Profit is a signal, not a sin, and what a loss tells a company

Somewhere tonight a cable segment is explaining, in a grave voice and over ominous music, that a company made a profit. Made one! On purpose! You can almost hear the anchor wondering why nobody has stopped them. The coverage never seems to include the fact that the same company, if it had made a loss, would be the subject of a different segment, with different music, about a company that is failing its workers. Profit is a scandal. Loss is a tragedy. Break-even, apparently, is when the cameras go home.

Folks, I want to put in a good word for the most misunderstood number in the American economy. Not because executives need my help, but because you need to understand what the number does. Profit is not a sin. It is not even mainly a reward. It is a message, and the message is the most valuable piece of information a free society produces. Once you hear what it says, you will never hear the coverage the same way again.

The definition, in one sentence

Profit is what is left when the money customers pay a business is greater than the cost of everything the business used up to serve them. The inputs are labour, materials, rent, equipment, borrowed money and the owner's own time. The revenue is what customers willingly handed over. When the revenue is bigger than the inputs, there is a profit. When it is smaller, there is a loss.

Notice the word willingly. Nobody forced the customer. He weighed what the bakery's bread was worth to him against the price, and he decided the bread was worth more. In a voluntary trade, both sides expect to come out ahead, or the trade does not happen. A profit is the evidence that a business created something its customers valued more than the resources it took to make. A loss is the evidence that it did the opposite: that it took in resources worth more than what it produced.

A bakery, with numbers

Let me work an example, and I am labelling it a hypothetical so no one thinks I found it in a ledger.

A small bakery sells 1,000 loaves a week at $5 each. Revenue is $5,000. The flour, yeast and packaging cost $1,200. The baker and two employees cost $2,300 in wages. The rent and utilities are $900. Together the costs are $4,400, and the profit is $600, a margin of 12 percent. In the language of the economy, the bakery has just received a message: keep going, the town wants more of what you are doing. The bakery's own response might be to buy another oven or hire another baker. Other would-be bakers, noticing that bakeries make money, may open their own. The extra supply pushes the price down toward the cost, and customers benefit.

Now change one number. Suppose the flour price rises, or the town's tastes shift toward a different kind of bread, and costs become $5,300 against the same $5,000 of revenue. The bakery now loses $300 a week. That is a message too, and it is just as useful: the resources you are using are worth more somewhere else. The flour, the labour and the oven time could be making something people value more than this bread at this price. The baker must change, cut costs, find a better product, or close and let the resources go where they are wanted.

That is the entire system. It is a thermostat. Profit says add heat, loss says turn it down, and the thing that is being regulated is the use of every scarce resource in the country.

What Mises saw

The Austrian economist Ludwig von Mises made the point sharply in his big treatise, Human Action. Profits and losses, he argued, are how consumers instruct entrepreneurs. A businessman who serves the public well earns a profit and gains more capital to command; one who serves it badly takes losses and loses control of capital. The consumers, by buying or not buying, decide who runs the factories. In his essay "Profit and Loss" he described the same idea as a daily repeated plebiscite, and I think the comparison is a good one: the economy holds an election every time you walk into a store, and the candidates are the products.

Mark what follows from that. The system does not depend on the wisdom of any one person. The entrepreneur may be mistaken, and many are. What matters is that mistakes are expensive to the person who makes them and so they get corrected, while good ideas are rewarded and so they spread. A loss is not a punishment. It is a redirection. It says to the entrepreneur: you are wasting something that is needed elsewhere. For more on how prices carry this information, and what happens when committees try to replace them, see a thought experiment where every price in town is set by a committee.

Margins differ, and that is the point

A common trick in the coverage is to quote a big profit number without telling you what it is a percentage of. Profit in dollars is not the useful figure. The useful figure is the profit margin, the profit as a share of revenue, and it varies enormously from one kind of business to another.

Grocery retail is a famously thin-margin business. A supermarket chain typically keeps only a few cents of net profit from each dollar of sales, often in the range of one to three cents. Software is at the other end: a company that has written a program can sell the next copy at almost no added cost, so mature software firms often report net margins in the neighborhood of fifteen to twenty-five percent. These are broad patterns, not exact figures for any year, and anyone who wants the current numbers should look at company filings.

Why does this matter? Because the difference tells you something. A grocery store's margin is thin because the business is easy to enter, competition is intense and customers compare prices at a glance. A software firm's margin is higher because the costs are front-loaded, the successes are concentrated, and many software ventures lose everything. A high margin, in other words, is a signal too. It says: this is a place where someone is serving customers unusually well, or where entry is hard. High profits attract competitors. Low ones repel investment. A reporter who says "grocers make a fortune off your food" has multiplied the dollar figure and forgotten to divide by the revenue.

Failure is a feature

Now the part where people get uncomfortable. If profit tells a firm to grow, loss tells it to shrink or die. And firms do die, constantly. Some famous names make the lesson clear.

• Borders, the big-box bookseller, filed for bankruptcy in 2011 after a decade in which readers moved to online retailers and e-books.
• Blockbuster, which once rented movies from thousands of stores, filed for bankruptcy in 2010 as streaming and mail rentals took over its customers.
• Kodak, a giant of film photography, filed for bankruptcy in 2012. It had invented an early digital camera in the 1970s, but its business stayed tied to film.
• Circuit City, a leading electronics retailer, liquidated in 2009.

Every one of those failures was a loss for owners and a painful moment for employees, and I do not make light of that. But think about what the loss did. It told the economy that the stores, the staff, the property and the money tied up in them would do more good elsewhere. The people moved, the buildings were reused, the capital went into things customers wanted. The alternative, in which the government declares these firms too important to fail and keeps them alive, is how you end up with a country that keeps paying for the last decade's idea. The longer story of why this churn is the engine of growth is told in Creative destruction, why the buggy whip makers lost and America won.

The steelman

Let me give the other side its best shot. The critic of the profit system says that profit does not measure value, only willingness to pay, and willingness to pay depends on how much money one has. A company can make a fortune selling something frivolous to the rich while a real need goes unmet because the people who have it cannot pay. Profit, he says, also ignores costs that fall on others, such as pollution. And profit-seeking can lead firms to cut corners, mislead customers or squeeze workers.

Those objections have some force, and a conservative should answer them rather than shrug. Here is my answer in four numbered points.

1. Willingness to pay is the only measure that respects the person. If you do not use it, someone else has to decide what you "really" need, and then he will be spending your money on his judgment. That is a worse arrangement for the poor, not a better one, because the people with the authority to decide are never poor.
2. The poor are served by profit more than anyone. Cheap clothes, cheap food, cheap phones and cheap transport came to ordinary families because firms found it profitable to serve a mass market. The profit motive pushes firms to make things that millions can afford.
3. Costs imposed on others are a real problem, and the answer is law, not abolishing profit. Property rights and the courts exist so that a firm that dumps its waste on your land pays for it. That is the common law at work, and it is the reason a rule of law is part of the case for markets.
4. Cutting corners gets punished. Customers leave, reputations collapse, lawyers appear. The firms that last are the ones that earn trust.

The contrast: programs that grow when they fail

Now take the same logic over to the other side of the ledger. A private firm that fails shrinks. What does a government program that fails do?

It grows. Here is the pattern, and I would invite you to test it against any program you can name. A program is launched to solve a problem. The problem does not go away, or goes away only partly. The advocates declare that the program has been underfunded. Its budget rises. The problem is still there, so the budget rises again. Nobody in the chain has anything riding on the result. The administrator's budget, and with it his rank, depends on the problem staying alive.

There is no profit-and-loss statement for a government agency, so there is no signal that says: you are wasting resources. The agency's measure of success is its own size. If a bakery that lost money every week kept getting bigger because it lost money, you would call it a madhouse. We have an entire federal government that works on that principle. The railroad that has needed subsidies since the day it was created is discussed in Solyndra to Amtrak, why government picks losers when it picks winners, and the way a baseline can make a smaller increase look like a cut is explained in baseline budgeting, where a smaller increase gets reported as a cut.

I would put it this way, and I think the joke has a point: if the government ran the bakeries, we would have a Department of Bread, a Bread Task Force and a Bureau of Loaf Equity, and the loaves would cost more each year, with a press release explaining that the bread crisis proves we need more bread funding. And when the bread ran out, the head of the Department would testify that he needed a larger budget to prevent the next shortage. What he would not be able to do is close the bakery that nobody wants to use. No signal would tell him to.

The Founders and the logic of consequences

There is a constitutional echo here, and it is worth hearing. The Founders did not design a government that relied on good men being in charge. In Federalist No. 51, Madison wrote that ambition must be made to counteract ambition, which is to say that the system should make the self-interest of each official a check on the others. The market works on the same principle: it does not rely on virtue, it harnesses self-interest to serve others, because the only way to profit is to give a customer something he wants. A government with no profit test lacks that discipline, and the Founders compensated with elections, separated powers and budgets that Congress must approve. When those checks weaken, the waste follows. For a look at how heavy rules reward the biggest firms, see big companies love the regulations their small rivals cannot afford.

I will add one note of fairness. Government has jobs that markets do not do well, starting with defense and the courts, and no one can measure the profit of a lighthouse. My point is not that every public function should be run for profit. It is that when a function leaves the market, it leaves the signal behind, and we need to ask what replaces it. Too often the answer is nothing.

What to do with all this

Next time you hear that a company "made billions," ask three questions. What was the margin? What did customers get for the money? And what would the alternative be, a world in which that company made no money and the resources it used went to someone with a worse idea? Ask the same questions about a federal program, and you will find that the margin is not defined, the customers are not asked, and the alternative is never considered.

The case in brief

1. Profit is what remains when customers' willing payments exceed the cost of the inputs; it is evidence of value created, not value taken.
2. Loss is the matching signal, telling firms and investors that resources are better used elsewhere, which is why failures like Borders, Blockbuster, Kodak and Circuit City, though painful, served a purpose.
3. Margins differ widely, roughly a few percent in grocery retail and far higher in software, so a dollar figure without a margin is a headline, not an argument.
4. Government programs have no profit-and-loss test, so failure produces bigger budgets rather than correction.
5. The remedy is not to abolish profit but to protect property, enforce the law against those who impose costs, and ask of every public program what signal it would receive if it were failing.

What you can do: choose one federal or state program in your area, find its stated goal in its own budget documents, and write to your representative asking what measurable result would cause the program to be reduced.