Ten Myths About Profits, Part 2

By: Gary Hoover

This is the second installment of a three part series. In a prior post I discussed the first myth about profits. Here are four more, to be followed in my next post with the final five myths.

Myth #2: Society would be fine without profits.

Within the context of my prior post, 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 preceding paragraphs show how profits serve customers, employees, suppliers, and the community.

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

This is Part 2 of a 3 Part Series on Profit — Stay tuned for the final myths about profits!

Gary Hoover is an entrepreneur, business historian, and frequent contributor to the Archbridge Institute. Read more about America’s most pioneering entrepreneurs in his American Originals series.