Profitability

Many years ago I was a CPA. The topic of this page has almost nothing to do with accounting.

Drucker once said that profitability is the result of performance in marketing, innovation and productivity.

From Management, Revised Edition

by Peter Drucker with Joseph A. Maciariello

  

Amazon Links: Management Rev Ed and Management Cases, Revised Edition

See contents of Management Cases, Revised Edition

Asked what a business is, the typical businessman is likely to answer, “An organization to make a profit.”

The typical economist is likely to give the same answer, “to maximize profits.”

This answer is not only false, it is irrelevant.

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The danger in the concept of profit maximization is that it makes profitability appear to be a myth.

Profit and profitability are, however, crucial—for society even more than for the individual business.

We are a multi-institutional society.

Public-service institutions are supported by the economic surplus produced by economic activity.

They are social overhead.

The growth of the public service institution in the twentieth and twenty-first centuries is the best testimonial to the success of business in discharging its economic task—producing economic surplus.

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Yet, unlike the early nineteenth-century university, the service institutions are not a luxury or an ornament.

They are essentials of a modern society.

They have to perform if society and business are to function.

These service institutions are the main expense of a modern society.

Approximately half of the gross national product of the United States (and of most of the other developed countries) is spent on public-service institutions.

Every citizen in the developed, industrialized, urbanized societies depends for survival on the performance of the public-service institutions.

These institutions also embody the values of developed societies.

Education, health care, knowledge, and mobility—not just more food, clothing, and shelter—are the fruits of our society’s increased economic capacities and productivity.

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Yet the evidence for performance in the service institutions is not impressive, let alone overwhelming.

Colleges, hospitals, and universities have grown larger than an earlier generation would have dreamed possible.

Their budgets have grown even faster.

Yet everywhere they are in crisis.

A generation or two ago their performance was taken for granted.

Today they are attacked on all sides for lack of performance.

Services that the nineteenth century managed successfully with little apparent effort—the postal service, for instance, or the railroads—are today deep in the red and require enormous subsidies.

National and local government agencies are constantly being reorganized for efficiency.

Yet in every country citizens complain loudly of growing bureaucracy in government.

What they mean is that the government agency is being run more for the convenience of its employees than for contribution and performance.

This is mismanagement.

Yet profitability is, not the purpose of, but a limiting factor on business enterprise and business activity.

Profit is not the explanation, cause, or rationale of business behavior and business decisions, but the test of their validity.

If archangels instead of businessmen sat in directors’ chairs, they would still have to be concerned with profitability, despite their total lack of personal interest in making profits.

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The root of the confusion is the mistaken belief that the motive of a person—the so-called profit motive of the executive—is an explanation of his behavior or his guide to right action.

Whether there is such a thing as a profit motive at all is highly doubtful.

It was invented by the classical economists to explain the economic reality that their theory of static equilibrium could not explain.

There has never been any evidence for the existence of the profit motive.

We have long since found the true explanation for the phenomena of economic change and growth that the profit motive was first put forth to explain.

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It is irrelevant for an understanding of business behavior, profit, and profitability whether there is a profit motive or not.

That Jim Smith is in business to make a profit concerns only him and the Recording Angel.

It does not tell us what Jim Smith does and how he performs.

We do not learn anything about the work of a prospector hunting for uranium in the Nevada desert by being told that he is trying to make his fortune.

We do not learn anything about the work of a heart specialist by being told that he is trying to make a livelihood, or even that he is trying to benefit humanity.

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.

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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 hostility profit, which are among the most dangerous diseases of a society or (of) organizations.

It is largely responsible for the worst mistakes of public policy—in this country well as in Western Europe—which are squarely based on the failure to understand, the nature, function, and purpose of business enterprise.

And it is in large part responsible for the prevailing belief that there is an inherent contradiction between profit and a company’s ability to make a social contribution.

Actually, a company can make a social contribution only if it is highly profitable.

Profit is needed to pay for attainment of the objectives of the business.

Profit is a condition of survival.

It is the cost of the future, the cost of staying in business

See The Changing World of The Executive

From The Daily Drucker

21 JAN — Profit’s Function

Today’s profitable business will become tomorrow’s white elephant.

Joseph Schumpeter insisted that innovation is the very essence of economics and most certainly of a modern economy.

Schumpeter’s Theory of Economic Development makes profit fulfill an economic function.

In the economy of change and innovation, a profit, in contrast to Karl Marx’s theory, is not a “surplus value” stolen from the workers.

On the contrary, it is the only source of jobs for workers and of labor income.

The theory of economic development shows that no one except the innovator makes a genuine “profit”; and the innovator’s profit is always quite short-lived. ¶¶¶

But innovation, in Schumpeter’s famous phrase, is also “creative destruction.”

It makes obsolete yesterday’s capital equipment and capital investment.

The more an economy progresses, the more capital formation will it therefore need.

Thus, what the classical economist—or the accountant or the stock exchange—considers “profit” is a genuine cost, the cost of staying in business, the cost of a future in which nothing is predictable except that today’s profitable business will become tomorrow’s white elephant.

ACTION POINT: 

Insure that you are investing enough in innovation to prepare for the day when your profitable business becomes obsolete.

The Ecological Vision

17 MAR — The Purpose of Profit

Profit is the ultimate test of business performance.

Profit serves three purposes.

1. One is it measures the net effectiveness and soundness of a business’s efforts.
2. Another 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.
3. Finally, profit ensures 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 inducement for new outside capital in the form in which it is best suited to the enterprise’s objectives.

ACTION POINT: 

Decide to pull the plug on an unprofitable business if it is not covering the cost required to stay in business or providing enough capital for future growth.

The Practice of Management

18 MAR — Morality and Profits

Is there sufficient profit?

Joseph Schumpeter’s “innovator,” with his “creative destruction,” is the only theory so far to explain why there is something we call “profit.”

The classical economists very well knew that their theory did not give any rationale for profit.

Indeed, in the equilibrium economics of a closed economic system, there is no place for profit, no justification for it, no explanation of it.

If profit is, however, a genuine cost, and especially if profit is the only way to maintain jobs and to create new ones, then capitalism becomes again a moral system. ¶¶¶

The weakness on moral grounds of the profit incentive enabled Karl Marx at once to condemn the capitalist as wicked and immoral and assert “scientifically” that he serves no function.

As soon, however, as one shifts from the axiom of an unchanging, self-contained, closed economy, what is called profit is no longer immoral.

It becomes a moral imperative.

Indeed the question then is no longer:

“How can the economy be structured to minimize the bribe of the functionless surplus called profit that has to be handed over to the capitalist to keep the economy going?”

The question in Schumpeter’s economics is always:

“Is there sufficient profit?”

Is there adequate capital formation to provide for the costs of the future, the costs of staying in business, the costs of “creative destruction”?

ACTION POINT:

Check to see if you are earning enough profit to cover the cost of capital and provide for innovation.

If not, what are you going to do about it?

The Ecological Vision

30 JUN — Effective Management of Nonprofits

Nonprofits need management even more than business does.

In the early 1990s, people sentenced to their first prison term in Florida, mostly very poor black or Hispanic youths, were paroled into the Salvation Army’s custody—about 25,000 per year, Statistics showed that if these young men and women had gone to jail, the majority would have become habitual criminals.

But the Salvation Army was able to rehabilitate 80 percent of them through a strict work program that was run largely by volunteers.

And the program cost a fraction of what it would have to keep the offenders behind bars. ¶¶¶

Underlying this program and many other effective nonprofit endeavors is a commitment to management.

Forty years ago, management was a dirty word for those involved in nonprofit organizations.

It meant business, and nonprofits prided themselves on being free of the taint of commercialism and above such sordid considerations as the bottom line.

Now most of them have learned that nonprofits need management even more than business does, precisely because they lack the discipline of the bottom line.

The nonprofits are, of course, still dedicated to “doing good.”

But they also realize that good intentions are no substitute for organization and leadership, for accountability, performance, and results.

Those require management and that, in turn, begins with the organization’s mission.

ACTION POINT:

Commit your nonprofit organization to effective management.

Adopt high standards of organization, leadership, accountability, performance, and results.

Managing for the Future

24 JUL — Worship of High Profit Margins

High profit margin holds an umbrella over the competitor.

Most businesspeople are aware that profit is not the same as profit margin.

Profit is profit margin multiplied by the turnover of capital.

Maximum profitability and maximum profit flow are thus obtained by the profit margin that produces the optimum market standing and with it the optimum turnover of capital. ¶¶¶

Why is the worship of high profit margin likely to damage—if not destroy—the business?

It not only holds an umbrella over the competitor; it also makes competing practically risk-free and virtually guarantees that the competitor will take over the market.

Xerox invented the copier, and in all of business history very few products have been as successful as the Xerox copy machine.

But then Xerox began to chase profit margin.

It put more and more gimmicks on the machine, each developed primarily to increase the profit margin.

But each of these new accessories also increased the price of the machine, and what was probably even more important, each made it more difficult to service the machine.

And the great majority of users didn’t need these additional features.

And so a Japanese company, Canon, developed what was not much more than a replica of the original Xerox machine.

The Canon model was simple and cheap, and easy to service, and it captured the U.S. market in less than one year.

ACTION POINT: 

Is your organization guilty of worshiping high profit margins?

Managing in a Time of Great Change

The Five Deadly Business Sins (Corpedia Online Program)

20 OCT — The Efficiency of the Profit Motive

The profit motive alone gives fulfillment through power over things.

The only relevant and meaningful question is whether the profit motive is the socially most efficient one of the available directions in which the drive for power can be channeled.

But we can say that of the channels available and known to us, the profit motive has a very high, if not the highest, social efficiency.

All the other known forms in which the lust for power can be expressed offer satisfaction by giving the ambitious man direct power and domination over his fellow men.

The profit motive alone gives fulfillment through power over things.

ACTION POINT: 

Take a position: power over things is less dangerous socially than power over people.

Concept of the Corporation

30 OCT — Fund Development in the Nonprofit

Fund-raising is going around with a begging bowl.

The nonprofit institution needs a fund-development strategy.

The source of its money is probably the greatest single difference between the nonprofit sector and business and government.

A business raises money by selling to its customers; the government taxes.

The nonprofit institution has to raise money from donors.

It raises money, or at least a large portion of it—from people who want to participate in the cause but who are not beneficiaries. ¶¶¶

A nonprofit institution that becomes a prisoner of money-raising is in serious trouble and in a serious identity crisis.

The purpose of a strategy for raising money is precisely to enable the nonprofit institution to carry out its mission without subordinating that mission to fund-raising.

This is why nonprofit people have now changed the term they use from “fund raising” to “fund development.”

Fund development is creating a constituency that supports the organization because it deserves it.

It means developing a membership that participates through giving.

ACTION POINT:

A nonprofit institution that becomes a prisoner of money-raising has a serious identity crisis.

Have you seen examples of this in your associations with nonprofits?

Managing the Non-Profit Organization

31 OCT — Effective Nonprofit Boards of Directors

Membership on this board is not power; it is responsibility.

To be effective, a nonprofit needs a strong board, but a board that does the board’s work.

The board not only helps think through the institution’s mission, it is the guardian of that mission and makes sure the organization lives up to its basic mission.

The board has the responsibility of making sure the nonprofit has competent management—and the right management.

The board’s role is to appraise the performance of the organization.

The board is also the premier fund-raising organ of a nonprofit organization. ¶¶¶

Over the door to the nonprofit’s boardroom there should be an inscription in big letters that says:

MEMBERSHIP ON THIS BOARD IS NOT POWER; IT IS RESPONSIBILITY.

Board membership means responsibility not just to the organization but to the board itself, to, the staff, and to the institution’s mission.

A common problem is the badly split board.

Every time an issue comes up, the board members fight out their basic policy rift.

This is much more likely in nonprofit institutions precisely because the mission is, and should be, so important.

The role of the board then becomes both more important and more controversial.

At that point, teamwork between the chairperson and chief executive officer becomes absolutely vital.

ACTION POINT:

Have you served on one or more nonprofit organization boards?

Have these boards helped fulfill the nonprofit’s mission or frustrated the mission?

Managing the Non-Profit Organization

To explore this topic further, search Drucker's books for the word stem “profit”

PIMS — Profit Impact of Market Strategy (PIMS in Wikipedia)

List of topics in this Folder

To explore in a broader context harvest: The memo THEY don’t want you to see

and Knowledge Economy and Knowledge Polity

“The greatest danger in times of turbulence is not turbulence; it is to act with yesterday’s logic”. — Peter Drucker

The shift from manual workers who do as they are being told — either by the task or by the boss — to knowledge workers who have to manage themselves ↓ profoundly challenges social structure …

“Managing Oneself (PDF) is a REVOLUTION in human affairs.” … “It also requires an almost 180-degree change in the knowledge workers’ thoughts and actions from what most of us—even of the younger generation—still take for granted as the way to think and the way to act.” …

… “Managing Oneself is based on the very opposite realities: Workers are likely to outlive organizations (and therefore, employers can’t be depended on for designing your life), and the knowledge worker has mobility.” ← in a context

These pages are attention directing tools for navigating a world moving relentlessly toward unimagined futures.

What’s the next effective action on the road ahead

It’s up to you to figure out what to harvest and calendarize
— working something out in time (1915, 1940, 1970 … 2040 … the outer limit of your concern) — nobody is going to do it for you.

It may be a step forward to actively reject something (rather than just passively ignoring) and then working out a plan for coping with what you’ve rejected.

Your future is between your ears and our future is between our collective ears — it can’t be otherwise. A site exploration starting point → The memo THEY don't want you to see

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