Ten Myths About Profits, Part 3
By: Gary Hoover
This is the third and final installment of a three part series. In the first post and second post I discussed the first five myths about profits. Here are five more.
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 three parts of this list of myths 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
This is Part 3 of a 3 Part Series on Profit — check out the previous posts for more 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.
