The Delusion of Profits and Measuring Business Performance

From my archives (intro by me):

I saved the following essays by Peter Drucker because many would be entrepreneurs fail to understand some basic concepts of running a business and more importantly, how to keep said business running.  Twenty years may seem like a long time to hang onto something but apparently the New York Times has a similar mindset (see their original publication date below).  But I did want to bring this up during this time of promoting Socialism in a Capitalist society.  Remember Socialism is not for the Socialists; it's for the working class.  The elite will retain all the capital.  

I don't want to bore you with tons of reading material but in order to get a handle on Drucker's rants, it would be wise to get a grasp of why Socialism is not a good idea and we can learn from greater thinkers than I with the following by Pope Leo XIII.

"It is surely undeniable that, when a man engages in remunerative labor, the impelling reason and motive of his work is to obtain property, and thereafter to hold it as his very own. If one man hires out to another his strength or skill, he does so for the purpose of receiving in return what is necessary for the satisfaction of his needs; he therefore expressly intends to acquire a right full and real, not only to the remuneration, but also to the disposal of such remuneration, just as he pleases. Thus, if he lives sparingly, saves money, and, for greater security, invests his savings in land, the land, in such case, is only his wages under another form; and, consequently, a working man's little estate thus purchased should be as completely at his full disposal as are the wages he receives for his labor. But it is precisely in such power of disposal that ownership obtains, whether the property consist of land or chattels. Socialists, therefore, by endeavoring to transfer the possessions of individuals to the community at large, strike at the interests of every wage-earner, since they would deprive him of the liberty of disposing of his wages, and thereby of all hope and possibility of increasing his resources and of bettering his condition in life. (Circa 1891)"

Norman E. Hooben
April 1, 2023



The Delusion of 'Profits'

A company that loses money is socially irresponsible.

BY PETER F. DRUCKER
Monday, June 2, 2003 12:01 a.m.

(Editor's note: "The Delusion of 'Profits' " appeared in The Wall Street Journal, Feb. 2, 1975, and "Measuring Business Performance" appeared Aug. 3, 1976.)

Businessmen habitually complain about the economic illiteracy of the public, and with good reason. The greatest threat to the "free enterprise system" in this country is not the hostility to business of a small, strident group, but the pervasive ignorance throughout our society in respect to both the structure of the system and its functioning.

But the same businessmen who so loudly complain about economic illiteracy are themselves the worst offenders. They don't seem to know the first thing about profit and profitability. And what they say to each other as well as to the public inhibits both business action and public understanding.

For the essential fact about profit is that there is no such thing. There are only costs.

What is called "profit" and reported as such in company accounts is genuine and largely quantifiable cost in three respects: as a genuine cost of a major resource, namely capital; as a necessary insurance premium for the real--and again largely quantifiable--risks and uncertainties of all economic activity; and as cost of the jobs and pensions of tomorrow. The only exception, the only true "surplus," is a genuine monopoly profit such as that now being achieved by the OPEC cartel in petroleum.

(1) All economists have known for 200 years that there are "factors of production," that is, three necessary resources: labor, "land" (i.e., physical resources) and capital. And all of us should have learned in the last 10 years that there are no "free" resources. They all have a cost. Indeed, the economists are way ahead of most businessmen in their understanding and acceptance of a genuine "cost of capital." Some of them, such as Ezra Solomon, a former member of the Council of Economic Advisers now back at Stanford University, have worked out elegant methods both for determining the cost of capital and for measuring the performance of a business in earning it.

We know that in the post-World War II period until the onset of global inflation in the mid-'60s, the cost of capital in all developed countries of the Free World ran somewhat above 10% a year (it is almost certainly much higher in Communist countries). And we know that very few businesses actually earn enough to cover these genuine costs. But so far only a handful of businesses seem to know that there is such a cost. Fewer still seem to know whether they cover it or not. And even these few never talk about it and never in their published accounts subject their own performance to the test. Yet not to earn the cost of capital is as much a failure to cover costs as not to earn the costs of wages or of raw materials.

(2) Economic activity is the commitment of existing resources to future expectations. It is a commitment, therefore, to risk and uncertainty--in respect to obsolescence of products, processes and equipment; in respect to changes in markets, distributive channels and consumer values and in respect to changes in the economy, technology and society. The odds in any commitment to the future are always adverse; it is not given to human beings to know the future. The odds, therefore, are always in favor of loss rather than gain. And in a period of rapid change such as ours, the risks and uncertainties are surely not getting smaller.

These risks and uncertainties are not capable of precise determination. But the minimum of risk in these commitments to the future is capable of being determined, and indeed quantified, with a fair degree of probability. Where this has been attempted in any business--and in both Xerox and IBM, for instance, it is known to have been done for years in respect to products and technologies--the risks have proven to be much higher than even conservative "business plans" assumed.

The risks of natural events--fire, for instance--have long been treated as normal business costs. A business that failed to set aside the appropriate insurance premiums for such risks would rightly be considered to be endangering the wealth-producing assets in its keeping. Economic, technological and social risks and uncertainties are no less real. They too require an adequate "insurance premium"--and to supply it is the function of profit and profitability.

The proper question for any management therefore is not: "What is the maximum profit this business can yield?" It is: "What is the minimum profitability needed to cover the future risks of this business?" And if the profitability falls short of this minimum--as it does in most companies I know--the business fails to cover genuine costs, endangers itself and impoverishes the economy.

(3) Profit is also tomorrow's jobs and tomorrow's pensions. Both are costs of a business and equally costs of the economy. Profit is not the only source of capital formation; there is also private savings, of course. But business earnings, whether retained in the business or paid out (returned to the capital market), are the largest single source of capital formation for tomorrow's jobs, and, at least in the United States, the largest single source of capital formation for tomorrow's pensions.

The most satisfactory definition of "economic progress" is a steady rise in the ability of an economy to invest more capital for each job and thereby to produce jobs that yield better living as well as a better quality of work and life. By 1965, before inflation made meaningful figures increasingly difficult to obtain, investment per job in the American economy had risen to from $35,000 to $50,000. The requirement will go up fairly sharply, for the greatest investment needs and opportunities are in industries: energy, the environment, transportation, health care and, above all, increased food production, in which capital investment per job is far higher than the average in the consumer goods industries which have dominated the economy these last 25 years.

At the same time, the number of jobs required is going up sharply--the aftermath of the "baby boom" between 1948 and 1960. We will have to increase the number of people at work by 1%, or almost a million people, each year these next few years to stay even with the demographics. And at the same time, the number of people on pensions will also increase, if only because workers reaching retirement age live longer, and so will the expectations of the pensioners. Any company which does not produce enough capital, i.e., enough earnings, to provide for this expansion in jobs and pensions fails to cover its own predictable and quantifiable costs and the costs of the economy.

These three kinds of costs--the costs of capital, the risk premium of economic activity and the capital needs of the future--overlap to a considerable extent. But any company should be expected to cover adequately the largest of these three costs. Otherwise it operates at a genuine, certain and provable loss.

There are three conclusions from these elementary premises:

(1) "Profit" is not peculiar to capitalism. It is a prerequisite for any economic system. Indeed, the Communist economies require a much higher rate of profit. Their costs of capital are higher. And central planning adds an additional and major economic uncertainty. In fact, the Communist economies do operate at a substantially higher rate of profit than any market economy, no matter that for ideological reasons it is called "turnover tax" rather than "profit." And the only economies that can be considered as being based on "profit planning" are precisely Communist economies in which the producer (state planner) imposes the needed profitability in advance rather than let market forces determine it.

(2) The costs which are paid for out of the difference between current revenues and current expenses of production and distribution are fully as much "economic reality" as wages and payments for supplies. Since a company's accounts are supposed to reflect "economic reality," these costs should be shown. They are, to be sure, not as precisely known or knowable as the accountants' "costs of doing business" supposedly are. But they are known and knowable within limits that are probably no wider or fuzzier than those of most cost accounting or depreciation figures--and they may be more important both for managing a business and for analyzing its performance. Indeed, it might not be a bad idea to tie executive bonuses and incentives to a company's performance in earning adequately these genuine costs rather than to profit figures that often reflect financial "leverage" as much as actual economic performance.

(3) Finally, businessmen owe it to themselves and owe it to society to hammer home that there is no such thing as "profit." There are only "costs": costs of doing business and costs of staying in business; costs of labor and raw materials, and costs of capital; costs of today's jobs and costs of tomorrow's jobs and tomorrow's pensions.

There is no conflict between "profit" and "social responsibility." To earn enough to cover the genuine costs which only the so-called profit can cover, is economic and social responsibility--indeed it is the specific social and economic responsibility of business. It is not the business that earns a profit adequate to its genuine costs of capital, to the risks of tomorrow and to the needs of tomorrow's worker and pensioner, that "rips off" society. It is the business that fails to do so.

Measuring Business Performance
The meaninglessness of "earnings per share."

BY PETER F. DRUCKER

(This article appeared in The Wall Street Journal, Aug. 3, 1976.)

One of the basic causes of poor performance on the part of analysts, investors and business managers is the yardstick they use to determine how a business is doing--"earnings per share."

Performance in a business means applying capital productively and there is only one appropriate yardstick of business performance. This is the return on all assets employed, or on all capital invested (the two differ, but not significantly). Whether the assets come from outside or inside makes no difference. Retained earnings are just as much money as a bank loan or new equity. A business that does not earn the going cost of capital on all the money in the business fails to cover its true costs and has an earnings deficiency, whatever its earnings per share.

The return on assets must include all monies available to service capital. This includes not only profits from which dividends can be paid, but also all interest charges on all debt. It includes depreciation, which does not figure in earnings per share, but it excludes inventory profits, which frequently do, depending on a company's accounting practices.

These are the measures that make economic sense. If investment flows to companies with high return by these yardsticks, the economy's performance will be optimized. These are the measures of the economic regulating function usually assigned to "profits."

What then are the "earnings per share" that companies and their accountants grind out so regularly and publicize so mightily? The conventional "earnings per share" figure not only doesn't measure corporate performance but it rarely even measures true "earnings per share." What it really represents is "taxable earnings." It is what is left after all the charges the tax collector accepts as deductible. But this is a purely arbitrary figure that has little or nothing to do with economic performance.

"Earnings per share" as reported are practically never what people think they are, that is "earnings available to the shareholder." If they were, companies could or would distribute most or all in the form of dividends--and practically no company does. Before one can really know what a company has truly earned on its equity capital, he therefore has to correct the reported figures for those capital charges which, while genuine costs, are not accepted as tax deductible by the tax collector and are therefore included in the reported "earnings per share." This requires starting out with the return on assets or on total capital deployed. Only this figure shows what capital charges are needed, over and above those which the tax collector accepts.

There are four such genuine capital charges--each a true "cost," even if included in the reported "earnings" figure. The first is deficiency of revenue as measured against the cash needs ahead--the only area, by the way, to which analysts pay much attention. A business that cannot provide out of its revenues for the foreseeable cash needs of operations, including service on its debt, does not earn enough.

A business, secondly, must earn the going cost of capital on all the money in the business. A company which shows high "earnings per share" because it still enjoys the benefits of the lower interest rates of the past, for example, is using up capital and reporting it as earnings. But sooner or later--and usually sooner--the low-cost capital has to be replaced; and then the going cost of capital has to be paid. A gain resulting from low money costs of the past should go into a reserve rather than into earnings. It does not truly reflect the company's profitability.

The third adjustment is the provision for known and unforeseeable risks. This is a genuine cost, as is any insurance premium. The most common risk is the cyclical one. It is a known and foreseeable hazard and has high probability. One year's earnings, like any one month or quarterly figure, are therefore by themselves misleading unless adjusted for a cyclical period. Another typical risk for which earnings need to be adjusted is the high risk of over-exposure and vulnerability after a period of rapid growth. It is prudent to assume that even a slight setback after such a period will reduce sales to where they would have been if the company or the industry had grown throughout the period at a rate somewhere between that of the lowest year in the period and the average year. This formula, though quite unscientific, fits remarkably well with actual experience--that of the mobile home industry, for instance, in the '60s and early '70s. And then one adjusts earnings to the most probably long-term figure considering the risk of growth, in order to have a reliable measurement of business or industry performance.

Finally, the "earnings per share" figure needs to be adjusted to account for the known and foreseeable needs of the business. One of them is the need to provide for the growth required to maintain a company's market position in an expanding market or its technological leadership in an expanding and changing technology. A company that fails to do so endangers its very survival. A second such need is protection of capital against the ravages of inflation. Depreciation surely has to be adjusted to inflation, rather than be based on historical cost.

All this was known 75 years ago. "I never listen to the securities analysts; I listen to the credit analysts," Bernard Baruch is reputed to have said when asked to explain his performance as Wall Street's biggest and boldest speculator in the early decades of this century. Fifty years ago the DuPont Co. codified this knowledge in its famous "return on investment charts, around which the DuPont management was organized.

But the definitive work on earnings, on costs of capital and on measuring economic performance has been done in the last 30 years. Some important books are "Managerial Economics" by Joel Dean (Prentice-Hall); "The Theory of Financial Management" by Ezra Solomon (Columbia University Press) and "Earnings Per Share and Management Decisions" by John F. Childs (Prentice-Hall).

As a result of this work, we know that "assets employed" and "capital invested" mean precisely what the words say. Whether the money has been put into buildings or into receivables is irrelevant; there are different uses for money, but no different money. Whether the money is equity or loans also makes no difference. John F. Childs demonstrated in the book mentioned above that earning power and, above all, "earnings per share" are seriously damaged--and very soon--if retained earnings are invested at a lower rate than the full cost of outside capital.

We further know what to include in "return on capital" or "return on assets." Since the purpose is to measure the economic performance of a business, all monies available to service capital are part of "return." This includes all interest charges on all debt, depreciation (which in economic terms is essentially non-taxable return), as well as what is traditionally considered "earnings on equity capital." It does not, however, include profits which do not reflect the earning power of the business. Inventory losses are genuine losses. But inventory profits do not belong in "return on assets" or in "return on capital employed." Other non-recurring gains incidental to the business, such as the gain from selling a plant, are also not part of "return on capital employed"--except in a company whose business it is to buy and sell plants.

Return on all assets or on all capital investment is not the only yardstick available in measuring the performance of a business. Indeed every business might well use a second one. In a manufacturing business, for instance, return on "value added in manufacturing"--that is on the difference between revenue on goods sold and money paid out for supplies and materials--is an important measurement. It is very sensitive and a "leading indicator" that tends to go up or down before returns on total capital invested or on assets employed show significant changes. For a retail business, return on selling space is similarly an important indicator of performance.

But these additional measurements have to fit individual business. The value-added yardstick only makes sense for business that are truly "manufacturing" businesses. Also, this second yardstick is usually available only to the insider and rarely to an outsider.

Though many business executives are skeptical of the accuracy of "earnings per share" as a business management, they often say, "What choice do we have? The market uses this measure whether it makes sense or not." But this is a half-truth at best. Witness the enormous differences in "price-earnings ratios." The main reason is that the stock market tends to value a stock primarily on the basis of a rough guess at total return rather than on the basis of the highly publicized and visible "earnings per share" figure. Despite its follies, foibles and fashions, the stock market is a good deal more rational than the "experts," at least over any extended period of time.

The best examples of this were the stock prices during the acquisition binge of the late '60s. a good many of the "conglomerates" played the "earnings per share" game and structured the purchases of an acquisition in such a way as to show increased "per share earnings" even though total returns did not go up and often went down. The people who sold their businesses against what eventually came to be known as "Chinese money" all lost heavily in the end--unless they immediately sold the securities they god. The stock market speedily adjusted the share price to the actual returns o capital, rather than to reported per share earnings.

Thus there is something to the old-fashioned belief that the stock price reflects the discounted value of future dividends, that is the present value of future earnings actually available for distribution.

It is possible, with a little work and ingenuity, to determine with adequate probability the return performance of publicly owned companies. But it might not be a bad idea for companies to provide the necessary information themselves. The demand for "full disclosure" increasingly focuses on the economic prospects of a company and on its economic performance--that is on the extent to which it actually produces wealth out of the resources entrusted to it.

The key figure for this is return on all assets (or on capital employed), related to cash needs, to cost of capital, to risks and needs. This rather than the meaningless "earnings per share" figure is what the public, the SEC, analysts and, above all, the stockholders should expect--and might demand--from a company's published accounts and annual statements.

And it is this figure that should provide the link between business performance and executive compensation. It is legitimate and desirable to relate executive rewards to company performance--but it had better be true performance. To tie compensation to reported "earnings per share" subordinates performance to appearances. It may even reward executives for milking rather than building a company.

Mr. Drucker is a professor of social science and management at the Claremont Graduate University.