Profit or loss is working to add more value, and seeing customers decide

Return on assets of US firms shows profit or loss offers on average little margin for error

Return on assets of US firms [1]

Profit or loss means buying low now and selling high later, using capital and labor to add value

The activities of the entrepreneur consist in making decisions. He determines for what purpose the factors of production should be employed.[2]

The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest. The difference between the general interest rate and his actual return is his… profit…

Profit or loss measures net value added compared to all other value-adding

Every entrepreneur… invests in a process because he expects to make a profit, i.e., because he believes that the market has underpriced and undercapitalized the factors in relation to their future rents. If his belief is justified, he makes a profit. If his belief is unjustified, and the market, for example, has really overpriced the factors, he will suffer losses.

…profits are an index of maladjustment, but in a sense precisely opposed to that usually meant. …profits are an index that maladjustments are being met and combatted by the profit-making entrepreneurs. These maladjustments are the inevitable concomitants of the real world of change. A man earns profits only if he has, by superior foresight and judgment, uncovered a maladjustment—specifically an undervaluation of certain factors by the market. By stepping into this situation and gaining the profit, he calls everyone’s attention to that maladjustment and sets forces into motion that eventually eliminate it. [3]

Profit or loss is finally booked when customers agree to final prices and quantities

…entrepreneurs… are unconditionally and totally subject to the sovereignty of the buying public, the consumers.

The consumers by their buying and abstention from buying elect the entrepreneurs in a daily repeated plebiscite as it were. They determine who should own and who not, and how much each owner should own.

Each ballot of the consumers adds only a little to the elected man’s sphere of action. To reach the upper levels of entrepreneurship he needs a great number of votes, repeated again and again over a long period of time, a protracted series of successful strokes. He must stand every day a new trial, must submit anew to reelection as it were.

Profit and loss are the instruments by means of which the consumers pass the direction of production activities into the hands of those who are best fit to serve them.[2]

It is the consumers… who make the decisions for the economic system. The consumers, through their buying and abstention from buying, decide how much of what will be produced, at the same time determining the incomes of all the participating factors. And every man is a consumer.[3]

  1. Hagel, John, et al. 2016 Shift Index. The paradox of flows: Can hope flow from fear? Deloitte University Press, 2016, p. 26.
  2. Von Mises, Ludwig. Planning for freedom, and twelve other essays and addresses. 3rd ed., Libertarian Press, 1974, pp. 108-150.
  3. Rothbard, Murray N. Man, economy, and state with power and market. 2nd ed., Ludwig von Mises Institute, 2009, pp. 509-516.

Profit option signals are generated by activity-based costing (ABC)

The hierarchy of factory operating expenses show profit option signals

The hierarchy of factory operating expenses

Profit option signals from allocating costs to where value is added

The gross numbers on corporate financial statements… represent the aggregation of thousands of small stories about bow the company designed, produced, and delivered its products, served customers, and developed and maintained brands.

  • Some activities like drilling a hole or machining a surface, are performed on individual units.
  • Others – setups, material movements, and first part inspections – allow batches of units to be processed.
  • Still others – engineering product specifications, process engineering, product enhancements, and engineering change notices – provide the overall capability that enables the company to produce the product.
  • And plant management, building and grounds maintenance, and heating and lighting sustain the manufacturing facility.

…managers need to distinguish the expenses of direct labor, direct materials, and electricity, which are consumed at the unit level, from the expenses of resources used to process batches or to support a product or a facility. Batch- and product-level expenses can be controlled only by modifying batch- and product-level activities.

Profit option signals from unit, batch, product, and facility costs

The example of a large equipment manufacturer with a machining shop containing dozens of numerically controlled machine tools shows the important distinction in emphasis between traditional cost systems and ABC analysis.

A detailed ABC analysis revealed that more than 40% of the department’s support resources were not used to produce individual product units. The company developed five new drivers of overhead resources:

  1. setup time,
  2. production runs,
  3. materials movements,
  4. active parts numbers maintenance, and
  5. facility management.

The first three related to how many batches were produced, the fourth to the number of different types of products produced, and the fifth to the facility as a whole rather than to individual products.

For a simple drive shaft, for example, the traditional system had allocated $13.38 of factory overhead to every 100 units. For the 8,000 units actually produced, the allocated overhead costs were $1,070. In contrast, the ABC system signaled that production of the shaft consumed about $1,700 of unit, batch, and product-sustaining support resources.

The heavy equipment manufacturer in our example recognized that its low-volume products were a drag on profits. To avoid outsourcing all of the low-volume products, the division opened a special low-value-added job shop.

It went from a single facility producing a broad mix of products to two focused facilities: one for high-volume products and the other for low-volume products.

Profit option signals guide repricing, resource saving, and resource management

Managers should take two types of actions after an ABC analysis.

First, they should attempt to reprice products: raise prices for products that make heavy demands on support resources and lower prices to more competitive levels for the high-volume products that had been subsidizing the others.

Second, and more important, managers should search for ways to reduce resource consumption. Reducing resource consumption gives managers an opportunity to boost profits.

…management can use the freed-up resources to increase output, which in tum generates more revenues. …management can eliminate or redeploy resources periodically to bring spending down to the new lower levels of resource consumption.

….management must take some action to capture the benefits from the signals ABC analysis sends.

  1. Cooper, Robin, and Robert S. Kaplan. “Profit Priorities from Activity-Based Costing.Harvard Business Review 69.3 (1991): 130-135.

Profit means satisfied customers and investors

Revenue, taxes, expenses, and profit are graphed vs. production rate, and break-even point and shut-down point are identified.
Profit is net income after taxes.
(FIT is corporate federal income tax.) [1]

Profits… resulting from the relationships of costs to prices, not only tell us which goods it is most economical to make, but which are the most economical ways to make them.

…profits… put constant and unremitting pressure on the head of every competitive business to introduce further economies and efficiencies…

…the prospect of profits decides what articles will be made, and in what quantities—and what articles will not be made at all. If there is no profit in making an article, it is a sign that the labor and capital devoted to its production are misdirected: the value of the resources that must be used up in making the article is greater than the value of the article itself.

…profits… guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand.

The total profits of General Motors… are taken as if they were typical rather than exceptional.

Profits actually do not bulk large in our total economy. The net income of incorporated business in the fifteen years from 1929 to 1943, to take an illustrative figure, averaged less than 5 per cent of the total national income.

…what government officials would undoubtedly regard as “excessive” or “unreasonable” profits… would not only cause every firm in that line to expand its production to the utmost, and to reinvest its profits in more machinery and more employment; it would also attract new investors and producers from everywhere, until production in that line was great enough to meet demand, and the profits in it again fell to the general average level.

Few people are acquainted with the mortality rates for business concerns. They do not know… that “should conditions of business averaging the experience of the last fifty years prevail, about seven of each ten grocery stores opening today will survive into their second year; only four of the ten may expect to celebrate their fourth birthday.”

…any individual placing venture capital runs a risk not only of earning no return but of losing his whole principal.

…over a long period of years, after allowance is made for all losses, for a minimum “riskless” interest on invested capital, and for an imputed “reasonable” wage value of the services of people who run their own business, no net profit at all may be left over, and that there may even be a net loss. …optimism and self-confidence too often lead… into ventures that do not or cannot succeed.[2]

  1. Couper, James Riley. Process engineering economics. Marcel Dekker, 2003. p. 256.
  2. Hazlitt, Henry. Economics in one lesson. Harper & Brothers, 1946. pp. 168-172.