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Jun 3, 2009

They Are Profiting From My Needs

Birthday Party

Around 1979, I was asked to leave a birthday party in Cambridge, MA. The party was by and for "Alice" who was a friend of my girlfriend at the time. About 20 of Alice's friends and their dates were there.

Alice bought a birthday cake for her party, for $35 at today's prices. During conversation, Alice complained that the cake was great, but too expensive. She knew the price when she ordered it. She said the bakery had "ripped her off" because they had made a profit selling her the cake. She needed a cake, and they had profited from her need.

I was hooked. I suggested that she could have bought a cheaper cake at a different bakery, or could have made the cake herself. Why did she blame the bakery for selling her a cake that she wanted to buy? I said these things nicely. I really wanted to know why she felt that way.

Alice said that she couldn't make such a nice cake, so she was forced to buy one. She knew that the ingredients cost about $10, so the bakery was adding in a big profit. It was a rip-off.

Read more ...

I said that the bakery had to pay the bakers, and rent the store, and other expenses, and have something left over, so the cake was going to cost much more than the ingredients. Alice replied that she didn't make any profit working for the City of Cambridge, so why should the bakery make a profit from her?

I suggested to Alice that her salary was her own profit, after subtracting her costs such as taking the bus to work. Alice said that she wasn't in business and didn't make a profit. She worked for the City of Cambridge helping residents, and she was paid too little for the hard and good work that she did.

She said that things would cost a lot less if businesses weren't taking those profits from her. I said that the bakery would not stay in business if it could not earn a profit. She said that it was fine with her if they went out of business, but that they shouldn't overcharge her as long as they were in business.

You may have guessed that there was increasing tension in this conversation.

I said that she was missing the central point. She said that I was being a pain. Cambridge is a liberal town in a liberal state. Many of Alice's friends also worked for Cambridge, and no one was helping to explain my view. After a few quiet whispers from her friends, my girlfriend suggested that everyone would be happier if we left. I didn't get a slice of the cake.

Yes, now I'm more resigned about these attitudes, and I won't do it again.
 

Non-Profit vs Profit

Profit is a dirty word to some people all of the time, and to most people some of the time. An "AntiProfit" thinks that profits are evil. According to an AntiProfit:

  • Non-profit is associated with hospitals and charities. Idealistic people work for non-profit organizations and governments, which are supported by contributions or taxes to do good works.

    If a non-profit collects fees for some services, those services are delivered below cost, so this activity is still pure and helpful. If a service is delivered above cost, for example registering cars, the "additional revenue" supports the organization, so it is good.

    Motto: "We're here to help"

  • Profit is associated with deal-making and pressure to buy. They have stuff that you want, and they make you pay for it. They try to sell products above cost and for the most profit. This profit could have stayed in their customer's pockets. Most of the employees are good people, but management is grasping for outsized salaries and money making schemes.

    Motto: "We charge as much as possible".


Understanding Profits

I don't hate profits, and I don't see profits as being the result of greed. I feel this way because I understand how businesses operate and where the profits come from.

The short answer is that "profit" is only a special name for what the owners and investors are paid. Profit is not "extra", "excess charges", or "anything we can squeeze from the customer".

The long answer is that profit becomes clear when you understand some detail about how a business operates. You probably won't hate profit after seeing where it comes from. We will look at Jim The Waiter, a service business; Busy Eats restaurant combining investment with service; and a pure Investor.

When you see a business as being a group of the managers, employees, service providers, and owners all together, then profit is the portion of business income paid to the owners, with the rest of business income paid to the other participants and suppliers. Business income is divided among the people who contribute to the business, including the owners.
 

Jim The Waiter

Jim earns about $50 in wages and $60 in tips each workday. He tips the busboys $4, spends $5 on commuting, and sets aside $1 for cleaning his work clothes. He has $100 remaining on average (net income before taxes).

We can regard Jim as the sole-proprietor of a service business. He sells a service to the restaurant and its customers and makes a profit before taxes of $100 per day.

Jim wants the highest income he can get from his work. AntiProfits don't object if Jim as a worker asks for $5/day more in wages. He has a right to sell his services for anything he wants. Jim can ask for a raise, and his employer can agree or not. Either side can end Jim's employment. Then Jim can find another job, maybe at a higher wage, and his employer may hire the services of someone else.

Jim earns extra income (more profit) by delivering better and faster service. He serves four more tables each shift than he did when he was less experienced. Jim's customers are not hurt by Jim's extra profit. Rather, they enjoy the better service and pay more 20% tips.
 

Busy Eats Restaurant

The Busy Eats restaurant employs Jim, other waiters, busboys, cooks, and a manager. It rents its building and buys accounting, advertising, electricity, and security monitoring. It uses tables, dishes, cooking ranges, and refrigerators. It buys, stores, and prepares food. It pays taxes on its own income and withholds taxes for its employees. The owners have spent money setting this up or buying an operating business, and they manage the business or hire managers.

It is convenient to say "Busy Eats" when it is really the owners and managers who have the risk and responsibility for delivering a service. The manager's salary and bonus comes from attracting customers by offering good food, service, and atmosphere. The customers can easily refuse this offer.

Any cash remaining after expenses belongs to the owners as their share (profit). Making money from the business is the reason the owners paid money (invested) to start or buy the restaurant, and took the risk of loss. The owners and managers must create and sell a service that will pay their salaries and profit, or the managers will lose their jobs and the owners will lose their money. The owners probably have restaurant experience that increases their chance of success.

Losing money operating Busy Eats would be as painful as putting $10,000 into a mutual fund and getting only $5,000 back, or nothing back, or even having to lose $2,000 more in addition.

  Break Even

Each meal served gives Busy Eats a little extra cash, the bill minus the cost of the food and cleanup. The cook and the waiter are on an 8 hour shift and need to serve many meals to pay their salaries and make tips. Busy Eats pays monthly rent on its building which must be paid from serving many meals. And so on.

"Break even" for Busy Eats is the sales needed to pay all of the expenses. That may require being 60% full for six hours each day. This level of success is unhappy for the owners, who couldn't sell the business for much. It isn't making any money for the owners (no profit), so it is no good being an owner.

Things are OK at 70% full. The cash from the extra customers pays the owners and a bonus to the managers. If Busy Eats cost $200,000 to set up, and it makes $20,000 in profit each year, the owners get about a 10% yearly return on their investment. Busy Eats could be sold for about what it cost to set up.

  Doing Well

Busy Eats might operate at 95% full, if they serve great food and people love the place. They would be happy making a profit of $70,000 on their investment of $200,000, giving them a 35% return. They could sell Busy Eats to new owners for about $700,000. The new owners would be getting a 10% return at that price on a successful business. The original owners would receive a "capital gain" of $500,000 above their investment of $200,000.

Where did all of this value come from? The owners created something that delivers value to their customers. They organized the services of their employees and managers, and they invested in the building, interior design, and equipment to convert groceries into great meals in a nice atmosphere.

The owners are using resources efficiently. They serve 95 people using the same physical resources that would have served only 70 people at 70% full. The owners employ 30% more cooks and waiters than they would have at 70% full. Jim the Waiter is happy to be earning a reliable salary and tips from a busy dining room.

  Prices

The price of a meal did not change; it is the efficiency of operating at 95% full that is earning the owners their large profit. The profit doesn't make the food and service great; it is the food and service that make the profit great. So, a customer usually gets a better meal at a profitable restaurant than at a less profitable one.

Where does AntiProfit go to lunch? He likes the restaurant Quiet Time down the street, operating at 60% full and making no profit. He appreciates that they aren't making any money off of him above their costs. The food is passable and it isn't crowded, while it stays in business.

AntiProfit dislikes the restaurant Busy Eats, operating at 95% full and making a big profit. AntiProfit thinks they are charging too much, although their meal price is about the same as Quiet Time. The food is great. He is offended by the crowded atmosphere and the large volume of dirty dishes, at least 25% more than at Quiet Time. He feels sorry for his waiter Jim, who is busy serving many tables.

  Waiting Lines

Some time later, Busy Eats finds that it is operating 100% full at a profit of $80,000 per year. They often have a 20 minute waiting line. Their first choice would be to expand the restaurant, but that would require closing for six months, a big loss of revenue. While they plan a bigger restaurant nearby, they raise the price of meals 3%. This pushes 6% of their business away, the line disappears, and they operate at 98% capacity with a profit of $90,700 per year. The customers who continue at Busy Eats are willing to pay more for the great food and atmosphere but may not eat there quite as often.

Busy Eats raised prices only 3% because they wanted to keep as many customers as possible. Their customers are sensitive to price, even for great food.

Most customers appreciate the shorter lines more than they dislike the higher prices. Before, they lost time waiting or they stayed away; now they pay more. Jim the waiter gets an automatic 1.5% raise based on the higher meal price and tips; his excellent skills are worth more in a busy restaurant. The "market" was telling Busy Eats to raise its price.

The supply of meals at Busy Eats was less than its customers (the market) wanted. It can charge more and deliver its service with short lines and more profit, instead of rationing its meals by having long lines. Its high profits at this location helps the owners to get investments for their next location.

  Profitable Changes

Quiet Time is looking for ways to make a profit. It lowers its prices and changes the menu. It gets some of the customers who would have eaten at Busy Eats. It manages to be 70% full with lower prices and lower costs, making $20,000 in profit each year. That saves the restaurant and restores its value to the owners. The owners then have some time to try other things that would be more appealing to customers.

The supply of meals at Quiet Time was more than the market wanted. This told Quiet Time to make its meals less expensive and/or more desirable.

AntiProfit complains that Busy Eats is making too much profit after raising its price. He would prefer that it serve the community and himself better by lowering prices so that he could eat there more often. AntiProfit says Quiet Time is a good member of the community, offering solid food at a newly lowered price, and it is a quieter place to eat.

AntiProfit has things backwards. The price at Busy Eats is higher because of higher demand for its meals. The value of its service produces the higher prices and profit. It charges more because it wants to make higher salaries and returns on its investment. It deserves a raise for its good management.

Busy Eats couldn't serve many more customers even if it charged less. It hopes to serve many more customers at a second location, where it can make even more profit at the original, lower price.

The price at Quiet Time is lower because people aren't as happy with its offerings. Quiet Time is not full and could serve more meals, so raising prices would be a mistake. It makes a smaller profit because it is inefficient, not because it is a better member of the community. It employs fewer waiters and cooks than it would if it were more successful delivering what people want.

  The Cost of Profit

How much could a Busy Eats customer save if Busy Eats "gave back" its profit?

Busy Eats is just worth the owner's investment at 70% full, making $20,000 profit per year. That is the level where the owners don't lose the money they spent to set up the restaurant. Let's give them that.

Compare this to the $80,000 profit per year when Busy Eats is 100% full serving $500,000 in meals per year. The extra $60,000 profit is 12% of the meal price. So, Busy Eats could "give back" that profit by lowering the price of a $15 meal by $1.80, down to $13.20.

         Full     Sales   Profit   Extra  Extra
                                   Profit   Pct
Just OK   70%  $350,000  $20,000  $     0    0%
Full     100%  $500,000  $80,000  $60,000   12%
Pricey    98%  $504,700  $90,700  $70,700   14%

The Busy Eats customer is not paying much toward profits to eat at a great restaurant. Jim The Waiter actually makes more money in 15% tips on each meal than the restaurant makes toward the extra $60,000 profit.

As noted before, Busy Eats and its customers are all better off when the $15 meal price is raised 3% to $15.45. The waiting line disappears, the profit goes up to $90,700 at 98% full, and the owners want to open more restaurants, hire more staff, and serve more people.
 

Restaurant Financial Model

Below is the financial model for the Busy Eats and Quiet Time restaurants. I am not a restaurant expert. These figures may be different for an actual restaurant, but they are consistent about profit and expenses.

As Busy Eats sells more meals, it spends more on groceries, waiters, cooks, waste disposal, dishwashing, and bonuses, yielding 40% profit on meals served. Busy Eats has to pay fixed expenses like rent, electricity, bookkeeping, and advertising. Anything left over is the owner's share, the overall net profit.

I estimated the total business value of Busy Eats at 10 times yearly profits. A real value would depend on other risks and benefits, and might be between 5 and 15 times yearly profits.

See the Excel Spreadsheet for these figures


(Money in 1,000's)  Break                
                     Even           OK      Success
                    -----           --      -------
Maximum Sales        $500         $500         $500
How Full?       60%   300    70%   350    95%   475
Meals Expense   60%  -180    60%  -210    60%  -285
Meals Profit    40%   120    40%   140    40%   190
Price Increase          0            0            0
Fixed Expense        -120         -120         -120
Net Profit              0           20           70
                                              
                     Full         Pricey       
                     ----         ------
Maximum Sales        $500         $500
How Full?      100%   500    98%   490
Meals Expense   60%  -300    60%  -294
Meals Profit    40%   200    40%   196
Price Increase          0     3%    14.7
Fixed Expense        -120         -120
Net Profit             80           90.7


An Owner/Operator

Busy Eats illustrates a typical business that combines investments with operations. The owner buys the equipment, rents the building, and organizes the business. Up-front payments (investments) are necessary.

A promise to pay suppliers after everthing is running is not enough. The owner or a trusted manager supplies the plan for Busy Eats, hires the staff, and starts things working. Any profits from Busy Eats pays the owner for running and creating the business. He risks losing his setup money, or more, if Busy Eats fails.

The owner of Busy Eats combines his investment with his intelligence, experience, work, and the work of employees to deliver a service to customers. Any profit is what the owner is paid for his current work and for supplying the investment that created the restaurant.

Jim The Waiter combines his abilities and a small investment in work clothes to deliver a service to Busy Eats and to customers. Busy Eats pays him an hourly wage and his customers pay him in tips for his effort. His profit from working is what remains after some expenses.

Profit is not being stolen from employees or customers. It is the name for the useable part of each person's pay for the services and investment he provides, after subtracting work related expenses.
 

An Investor

An Investor buys stocks, bonds, commodities (like soybeans, copper, or oil), or all or part of businesses, with the intent to be paid, to make a profit. We could just as well talk about a group of people or a business buying these things.

AntiProfit sees an Investor as the pure evil of Capitalism. The investor wants to make a profit, to be paid for doing absolutely nothing, just by buying something and owning it for a while.

Actually, buying business equipment and structure supports making things. Making things is what gives us tools, houses, appliances, cars, and everything manufactured. Natural resources are also manufactured. Coal, concrete, iron ore, and wood must be mined, processed, and shaped to be useful.

Manufacturing, transportation, and accounting require tools, buildings, desks, and the entire infrastructure of business. Somebody has to provide the intelligence and resources (capital) to organize and build the infrastructure to do these things.

Busy Eats was designed and constructed before it could serve meals. It had to operate while losing money during the time that it was building a base of customers.

The owners supplied the investment. They made money for themselves if they did it right, or lost money if they did it wrong. They had to have knowledge and faith in themselves. They needed the possibility of a big profit to risk their money on something that might go wrong. There are many examples, such as Quiet Times where things did go wrong, and the owners invested their money only to lose it or barely get it back.

AntiProfit is mistaken that investing is "doing nothing" and getting paid for it. The investor must do useful things to earn money, then save those earnings, then invest that money at risk. The investor gets his money back if everything goes OK. He is paid for his foresight and risk If things go well. He loses some or all of his money if something goes wrong.
 

Safe and Risky Investing

Some investments seem safe. Why should investors be paid for buying and holding a sure thing?

The investors in Busy Eats have a steady business after 3 years. They spent $200,000 to start it, and it is now worth $850,000. That is based on a profit of between $80,000 to $90,000 each year. New investors are willing to spend that much to earn a 10% return on an investment that increases with inflation.

The new investors are not "parasites" on the value produced by the employees of Busy Eats. The employees have always been paid for their work. The new investors are buying the profits that are due to the original owners for starting and establishing Busy Eats. The original owners organized and provided jobs; they are not "stealing profits" from the employees.

The new investors are voluntarily paying $850,000 for a business that cost $200,000 to start. They do not feel robbed. They are happy to buy a business that earns 10% plus inflation. But, there is always some risk, and they will pay attention to keep good management and adapt to their customer's preferences.

The original owners have made $650,000 above their investment of $200,000. After a bottle of wine and smiles all around, they are likely to use this "capital" to start more restaurants.

This shows a pattern in investing and life. Entrepreneurs (high risk/reward investor/operators) start businesses and establish them as being stable. They often sell these businesses to managing investors (lower risk/reward investors) who are content with managing businesses for profit.

Entrepreneurs do something new using their own money and money from people who trust them personally. Managing investors use money from banks and stockholders who trust mostly in the documented performance of proven businesses. Each type of investor is matching risk against return. All investment is done at risk.

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To commentor Ted S.: Thanks for adding your experience.

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Free Markets, Businesses, and Crony Capitalism
03/23/10 - The Common Room by Headmistress, Zookeeper

This post kindly links here, and provides an anecdote about a woman who felt used books are improperly sold at market value, rather than what she imagined as a reasonable price.

Headmistress points out "There is nothing inherently immoral about profiting from needs".

1 comment :

Ted S. said...

Phew, that was a long post! But I think your synopsis of the world view of an Anti-Profit is spot-on.

I once consulted for a nonprofit run by Anti-profits. I learned some things.

1) Change the word "profit" to "surplus" or "non-deficit" and *poof* suddenly it is okay.

2) Change the word "profitability" to "sustainability" and *poof* everything happy.

3) Instead of speaking of "money" speak of "resources" and *poof* everyone is interested.

I met with one of the middle managers whose department was chronically losing money. He opened the interview by saying "we're not here to make money." I tried to point out some facts, like that if they lose enough money they won't be there at all, but to no avail. Later I attended on of the organization's salary meetings (yes, they all met together to decide who should be paid how much). Guess who argued most vociferously against everyone else's pay and for an increase for himself. Mr. We're-Not-Here-To-Make-Money! If only he felt the same way about his employer!

The term "nonprofit" itself is a bit of a misnomer. The point of nonprofits is not that they shouldn't make a profit, it is that any profits they make are not distributed to owners, since there aren't any. So really, "nonprofit" is a sort of verbal contraction for "non-profit-distributing", which is too much of a mouthful for common speech. Unfortunately, this contraction has imbued the term with a false but popular meaning. Maybe it should be replaced with "non-distributing" or some such.

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