What could be more central to business than profits? For-profit businesses have a goal to make profits by definition. As such, you might think that we all had a pretty good shared idea of what profit is. Of course, you would be wrong. Profit measurement is surprising open to interpretation. You can often choose your own level of profit.
Do People Really Agree Profit Is A Vague Term?
If you aren’t sure I’m right have a quick think about those who maintain that business is only about the money. What do followers of Milton Friedman say the objective of business is? (Before this gets too controversial this post isn’t about whether they are right or wrong but just their terminology). The phrase they use is that for-profit firms should “maximize shareholder value’. To be clear they could use the phrase that for-profit firms should maximize profits but they don’t. Why? Because everyone knows the idea of profit is a mess.
Good And Bad Profits?
Profit means different things at different times to different people. Indeed, Fred Reichheld‘s critique of the way marketing is treated claims that there are two types of profits — good and bad profits. Good profits being those that are sustainable, and bad profits being those that destroy future value.
Bad Profits Are Not Profits
I totally agree with Reichheld’s aim but his terminology is a problem. I would say that many bad profits aren’t really profits at all. They are just mistakenly called profits. Instead they are just reducing assets. You don’t call it a profit when you sell your car for less than it is worth. You call it a loss. A lot of what might be classed as bad profits are simply losses confusingly accounted for.
Why Would Profits Differ Depending Upon Who You Ask?
Maybe you aren’t totally on-board with my comment about bad profits not being profits (yet). But you should recognize that different people look at profits differently. Why is this the case?
Profit measurement is a human activity. Different choices will give you different numbers. This can sometimes have very different implications for a for-profit firm.
I am going to look at five different ways to look at profits.
Five Ways to Look At Profits
- Managerial Accounting Profit
- Financial Accounting Profit
- Marketing Account’s Profit
- Full Economic Profit/Opportunity Cost Accounting
Each has their own advantages. (One approach is mine so expect me to cheerlead for that). As such, you should always be clear when someone says profits which of the five options (or others I haven’t noted) they are choosing.
1: Profit Measurement Using Contribution
Take an introductory economics class and you will quickly encounter the idea of contribution. It is a neat idea and theoretically it works wonders. This means you will see it a lot in economic models.
The logic behind contribution is sound. See an earlier discussion on contribution here. It is also in our Marketing Metrics book.
“Contribution represents the proportion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs.”Bendle, Farris, Pfeifer and Reibstein, Marketing Metrics
Contribution and Sunk Costs
The idea behind contribution is simple. It looks at what changes with each sale — costs and revenue. You can then say how profitable each sale was. Contribution ignores any sunk costs. These are costs that are not relevant to the decision you are making because they do not change with the decision at hand. Thus, using contribution is great in the short term. Should I make a single sale to a single person that won’t impact anything going forward? Use contribution.
The Challenge With Contribution
The challenge is that in the long term there are many costs that are irrelevant to any single decision that must become relevant to some decision at some time.
Sure, absent bonuses, staff costs won’t change with any single sale but at some stage you have to account for the staff costs somewhere.
Contribution is a great start to understanding profit but it loses its value when scenarios become more complicated. Especially when you are trying to look at the profitability of an entire firm.
2: Profit Measurement In Management Accounting
Management accounting is the discipline that aims to help managers understand their businesses. As such you would expect managerial accountants to have their views on profitability and they do.
Given managerial accounting can be whatever people want it to be there isn’t a single formula That said, if I may simplify a bit, the managerial accounting view might be termed the profit you get after applying all the relevant costs you learned in your cost accounting courses. (If you missed these I promise you missed a lot of fun).
How To Find Full Costs
You find the full cost of a sale through allocating all costs. This will include allocating things like the electric bill and headquarters cost to each product according to some sort of fair allocation system. To be clear this is really hard, one might even say impossible, so no one is ever happy.
You can then see how much money each product/unit etc.. makes.
What Is Wrong With Managerial Accounting?
Theoretically this works and can even work for small product ranges. The main challenge is that often as we get to higher levels of the firm management accountants lose their nerve. They often don’t link their product level analysis up to the firm level. They typically don’t get into full balance sheets. When looking at the full firm we often find management accountants defer to external reporting rules ignoring everything they normally say about relevance and proper allocation. To be clear management accountants shouldn’t do this. But being human it makes their lives easier if they use the same rules as their financial accounting colleagues when looking at more aggregated views. So managerial accounting usually is most useful for individual profits and seems to lose its way looking at firm-level profits.
There are also challenges when you account for profits at the product level. This can encourage you to drop products that are vital to a customer relationship. For more on seeing the customer, rather than the product, as the source of profit see here.
3: Profit Measurement In Financial Accounting
Most probably mean financial accounting profit when they say profit. This is profit that accounting rules, GAAP, allows to be recognized. (It might be worth adding another type of profit — taxable profit — which is profit the tax authorities recognize. This often gets quite a bit out of whack with financial accounting profit but that is another story.)
Financial accounting profit isn’t really that meaningful as a decision aid for managers. (Hence why managers at for-profit firms do not seek to maximize it).
“Simply put, earnings no longer reliably reflect changes in corporate value and are thus an inadequate driver of investment analysis.”Gu and Lev, 2017, page 25.
Why Isn’t Financial Accounting Profit Useful For Managerial Decisions?
There are any number of ways financial accounting classifies things that clearly depart from economic reality. There are often reasons for the choices that financial accountants make. A classic reason, that clearly has some validity, is to limit the opportunity for managers to cheat. That said, the sort of strange, we might call them defensive, choices financial accountants make do make the profit numbers they present a poor guide to how a firm is doing.
Accounting profit is not economic profit. It isn’t meant to be. If you are trying to maximize economic profit then don’t use information uncritically based upon the external financial statements.Neil Bendle
The challenge for marketers is that financial accounting does an especially poor job of accounting for marketing. If you look at financial accounts you will often be left with the impression that marketers are doing nothing. The profit reported by financial accounts is thus often a pretty terrible take on firms that do a lot of marketing. The reported profits are also not-useful for firms that rely on other similarly hard to account for assets, see here, here and here. If you are a marketer financial accounting profit is likely to make you want to cry.
4: Profit Measurement In Marketing Accounts
My paper with Xin Wang offered a solution to the financial accounting view of the firm. What we called Marketing Accounts are really just management accounts designed to highlight the full contribution of various assets to the firm. Marketing accounts are management accounts as they are controlled and for the use of management not investors. They do not come under the same financial accounting rules that statements made to investors do.
The full text of this research article is available free of charge here (thanks to SSHRC/the Canadian government).
A key difference between financial and marketing accounts is that the matching principle – a central pillar of accounting — is applied much more consistently in marketing than financial accounts. (Financial accounts tend to sacrifice matching to avoid the chance of overstatement of values. Given marketing accounts are internal documents we advocate using the expected value of an asset. this accepts the risk of overstatement to limit the damage done to managerial decisions by understatement.
If a marketing investment creates a marketing asset, then this asset’s value should be accounted for rather than simply pretending it wasn’t an investment and no asset was created.
If we account fully for all assets this means that marketing investments are accounted for as investments, not costs. This changes reported profit. This gives a more accurate figure for profit.
5: Profit Measurement Including Opportunity Cost
This is when things get really weird. While our marketing accounts gives better profit numbers a strong rejoinder is that profit is only really what occurs when you do better than your alternative options.
So investing in something only generates a profit if it gets a better return than other options you could have invested in. You should account for the opportunity cost — other options you had to forego to make the investments — and remove this alternative option value before declaring a profit.
This is theoretically sound. Unfortunately it runs into the need to find what the other options were. Narrowly we might compare to just a small set of options but why? If you are a retailer why not compare your investment to investing in a new space flight, or taking over planting coffee beans, or what you could make in the illegal drug trade. (Maybe we can rule that last one out). The point is that this gets really hard really quickly. Worrying about opportunity cost isn’t wrong, theoretically, it is superior. Just doing so is so hard you might want to limit your ambition and focus on a tighter definition of profit.
Summary: Profit Is Tough
I don’t mean earning a profit in business is hard, though it can be. The main point here being that judging profit is really hard. One has so many options this allows those stating profits to heavily influence what they report. When someone mentions profit, ask them what they mean. Likely many don’t really know.