Profit is Legitimate. Unlike governments, businesses need profits to survive. Let’s look at how profits originate using two fictitious companies, Bensons Ltd, and Drummond’s Inc.
Bensons Ltd is established and growing. Drummond Inc is new, trying to secure long term customers, and chose not to pay a return to its owners. Still, the government taxed it even though it needs those funds to reinvest to strengthen its business.
To continue competitively, each business needs to make a profit. At a minimum, it must cover its costs. But in the long run, it must pay a return to its owners, keep funds to reinvest to modernize, create jobs, research, and so on. That’s why a business needs to ensure it has sufficient margin to cover all its costs and have enough left to invest to provide for its future. In short, profit is legitimate.
Computation of Retained Profit
|Sales: revenues from goods and services sold
|Cost of Sales: cost incurred to produce and sell goods and services
|Gross Profit (margin)
|Profit after taxes
|Dividend to owners 20%
|Retained profit available to reinvest
Profit is Legitimate
Sales are straight forward, it’s what customers will pay for a company’s services and products. It’s unusual to have a monopoly where the business can charge customers whatever it decides. Ultimately, the market will decide prices. Do governments and the general public understand this?
Generally, a firm does not control prices for its products, but eventually it control inputs that make up its cost of sales: employee compensation and benefits, energy, materials, utilities, rent, transportation, and so on. When governments and unions wittingly or unwittingly force-up a business’ costs, often, the business can’t pass on price increases, so it has to reduce its inputs. Regrettably, the first item reduced most often is compensation and benefits, which means laying off employees. This is the wrong way to go. A firm’s greatest asset is its people, and it should treat treat them fairly.
We see effects of a forced cost increase in a mandated hike in the minimum wage. It seems like the right thing to do, but unfortunately, it forces several small business owners to either cut their costs—usually people lose jobs—or close. Sometimes, the small business owner can pass on the cost to the consumer. However, in each scenario the people whom the increased minimum wage should help get hurt. I believe business should pay its employees well; however, in the process, we must ensure small businesses can survive these increases. Otherwise, they can’t provide jobs–another reason, profit is legitimate.
Profit is Legitimate as a Return on Investment
Occasionally, to survive, a business decides to transfer its production where labour is cheaper and unions non existent or less antagonistic. Outsourcing is unpopular, but sometimes a firm has to do it to remain alive. In the long run, the choice is simple: stay where you are and lose customers because you can’t compete, or go elsewhere while ensuring you treat employees fairly.
Profits represent returns on funds invested in an entity or business venture, while interest is a return on funds deposited with a financial or other entity. Society accepts interest income as legitimate, but not profits. Many people do not believe profit is legitimate. Why? People associate profits with large corporations where several inept, highly overpaid executives in large public corporations do lousy jobs. These CEOs cause their businesses to destroy wealth. Steven Clifford in his book, The CEO Pay Machine: How It Trashes America and How to Stop It, says, “Many studies have concluded that high CEO-to-worker-pay ratios lower morale and company performance. … this is as surprising as studies that reveal that the Pacific Ocean is actually full of water.”
We must change how we compensate CEO’s and remove the overpaid, greedy ones who present a false picture of business. Happily, they are a minority.
How Much Legitimate Profit is Enough
The question then becomes, how much profit is legitimate–enough? I could present sophisticated analyses to show the cost of different forms of capital and how we could answer that question technically. However, that’s outside the scope of this blog. For our purposes, I suggest a “fair” profit arises after the business owner provides for at least these items from revenues:
- Proper compensation and benefits to its employees
- Adequate health and safety arrangements for employees
- Proper stewardship of assets used in the business to earn income, and steward the environment
- Future development of the business
- Adequate funds to deal with business cycles to mitigate or prevent lay offs at the bottom of the cycle.
I can hear the reaction: “These are highly subjective!” Yes, they are. That’s why executives need to engender trust through transparency in dealings with employees, and unions., where they exist. Each situation is different and businesses should address each separately using those five principles. They provide the basis for fair employee treatment, and should be non negotiable. They are the right things to do. Don’t cut them when times get tough!
In bad times, it’s the profit that’s eroded. And in good times, it’s the profit that’s increased. That’s fair; owners take the risks in bad times, and benefit disproportionately in good times. However, they must treat employees as they would like to be treated. The resulting balance from revenues should allow the owner a competitive return for her invested capital. Surely, a reasonable profit is legitimate.
(c) 2017 Michel A. Bell
Excerpts from Michel’s soon to be published book, Business Simplified.
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