Profit and loss – more than a simple equation

In the real world, profit may be achieved fortuitously through little effort, minimal investment, almost immediately and at next to no risk. Conversely, losses can be incurred despite enormous effort, huge investment, tremendous ‘patience’, and great risk. Profits are NOT therefore a reward for these qualities, so what entitles a business to make them?

The Western economy is portrayed as operating within a ‘free market’. This model argues that profits are the result of a business offering products and services at a price that is determined through competition, at a cost achieved through the efficient use of resources. Among competitors, the business that conserves resources (ie keeps costs low) is rewarded with the greatest profit. Of course, there are many markets that do not operate competitively – monopolies, cartels, and those where the price is predominantly determined by Government levies are obvious examples. In these price is actually determined by what the customer is prepared to pay. The company can therefore manipulate the price to maximise their profits, which leads to the question of what is a “fair” profit for them to make?

There is plenty of evidence that good firms invest wisely in new products, but this often focuses on applications rather than new technologies and has sadly been used as an excuse by some to dilute their profit and justify exceptional earnings, while it is actually escalating their profits in the longer-term. How much should a company be expected to invest in itself to sustain its future?

In this environment, it is important that there are some who can take a longer term view, who have a belief in the potential of almost anything and who are prepared to tie up their resources (generally financial but occasionally intellectual) until a return can be achieved. These people effectively regulate the free market economy by managing shortages and surpluses. Such speculators depend on the quality of their knowledge, imagination and luck. Society has strong views about the behaviour of speculators especially when their ‘knowledge’ is gained through insider networks, or the result of their ‘luck’ is actually a ‘fortune’. Is luck an appropriate basis on which to manage a business?

Another form of speculation is internal investment in new technologies. The speculator alone though cannot create wealth – they create the opportunity but they don’t create the products. Instead, they depend on someone finding a way of converting the raw materials (and ideas) into merchantable goods and services. Such people are ‘entrepreneurs’, balancing risk of failure with longer-term investment in the future. But, there’s a finite pool of money to reward investors (including employees) and develop capacity. How much should a company risk investing in speculative new ventures?

Under the free market model, it is at the individual level (corporate and personal) that ‘success’ is measured in profits, yet it is often self-reinforcing – the more successful someone is, the less they risk and the less important luck is. This leads to the view that there should be a fairer distribution of profit either through government intervention (taxation) or personal discretion (philanthropy).
There’s good evidence that philanthropic organisations out-perform those who are more self-interested, though that’s a view that is not popular with many companies! Nevertheless, a US survey demonstrated that companies who are committed to giving increased their contributions by 14% last year, closely tracking their profits which rose by 17% and their turnover which rose by 15%. Philanthropists are often inspired by their Faith and such people formed the bedrock of social reform in the Industrial Revolution, but today there’s frequently cynicism about the motives of industrialists who sponsor educational institutions or engage in politics. Is philanthropy something that should be expected, required, or left to individual judgment and what proportion of profit should a business expect to contribute?

NB These notes were used to stimulate discussion at a management retreat that I led recently.

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