This article was originally published in December, 2020, as a three-part series on The Archbridge Institute website.
Profits! What are they? Good or evil?
The Internet and other media are full of discussions and diatribes about profits and what they are and what they mean. At one extreme, profits are seen as evil, a rip-off from society that feeds the rich and powerful. From another extreme, they are seen as the sole purpose of business enterprise, the holy grail for corporate executives. Business school professors and corporate executives debate the value and meaning of that latter idea.
Too often, from both business leaders and from corporation-haters, I see a failure to understand profits, what they are, why they exist, and the role they play in society.
I have been studying business since I was twelve. In the ensuing fifty-seven years, I’ve worked for corporate giants, founded and led young companies, analyzed companies, and written and taught about companies. I was also lucky to learn economics from some great scholar-teachers, including Milton Friedman and George Stigler. I continuously observe business practice and education, as well as the general public’s understanding of business, corporations, and profits. I have also engaged with other types of organizations, and today serve on five non-profit boards and advisory councils.
Here is my take on “ten myths about profits:”
Myth #1: The purpose of an enterprise is to make a profit.
This idea is most commonly attributed to Milton Friedman and the Chicago School of Economics – more on him and his thinking in a moment. It is safe to say that he did not invent the idea and that it was widely held long before he memorialized it.
But I believe it is wrong.
A business – or a non-profit organization – is part of larger society. In order to succeed, human organizations require the contributions of many people and other organizations. Each of these participants have a stake in the success of the business or non-profit.
Consider the “Stakeholders” in any business or organization:
For the workers, executives, employees, or “associates” of an organization, the goal is to have an interesting job that pays appropriately, rewards effort, and hopefully allows each person to grow. Jobs are the purpose of the business for these people.
For the communities in which a business or organization operates, the purpose is to provide jobs, to pay taxes as appropriate, and to support and contribute to the community as much as possible.
For the suppliers and vendors, consultants, lawyers, accountants, and many others who “supply” the organization, the goal is to have a good customer that pays their bills on time and buys more of their products or services.
The customers of a company or the service recipients of a non-profit see the purpose of the enterprise as providing them with great products or services, reliably and predictably, at a fair price. Value is the ultimate measure – what the customer gets for their money and effort. If the organization is innovative and develops new products or services, even better.
Those who put up the money for the enterprise, the providers of capital, can be thought of in three categories:
- Lenders who want their loans paid back on time according to agreed-upon terms, with appropriate interest.
- Investors in equity (stockholders) who want to see a return on their investment, which is at higher risk than the lenders. They want to see the value of the company go up. The true value of a company (to stockholders) is the present value of the future stream of profits, the total of all the future profits of the company. So yes, from their viewpoint, profit may be the purpose of the business. (“Present value” means you must count a dollar that you will see in 20 years less than you count a dollar today – with plentiful debate about what “discount rate” you should use in valuing those future earnings.)
- Donors who support a non-profit want the organization to achieve its goals by serving its customers well and fulfilling its stated mission.
Thus, the goal or purpose of an organization is different from the perspective of each contributor or group.
Real or perceived conflicts between these groups are at the heart of most present debates.
Yet any in-depth study of successful and unsuccessful organizations, especially business organizations, yields the conclusion that none of these “stakeholders” will be happy if the organization does not serve its customers. If a company fails its customers, all else fails, sooner or later.
Great leaders like Robert Wood who turned Sears into the greatest retailer in the world understood this, at the same time that he worked hard to serve all the above-listed constituencies. Sam Walton pointed out that no competitor or outside force could kill Walmart – only the customer could “fire” the company. Peter Drucker, arguably the greatest scholar of business corporations, said that the purpose of a company is to “create a customer.” These great minds all thought alike.
Both John Deere and Procter & Gamble celebrated their 183rd year in business in 2020. Those companies would not exist today, they would have no workers and no stockholders, if they had not continually provided products to their customers, always innovating and trying new things.
The logical conclusion to this is that the only valid purpose for any enterprise, for profit for non-profit, is to provide products and services to customers, to the public or whatever market the organization serves. Every other benefit, for every other stakeholder, flows from successfully fulfilling that purpose.
Because it is such a hot topic among business leaders and scholars, I here need to touch upon why I disagree with Milton Friedman on this issue.
Mr. Friedman was one of the greatest teachers I have ever had, with the highest intellectual principles. We became friends late in his life. He started out poor, the son of immigrants, and his entire life was devoted to figuring out how to make people’s lives better – all people, especially the poor and unfortunate.
But perhaps he was subject to the blind spot that I see in many scientists and scholars. His lens was limited. This is parallel to the nutritionist who sees food as only nutrition and ignores the social and setting aspects of dining. Or the automotive engineer who sees cars as machines and not as the symbols of power, sex, speed, and the many other things consumers buy them for. As the saying goes, to a hammer, everything looks like a nail.
Profits are indeed the lifeblood of a company, the “engine” that powers innovation and future success – more on that in a minute. But profits are not the purpose of a company, the reason it exists.
To say that the reason a company exists is to make a profit is like saying the reason you or I exist is to carry around our heart, lungs, and brain. Without them in working order, we are not of much use to anyone. But most thinking people would agree that providing our organs with a container is not the reason we exist, not our primary purpose.
In Friedman’s defense, we need to understand why he became so outspoken about this issue. In his era, it became common for companies to talk about “social responsibility.” This movement has only grown in the ensuing years. Yet observers of companies and their leaders often see corporate executives promoting their own pet projects and priorities under that umbrella. Funds that could go to making better products, lowering prices, paying higher wages, or making higher profits – any of which serves one or another stakeholder – instead go to animal welfare, environmental causes, or a million other worthwhile things.
Friedman was not comfortable with this. If you are taking money out of profits – shareholder money – why not give it to the shareholders and let them decide which charity or cause to support? If you are taking it out of the pockets of customers or employees, why not let them have the benefit, and put their money behind the causes they believe in? It is a slippery slope.
Every company faces these dilemmas. Most want to help their communities, or at least appear to help their communities. For years, Seven-Eleven had contribution jars to Jerry Lewis’s charities at each cash register, perhaps the most valuable retail “real estate” in the nation, raising millions without taking money out of the pockets of their workers or stockholders. Customers gave money voluntarily.
In Sears’ long-gone glory days, CEO Robert Wood required that local store managers lead their local United Ways, Community Chests, and Chambers of Commerce. If they didn’t, their chances of promotion were slim to none.
At the first company I started, the BOOKSTOP bookstore chain, we gave money to literacy and library organizations even before we were profitable. We justified this because we felt that creating and encouraging readers would ultimately benefit the company and all its stakeholders.
Target, probably the most philanthropic major US company, has a history of supporting families and kids because they understand who their customers are and what causes serve them best.
Many companies support public television – we did that at BOOKSTOP because we knew those viewers were our best market for books.
I do not think Friedman would object to these examples. He would excuse them as saying that they were efforts to increase our profits over the long term.
Each company must deal with these hard decisions, these slippery slopes. Sometimes, the efforts seem odd: cigarette companies sponsoring tennis matches or art exhibitions to show they are “nice guys.”
If any organization does stupid things, the investors, employees, and customers are free to boycott the company or find another job, etc.
The greatest risk to any organization is that these efforts become distractions, taking the company’s focus off of serving customers, making better products, taking care of employees, or the other goals listed above. That proves fatal when eager competitors are highly focused on what really matters.
Similarly, some investors are adding societal goals to their investment strategy, rather than just looking for the highest return on investment. Some argue that companies that are “socially responsible” do better financially, as well. That may well be. But these investors are on the same slippery slope, and at some risk of losing focus. Those investors who focus simply on making the most money have a simpler life. (I take no sides on this controversy. Each investor must figure that out for themselves.)
So I think Friedman’s warning is still worthy of merit, though the mantra of “the purpose of business is to make a profit” does not serve us well. Profit is the “how” a business works, not the “why” a business exists.
There are four parties to any business….the customer comes first….the employee comes next….then comes the community….last comes the stockholder…if the other three….are properly taken care of, the stockholder will benefit in the long pull.” – Robert Wood
(During his tenure, Sears’ revenues grew from $200 million to $3 billion and profits rose from $14 million to $141 million. The value of Sears’ stocks rose from $386 million to $2 billion during his reign and then on to $10 billion as the company continued with his principles after he retired. He did not mention suppliers in this remark, but he was famous for financing them and making them rich, too.)
Myth #2: Society would be fine without profits.
Within the above context, it might seem that profits are just a tiny part of the story, and only relevant to the investors and stockholders. But the reality is far from that.
Profits – the gap between how much money the organization takes in and how much it spends – play several roles critical to success and survival.
The first and most obvious is return on investment, paying for capital. Every business organization requires capital, either by saving up past profits (“retained earnings”) or by selling stock or borrowing money.
If my friend wants to have a food truck but says she will lose all the money and close up, I am probably not going to help fund her mission. Investing with the hope of a return on money is critically important to our economy and to the great rise in wealth worldwide over the last two centuries.
Through direct investments and 401k and other retirement programs, about 55% of all Americans own stock in big corporations. They all hope that the value of those stocks rises. There is nothing wrong with that.
If an organization hopes to grow, it often needs to attract more capital. If the company is not profitable, it will not be able to attract capital, or any capital it can raise will be very expensive (either high interest rates on loans and debt or a low Stock Price-to-Earnings ratio if it sells more stock).
But profits also serve these critical purposes:
Profits are the source of innovation. Peter Drucker might say profits are the future. If the iPod had bombed, we would never have seen the iPhone or iPad. The large profits Procter & Gamble made by introducing a successful detergent (Tide) in the 1940s enabled that company to fund the first toothpaste with fluoride, Crest, and improvements in household paper products (Puffs, Charmin, and Bounty). Boeing developed the finest and earliest successful jet airliners with the profits it had made on military bombers. Unprofitable companies cannot place “big bets” or risk millions on new ideas. Profitable companies can.
Profits are security for hard times. Companies that are highly profitable can still squeak by some profits even in a recession; unprofitable and debt-laden companies die in recessions. Companies that pay out all their profits in dividends and share buybacks have no reserves to fall back on. They are ill-prepared for a stock market crash or a pandemic. Many companies are getting a hard lesson in this in 2020. Being unprofitable does not well-serve employees, customers, suppliers, or the community.
For all these reasons, profits are the lifeblood of successful organizations.
Myth #3: Non-profits do not make or need profits.
I am a believer in great, successful non-profit organizations. Ones which pursue and achieve important goals, the purposes I believe in. (My life has been largely dedicated to education, whether by building bookstores or business information companies, or by giving my beloved alma mater more money than I kept for myself.)
Yet any organization, for-profit or non-profit, will not be long for this world if it spends more money than it takes in.
While non-profits are different from companies in terms of governance structure, accounting systems, and whether they contribute to the community’s tax base, they still have goals and purposes.
Non-profits are so averse to the term profits that they have to use different terms, like “earned income” in museums and “ancillary revenue” at universities. Some mutual insurance companies claim they are better because “we do not have stockholders, we serve you,” when in fact they do have shareholders, who just happen to be their customers. Credit unions and co-operatives (like Best Western hotels) operate in a similar manner. Yet ALL must have cash flow in order to innovate, survive, and prosper.
Non-profits have the special challenge in that their “capitalists” – their donors – have more complex goals than stockholders in a company usually have. I have sat on many non-profit boards and their goals easily become blurred.
At one long-range planning meeting of a significant school within a major university, I counted twenty-two “top priorities.” I told the group that this meant they had no priorities and were unlikely to achieve any of them. Success at anything requires focus.
If a for profit company fails to serve its customers, it is history. Look at Sears after they stopped putting customers first. Study General Motors as it fell from being the best and most profitable big company to being bankrupt a few years back. Look at Pan American, Eastern, or Braniff Airlines. The search for profits tends to keep companies focused on what counts.
Non-profits do not have this incentive (or imperative) and often find it hard to actually serve people, to put the “customers,” however defined, first.
Hospitals and universities are particularly beset by not being sure who the customer is – is it the donor or state government, the hospital or university administrator, the doctors or faculty, the family and parents, or maybe, just maybe, the patients or students? I do not envy their leaders their situations, with forces pulling them in many directions. While the leaders of Procter & Gamble or Walmart also have many stakeholders pulling on them, they understand that it all starts and ends with that customer at the cash register. (See this great article.)
Great, successful, lasting non-profits figure all these issues out. They overcome the substantial handicap of not having profits to ensure their focus. But they still need to take in more money than they spend, in a sense make a profit, in order to survive and certainly to innovate.
Myth #4: Profits are obscene at some companies.
I remember one very intelligent, entrepreneurial CEO friend of mine saying, “I think it is immoral how much profit ExxonMobil makes.” So even the best of us are sometimes bamboozled by large numbers.
The fact is that some industries, like airlines, electric utilities, railroads, drug development, and oil and gas exploration, require enormous amounts of capital. Others, like wholesaling and restaurants, require much less.
ExxonMobil has required billions of dollars to get where they are.
The key number to look at is return on capital or return on investment, the ratio of profits to the amount of money invested. By that measure, Apple is at least four times as profitable as ExxonMobil. Yet I hear few complaints about Apple’s profitability. (It is great to be an “in” company but equally tough to be an “out” company.)
Dollar figures with lots of zeros after them tend to confuse or mislead many people. Few can really grasp the size of the federal debt, in the trillions. Yet fifty-plus years of studying these things tell me the numbers just get bigger and bigger and bigger over time. Even at low rates of inflation, more zeros are added to the numbers every year.
The intelligent thinker or analyst needs to learn how to deal with those ballooning dollar numbers. And look up the actual return on investment data to see which companies’ profits are indeed high and which are low. (My first tool is the annual Fortune 500 magazine issue which includes return on investment data on America’s 500 largest publicly-held companies.)
Myth #5: Profits just line the pockets of the rich.
While the rich do own a lot of stock, the rest of us also have stock through pension plans, 401ks, accounts with brokerage houses, mutual funds, and other investment vehicles. Every teacher and professor in Texas depends on huge stock funds for their retirement.
But well beyond those stockholders, the above paragraphs show how profits serve customers, employees, suppliers, and the community.
Myth #6: Companies focus on short-term Profit Maximization.
Like Myth #1, this myth is a complex one.
If asked, most corporate leaders will tell their stockholders and investors, “our goal is to make the highest profits possible.”
Yet, in the back of their minds, they are saying to themselves, “making the highest profits possible while pursuing only legal activities, while paying our people enough to keep them and attract new people, while investing in risky future ideas, while paying our legislatively-determined share of taxes, while keeping prices low enough to keep away competitors, while dealing with ingredient and parts prices that fluctuate, while dealing with tariffs imposed on imported parts and exported final products, while keeping up with new government regulations, and a few dozen other forces acting on the company.”
Returning again to Peter Drucker: he thought the idea of profit maximization was not only irrelevant, it was dangerous. I also believe it is impossible and unrealistic.
Drucker would tell us that the right term, the goal to shoot for, is profit optimization, not maximization. That is, it is not about the most profit, it is about the right level of profit given the company’s role in society.
In other words, it comes down to “how to divide the pie.” An organization not only must pay its investors a fair return on capital (enough to encourage more investment), but it must pay its lenders, suppliers, and employees enough to justify their continuing efforts. And it must allocate funds to new products, to supporting and improving existing products, to finding new customers, to letting people know about its products (marketing and advertising), to customer service, and on and on.
Each company and industry divides that pie in different ways. One way I have looked at it is to total the amount of money a company has left after all expenses except payroll and profits (before taxes). Based on rough estimates, my numbers tell me that Apple divides this pie into perhaps 20% for employees (including executives) and 80% for the investors. At the giant bank JP Morgan Chase, the workers get around one-third and the stockholders two-thirds. At the other extreme, at Walmart “labor” gets at least 70% of the pie, leaving 30% or less for stockholders; at UPS the employees get about 82% while the stockholders get 18%. Many factors drive these divisions of the pie; I think they are worthy of further study.
The reason I called profit maximization impossible and unrealistic is this:
Say you are the CEO of a big company. You wake up one morning and say, “I am going to make the company the most money possible.” So what do you do? If it is easy, why didn’t you do it yesterday? If there is an easy answer, why aren’t all your competitors also doing it?
The reality is that no one can answer that question. Raise prices? Lower wages? Those have been tried, with little success (see the next two myths, which are corollaries of the profit maximization myth). There is no easy way to act on this idea of profit maximization.
I would add that, having served on the boards of directors of both private and public companies, their leaders often have an incentive NOT to maximize profits. That is, their compensation is based on hitting goals. Those goals are normally set by that same management, with the buy-in of the board. But more than once I have seen executives set low, more easily achievable targets. They want to lower everyone’s expectations. So companies that might have shown a 10% increase in revenues and profits instead produce a goal of 5%. When the company hits 6% or 8%, everyone celebrates and the executives get big bonuses.
As a founder of startups, I must admit my projections were often very ambitious. So that when we only grew at 30% rather than my dream of 40%, I was in the doghouse.
So this is yet another tricky issue for every company and its leaders to deal with. And all those numbers, after all, are just best guesses, and rarely anticipate a recession or pandemic.
The last and most important issue in considering profit maximization is, “Are we talking long-term or short-term?”
Leaders can take actions which balloon this year’s profits but wreck the future. This is not good for anyone except leaders who bail out and investors who sell their stock at the peak, if they can guess when that is.
Great companies make investments, they lose money on new projects, they try things, they are building their long-term profit. Which, given that stock prices reflect ALL future profits, means that they increase the value of the company.
All these factors tend to muddle any discussion of the maximization of profits. Our time and energy are better used focusing on how to better serve customers, better treat employees and suppliers, and, as Robert Wood said, the stockholders will be taken care of.
“The profit motive and its offspring, maximization of profits, are just as irrelevant to the function of a business, the purpose of a business and the job of managing a business. In fact, the concept is worse than irrelevant. It does harm. It is a major cause for the misunderstanding of the nature of profit in our society and for the deep-seated hostility to profit which are among the most dangerous diseases of an industrial society.” – Peter Drucker
Myth #7: Lowering wages is the key to increased profits.
This myth is a corollary to myth #6.
If increasing profits were as easy as lowering wages or paying less than your competitors for talent, then everyone would do it. Certainly in recessions and other turbulent times, some companies have done this. But as a strategy under normal circumstances, it doesn’t work. Those companies rarely survive or prosper.
Wages are set by the marketplace. This can be seen by the fact that, pre-COVID, only 2-3% of American hourly workers were paid at or below the federal minimum wage. This percentage has been dropping for at least forty years, as the market has risen but the minimum wage has not. Companies from Starbucks to Target to Walmart are all raising their starting pay levels, because they must, in order to get the talent they need. Even these big companies must deal with the market, which varies tremendously from, for example, New York to Mississippi. Every worker in America has multiple choices as to where to work. The companies know it.
Smart companies realize that pay levels also reflect productivity – how much work people get done. Those companies with streamlined systems, training, and tools for their people achieve higher productivity than their competitors.
Southwest Airlines is known for giving its customers outstanding value for their money. Yet Southwest is among the highest paying airlines and is also the most consistently profitable of the airlines. (Because COVID has cut deeply into travel, the airlines are hurting now, but Southwest is already making plans for the future and will ultimately be back on its feet.)
Costco, along with rival Sam’s Club, operates on the lowest gross margins of any big retailer, which means the lowest prices. And yet their people are among the highest paid in the retail industry, with veteran clerks earning in excess of $20 per hour.
Both Southwest and Costco have been great to their stockholders over the years, reinforcing the views of Robert Wood.
In addition to base wages, workers look at benefits and the ability to grow, develop, and move up in the organization. Walmart has not only created something like one hundred new jobs a day 365 days a year for over fifty years, but the company has provided the chance to move up, no matter what your education level, race, color, or creed. Few companies can match its record. (The whole Walmart story, pro and con, is worthy of another essay.)
Myth #8: Raising prices is the key to increased profits.
Another corollary to myth #6.
Again, it if were easy, every company would do it.
Instead, many of the greatest and most successful companies find that lowering prices, not raising them, increases their profits (because they sell more stuff).
Henry Ford made enormous amounts of money early in the 20th century as he lowered the price of the Model T by 70% or more. Toyota, Microsoft, Sears, Kmart, Walmart, Costco, and many other highly profitable companies have lowered their prices or come in below what other companies charged, and usually forced the competition to lower their prices, too.
Myth #9: All profits should be taxed.
Every company, like most individuals, does not want to pay more taxes than are required by law. Legions of tax attorneys and tax accountants work to ensure this, often dealing with gray areas in the tax code.
Those codes are created by legislative bodies, theoretically representing “the people.” Some aspects of the tax code, like lower taxes on capital gains, are used around the world and generally supported by economists as doing more good than harm. Other elements result from legislators favoring certain industries in their home districts. It is a complex issue.
One of the most misunderstood principles is that of tax-loss carryforwards. The idea is quite simple. If a company loses say a hundred million dollars starting up a new retail chain, developing software, or creating a new drug, then they make ten million in one year, they can “carry forward” their losses to offset that ten million. They do not pay income taxes on any profits until they are at break-even, until they earn back the hundred million in initial losses. This appears fair to most people, including taxing authorities and legislators. It is one reason many of today’s big tech companies are not yet paying full taxes.
Even during those periods when a company is losing money and not paying corporate income taxes, they are paying social security, Medicare, workers compensation, real estate, and sometimes sales taxes on their purchases. So they are not exactly taxless. The company’s employees and suppliers are also paying taxes. Government coffers would be less full without the existence of these companies, even during those early loss periods when little or no income taxes are paid.
Again, these are complicated issues, often highly politicized.
Myth #10: Ownership of Intellectual Property Gives Unfair Profits to Some.
The last issue I will touch on are the profits earned by those with “intellectual property.” This is only partially a myth, but still needs to be understood.
Nations around the world tend to agree that authors, artists, composers, songwriters, publishers, inventors, movie and television producers, drug developers, and many others deserve to profit from their creations.
There is no question that some of them make enormous amounts of money on their ideas, and sometimes can charge very high prices.
Yet, again, these rules are determined not by the companies, but by legislators. Setting the time that one can hold a patent or copyright, and limitations on their use, can be controversial and politicized issues. But they are part of life, and each creator has the freedom to use those privileges as they see fit.
Overall, giving a creator the rights to make money off their ideas is a good idea. Exactly how much and for how long remain subjects of debate.
A Final Word
I hope the above paragraphs stimulate thinking and understanding about the very important idea of profits.
Nothing I have said should be interpreted to imply that all companies are smartly run, that they are all honestly run, or that everything they do is good and “okay.” Companies also tend to have lifecycles, following an arc from greatness to mediocrity or failure (e.g., Sears).
But my observation is that those companies which are smart and honest survive much longer and, in the long-term, make more money for their shareholders, than those that are not. Putting customers first is ultimately what counts, and good companies serve their customers, employees, communities, suppliers, and stockholders well, decade after decade. Great companies do amazing “public service,” as we see every day from UPS, John Deere, Target, and many others. When they stop serving people, they die.
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. – Peter Drucker
