How profit works and how you can make a good living without profit.
The difference between income and profit
When speaking to small one man businesses, many confuse the difference between the cost of the services or products and the price charged for those services or products as profit. It’s not. It's income. Profit is something very specific. No business needs to earn a profit in order to flourish and for everyone to have a good income.
The difference between wages, salaries, and profit
Wages are paid on an hourly rate whereas salaries are paid on a monthly rate. Profit is paid annually after all business expenses, including the salaries of the staff and owner/s are paid. Many small businessmen and contractors confuse their salary with profit. It’s not.
Typical business expenses
Typically, businesses have the following expenses.
- Cost of raw materials
- Wages and salaries for blue collar workers
- Sales Commissions and/or bonuses
- Line staff and executive salaries
- Depreciation of assets
- Investment fund for capital equipment, etc.
- Emergency Fund.
Please note that the salaries are not taken from profit; they are taken from business expenses.
Setting a price for goods or services
Price setting until the mid-60s
Up until the mid to late 60s, the price setting of goods was based on the cost involved in producing the goods. So, for instance, if the cost of making a lounge suite was $60 (cost includes all business expenses as well), then a set percentage would be put on which would create the year end profit.
This would mean that if the owner of the business decided he didn’t want to make a profit but was perfectly happy with his $5000 a month salary plus year end bonus (the cost of his salary and bonus had already been factored into the cost of producing the lounge suite) he could simply sell the suite at cost. He would still have a sustainable business.
If on the otherhand, he wanted to make a profit over and above his salary and year end bonus, he could up the price of the suite and add a standard percentage – say 50%. The couch would then sell for $90 and at year end, because he had sold 10000 couches during the year, he would have a profit of $300,000.
The set percentage added to the goods would always be the same as there was a definite relationship between the cost of manufacture and the price of goods.
Price setting after the 60s
This method of determining what the profit factor would be, however, changed towards the end of the 60s. This was a result of Austrian economist, Von Mises, stating that entrepreneurs should set price (and profit) according to what the market would bear, i.e. what the man in the street would be willing to pay for it.
The following analogy will explain this.
If a man produced 10,000 bottles of water at a cost of $1 per bottle and drove into the Sahara desert where water was scarce, he could charge a much higher price. So while the earlier model of profit meant that he added a 50% (any percentage really) value making the price $1.50, charging what the market would bear (market forces) meant that the entrepreneur could charge anything he liked.
So let’s pretend he comes across a caravan of merchants after a two day drive. They’re all lying around half dead, unable to proceed because they’re literally dying of thirst. They have an amazing cargo of goods with them.
The entrepreneur, because he is charging what people would be willing to pay, can up the price of his cargo to $100 a bottle and negotiate a deal where he gets half of the caravan’s profit. The entrepreneur walks away with a cool million dollars, plus the profits of half the caravan load. The merchants in the desert, however, have their lives plus only half the profits.
This is the major difference in how prices are set for products. It depends on whether the entrepreneur is happy to run a sustainable business where everybody earns a living wage plus a year end bonus, with the business is in the black, whether the entrepreneur wants a reasonable profit by correlating the cost of the goods to the price of the goods, or whether the entrepreneur is out to become a millionaire or billionaire – in which case, he charges exactly what he can get away with. This last is is called ‘ charging according to market forces.’ Some would call that way of making money unethical.
Two types of profit
There are two types of profit – gross profit and net profit. These are both reflected on the balance sheet. Gross profit has to do with the immediate costs of producing the product and net profit has to do with the expenses that have to do with line management. It is the net profit that is sent to shareholders or goes to the owner of the business to buy his yacht.
Check the diagram below to understand the difference.
The reasons wealth gravitates upwards and there is no dribble down effect
The reason that wealth gravitates upwards is a direct result of the effect of profit. The dribble down effect would only happen if business entrepreneurs paid their workers a substantial percentage of the profit. The other way that the growing gap between rich and poor can be prevented is by government regulating profits. This is done by taxing profits and spending those profits on education, welfare, medical, and more.
Advantages of sustainable businesses that do not make a profit
- You can undercut competitors because your prices are cheaper
- You have happier staff because they are paid well.
- You are happier because you have less stress because the business doesn’t have to make so much money
- While you will earn more than your staff, there won’t be such a large inequality gap between entrepreneurs and workers.
- Communities become wealthier. The Basque province in Spain is the most prosperous in Europe as a result of working on this model.
Three business models
What model for business do you believe to be the most ethical? This means for the greater good of the greatest number of people.
Is profit the only motivation?
Repeatedly when mentioning that profit is not necessary in order for a business to produce and distribute goods, the comment is made that if there wasn't profit, there would be no motivation to set up a business. This is not true, and numerous studies have shown it not to be true.
- Most people work for income, i.e. wages and salaries, not profit.
- Mondragon, a cooperative in Spain was established to manufacture without profit. It is hugely successful internationally.
- Being the boss man is satisfying to some and is motivation to own a business.
- People need to eat; they grow food to eat - not to make a profit.
- People need goods. They make goods in order to have them, not to make a profit. So even if it demotivated those are tempted by greed, ambition, the lust for power, etc. there would still be production and distribution.
- People would still innovate and invent. Tesla didn't want to make a profit on electricity. Alexander Flemming did not invent antibiotics to make a profit. His purpose was to cure disease.
There are many motivations for owning a business. There are many different motivations for innovation, creation, and invention. To claim that the only reasons anyone would do anything is the love of money is simply not true.
Running a business without making a profit
It is not necessary to make a profit in order to earn a good living. It is necessary to set a fair price that covers a good salary and a good bonus for year end.
© 2015 Tessa Schlesinger