02 April 2016

Why Profits Are Not Too High and Are Not Done Rising

Even the Economist has joined the chorus claiming that corporate "Profits are too high." It's time to challenge a popular delusion about profits so that my seven readers can know what the Economist's seven million readers apparently don't.

Profits should get progressively higher with economic progress. Why? Profits allow you to make money without having to commit your time to the enterprise. (Doing time is something employees and prisoners do.) The problem is not that profits are too high. The problem is that they are not yet high enough and are not shared widely enough. To make profits even higher and share them more broadly will be one of the outcomes of the popularization of entrepreneurship. But first, just a simple reminder of what profits are.

When you start a business, it’s like trying to create a box that brings money in one end (those are your costs) and generates money out the other end (those are your revenues). If your revenues are more than your cost, you have a profit. If your revenues are less than your cost, you have a loss. It’s kind of odd to say that American businesses getting better at designing boxes to create profits is a bad thing.

Such a claim comes from the belief that profits are a return to capital. They are not. Profits are a return to creativity and entrepreneurship. You could borrow capital and pay it back interest. That's separate from profits you may or may not generate.

Andy Warhol went to the store and bought cans of Campbell’s soup, paying pennies per can. He also went to the artist supply store and bought canvases and paints and paint brushes, paying dollars for these inputs. He turned these cans of soup into a series of 32 small paintings he then sold for $1,000. That was a good return for grocery shopping in 1964. Were his profits too high? Should he have paid more for the soup or sold his paintings for less? The market didn’t think so. The art dealer who bought the 32 canvases eventually sold them for $15 million. In any case, he wasn't paid some reasonable markup for his soup can costs. He was paid for the value he created.

Input costs should be incidental to the value of what you generate. If you can create a million dollars of value from 39 cents worth of soup and $4 worth of art supplies, hallelujah to ya. Profits are a reward for creativity.

So what is the real problem?

The real problem is that we don’t create enough profits and don’t spread them around more evenly. Those two problems are related. First a quick digression on companies.

Imagine that you have designed a box with four of your friends and you agree to share ownership of the box equally. You agree to all make salaries of, say, $30,000 a year. Given your education and experience, you could get jobs making 3 to 6X that much in the roles of software programmers or marketing guys or whatever but for now you are going to live on this $30,000 while you build a great box. You don't need to hire anyone else. It's just you five doing this.

Now, imagine that you are successful. You've created a box that regularly turns $100 into $400. 

Because it's such a great money maker, you can sell it for $105 million.

So, the employees in this startup of yours made just a fraction of what it could have in other companies but the entrepreneurs in your startup walked away with $21 million each for three years of work. You and your partners were paid only $90,000 in wages over 3 years but you "made" an average of $7,030,000 a year. (At this point it's worth pointing out that Steve Jobs worked as CEO for a dollar a year. And billions in equity. He liked to quip that he got 50 cents a year just for showing up and the other 50 cents was for actual work. The idea that the employee part of you would be paid a small amount and the entrepreneur part of you would be paid more is not novel. It already happens.)

In this example you feel no outrage because employees and entrepreneurs are the same people. And in this scenario you would likely agree that it makes sense to make the box as efficient at generating profit as possible. It makes no more sense to regulate these boxes to be inefficient at generating profit than it does to regulate cars to get low gas mileage. So back to the problems.

First of all, we still have a dated notion of investment. Once upon a time, investment referred to the money needed to buy capital that would produce goods. Labor would work with the capital (the classic example being a factory that hired workers to work on its assembly lines) and it would get its wage while the capitalists who put up the money would get their profits. It is this old model that The Economist is referring to when it says that too much profit is a bad thing. In this model, whatever capitalists get, labor doesn’t.

But business is more complex than that now. There are so many things dated about this model, but I’ll just focus on one of them for now: intellectual capital is now the real investment. It’s intellectual capital that will be the biggest driver of profits (even if it is not currently getting the biggest returns.)
A software programmer can create code on a laptop that he owned even before joining a company. To pretend that the revenue from the code he writes should mostly go the “capitalist” who bought his new, $1,000 laptop is silly. The real capital is his knowledge of coding. In this model of the world, it only makes sense that the programmer be treated partly like an employee (that's how he earns his wage for work) and partly like a capitalist (that should show up as a return on his investment for knowledge). That is, the model for the modern work has to include treating knowledge work as an investment.

What’s obvious with programmers or designers is also true even of fast-food and factory workers. To stay competitive, such jobs have to be infused with steady improvements and occasional breakthroughs in process and product. This doesn't just come from headquarters. In fact, properly done it's more likely to come from the minds of the of the folks who are hands on with the product or service. (From variants on the sort of quality improvement initiatives that W. Edwards Deming advocated.) This, too, is a form of investment and deserves recognition. Someone who is steadily improving the process for building kitchen counters or making tastier sandwiches is also creating value through experimentation, discovery, and knowledge. A person making pickles could be adding more value through creativity than a person making posters.

Profits will increase as we popularize entrepreneurship, making more employees more entrepreneurial. One of the ways the popularization of entrepreneurship would show up is through employees taking ownership of process and product evolution and – as befits ownership – gaining a return for such work. If higher productivity roughly tracks with higher wages, higher creativity should track with higher equity shares.

Business is a black box that brings money in one end and spits money out the other end. We are getting better at designing and redesigning businesses to create larger gaps between the costs of inputs and the value of outputs. The problem isn’t that profits are going up. The problem is that we have a model that inaccurately assumes that the investment easiest to measure is the investment that is doing the most to create these profits. It's not just the $100 an investor puts into the firm that deserves a return; it's also the knowledge that an employee brings in and even more importantly, the creativity they apply. A more realistic assessment of the source of profits would mean a more equitable spread of the profits. Wages will drop as a percentage of total revenues but more equity will be created and more broadly spread.


David Evans said...

Well I read the whole thing so you can increase your reader count to 8.

Ron Davison said...

Thanks David. I might just write a blog post about this. "Reader numbers rose 14% in early April ..."