The harm that profit does

by Michael Woodhouse. This article was originally written for an end-of-financial year magazine edition.

For those who believe, God is the absolute we approach through our own imperfect concepts.

"Profit" however is only a concept. It's no more than what we make it.

As we celebrate the highest holy day of profit –€“ the end of the financial year –€“ it's well to remember that what we call profit is only central to business because we agree to make it so.

And to turn a blind eye to the ways in which profit actively harms business.

Profit and tax

Our concept of profit is owned by the tax offices who define it. It's primarily a government revenue tool, not a business management tool.

If you don't believe this, try writing your own depreciation rules reflecting what really happens in your business. Or, try scrapping depreciation accounting altogether if its benefit to you is less than the cost of doing it.

Profit as we are obliged to measure it is a contrivance that mixes some (but not all) cash transactions with a range of notional costs to produce a nominal taxable income.

Profit and the blind eye

Profit does not attempt to measure:

  • The value of a company
  • Its financial security
  • The worth of its investments in the future
  • The strength of its people and management structures.

You may have survived the year on a windfall, be holding an empty order book and more bills than you can pay, listening to your staff bicker while they read job ads on your time, but your profit figure will look as good as any other.

Of course, profit is a useful management information tool. But it is not the only tool and not always the most important.

Taxing profit and free enterprise

The practice of taxing business profits is anti-free enterprise.

It makes well run and successful businesses pay extra tax. Hardly a reward.

It excuses bad businesses from having to pay their share of tax. They still get the benefits of developed infrastructure but the taxpayer foots the bill for them. Hardly a punishment for sloppy performance.

The taxpayer subsidised sales made by bad businesses are in effect robbed from good businesses and hold back their development. Consumers get less for their money and the whole economy suffers from this inefficiency.

Far better to tax market access, but the dominance of profit disallows this.

Governments don't do profit accounting

Governments do cash flow accounting. They don't separate out capital spending and bring it to book over three or five or twenty years.

They don't do profit accounting because it would be time consuming and largely meaningless and it would fail to tell them what they need to know, which is whether or not they have enough cash to continue.

Why do they make you do profit accounting? Because deferring the tax deductibility of what they deem to be capital purchases increases your taxable profit and thus government revenue.

Profit as a management information tool

You may remember a recent, well-hyped book Nobody ever went broke making a profit. This is an absolute lie. Businesses regularly go broke while making a profit, especially when they are expanding or during credit squeezes when banks change their lending policies. They go broke coming out of a recession, when trading conditions improve but surviving has drained them of the cash needed to service new clients and an expanding debtor list.

They simply run out of cash.

Not out of value, equity, prospects or sales, but cash.

No business was ever forced to close while it still had cash. Lots of businesses fail while making a technical profit.

The pulse of your business is cash, not profits, and that's where you should keep your finger.

But mostly we don't. We squander our energies and resources on the profit accounting required by the tax office and don't get around to the cash flow accounting which would be a much better – or at least an essential supplementary –€“ management tool.

And failure to manage cash flow sends essentially good businesses broke.

Profit is an unreliable measure

One of the innovations of the nineties was individual businesses losing over a billion in a year. From cowboy raiders to blue ribbon corporates, even a venerable bank.

These staggering losses were not the culmination of mounting year by year shortfalls. Most often they followed profitable years. For those who survived, the profits returned.

Does this mean that in the big loss years the businesses suddenly, unexpectedly, experienced a total sales failure?

Of course not. Their sales patterns more or less continued longer trends.

The figures represented accounting decisions which at first hid real losses and then gathered them up into one big blood-letting.

Profit accounting, in other words, is not necessarily a reliable management tool for assessing current performance.

Profit and value

To survive you must add value to your business. But profit does not measure value.

Imagine you are in charge of, say, a financially strapped car manufacturer. It's time, in the normal course of events, to start work on developing the new technology model you'll release in three years.

You could save a billion dollars by scrapping this development work. You could argue for running the current model for twice as long, disguised by a facelift.

This would increase profits but decrease the value of the business in the future.

Or you could push ahead with developing a new model to lead the market in three years' time.

This would decrease profits but increase the future value of the company.

Current profit based accounting systems are unable to represent the differences between these two decisions. They will simply report one decision as more profitable right now.

Profit is not always good for you

There's a Chinese proverb which advises, "Live for today but farm for a thousand years". Australian farmers need a tolerant attitude towards profit, because currently farming is a profit-stupid activity. But I can return any farmer in Australia to profit this year. It's simple. Harvest this year's crop but don't bother planting next year's. Sell the seed. If you're in livestock, sell every head.

Of course, this stupidity is too blatant to countenance, but how many CEOs this year will cut R&D and market development budgets to keep P&Ls (and personal bonuses) on track?

How many will cut staff to squeeze greater profit out of current sales, deferring to next year the problem of sales decline resulting from decreased service and morale?

Going back to my car manufacturer example, let's now imagine you're on a substantial profit-bonus and you're looking at a two year horizon to your next job. Will you choose two years of losses and a year three return to a strong profit and future, or will you go for profits this year and next, and skip before the future arrives?

Because "profit" does not measure investment for the future it can encourage decisions which harm a business in the longer term (like, longer than the current dividend period).

Profit increases vulnerability

My first encounter with a management consultant was more than 30 years ago, when I was a manager with a medium sized family company. The family owned its head office premises and the consultant was advising a sale and lease back, as the return on investment the family was getting from the land was below par.

This is what a strong profit orientation does: it drives you to push every asset harder, which increases your exposure.

It's contrary to a natural human instinct to build secure assets against future hard times.

A year or so ago I helped prepare an award submission for a similar sized private company whose management I admired. They had systems, they got daily key financial data, they had a five year plan they were on track with after two years. They won the award. Last month I was shocked to read the business had collapsed following losses on an international trade deal. The losses were less than their previous year's profit but the company apparently was pushing so hard on all fronts there was no lazy reserve to fall back on.

My original employer turned down the lease-back idea and later relied on that asset to get it through a severe industry down-turn. They're still trading.

Are profits essential to survival?

Post-war Australian Governments ran losses every single year until 1986. Forty years of straight losses, while the "company" that is Australia went from economic strength to strength with rising wages, GDP –€“ any measure you care to mention.

The answer is not that these loss-making Governments ran up huge debts. Even today, Australia has extremely low Federal Government debt (States, companies and private citizens are another matter).

The commercial air transport industry was recently reported to have made an aggregate loss since it was begun. But it's still there.

World agriculture is a loss making business, but we still farm.

If we insisted on counting the cost of replacing raw materials, or the cost of cleaning up after itself, the world energy industry would be revealed as running at a staggering loss.

All of these examples should cause you to think of qualifying factors which muddy the water. Say, farmers get subsidies and pollution is free.  That's my point: the waters of profit are murky.

Profit is a sloppy statistic, designed for taxation purposes but used as a measure of real value. It isn't any such thing.

Markets know best

It's established journalistic practice to measure economic policies by their effect on "the markets".

Even this stunningly simplistic approach gives the lie to the importance of profit.

Share prices (which supposedly reflect the worth of a company) can go down after profits are announced, even if the profits are in line with expectations or higher.

The value of loss making companies can go up when they announce they intend to take on yet more debt in order to acquire another loss making company.

In fact, at the turn of the century our market gods valued a whole range of companies at price to profit ratios they couldn't have repaid in a century.

If markets are in any way consistent it's in looking for value rather than profit, because perceived value drives share prices up much faster than even the most generous dividends.

Balance adds value

For a business to continue it must:

  • Earn revenue from what it is doing.
  • Prepare itself for the future.

Both of these objectives require resources. Putting resources into one detracts from the other.

Value is added when the two are successfully balanced.

What we define as profit is but one measure of one of the objectives.

Developing better measures

P&L accounting systems are well-developed and defined in thousands of pages of rules, which reflect government decrees. There are ready resources of tools and expertise.

Decide that you want also to run a cash flow projection system and the skills become scarcer and more expensive. There are no well developed, off the shelf software systems. The necessary office and management disciplines are not widely practised.

Go for a value based accounting system and you're into unchartered waters.

It's something to ponder during the high holy season of profit.