Why don’t businesses profit maximise?

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I've been asked why businesses do not profit maximise (see my earlier post in which I said this).

There are several reasons, but I'll try to keep things straightforward. First of all, there are two concepts of profit. There is 'accounting profit' and there is 'economic profit'.

Dealing with accounting profit first, under historic cost accounting this was generally considered to be the sales of the business less expenses such as wages, raw materials, overhead costs, interest on loans and depreciation. But this has now been laid aside and we do instead have "fair value accounting" as promulgated by the International Accounting Standards Board. In this the terms income and expense are changed so that they now mean:

  • Income. Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
  • Expense. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Which is, of course glaringly obvious but basically means that the entire logic of accounting has been reversed. Profit used to be measured in the profit and loss account and the balance sheet showed what was left over. Now, balance sheets are measured and the profit and loss account is the difference between two balance sheets - and since the basis on which balance sheets are now measured has also changed enormously, profit and loss accounts under the old and new systems are almost impossible to compare. This, by the way, is nothing new. Under historic cost rules the revaluation of assets or any inflation also meant that adding up so called similar pounds, dollars or euros was, over time, meaningless since each had a different value when it was incurred.

All of which means that almost no one has any real clue what an objective measure of profit is in accounting terms any more. Then add two further complications; the first being that taxable profit is not the same as accounting profit because accounting profit is always adjusted for tax purposes. And finally, when we're talking of accounting profit it's quite important to note that a distinction has to be drawn between that of a company and that of a group of companies. A company is usually reasonably easy to identify (but there are exceptions). A group is a lot harder to identify. For example, not everyone agrees on who owns some companies. I have recently seen the case of a subsidiary worth billions being consolidated into the accounts of two quite separate groups since the company was deemed to be owned by both - which cannot have been true! Furthermore, consolidated results are, quite frankly, a work of fiction. Transactions between all group companies and the rest of the world are supposedly reflected, with assets and liabilities shown, but very often the group has no overall responsibility for those liabilities, and many of the profits may be hidden far away from places where they could be paid to shareholders, so this adds yet another confusion to accounting profit as despite these anomalies (and the fact that no one knows what happens within the group) it's these accounts that usually go to the shareholders.

And then we turn to economic profit. That might be said to arise when when its revenue exceeds the total opportunity cost of its inputs - but that explicitly requires knowledge of two things. The first is the future, since alternative uses of inputs in the future have to be appraised to come this assessment and secondly externalities must be known (i.e the impact of the activity on third parties affected by it even though they have no contractual relationship with the company) and that then requires consideration of how this might be accounted for or be compensated.

Innumerable problems remain in all those definitions which there is not time to consider here. But the messages are clear:

  1. there is no one concept of profit;
  2. there is no one measure of profit even when the concept is agreed;
  3. within any measure there are conceptual problems in applying any yardstick.

Which means:

  1. profit maximising is not possible, because profit cannot be determined;
  2. if profit cannot be determined then to pursue it is irrational;
  3. people actually know this and so substitute other (easier to understand) aims such as sales growth, rule manipulation (such as increasing earnings per share, which is much easier to comprehend than profit maximising), or in the case of smaller business in particular they strike a work life balance. In larger business that's represented by a broad vector of aims - and curiously you'll find this is exactly what is reflected in 'mission statements' - not one of which I have ever seen say 'we're in this profit and nothing else' - which is what they should is the business school mantra was true.

So, that's why people don't and can't maximise profit.