The Downside of Profit

Strategy means achieving a good profit at a strong and steady free cash flow! Is there a potential downside on this approach? Do high profit and free cash flow have the potential to have a negative impact on societies and companies? 

On the first sight I want to answer: No! Of course not! Profit and free cash flow is the catalyst of companies and societies! No profit, no economy! But fortunately I did not listen to my first reflex and slept over. The truth is I spent a night thinking the question over. In the morning it was clear that a proper approach to answer is not that easy as I thought it was at first sight.

Why? Because the answer differs regarding the perspective you are taking. If you are an individual worker in a factory the answer might differ from the company owner’s one. So we should consider at least two major perspectives on the question: a societal and an entrepreneurial point of view.

1. The societal Impact of Profit and Free Cash Flow 

A couple of years ago Austrian chamber of commerce had an advertising campaign promoting: „Does economy well, all of us are doing well!“. And somehow this made sense to most of us. A well doing economy provides jobs and reduces unemployment, companies are paying taxes on profits and have motivation to invest to create more jobs and pay more taxes. A very simplified picture but it shows the principle quite well.

So identifying the benefits of high profits and high cash flows is easy: It’s about stability and safety for entrepreneurs as well as for employees, it’s about taking a responsible role in society and contributing a share of the profit to the public, it’s about investing in human resources and infrastructure, etc. I don’t want to go into the details of that because you can read any aspect of this thinking from economists of the 20th century like Friedman, Hayek and many, many others.

To identify the downside of profit and free cash flow on society we have to dig a little bit deeper and understand the nature of a capitalistic and competition driven systems:

1. What is the idea of competition? To win! 
2. What means to win in an market environment? To conquer the market and ideally create a monopoly. 
3. What to do with a monopoly? To control the price and the margin of the offer! 
4. What is the downside on society? To lose efficiency by losing the best offer! 

We realize these tendencies and an increasing number of oligopoly structures in plenty of industries where we have seen and still see rapid market consolidation. Examples are telecom, steel, oil&gas, mining, banking, food, etc.  The effect is that the consumer is losing buying power through the increased margin of the offer. And to increase margin and profitability is a necessary procedure to increase the profits and the cash flow. There’s an exchange of money and the higher the margin, the worse the deal becomes for the consumer and the better for the entrepreneur.

If we consider that the industries where we see the highest pace of consolidation are mostly providing commodity goods as food, petrol, telecom and banking services, we will see that most of these offers are at the very bottom of Maslow’s pyramid. Needs which have to be fulfilled at very beginning when you get your monthly pay cheque. And this means that the high profit and stable cash flows of these industries drain money out of individuals, markets and society.

A great (although slightly populistic) illustration of this tendency is the development of the wealth of the Forbes-List-billionaires compared with the development of private debt in Europe and US. Both increased significantly over the last few years and the development is accelerating.

This acceleration is stimulated by a second very negative impact on society in our „Create Profit and Cash Approach“:

To produce profit and cash you have two options: To create revenue at a high margin and to save cost. If you are an excellent manager you will have an eye on both. The matter about the margin we have already addressed.

Let’s have a look on the cost. In most of organizations the biggest portion of operating expenses is labour cost. The cash you pay to your employees and on employment taxes. And for any manager this is the easiest approach to increase profits short term: to reduce labour cost. Beside the impact on the individual which gets paid less or gets laid off, this has an enormous downside on society. The increased efficiency is eating our society.

These workers will spend less in the consumer-markets and this progress will force companies to become even more efficient. It’s a self-fulfilling downward spiral!  If the workers are laid off the increase of public unemployment cost and and the cost of securing social security rise. When the cost of unemployment and social security rose, taxation will rise as well. And this forces companies again to become more efficient. With the catalyst of the previously described market consolidation – which are always „synergy and cost reduction driven“ – we create a rapidly moving downward spiral.

The ultimate problem of this development is that the whole capitalistic system we are living in is based on consumer markets. Consumption is the fuel of our present global society. And we are reaching a phase in European and American history where we are already monitoring a decrease in private spending and in these cases where spending is still happening it is often based on high private debt and high risk.

The subprime-mortgage-crisis of 2008 is an excellent example how fragile the balance of private debt and consumption and its financing already is. During the crisis it became clear that a huge percentage of all the US house owners cannot effort their lifestyle. For the real estate markets this means that the consumer market they face today is nothing else than a fiction created by the necessity of banks to sell loans and mortgages. Today we know that approximately 20 percent of all the house owners in the Untied States do neither have the credit rating nor the liquidity to purchase the real estate they are „owning“.  This is an artificial market which is artificially stabilized. But it is neither healthy nor sustainable. It is a symptom of our „live-now-pay-tomorrow“ society which is visible on individual, entrepreneurial and public level. The problem we might face is: Tomorrow is coming for sure and there might be significant corrections.

Summarizing these arguments we can say that profits always carry an inherent problem of distribution. The profit of an entity is always on the cost of another entity. And through an imbalance of market power we face more and more the problem that the system gets out of balance.

Increasing the efficiency of labour cost means nothing else than changing the distribution of created value from the employee to the company. Increasing taxes means nothing else than changing the distribution of the gross domestic product.

In a darwinistic system – as capitalism is by its nature – this means that over the time the distribution of wealth is accumulating with the strong entities. The ones who are positioned better to enforce their interest are succeeding in this competition for profit and cash.

And this creates an increase of inequality within society which is a natural threat for peace and freedom. I consider Arab Spring, Occupy Wall Street and even Islamic State or the German Pegida movement as mainly driven by inequality and economical imbalance.  And I consider these movements as the first signs of a much bigger threat: an increase of social frictions and a decrease of freedom to ensure future profits.

When I grew up in Austria – which through it’s geographic and historical exposure to the iron gate and eastern Europe was always highly western oriented – it was very clear to all of us: Capitalism comes hand in hand with freedom. The paradigm was there’s no capitalism without democracy.  But meanwhile we know – learned on the extraordinary successful example of China – that this paradigm is not just not true, but enormously wrong! The opposite is the case. Capitalism without the burden of democratic structures is much more efficient and therefore more profitable. If we consider global competition as given, if we assume that social frictions are on the brink we can consider a decrease of personal freedom as a proper approach to keep stability in an increasingly imbalanced system. Capitalism is not known for fairness but for efficiency.

Accordingly we can assume that if we continue our run for profits long enough and enforce our capitalistic believes we have to give up our ideas of freedom and equality. It’s a trade and from a holistic perspective we might realize that we are having much to much human beings on this planet to run the system efficient. The cost of keeping the global masses calm are already today overwhelming in comparison to the increase of public wealth and productivity.

Latest since Adam Smith it is clear to everybody that the perfect market is an illusion and it needs regulation to keep them under control. Today we know that there are imperfections which accelerate the development that the markets are eating themselves:

First we developed a fully globalized economy during the last decades without building the necessary political environment to set global regulations. The decision processes of global acting companies are much faster than the ones of national administration and international organizations that we face hardly any effective regulation today.  The global discontinuity of taxation approaches is a good example to illustrate that.

The second and much more frightening aspect that is in the nature of competition that it creates winners and losers. The ones who make the profit and the ones who make the loss. Out of the fact that the position of the winners is strengthened over time it is a matter of fact that the position of the losers is weakened. And just like in a tennis tournament like Wimbledon you start with a broad base of players and by the ongoing of the tournament more and more players will be eliminated.

With tennis this is not a big issue since there is a next tournament beginning the next. But within global economic competition there is hardly a next chance. If money and power is once accumulated it becomes (like Thomas Piketty explained perfectly in his book Capital) a kind of self-fulfilling prophecy and becomes its own quality: the talent of capital.

Concluding the question what the societal impacts of producing growing profits and cash are, we can state that it is leading to an increased imbalance within societal stakeholders and an increased risk of social friction.

The profit-oriented system in itself must lead to a collapse because either the profiting entities realize that a further increase of efficiency has to be reached on the cost of the masses. Or the masses realize that profits are always created on their cost and stand up against the system (which is already increasingly happening). This implies a higher level of control and repression of the masses and most probably future profits and social stability will be ensured either through an George Orwell or Aldous Huxley approach.

We know through history and by empiric experience of pseudo-marxistic trial-societies that an equal society with a fair distribution of resources is and will stay an utopia because of the people themselves. It is inherent part of evolution and an important driver of human development being competitive and aiming for individual growth. Nobody can eliminate this natural drive. Out of this we face the paradox situation that nobody considers it as fair if everybody is treated equally. And it is less important what people have as long it is more than what the neighbors have. This is a major paradoxon among all beings, not just humans.

Knowing these societal downsides of optimizing profits and cash flows we identify another critical downside: Although we know we are heading for the edge nobody can stop the development. As long as we are caught in competition no manager or leader can exit this downward train first. The motivation or excuse is always the same: If we don’t do it, our competitors will do it for sure! And so it becomes a rat race to the obvious wrong direction.

2.  The entrepreneurial Impact of Profit and Free Cash Flow 

As I outlined in my article „The 6th Force of Strategy“ I am a great fan of profit and free cash flow when it comes to define the purpose of a strategy. Especially in my role as a corporate leader I make it to my obsession to motivate my team to run for profits and to ensure cash flow. As said before: We are all stuck in a rat race. And I am having the very best arguments for having this approach. It is my responsibility to all of the stake holders of our company. The shareholders want to see an increased share value and dividends. Therefore profit and cash flow is needed. The employees want to get their wages and have the expectation that the company will succeed in competition and provide job security to them. Also profit and cash flow is needed for. Our customers and suppliers want to rely that we deliver goods and money to them. Again it’s about the profit and the cash. And also the public demands its stake in form of taxes. And again we are in need of profits and free cash. And of course also my ego as a manager is in place: At the end of the day profit and free cash flow (which defines the share-value) are the ultimate benchmark regarding the quality of my work:

Out of this we have formed an aggressive international team in our company and we have been very effective in gaining market shares in our industry, profits and cash over the last years. This lead us to an issue we are dealing today and which asks us to act highly sensitive and responsible.

The company I am heading as CEO is specialized in providing premium rate telephony numbers as micropayment tool. We are supplying this service presently in approximately 100 countries to media companies, TV-producers, advertisers, and many others. During the last years we have gained significant market share and are meanwhile global market leader within the niche of International Premium Rate Numbers. Even more important we became the most profitable company in this industry. We focused on highly educated staff within sales and purchasing what helped us gaining bargaining power with suppliers as well as with customers.

During the year 2013 we faced an untypical high volatility within our market. The volumes of phone-calls where below the 2012 figures and a forecast was hard to predict. I did what any profit and cash flow oriented CEO would do and ordered our team to avoid discounts on the customer side and use our market power to demand discounts on the supplier side. This worked out quite properly and we kept our cross margin stable. Even better was that some of our competitors did not survive the market turmoil and the following consolidation brought us a gain of market share again.

The year 2014 was a record year and we increased or revenue by 49 percent and our gross margin even by 53 percent. Profit rose even more. So everybody could be happy and celebrate the huge profit and cash we made.

But since the last two quarters of 2014 we are realizing that we might be heading for a dead end. Not just that the market is not infinite. The even bigger issue is that by our own market power we are damaging the value chain around us. Two of Mr. Porters five strategic forces – bargaining power of customers and suppliers – are becoming to have a tail-whip for our company because we drove it too far. During the period we drove our cross margin up our suppliers as well as our customers lost margin, profit and free cash flow and some of them are meanwhile on the brink of being profitable.

The dilemma created is obvious. If we continue our track we will lose customers and suppliers over the time. If we lower our margins we will knowingly refuse potentials of the development and work against our education of profit maximization. Even worse in the short run we would work against the interest of our stakeholders. If we continue our track of improvement we have to consider if too much players of the value chain are failing because of our strength we have to consider taking over bigger parts of the value chain with cheap takeovers of weakened partners and drive further market consolidation.

And of course the drive for growth of profit is the only acceptable approach to the dilemma. Because if I – as the CEO – would chose a different – more balanced – approach I would harm the dividends and share value of my owners, I would harm the bonus-payments of our staff and even the country and the tax authorities would not be happy because they aim for maximized taxes which depend on maximized profit. Our shareholders would vote with their feet and either walk away or kick me out, the best talent of the staff would leave for an entity which is going for the highest bonus-payments possible and the tax-authorities will send a controller because they expected to get more.

And again we face the inherent problem of profit and cash flow: a fair and balanced distribution of created value within an darwinistic system is impossible. Even if we are aware of the negative impacts and even if we can anticipate the downside of this approach we are forced into a system (a global belief) which you cannot rid off as an economic entity. If you don’t want to play the game, you are out. If you don’t play the game good enough, you’re also out! The problem is that there is no other game! And there are meanwhile more and more entities and people out of the game. There is presently no alternative to our global economic system available. So from an entrepreneurial point of view you play by its rules.

Corporate warfare for profits and cash does – unlike the Roman empire – not create colonies. Companies do not take prisoners but eliminate the enemy and most of its troops. If a company takes over a competitor or a supplier it is done for the synergies. Meaning getting more for less. And less means most of the time less human resources and less investment into infrastructure. So each time an acquisition or a merger is done or a competitor goes bankrupt the whole system gets a little bit more efficient and produces a little bit more profit at the cost of society and individuals who were laid off.

The idea of any entrepreneurial activity is to create growing profit and a sustainable cash flow. Out of this we will never be able to ignore this paradigm of economy, capitalism and society as we know it.

The critical issue and the potential downside of this approach is proper distribution of the value created where we will have to find balance among all the stakeholders. As already figured out in the previous chapter on the societal impact, we are living in world with an outraging imbalance of power and resources. And this imbalance will most probably get worse over the years. Since – as illustrated – these are inherent problems of capitalism and there is no idea how to regulate the „greed-is-good-mentality“ in our society and no plan to achieve a more balanced system, it will demand a lot of courage and insight of individual (corporate) leaders to influence for the good within their environment.

There are ways to achieve sustaining profit and cash flow by establishing a fair share along the value chain by neither skimming the customers nor pressing the suppliers. Strong entities have the power to enforce a fair distribution and to create the benefit of the sustainability of the value chain. But this demands a commitment that the best deal is not always the cheapest and that short term profit often with the cost of long term potential. Since most players of the corporate world are fundamentally driven by quarterly results and annual growth, this might be a long, long track ahead.

In my article „the 6th Force of Strategy“ I’ve chosen the formulation: „superior performance means establishing a strong and steady cash flow at a good profit.“ I avoided by purpose to claim profit maximization as a goal of strategy because this normally makes people think short term and make them focus too much on strong cash flows than on the steadiness of this vital essence of any business.

Concluding we can say on the entrepreneurial impact of profit and free cashflow lies in the nature of doing business. But more and more we are facing the need of not just achieving profits but achieving them in a kind of balanced, ethical and sustainable way. It will lead any company to a dead end over time if it does its profits on the shoulders of its employees, its clients or its suppliers because this will harm the steadiness of the cash flow over time. Finding ways of fair distribution of created value among all the stakeholders will be one of the most complex challenges for corporate leaders in the future. This challenge will demand a certain level of self control and established ethical standards in the corporate world since it is – as illustrated in the previous chapter – a field that hardly can be politically regulated because of its complexity, the nature of capitalism and the simple non-existence of valid global authorities who could develop and enforce global regulations.

3.  Conclusion 

Thinking through the matter of good profit and strong and steady cash flow we can conclude: it is very much about how the profit and cash flow is done and how it is distributed.

We have to see that without profits we would lose the fuel of any economic and societal development. Therefore I am still deeply convinced the definition „Strategy means finding ways to achieve good profit and strong and steady cash flow“ is a correct approach for any corporate leader. The question is less about if profit is needed but very much about how it is created and how it is distributed.

It is a matter of fact that greed is a major motivation inherent to almost any human being. If we consider the historical experience of mankind also the need for competition seems to be manifested in our genes.

It’s simple logics that if you apply a time frame which is just long enough, you will have one winner (or one winning team) and many, many losers in any kind of competition. That’s the nature of a competition. As mentioned before by its nature competition is highly darwinistic and as any evolutional process irreversible.

So we face the tricky situation that there are 7 billion greedy humans on a planet which major societal system is based on competition. And on a daily basis they see in television the prime motivation of their being is to maximize their money and how enormously satisfying it is to be rich.

For our global society this means how the elites (the strong among us) will be able to adopt their darwinistic behavior and regulate themselves for the sake of community. We have to find ways to distribute the globally created value and wealth in a more efficient and sustainable way to keep social balance, freedom and security. Sustainable balance has to replace short-term maximization to ensure future stability of society.  We already have important tool sets as the Nash-equilibrium which give us the mathematical background to elaborate how to achieve the best results for multiple involved players. The theoretical basis to improve is given. It is a matter of economical and political decisions.

The alternative approach is to find ways how to imply more control over the masses of losers of the development and keep them calm to ensure social and commercial stability and security. Television, Facebook, Internet porn and cheap alcohol and pot (like in Colorado or Amsterdam) are great examples that Huxley’s Soma is working properly in our brave new world.

As leaders we are meant to transform the world we are living in. No doubt that we are obliged by our roles to create profit at a good and steady cash-flow. But it’s on us how and how sustainable we achieve this!