Quantum of profitability

Profit serves three purposes. It measures the net effectiveness and soundness of a business’s efforts. It is indeed the ultimate test of business performance.

It is the “risk premium” that covers the costs of staying in business – replacement, obsolescence, market risk and uncertainty. Seen from this point of view, there is no such thing as “profit”; there are only “costs of being in business” and “costs of staying in business.” And the task of a business is to provide adequately for these “costs of staying in business” by earning an adequate profit – which not enough businesses do.

Finally, profit insures the supply of future capital for innovation and expansion either directly, by providing the means of self-financing out of retained earnings, or indirectly, through providing sufficient for new outside capital in the form in which it is best suited to the enterprise’s objectives.

None of these three functions of profit has anything to do with the economist’s maximization of profit. All the three are indeed “minimum” concepts – the minimum of profit needed for the survival and prosperity of the enterprise. A profitability objective therefore measures not the maximum profit the business can produce, but the minimum it must produce.

The simplest way to find this minimum is by focusing on the last of the three functions of profit: means to obtain new capital. The rate of profit required is easily ascertainable; it is the capital market rate for the desired type of financing. In the case of self-financing, there must be enough profit both to yield the capital market rate of return on money already in the business, and to produce the additional capital needed.

It is from this basis that most profitability objectives in use in business today are derived. A business venture expects for a return on capital of at least 25% before taxes, is accountant’s shorthand way of saying: A return of 25% before taxes is the minimum we need to get the kind of capital we want, in the amounts we need and at the cost we are willing to pay.

This is a rational objective. Its adoption by more and more businesses is a tremendous step forward. It can be made even more serviceable by a few simple but important refinements. First, as Joel Dean has pointed out, profitably must always include the time factor. Profitability as such is meaningless and misleading unless we know for how any years the profit can be expected. We should therefore always state anticipated total profits over the life of the investment discounted for present cash value, rather as an annual rate of return. This is the method the capital market uses when calculating the rate of return of a bond or similar security; and, after all, this entire approach to profit is based on capital market considerations. This method also surmounts the greatest weakness of conventional accounting: its superstitious belief that the calendar year has any economic meaning o reality. We can never rationalize business management until we have freed ourselves from one company president (himself an ex-accountant) calls, “the unnecessary tyranny of the accounting year”.

Second we should always consider the rate of return as an average resulting from good and bad years together. The business may indeed need a profit of 25% before taxes. But if the 25% are being earned in a good year they are unlikely to be earned over the life time of the investment. A business may need a 40% return in good years to average 25% over a dozen years. And the people at the helm of the business must have to know how much they actually need to get the desired average.