Chapter V KNOWING THE KEYS TO BUSINESS SUCCESS
fromEconomics Book: THE INVISIBLE HAND
Insights into how our world works
and how you can get at least your fair share
* Economic Institutions have the Incentive of Profit to guide all their basic decisions.
Other company goals simply support the profit objective.
* Productivity or output per worker is an important measure of a company's performance.
Measuring profit is simple; achieving it is not.
High profit companies are better for society than lowered prices, higher worker pay, or charitable contributions.
Profits reflect value received and are a good measure of the efficiency and productivity of a society.
PROFIT IS KEY
In order to do well in a company, you need to know what makes it tick. But many people are uncertain about the main purpose of a business. It's no wonder. Companies themselves mislead us and even give mixed signals to their employees. At Ford, "Quality is Job 1." Don't believe it for a second! Quality isn't Job 1, it isn't even Job 2 or 3. General Electric used to advertise that "Progress is our Most Important Product." That was no more true than the primacy of quality at Ford. Business slogans are designed to make the public and a firm's employees feel better about the company. They are part of a public relations strategy, not an accurate description of company goals.
Small firms also give misleading signals about their purpose. Many emphasize the importance of the customer and talk about good customer service as fundamental. Others advertise their large volume of sales or particularly wide assortment of goods. Still others feature their low prices. All of these images are designed to attract customers; they do not reflect the main focus of successful businesses.
Employees who take a company slogan or image to heart can be in for a letdown. Spending too much time on a task aimed at better quality can make a boss upset. Making a customer happy by accepting a damaged return item is likely to draw a rebuke from the store manager. Employees gradually learn that neither quality nor customer satisfaction is Job 1. In successful companies, Job 1 is making a profit. It always has been and always will be.
Profit is what a business has left over after it pays all its bills. It is calculated by writing down total sales dollars, then subtracting a company's expenses. The answer to this subtraction, or the bottom line of the calculation, is called profit. The phrase "bottom line" has been taken from this profit calculation to a broader meaning, indicating the most important result of any operation. Profit certainly is the bottom line of business. It definitely is Job 1. Employees should always keep this fact in mind.
OTHER COMPANY GOALS
Job 2 in most companies is to have healthy and growing sales. Without sales dollars coming in, there can be no funds to pay employees, and of course no profit. But sales is not the top goal of business. A firm that generates lots of sales dollars but has even higher bills will soon be forced out of business.
New product development (or new services) is another high ranking priority at most companies. Competitors quickly copy any product or service that becomes popular with customers. Firms that don't keep bringing out new moneymaking ideas can fall behind better managed competitors and will find their profits dwindling. Good new products that meet customer needs can be highly profitable. With patent and copyright protection, the government can protect those profits from unfair copying.
Cost control is an important job in all phases of a business. Unlike sales or product development, which are primarily handled in specific departments, the responsibility for cost control is shared by all employees. A successful lowering of costs in any department can have a measurable impact on a company's profit level.
The most noticeable cost control that companies do is to reduce their number of employees through layoffs. It's much better for everybody when such staff reductions can be done gradually, like not replacing workers who leave on their own. But sometimes when sales drop sharply, a company has to lay off a number of employees or face the possibility of not being able to pay its bills.
Whether staff reductions take place gradually or in a big layoff, they can provide a boost to company earnings. Often the remaining workers can produce almost as much as the larger staff had done previously. When this happens, the output per worker or productivity goes up. Companies that have the greatest productivity in their industry usually make the greatest profits. The free market system rewards the most efficient and productive organizations. We can be happy with this outcome, while at the same time be displeased with the poor planning that forces some firms to make big layoffs.
In many areas, an employee can have a noticeable impact on the bottom line of a business. The greater one's ability to increase profits, the more valuable an individual is to a company. And valuable workers are the ones most likely to get a raise or promotion. To maximize one's opportunities in a company, an employee should consider sales and new product development as attractive career paths. Good quality helps promote sales, but it is not Job One. General Electric's slogan has changed to "We Bring Good Things to Life." This motto reflects the importance of new product development at GE, but still hides the overriding importance of profit.
An employee or outside observer who believes that anything has a higher priority in business than long term profits is sadly mistaken. A good case can even be made that profits come ahead of following the law. Companies know that illegal or negligent actions can lead to expensive penalties and lawsuits, which can reduce earnings dramatically. Exxon is still suffering financially from the results of their big oil spill in Alaska. Where illegal actions are unlikely to be caught, as in smuggling or bribery in parts of the world, some businesses will take risks for a large profit.
When illegal business activity is uncovered, many observers are quick to condemn the profit motive that led to the wrongdoing. They usually overlook the benefits received by the consumers who willingly paid for the illegal goods, such as cigars from Cuba. Rather than attack the profit motive that encourages business to do what customers want, we should examine the laws that make something illegal. Perhaps we should be able to smoke Cuban cigars or to buy milk at a discount.
One very big advantage of having profit as the main goal of business is its simplicity. There is not much question on how to measure it. Like a math problem at school, calculating profit yields a definite result that is easily understood and can be certified to be correct. There is little room for interpretation or second guessing, as in the grading of an essay. In business, all matters can be analyzed in terms of their effect on the bottom line. Non-business operations like government don't have a simple bottom line. For them, the uncertainty among conflicting priorities (such as better service, lower taxes, or getting re-elected) prevents those organizations from getting a focus. It makes them less efficient than business. There isn't even agreement about how to define efficiency or even the primary goal for non-profit organizations.
In contrast, all companies can and usually do focus on bottom line profits. Since standard accounting rules are used, profit numbers from different firms in the US can easily be compared. Companies with the largest profits are the most successful ones. In fact they have contributed the most value to society in the past year. Large profits are the result of two successful actions by a company. First, the company offered products that many buyers thought were valuable. Second, it produced those products efficiently. Firms making large profits find it easy to expand, using new money raised from investors or loans from banks. Less profitable firms find it harder to expand. Since they contributed less to society, it is useful that the free market system doesn't encourage low profit firms to expand services.
ALTERNATIVES TO HIGH PROFITS
In spite of the fact that good profits means good value received by society, companies don't like to describe profit as their number one goal. They fear that emphasis on their profits may bring a negative public reaction. Although few people are accurate in guessing the level of profits at a company, they instinctively feel (wrongly) that profits should be kept within a reasonable range. In the public's mind, large profits are a sign of unnecessarily high prices. The common notion is that a business shouldn't be so greedy for profits. It is felt that instead, high profit companies should lower prices, increase the pay of their workers, and contribute more to the community.
Let's consider each of these suggested alternatives to high profits. First, lower prices do allow more people to buy an item and may reduce profit. But sometimes the added sales dollars are so large that a company can actually increase profits when lowering prices. Smart firms do just this, particularly with recently introduced products. On the other hand, increasing prices can so reduce sales volume that a business will actually have lower profits. In other words, high profit is not a reliable indicator that prices are too high. Instead, high profits usually indicate that a company's prices are in a useful middle area where lots of people are buying and the company can operate efficiently. Large profits are a good indicator that real value is being received by many consumers.
A business can choose to pay its workers more than normal, and this usually reduces profit. If a firm's wages remain above average for similar jobs, outside workers will want to get a job at that company. Some people will even move from lower wage areas to apply for those higher paying jobs. This is all part of the free market, naturally adjusting to new conditions. However if outsiders cannot get some of those better paying jobs, they will become frustrated. Unless a company needs to attract new workers, paying wages higher than average will lead to instabilities. Anger from job seekers and from other local employers paying normal wages are typical results. Over time, abnormally high wages lead to a business operation that can't compete with lower wage competitors. The high paid workers eventually lose their jobs. This unfortunate situation has occurred in many US auto factories where unions and other pressures had led to wages higher that what a free market (and the buying public) would support. The result was that consumers started buying more lower-priced, imported cars.
Reducing company profits by contributing more to community organizations is frequently applauded by the public. However, company contributions almost always are made with some hope of a return or benefit to the company. Often that benefit includes a political expectation that a company expansion or desire to continue polluting will be allowed. In any case, it's likely that a company's wishes for its local community will be somewhat different than the goals of the citizens. Encouraging a business to volunteer more money for the community is popular, but it is not the best way to fund local projects. Instead a community would be much better off encouraging a company to maximize its profits, but also enforcing laws guiding business activities, and levying appropriate business taxes. Companies are not set up to represent or act impartially on various needs of citizens. Local governments are; they ought be wary of gifts from businesses that inevitably comes with strings attached.
Companies are designed to create wealth, not to make decisions on how that wealth can best be used. They have no standards for determining how much profit should go to achieving some goal of society. If increasing wages and contributions to the community were desirable, how should funds from profits be split between the two? Overall, how much should profits be limited to pay for societal needs? Business leaders are not elected or trained to make such decisions. Their expertise is in the creation of wealth managing a profitable organization. Decisions on spending that wealth are best made by all of us, through our elected representatives. We have more tax dollars to spend when companies are allowed to focus on maximizing profits. Encouraging businesses to lower profit goals by spending in non-profit areas leads to less efficiency in both business and in how public spending is done.
PROFITS REFLECT VALUE RECEIVED
Most observers agree that focusing on profit is very helpful for making a business efficient. But does that mean we have to like what profit represents? The word profit seems to project images of greed, exploited workers, and rich capitalists. Unfortunately, profit has never been a popular word. People tend to focus on cash profits generated, not on the accompanying value that society has received. It is a common belief that profit is made at the expense of someone else's welfare. It is hard for many people to see that in a free, competitive market, high profits represent cash happily paid by consumers for items of real value to them, whether Oreo cookies or a singer's recordings. Profit is really a reflection of value received by buyers and of the higher standard of living it helps create.
Let's take a simple example of Barbra Streisand singing to a sellout crowd. She takes home a big cash profit on such occasions. But the audience also goes home with a feeling of having received a good entertainment value. They don't begrudge the high ticket prices; often they feel lucky just to have gotten a seat at the sold out performance. The profit Streisand makes is a reflection of the value received by her listeners. A less popular singer would command a lower ticket price. If Barbra Streisand had never been born, the world would be poorer in not being able to enjoy her singing. That loss can be measured roughly by the value of ticket and record sales she has created. Streisand's profits are a dollar measure of the added value she has brought to the world. Similarly, Henry Ford's fortune reflected the higher standard of living Americans enjoyed driving his popularly priced cars.
Still, why do profits have to be so large? Wouldn't it be better if Streisand concerts or Ford cars cost less? Not really. Items like Streisand tickets are in great demand. If they were priced less, there would be many more buyers than tickets available. Lots of frustrated buyers would show up at the concert and pay extra high prices to scalpers to see the show. The buying public determines the value and appropriate price for Streisand tickets or any other item. Ticket sellers, trying to maximize profits, aim for a price that will get all the tickets sold and have nobody left wanting to buy a ticket who could afford the price.
In other words, in the process of maximizing profits, the seller is also distributing tickets fairly, even though this is not the sellers intention. This is another example of the Invisible Hand at work. Similarly, Ford and other companies set prices to maximize profits. This maximum profit level also has the useful effect of balancing the ability of factories to produce against the ability of drivers to buy new cars. Any other price would lead to extra cars or extra buyers. When those imbalances happen, we know that somebody in a company made a pricing mistake.
So high profits do not mean that a firm's prices are unreasonably high. What do they indicate? In general, high profits indicate three things are happening, and all of them are good for society:
1. The prices are reasonable, encouraging a lot of people to buy.
2. People feel they are receiving reasonable value for their money.
3. The profit maker is efficient in minimizing the costs of product ion.
At Ford, the Taurus has been a big money maker because its design and quality are seen as good value, and its efficient manufacturing minimizes the costs of production. Other similarly priced cars don't generate the profit level achieved by the Taurus line. We don't applaud the lower profit levels achieved by these less popular cars. Price is only one, and not a major factor, in determining profitability of cars and most other items.
Job 1 at Ford and all other successful companies is making large, sustained profits. A car line that doesn't make a good profit is also not providing a good value to the buying public. Companies with unprofitable products have a huge incentive either to improve or to stop making them. Without this profit incentive, communist or nationalized firms have continued for years making products that the public didn't like very much. Our high profit companies, in contrast, are a reflection of the higher standard of living they have helped to create for us. Rather than be embarrassed by high profits, our successful companies (and Barbra Streisand) can proudly point to their profits as a result of the added value they bring to us all. Successful companies and successful people in companies never forget that healthy profits are Job One.
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