  It can also make a low profit on revenues and be very profitable.  A company that develops a new drug, new offshore oil well, or a new passenger jet might spend hundreds of millions on development, but never recoup their investment, even if making 60% on each sale.  On the other hand, a supermarket which turns over its inventory many times a year may have a relatively small investment, but still make an exceptional 20%+ return on investment.

ROI is usually measured as either Return on Assets (ROA) or Return on Equity (ROE).  Say you bought a house for $200,000 and now it’s worth $300,000.  Your Return on Assets, the total value, is 50% (gain of $100,000 on $200,000 cost).  If you paid cash for the house, without a mortgage, your Return on Equity, the amount of money you actually put up, is also 50%.  However if, like most people, you borrowed say 80%, or $160,000, your equity invested is only $40,000, and the $100,000 profit is a 250% (2.5 times) return.

(Since how much you borrow or “leverage” your equity is a decision you make rather than an indicator of true underlying profitability of the enterprise, I usually prefer to use ROA instead of ROE to compare companies.  Even then, you cannot compare other industries with financial services like banks and insurance companies because, as “retailers of money,” they make very low returns on total assets).

Compare some actual company results.  According to the latest Fortune 500 list, retailer Home Depot and big US oil company ConocoPhillips made about the same profit, $6.3 billion and $6.9 billion, respectively.  But what about profitability?  Home Depot generated 7.6% on sales, ConocoPhillips 12.3%, a 62% higher value.  Does that make the oil company truly more profitable?  In fact it took ConocoPhillips $117 billion in total assets (investment) to earn that much money, whereas the wizards at Home Depot did it with “only” $40 billon worth of “stuff.”  So Home Depot achieved a Return on Assets of 15.9% while ConocoPhillips’ ROA was just over one third as much, at 5.9%.

Further down the list of giant companies, Bed Bath and Beyond made a profit of $1.022 billion while high tech company SanDisk made $1.007 billion, neck and neck.  SanDisk made 15.2% on sales, BBB just over half that at 8.9%.  But because SanDisk had to invest (raise or save up) $10.3 billion vs. the home furnishing chain’s $6.4 billion, SanDisk only earned 9.8% on assets, almost 40% lower than Bed Bath and Beyond’s 16.1%.

Home Depot and Bed Bath and Beyond are far more profitable than ConocoPhillips and SanDisk.

If one compares two companies in the same industry which have extremely similar characteristics, like two dental offices or two shoe stores, the Return on Sales comparison has more validity.  Nevertheless, that also implies or assumes no one is doing anything really innovative or different, no one is trying a different strategy or business model.  There is often substantial risk in pursuing high profits as a percent of sales.  Here are four examples of how this can happen.

The most important one is market share.  If you sell a product or service similar to your competitors, or if your customers can readily buy somewhere else, they may be highly price sensitive (called a “highly elastic demand” by economists).  In this case, a slight drop in prices (and margins) may result in a large gain in market share.  This is true even of Walmart.  While it is a giant company, it still does not have a huge market share in most of its merchandise categories, and a small drop in price might result in getting 10% of the market instead of 5%.

Henry Ford had to buy out his stockholders because they would not let him drop the prices and make less money per car.  Once free, he dropped prices like a rock (while raising worker wages and shortening the work week), going on to make over $100 million a year in profits for his immediate family  – and that was before income taxes amounted to much.  A deep discount retailer like Costco often goes to great extremes to make sure their profit margin on merchandise does not rise, passing savings along to the customer in order to gain market share.  Remember percents don’t pay bills, dollars do.

Second, higher margins on your products often mean higher payroll, service delivery, and other costs.  When I was in the bookstore business, we made a gross margin (after paying for the books, but before all operating expenses) of at least 35% on books, but only 20% or less on magazines.  However magazines turn fast, are serviced by the companies that deliver them, and go back for credit if they don’t sell.  Back then the magazine companies would even help pay for the racks.  So it took no investment and no labor to sell them, and they might be as profitable as books.

A third risk I saw in action was high margins drawing your focus away from opportunities.  The big US department stores like Macy’s used to sell electronics, stationery, pet supplies, auto parts, sporting goods, hardware, and many other categories.  These categories carried gross margins of 20-30%, while apparel ran 40% and higher.  Top managers were obsessed with increasing gross margin percents, not dollars of profit, every year.  Over time they abdicated these categories and became primarily clothing stores.  The problem was that the categories they abdicated were the ones which grew fastest over the following 40 years, while apparel was a relative laggard.  Home Depot, Best Buy, Auto Zone, Lowe’s, Staples, Dick’s, PetSmart, and others went on to great success and profitability.  Walmart, Target, Costco, and other faster-growing general merchandise stores did not abandon these categories.  The department stores lost enormous share of the total retail business in this period.  They even lost share in most apparel categories, according to my analysis.

A fourth challenge of high margins is that they create an “umbrella” for your competitors.  If you build your organization making 20% on sales, build or lease a fabulous headquarters, and stay in the Four Seasons on business trips, it opens the door for someone else to come along, office in a former warehouse in a rougher part of town, and stay at Motel 6.  You provide an “umbrella” with your high prices, under which they can take away your business if they can match – or even come close – to delivering the same quality product or service.  Witness what Toyota did to General Motors and now what Hyundai and Kia are doing to Toyota.  What Sony did to RCA and now Samsung is doing to Sony.  While they did it internationally, the same concept can happen right in your city, in your business.

Parallel to these issues is the misunderstanding common among non-economists that raising prices raises profits.  We all sell to value-conscious customers, and often find that raising prices cuts demand so much, or loses enough share, that we sell less and profits drop.  Many times the route to higher profits is lower prices.  As Amazon founder-CEO Jeff Bezos has said, “There are two kinds of companies, those that work to try to charge more and those that work to try to charge less.  We will be the second.”  Time will tell if he can build a really profitable company, justifying the investment that has been made.  Harvard business historian Richard Tedlow gives more examples in his great book New and Improved.

For all these reasons, the obsession with profits as a percent of sales leads many to make bad decisions.  Too often, business people assume higher prices and higher profits relative to sales means higher total profits or higher profitability.  Often, it ain’t so.

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