The Ten Myths About Profits
By: Gary Hoover
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.
In this and my next two posts, I share my thoughts on ten myths about profits. In this post, I discuss the most important myth.
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:
1. Lenders who want their loans paid back on time according to agreed-upon terms, with appropriate interest.
2. 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.)
3. 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 Woods 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.)
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 1 of a 3 Part Series on Profit — Stay tuned for more posts on the 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.
