Profit, Its Uses and Abuses

October 28th, 2005

I am referring to the word itself, not the idea(s) the word is meant to represent. The common usages are diverse, incompletely defined, misleading, and often completely at odds with one other. Yet the idea of profit is completely bound to the idea of entrepreneurship, so a constructive sense of what it means, whatever label is affixed to the concept, is useful. It is fundamental to having a practical answer to the business owner’s perpetual question, how am I doing?

I am less concerned here about the use of profit to denote greed or theft or legalized gain at the expense of another (legal theft?). It is in some ways amazing that more than a decade after the very public and thoroughly documented failure of centralized decision-making as the preponderant means of organizing production, the idea that the curtailment of private property and profit, which are inextricably linked, is viewed as a workable solution to real or perceived ills. Utopian dreams are likely to be recurrent however many times we wake from them with a hangover, but this isn’t my subject. People who start and maintain their own firms by action demonstrate their confidence in the efficacy of individual action and personal responsibility. Besides which, there are many, many, defenders of the more-or-less-free economy more qualified to diagnose the dream, or treat the hangover.

It is more practical to discuss the or modes in which gain—-a word which is probably closest to what we mean when using the word profit conversationally—-is measured or perceived without strictly measuring. There are three broad categories.

The increase in cash is an important measure in its own right, and one of the very few in economics or finance that is free of ambiguity and nuance. Everyone with some responsibility in commercial life–not just those trained in finance–understands that changes in cash are not the same as profit. It is true, though, that the emotional impact of the ebb and flow–no one wants to run out, and we can’t help but feel comfortable when a pile of it is available–can cloud issues that require a longer view.

Liquidity is a near-term measure of viability. It speaks more to the adequacy of financial structure than the adequacy of an idea—much like running out of gas means just that, rather than that your prized Jaguar is no good.

Accounting profit. The derivation of this number is quite sophisticated, having evolved over the centuries, bounded by convention and tradition, and used widely as a factor in decision-making. It has the advantage of a reasonable degree of consistency as firms and industries are compared, or recent results are compared to results from the more distant past.

It is necessarily riddled with economic assumptions. Essentially the changes reported on a cash flow are modified by outflows for things that are still on hand at the end of a period, perhaps for many periods to come. There are also modified for promises made to pay for in the future things already received, and promises to receive payment for things already released. That is a short list, but you get the idea. Most owners have a working understanding of this as accrual accounting.

It is here that some judgments, not about what has happened, but what is anticipated, come in to play. Receivables will be paid in, payables paid out. Assets are worth something, and will last for some period of years. A judgment about how much they are worth, how long they last, how certain it is that promises to pay will be kept, is implicit in every report.

That these estimates are expected to be reasonably reliable is evidence in the attention, and sometimes furor, that the write-off of assets sooner than anticipated causes for publicly-traded companies. That this happens, routinely if not persistently, shows that in spite of our best efforts that these judgments turn out to be quite wrong.

I don’t mean to suggest a replacement for accounting as we know it. It is a part of scorekeeping. It has its place in economic assessment. The more subtle limitation of accounting is how judgments about what has happened are required to value things whose true economic value, their value on the market, if you will, are entirely based on what is expected to happen.

Just as cash is a lagging indicator of accounting profit—payables get paid, money due on receivables is received, inventory is sold—accounting profit is itself a lagging measure of things done some time earlier, yet it is these things on which the health of the firm rests. The financial statements are not a sufficient measure of the health of the business; the numbers are last year, and the actions that produced them are a year or more before that.

It’s not categorically the use of, but rather the misuse of financials, particularly the measure accounting profit, that can misdirect entrepreneurship.

Many entrepreneurs know this, and therefore tend to discount financial statements. This is not the best of solutions, either.

Economic profit. This is in some ways a term of art rather than direct mathematical calculation. Cash, however ill-suited, and accounting-profit, however riddled with often-unspoken economic assumptions, are at least nice mathematical calculations. The consideration of economic profit is a way of thinking about calculation, whether mathematical, reasoned, or intuitive. Economists have gone to great pains to derive some more specific measurements, and with some success, but when it gets to application at the level of the small firm…their findings are an excellent guide to thinking, but rarely of clear application.

It is helpful to think about gains in wealth in several categories, something economists have been doing for more than two centuries.

1) rents
2) interest or dividends
3) wages
4) calculable risks
5) unforeseen advantage

Accounting profit does not typically give guidance as to the source of gains, so any combination of the above can be represented in the “bottom line.” Some accountants have made efforts to distinguish the source of profit by treated profit centers separately, but such neat categories, problematic in large firms, are virtually impossible in small.

People who own assets realize some form of income from them—-hence categories 1 and 2. The 3rd is the recognition that in small firms, owners can significantly increase or decrease the firm’s measured profit by changing their pay. The 4th category basically denotes insurable risks; that is, those than can be statistically anticipated. The final gets to the entrepreneurial definition of profit: the gains that arise from successfully anticipating uncertainty.

In practice uncertainty depends on perspective. Agriculture gives one reasonable example, although any industry would provide telling illustrations. In advance of any harvest the production of a crop is “uncertain.” Not risky, in the sense of production being hurt or helped by hail, drought, or rain—-these vagaries are insurable. But just who is planting how much on how many acres is the real uncertainty, and not insurable for the person who needs the produce. This is where the entrepreneur comes in. The farmer [entrepreneur] can solve the problem by entering into a contract, price, quantity, and delivery date specified with the buyer. This solves the problem for the buyer of uncertainty. He has a claim to a needed quantity at an acceptable price. This commitment is not uncertainty, for the farmer, but risk. Knowing the acres and the typical yields, the remaining variability is the risk that is insurable, not unknowable.

That this is a valuable transaction is evidenced in the fact that agricultural futures are overwhelmingly higher before planting than at or later than harvest.

I realize that this still leaves us without practical application of the understanding of economic profit to real-life business. The example of the farmer selling his produce in advance of growing it gives a sense of how these calculations play out. The practical means of calculation has to engage productive forces, not just financial data, which are in a sense the last manifestation, a simple measurement, of a long string of action and consequence. The idea is to construct a flexible process to measure decisions, where the point isn’t so much one answer or set of projections, but the sense of a range of outcomes as they respond to a range of scenarios in important factors of production that remain partly or totally outside of the entrepreneur’s control. These combinations are known to the entrepreneur and few others; in that sense the uncertainty of others is resolved profitably by the acceptance of what is mere risk to the entrepreneur.

All of which is why the entrepreneur sees the question, how are you doing, as a calculation of the uncertain (profitable) future, and not merely the arithmetic of the certain past.