CHAPTER | THIRTY-TWO
The Purpose of Your Business Is Not to Make a Profit
Peter Drucker said and wrote a lot of things that on the surface sound absolutely outlandish. Perhaps this is what made him so “eminently quotable.” That was all the more so when his seemingly ridiculous claim turned out to be true. Such was the case when he said one day that the purpose of a business was not to make a profit! Oh, come on, Peter—get real! If the purpose of a business is not to make a profit, then what is it? Everyone knows the very basic “fact” that the purpose of any business is to make money. That is to say, to make a profit. This “fact” leads to a corollary: that the goal of any business is to make as much profit as possible. That is, profit maximization.
Now, if you accept the principle that making a profit is, in fact, a business's purpose, the second half just follows naturally. Profit maximization might even seem like a worthy objective to many. For instance, it was the creed of Michael Douglas's character Gordon Gekko in the 1987 movie Wall Street, so well stated as “Greed is good.” Even today, many in business “know” that greed, or profit maximization, is the correct prescription for business success, even if it doesn't seem to be “good” from a moral perspective.
As mentioned earlier, Drucker maintained that “whatever everyone knows is usually wrong,” and certainly Hollywood films are not excepted. He emphasized, first, that profit is not the purpose of business, and following that, he maintained that the concept of profit maximization was not only meaningless but also dangerous.1
Why the Myth of Profit Maximization Is a Fallacy
Many economists consider profit maximization a basic theorem. But Drucker said if you strip this theorem down to its fundamental principle, it is simply another way of saying that a business should buy low and sell high. That's pretty basic, right? However, he noted that this simple description doesn't begin to explain the success or failure of a business—any business.
For example, a local retailer may have been buying low and selling high. If that's all that you know, you don't know enough to claim that the business is a success (or a failure). Look at all the businesses that closed during the recession. Weren't all of them buying low and selling high, or at least attempting to do so? Consider the difficulties faced by many businesses struggling today to avoid joining the many failures that have already occurred. So, it is clear that buying low and selling high explains very little about why these businesses have failed, just as that idea explains very little about those who are successful, or those who are accelerating their success despite the obstacles they face.
Profit maximization seems to imply that you might save a business from failure by simply raising prices and creating a greater differential between revenue and cost—that is, that you maintain (or increase) the profit margin. In point of fact, as costs to businesses rise, be they gasoline, materials, or anything else, raising prices is the immediate and simplistic response that many businesses make. Yet these businesses still fail or succeed, independent of their act of raising prices. Thus, profit maximization by itself is absolutely not the determining factor for success or failure.
Not so long ago I was told that a local restaurant failed owing to the rising cost of fresh produce. Yet other restaurants in the same general area, serving the same target market, did not fail. Some are thriving and even increasing their sales, even though the cost of produce rose for all equally.2 Clearly, just creating a certain level of profit isn't the overriding factor.
But What About the Profit Motive?
The idea of profit motive was also fair game for Drucker's genius. The profit motive is yet another basic economic concept. On the face of it, there is little to question. A typical definition is: “The intent to achieve monetary gain in a transaction or material endeavor. Profit motive can also be construed as the underlying reason why a taxpayer or company participates in business activities of any kind.”3 Many economists take the macro view that in order to maximize an economy's growth, one must also maximize profits.4
But Drucker 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 that their theory of economic equilibrium could not fathom. Let's consider an example.
There is a good deal of volunteerism done, in which individuals—some quite highly paid in other roles, others not—work long, hard hours for the common good. They work in religious and community groups doing a variety of socially beneficial activities. Many don't get paid a penny for their efforts. Many other talented individuals knowingly choose occupations that are less financially rewarding so as to follow a personal interest or calling to help others. Drucker challenged the view that sky-high corporate salaries were necessary to attract quality personnel—that these people “would not work for less” owing to the profit motive. Yet, there are many top jobs that attract high-quality individuals but offer them extremely low pay.
For example, an organization that tracks corporate salaries listed top-rated charity organizations at which, even today, the CEOs earn annual salaries of only $21,000 to $58,000.5 Moreover, a top-ranked military commander—a four-star general, who may be responsible for the welfare and lives of from several hundred thousand to more than a million subordinates, responsible for millions of dollars worth of equipment, and accountable for outcomes of extreme importance—earns the relatively low compensation of about $200,000 a year.
From this we can conclude that while the prospect of profit can be motivating, it need not be the primary motivator; hence, the notion of maximizing profit as the goal for a business, or the life purpose of an individual, is at best overstated.
Now, don't get the idea that the need for profitability is a waste of time or is immoral, however. Of course, there are “bad people” in business—all businesses—and there always will be. But this reality causes some people to question the basic principles of capitalism and to wonder whether any profit is necessary at all. As a result, the profit motive is viewed as worse than irrelevant: It does harm because it creates hostility toward earning a profit—something Drucker called “the most dangerous disease of an industrial society.”
Drucker felt that this “disease” ends up causing some of the worst mistakes of public policy and promotes the notion that there is an inherent contradiction between profits and an organization's making a social contribution. As he noted, a company can only make a social contribution if it is profitable.
Some otherwise smart people in the nonprofit sector, in perhaps the epitome of ignorance, say, “I don't make a profit. Why should a business?” But Drucker proved that profitability—far from being a myth, immoral, or unnecessary—is crucial for the success of both individual businesses and society in general. Moreover, he considered profit (as opposed to profit maximization) even more important for society than for an individual business. However, profit is not the purpose of a business.
What Is the Purpose of a Business?
There is only one valid purpose for a business: to create a customer. 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.”6 In other words, society gives the business the means to achieve its purpose (gain a customer), in return for supplying the needs and wants of society's consumers. That sounds reasonable. But why is profit maximization not at least a goal of business?
Profits Pay for Innovation
Profit and profitability are absolute requirements. That's why even nonprofit corporations must strive mightily for “profitability.” The dean of a major business school recently confided to me that his school had been running in the red for several years. “Pretty good recommendation for a school of management, right?” he asked me sardonically. However, to return to Drucker, profit is not the basic purpose of a business. Instead, profitability is an essential ingredient of business, and is best spoken of in terms of optimal, rather than maximum, size.
The primary test of any business is not its maximization of profit, but the achievement of sufficient profit to allow for the risks of the financial activity, and to avoid any catastrophic loss leading to failure. Only through an optimal profit might a business achieve the success that will benefit both the business and society. So, profit is necessary, but it is not the purpose of business.
What was Drucker's logic? That profit is like oxygen for the human body. Oxygen ensures that the body lives, survives, and grows. Without oxygen, the body withers and dies, just as a business does without profit. And just as the body demands oxygen, so does a business demand profit, whether that business is legally incorporated as for-profit or is nonprofit. Both forms of business need profit to survive.
Why do both types of business need profit? Because the profit goes to support the two basic functions of any business: marketing and innovation. According to Drucker, these functions are needed to create action. Only a business action can create a customer, and that means innovation, advertising, salesmanship, strategy, customer service, quality—you name it. These business actions cost money, which comes from the difference between buying low and selling high.
Pure Profit Leads to Failure
As stated earlier, it is optimal profit that is required, just as the body needs the right amount of oxygen to survive. Too much oxygen can cause damage to cell membranes, the collapse of the alveoli in the lungs, retinal detachment, and seizures, and eventually death. Similarly, too much profit—that is, profit maximization without consideration of other elements in the business's equation—can cause business problems.
If the focus of the business is solely on profit maximization, the customer may be ignored or given secondary consideration. This, in turn, can lead to poor management decisions that result in cutting corners on safety, service, or product performance. Additionally, if profit maximization drives the company's purpose, the competition that maintains a different focus—to win markets by providing greater value or charging less—will move in. Recently we have seen many industries err in this way. In truth, these bad decisions as a result of profit maximization—what might be termed organizational toxicity—can and do occur in all industries, and the result is the same as too much oxygen for the body. The business may die.
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.
The Drucker Message
What has this to do with you or me? Well, regardless of your type of organization, and whether it operates for profit or not for profit, Drucker's truth holds. If you want your organization to be successful, you have to see profit as essential to support innovation and marketing actions, and view profit maximization as bad for society as well as hazardous to your organization's health.