Greed is Good? Think again, says Drucker
While "profit" is essential, writes Dr. William Cohen in this week's "Lessons from Peter Drucker", profit maximization is not the only purpose of a business. Indeed, it can even be bad for society and hazardous to our organization’s health. Here's why.
The purpose of a business is not to make a profit. I heard Peter say a lot of strange things when I was his student, but this has got to be one of the most unusual that I’d heard up to that time. I think most of my Drucker classmates agreed. Indeed, until Drucker came along most everyone believed the basic "fact" that the purpose of a business was to make money. That is, to make a profit.
This belief leads to a corollary, another myth, believed by all --- that is, that the goal of any business is profit maximization. In other words, whatever your business, your goal should be to make as much profit as possible. If you accept making a profit as a business’s purpose, the second part just follows naturally. This might even seem worthy to many. To quote Michael Douglas’s famous (or infamous) statement in his role as Gordon Gekko in the 1987 movie Wall Street: "Greed is good."
Even today many "know" greed, or profit maximization to be the correct prescription for business success, even if it is amoral or shouldn’t be "good" from a moral perspective. Not so fast, Gordon.
As Drucker so often said, whatever everyone knows is usually wrong, Hollywood films not excepted. Drucker told us first that profit is not the purpose of business and that the concept of profit maximization is not only meaningless, but dangerous.
The Myth of Profit Maximization and Why it is a Dangerous Fallacy
Drucker explained that the source of the confusion was that many economists consider profit maximization a basic theorem. In its simplicity it is simply another way of saying that a business buys low and sells high. However, as Drucker pointed out this simple prescription by itself, hardly explains the success or failure of any business. If we look at the difficulties as many businesses struggle today, and the many failures that have already occurred, it is clear that buying low and selling high explains very little about why these businesses fail, just as buying low and selling high explains very little about those that are still successful, and even those that are accelerating their success despite the current economic challenges of the day.
Profit maximization implies that you might save any business from failure by simply raising prices and creating a greater differential between revenue and cost, that is, maintain (or increase) the profit margin. In fact, as costs to business rise, be they gasoline, material, or anything else, this is the immediate and simplistic response of many businesses. Yet they still fail, or succeed, independent of the act of raising prices, and passing any increases on to the ultimate consumer may not be the determining factor. For example, I was told that a local restaurant recently failed due to the rising cost of produce. Yet other restaurants in the same general area serving the same target market have not failed. In fact, some are thriving and even increasing sales.
Drucker also called the "profit motive" into question. He claimed that there has never been any evidence for such a motive, and that the theory was invented by classical economists to explain a reality which their theory of economic equilibrium could not explain.
In support of his contention, there is considerable evidence against the profit motive. So called "dollar a year men" in the higher levels of government are examples which run contrary to the profit motive. But we don’t even need to look that far or that high up in management. A good deal of volunteerism in which individuals, some quite highly paid in other roles others not, work long, hard, hours for the common good in the Boy Scouts and Girls Scouts, religious and community activities and services, and more. They work and don’t get paid a penny. Moreover, few can doubt that many talented individuals knowingly choose occupations which are less financially rewarding due to their personal interest or calling guidance counselor to the Peace Corps. From this we can conclude that while profit can be motivating, it need not be the primary motivator and the notion of maximizing profit as the goal for a business or the life purpose of an individual is at best overstated.
Drucker pointed out that the danger is that we might think from all this that profitability in itself must be a myth, so why worry about it? It might even lead us to the mistaken belief that seeking profit in business or privately is not only a waste of time, but immoral. In fact, every time there is moral failure on the part of an Enron, or a business thief such as Bernard Madoff is exposed, we hear new cries to develop laws to protect us not just from illegal acts and lapses of morality, but from those who seek "excessive profits," and to punish and discourage perpetrators wherever possible. Some even question the basic principles of capitalism and whether profits are really necessary at all. As a result, the profit motive is worse than irrelevant. It does harm because it creates hostility to earning a profit which Drucker called "the most dangerous disease of an industrial society" causing some of the worst mistakes of public policy and the notion that there is an inherent contradiction between profit and an organization’s ability to make a social contribution when actually a company can only make a social contribution if it is highly profitable.
Drucker said considering profitability is a myth is the great danger because profitability, far from being a myth, immoral, or unneeded it is crucial for the success of both individual businesses and for society. In fact, he considered profit (as opposed to profit maximization) even more important for society than for an individual business.
Why Profit, but not Profit Maximization is Necessary
Profit and profitability are absolute requirements. That’s why even non-profit corporations must strive mightily for profitability. However, this does not mean that profit is the basic purpose of a business. Profitability really is an essential ingredient by itself which might be better spoken of in terms of an optimal, rather than a maximum size. In support of this thesis, Drucker noted that the primary test of any business is not the maximization of profit, but the achievement of sufficient profit to allow for the risks of the financial activity of the business, and thus to avoid catastrophic loss leading to failure. And we might add, achieve the success which would benefit both the business and society. So profit is necessary, but not the purpose of business.
Why is profit so necessary? Because profit is like oxygen for the human body. Without oxygen, the body cannot survive. Oxygen insures that the body lives, survives, and grows. Without it, the body dies. The same is true of profit for a "business" whether incorporated as for profit or non-profit under the law. Oxygen supplies the body with needed energy. According to Drucker, profit supplies the business with energy by supporting two basic functions: marketing and innovation. Only a business action can create a customer, and that means innovation, advertising, salesmanship, strategy, service, you name it, and these business actions cost money which come from the difference between buying low and selling high.
Some months ago a corporate CEO was attacked for the "unconscionable profits" made by his company. He pointed out that 90% of the so called "unconscionable profits" were actually re-invested in the corporation in research and development and marketing. Assuming the accuracy of his estimates Drucker would have probably agreed with the response of this CEO.
It is the right amount of oxygen that the body needs. Too much oxygen can cause damage to cell membranes, the collapse of the alveoli in the lungs, retinal detachment, and seizures. Too much profit, that is profit maximization without consideration of other elements in the business’s equation, like too much oxygen, can cause problems just as too little profit. If the focus is solely on profit maximization, the customer can be ignored or given secondary consideration. This can lead to poor management decisions resulting in cutting corners on safety, service, or product performance. We have seen this recently in many industries, including pharmaceutical, aviation, and automotive. In truth these bad decisions due to a profit maximization focus can and do occur in all industries.
If profit maximization drives the company purpose, it can allow competition with a different focus to win markets by providing greater value or charging less. Profit maximization can cause organizational toxicity in the same way that oxygen toxicity can damage the body.
What Should the Purpose of a Business Be?
According to Drucker, there is only one valid purpose for a business, and that is to create a customer. This is because as Drucker wrote, "The customer is the foundation of a business and keeps it in existence. He alone gives employment. To supply the wants and needs of a consumer, society entrusts wealth-producing resources to the business enterprise."
What has this to do with you or me? Regardless of our organization and whether it is profit or non-profit, Drucker’s truth holds. If we want our organization to be successful we have to remember that while "profit" is essential to support innovation and marketing actions, profit maximization is not the only purpose of a business. Indeed, it can be bad for society and hazardous to our organization’s health.