Profit is the excess of revenue over expenses. It is the return to the organization (and if the organization is a for profit business , profit is the return to the owner of the business, the one who took a risk by investing resources to own the business). There are a number of particular measures of profit, earnings, rates of return, and margins—all with value as metrics for scaling the profit against different denominators (assets, equity, assets, revenue, stock price, etc.). Retained Profit is valuable to all organizations in that it is a fund of resources that can use many purposes for improving the size, the quality, and the sustainability of the organization.
Profit is also a valuable metric in the economy, directing the attention of potential investors (persons and firms with money to invest) toward those investments in markets where consumer demand is growing, and where prices and profit margins are rising. And, causing them to shun investment activities where the opposite is true. Profits (excessive or inadequate to compensate for the risk) are the invisible hand of Adam Smith.
Trends in profit rates within our Hospital industry show the influence of ownership of hospitals. In hospitals, unlike most other industries, some Hospitals are privately owned and owners earn a return to their shares of ownership. Many hospitals are organized as Charitable organizations (IRS 501 C3), technically owned by the residents of their community, and as a result are exempt from all taxes in exchange for an operating mission to provide free community services to the community services. Other Hoxpitals are owned by cities, counties, and the federal government.
The chart below compares the profit performance for the Privately owned and the Charitable hospitals. Clearly, both groups of hospitals serve theoir missions by earning a positive profit. And, the private hospitals earn higher profits that the “so called” non profit hospitals (they should better be called “non taxed hospitals).
Why do non taxed hospitals value profit? Whats going on?
Role of Profit inside the Organization: Contribution Margin
One of the most important business concepts is “contribution margin”. It is the gap between the incremental revenue of doing something, and the incremental costs of doing it. This calculation, and this way of thinking stresses the point that fixed (sunk, overhead) costs are irrelevant to the decision). How much is the ‘doing something’ contributing to profit?
If we were asking how much a particular product (say the university classics department) is contributing to profit, we would as: How much revenue is attributable to that department? And, how much costs is attributed to the department? The difference is the “contribution margin” of the classics department.
Firms use “contribution margin” all the time to evaluate whether to take “one time offers”, like the training example. And, they more often use the concept to examine the profitability of various products and departments of a firm. Say, for example, you are trying to examine possibilities for reorganizing a place like Simmons, and want to strip away “losing” programs. So, you would proceed in one of two ways: (1) calculate the revenue attributable from each program, and costs associated with each program (these are called direct costs). The difference is contribution margin of each program. It tells us how much profit will go down or up if we wiped out the program. This way of looking at the “contribution” of each program to profit IGNORS all sunk costs, which will need to be paid if the program stays or leaves (like the president’s salary, and the building costs, etc.).(2) the alternate (and wrong) way to do is to this is to take all the fixed or sunk costs (sometimes called overhead costs) and allocate the share of these common costs that could reasonably be allocated to each of the existing programs (based on payroll size in the programs, or based on square footage used, or whatever). This we create a “fully absorbed” cost for each program. And, if we subtract this amount of program cost from program revenue we will get a measure of “profit” produced by each of the programs. Then you can scan these calculated profits, and decide which program to eliminate? Accountants love these kind of profits, where sunk costs are allocate down to each business unit. Accounting firms make consulting revenue by helping firms develop “fair” methods for allocating sunk costs. Actually these are not good metrics for deciding which business unit is pulling its own weight.
Fundamentally, the sunk costs cant really be properly allocated, so you can’t really be sure that these profits are really a good metric for understanding the “contribution” of particular program. The best approach to judging “which program is not pulling their own weight” is to measure direct revenue into that program, minus direct costs expended. Which revenue would be lost if the program were to be dropped? Which costs would be eliminated if the program were to be dropped? Direct revenue minus direct cost. Or, incremental revenue associated with the program minus incremental costs. This is the way to evaluate the decision to drop (or add) a program, or not. The revenues associated with it are weighed against the costs of doing it. Incremental revenues against incremental costs. Contribution margin!
So if General Motors was evaluating the Chevy Volt, trying to decide to keep the product or not, the idea would be to determine the contribution margin. This is determined by knowing the direct costs and the direct revenues. Or, the incremental costs and the incremental revenues. Common costs in General Motors, which are not associated with any particular product, are essentially sunk, and will be paid one way or the other. So, they don’t bear on the decision to drop the Volt or not. These common costs are the president’s salary, the costs of the accounting department, administrative buildings, etc.
Of course, to be sustainable, all costs have to be covered by revenue for the organization. And, products or departments that are not producing enough revenue to “pull their own weight” in terms of contributing their share of common costs are definitely problems. But, this is different that saying that because they aren’t pulling their own weight of commons costs they should be dropped. Indeed, if their contribution margin is positive, the organization would be worse off if they were dropped. Here is an example for the McDonald’s ice cream sundaes in the Boston stores in a week:
Item Direct contribution (sundae) All Products
| Revenue | 1,000 | 6,200,000 |
| Frozen Product & Meat costs | 600 | 600,000 |
| Container costs | 200 | 200,000 |
| All other Supplies (including choc sauce, strawberry sauce) | 100 | 400,000 |
| Advertising costs | 50 | 400,000 |
| Labor costs cooks | 800,000 | |
| Labor costs counter | 400,000 | |
| Store manager costs | 200,000 | |
| Building maintenance & depreciation | 2,200,000 | |
| Margin | 50 | 1,000,000 |
If this rough accounting is accurate, it says that the contribution of Sundaes is $50 a week. Or, said another way, the total profit of the stores would fall by $50 a week if we dropped sundaes from the menu. To be sure, the contribution margin is low, and they may not be pulling their own weight in terms of their share of total store costs. But, determining which of these other costs would actually “go away” if we dropped sundaes from the menu would be hard, if not impossible to compute and even harder to implement. Certainly some of the labor costs are consumed by dealing with sundaes. But whether any of that time could be eliminated seems doubtful. Also, the management costs would likely not be changed if sundaes were, or were not, on the menu. If so, then the labor costs are sunk with respect to sundaes. I would expect if we were considering eliminating all milkshakes, or drive-in services, or other items, it might be possible to compute the potential labor expense reductions that would accompany eliminating the product. But, it seems doubtful that labor costs or building costs would be reduced if the product was eliminated, so we wouldn’t consider it part of contribution margin.
This issue of the “relevance” of common costs (overhead costs) in assessing the sustainability of products in multi product organizations is a big issue in many places. Yes, in the long run, the contributions of revenue of all the products must be large enough to cover the all the organization’s expenses—including all common costs. Management must plan and strategize its product line, operating, and capital decisions to this end. But, in the short term (now, and in the foreseeable future) products that don’t produce enough revenue to pass this test may still be worth keeping if they return enough revenue to make a + contribution margin. That is, their revenues are big enough to cover their direct costs. These are the costs that would go away if the product line were to be dropped. In the event that contribution margin is negative, and revenue is less than direct costs, then the organization would experience an increase in profit if the product were to be dropped.
Profit in the Organization and in Non For Profit Organizations
Profit serves various functions inside the organization. It is the wage or price or return to ownership’s investment in the organization. Typically, a good bit of the earned profit is “retained” by the firm for reinvestment in the organization (bonuses and raises, new projects, acquisitions, debt payoff, etc.). In non profit organizations profit is used for these same things, though it is fully retained (eg cannot be paid out to owners, board, or staff).[1] This means that retained profits are a source of financing for the organization.
By way of background a NFP organization is a complete misnomer. NFP organizations are granted tax exempt status by the IRS and state Attorney General’s under the law based upon a quid pro quo arrangement: they will be free from paying property or income taxes (to the society) in exchange for providing services to the citizens in their communities. This arrangement is a by product of our brand of anti government thinking in America, where we look to private organizations and markets to steer the decisions about what to produce, how much, and who gets what. In many other societies, the role of government is to actively direct the economy, and to take care of the citizens who may be disadvantaged by those decisions. Here, where the role of government is so limited, the NFP concept helps fill gaps for people in the largely private economy. The NFP is not only given a huge cost break of not having to pay taxes (when they compete with for profit hospitals for example) but they are also given a huge incentive to help them raise funds through philanthropy[2].
NFP organizations cannot operate indefinitely at a loss (earning negative profits), and prefer to earn a surplus (even though they don’t pay it out to ‘owners’). When losses occur in any organization (even a NFP) nobody steps in to write a check to cover the problem (certainly not the government, unless it is BMC). Losses generally mean a discouraging process of no raises, no expansion, no new technology or equipment, cutting corners everywhere, and all leading to diminished service quality, the best staff leaving the organization, and even more challenges raising gifts.
Profit is an important source of financing for all organizations: for profit or non for profit. Financing is money that is used to pay for assets used in the organization. Assets (the left side of the balance sheet) are things of value that are used in the operation of the organization. So, we need financing to “set up” the business in the beginning. When the organization wants to expand market areas, or acquire complementary businesses, or invest in new technology, or start a new venture/project they also need financing to acquire more assets. Saved prior profits are one source of financing. The other sources of financing are:
| Kinds of financing | For profit organization | Not for profit organization |
| Profits from prior period operations (rev – exp) |
x |
x |
| Borrowing
|
x |
x |
| Philanthropy
|
x | |
| Selling more ownership shares |
x |
Borrowing is a self limiting source of financing, as it would be for a household. Profit is a very useful form of financing because management (and the Board) has control over its disposition within the organization. Philanthropy has more strings attached.
Profits (surplus) can be used to expand services (as usually imagined in the mission statement), to improve service quality and technology, to hire and retain better staff, and to generally improve the effectiveness of the organization’s footprint in the community.
Non profit organizations implies they don’t make any profit—or surplus– nor do they want to. That is silly. They like surplus because it is an important source of financing going forward—and because the absolute minimum profit they can safely earn is zero.
They should not be called “non profits”, they should be called “non taxed” organizations.
One final point on NFP organizations. They may not act as if they are maximizing profit, like for profit firms. But the economic theory about marginal rules of decision-making behavior apply here too. When deciding to do something, or not, the idea of weighing the incremental costs against incremental benefits definitely applies. The only difference is the metric being used to measure benefits. Any organization that has objectives, and is making decisions in order to achieve those objectives, will follow marginal rules of decision-making. This includes decision-making in the presence of sunk costs (which are not part of the incremental costs or benefits of a decision option). Fixed (sunk) costs are always important in every kind of organization. But, the still do not figure in (or stand in the way of) the incremental decision-making of any organization that has objectives and is trying to achieve them.
Profit in the Economy
Profits and profitability direct the flow of resources in the economy. The central concept in this is the demand for investment. When profits are good, organizations earning profit, demand and get more financing, which allows them to buy the resources they need to expand operations, create jobs, and serve more people. And, furthermore, profits are valuable signals to other investors too, who also want to make investments in profitable markets. Think of a traffic light: when the signal is green, high profits are being made, and investments in this marketplace are on the rise. When the lite is red, profits are not good, and inflows of financing and investments are down, and indeed, there will be an outflow of investment. When profits are “yellow” (neither green nor red) the level of financing in the market is rather constant, not increasing or decreasing.
This process of profit signals for investment demand doesn’t work for the NFP sector. Here, the flows of investment tend to follow community need, not return on investment. Persons with money want to earn psychic income, and want their money to be useful in solving important problems in society. In some instances it is clear that investment follows need: the huge outpouring of NGO investments in Darfour, in Katrina, in Haiti and the like is evidence that the investment in resources chases need around the world. In the U.S. the roughly $330B a year in philanthropy is collected from indiviuals (about 3/4) and much smaller amounts from Foundations, corporations and bequests. The uses of philanthropy devoted mainly to Health sector (about 1/3) and smaller amounts to Education , Human Services, and other sectors.
Within any for profit organization, how does the demand for investment projects work? Every organization (FP or NFP) has a schedule of projects that is worth doing, but vary in terms of their value to the organization (internal rate of return). It might look like:
| Project | rate of return expected |
| 1. new computer system 1,250,000 | 22% |
| 2. web site for retailing 870,000 | 18% |
| 3. acquire small vendor 2,500,000 | 14% |
| 4. buy a fleet of trucks 1,750,000 | 11% |
| 5. ad campaign for youth 4,000,000 | 10% |
| 6. aggressive loyalty prgms 1,950,000 | 8% |
| 7. leadership training prgm 750,000 | 7% |
The organization will determine which projects to choose based on what it costs them to raise the needed financing. So if their cost of raising the financing is say, 13%, then only the first three projects can rationally be pursued to protect the financial sustainability of the organization[3]. Even if they are using last year’s profit as contrasted with borrowing from the bank, they have to think about opportunity cost. Is profit a “free” form of financing? Yes, in one way; they certainly don’t have to make interest payments, nor do they incur costs of raising it as they do with gifts. But still there is opportunity costs of using the savings to fund, say the fleet of trucks. They could (1) invest the money and earn 7-8% possibly, (2) they could save it until next year, and possibly a more valuable need would arise by then, (3) they could use the money to pay off current debt. It isn’t clear what is best here, but the point is that using profit isn’t free, it still has opportunity costs in a NFP organization.
Capital markets exist for Stock (ownership of for profit corporations), Debt (IOUs to be paid back) and Philanthropy (gifts). They are interlinked markets. It’s the same set of ‘savings’ that are being chased in all instruments, with the main difference being that the returns in the form of asset appreciation or income are being chased in the Stock and Bond markets, while psychic income is the benefit in using the savings to make philanthropic gifts[4]. But in all cases, the demand for financing is driven by the financing needs of organizations: What growth prospects are they looking at, what new innovations or market expansions need doing, what is their schedule of potential uses of additional financing.
So, organizations with financing needs look across markets for solving their problem. They will use internal funds, or borrow, or other alternatives based on the costs and flexibility of the options. Places where profits are high will tend to demand more investment (from existing firms and from new entrants). Low interest costs engineered by government will also encourage more investment across the board.
When governments persist in keeping interest rates low in the bond markets it buys or redeems outstanding treasury bonds. Giving the bondholders cash. This pushed the bond prices up and the interest rates down. The purpose is to encourage more investment projects be accepted at a lower financing cost (see the above schedule), which fuels the economy, spending, jobs, etc). The acquisition price of a bond relative to the value at maturity and the number years in between determines the effective yield. If interest rates are above this yield, then there will be no demand to buy these bonds at their current price, and the price will fall until the yield rises to the level of the interest rates. So, if the government is actively purchasing bonds, they are pushing bond prices to be higher and higher, reducing the yields (and the effective interest rates).
When this happens, the demand for capital investments is increased as i rates are lower. So, looking again at the schedule of projects above, the investors will be able to rationalize more projects as being “worth it” as i rates (financing costs) are lower. This stimulates the economy of course (the purpose of government’s policy) but encourages more debt on business and consumer balance sheets at the same time.
Why do firms want their stock prices to be high? If they want to raise financing (for expansion, for a merger, etc) by issuing more ownership shares. The amount of dilution of ownership that have to give up to raise a 1$ is lower when the stock price is higher. And, generally stock prices tend to fluctuate with profitability. This is because the investors shopping for stock tend to chase the best return they can get on their investment, given the level of risk. The return they get is dividends from earnings, and appreciation in stock value. Profit fuels both components of return: dividends are paid out of profit, and appreciation is a function of future stock price, which tends to be higher as profits are higher.
Normal Profit
Economists have created a concept of profit that reflects the level of profit that a firm needs to earn to keep the capital structure of the firm intact given its level of risk. At profit rates higher than this level, then this firm and others will be trying to expand the level of financing and take advantage of the high returns, above the level of comparable investments in the economy. So capital will enter the industry at profit levels above normal. At levels of profit below the normal profit level the firms owners (stockholders) are earning less than they might get elsewhere, and nobody would be looking to invest in becoming a competitor. So, capital will flee.
The normal profit level is what we would expect firms to earn in highly competitive industries.
To earn above normal profits on a sustained basis, a firm needs to have be blessed with some barrier to entry that prohibits competitors from entering the industry with infusions of new financing.
Sustained Profits and Monopoly Power
Sustained profits above the normal level can be earned only if persisting monopoly power exists. Monopoly power allows the firm to manipulate profit margins (on revenue) to their best advantage. The metric of profit margin (R-C/ R) is a good proxy for the degree of monopoly power held by the firm. High margins will tend to attract capital into the market. The margins will dissipate through entry of capital into the industry and competition unless there are barriers to entry of new competitors. The kinds of barriers that can exist include:
- First mover advantage (which is thought to be temporary unless accompanied by one or more of the following)
- Control of necessary resources or product distribution channels
- Government grant of a necessary license or patent
- Prohibitively high capital requirements to enter the industry
- Brand or Loyalty advantages of existing firms
Profit Signals for Resource Needs Across Sectors of the Economy
To sum up, the levels of profit direct the economy’s new investments in products, services, equipment, resource demand, jobs, and the available financial resources in the economy. Profits are a source of investment financing, and they are also a signal to other investors about where investments might be best pursued. So resources flow in the direction of high profits in markets, and away from low profits in markets.
There are two exceptions. One exception is when monopoly power persists due to barriers to entry. Here, excessive profit margins can persist only if barriers to entry exist. A second exception is the non profit sector. The non profit sector is dependent on profit as a source of financing for doing their mission. But, the flow of overall resources is not driven by profitability. Rather, the allocation of investments is probably driven by factors other than investor profitability, including need, perceived need, and other factors.
[1] The owners of non profits are the ‘community’ of citizens who are served and who have supported the organization. In the event that a non profit is “sold” to a for profit organization (and the organization is dissolved) any surplus over debt payoff that is received is put in a trust for the benefit of the “community”,
[2] This break works as follows. People who choose to give money to the NFP are allowed to give pre tax money. This incentive is created when they are allowed to deduct the “gifts” from their income on their tax return. People could give money if they want to for profit organizations, or to private individuals standing in busy intersections, but they will not be able to deduct those gifts from their taxable income.
[3] The cost of raising financing is the ‘cost of capital’, generally computed as a weighted average of cost of equity and cost of debt. In the case of a NFP, where there is no equity capital, there is of course a cost of raising debt financing, but disparity in what the cost of equity capital is and how it might be computed. See Gapinsky Understanding Healthcare Financial Management (ed. 4).
[4] There is also a “money market” or asset preservation market too: it offers economic returns too, though small ones in the form of interest payments on balances.
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