The Linkages | Value Research For a better understanding of the nature of profit, it is important to first analyse why (and how) a company makes money in the first place
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The Linkages

For a better understanding of the nature of profit, it is important to first analyse why (and how) a company makes money in the first place

Ok, let's start with the clichés first. We all know that the profit motive is at the centre of capitalism, the raison d'être of an organisation. So profit is the purpose of an organisation and the shareholder (to serve whom the organisation exists) is the primary stakeholder.

An organisation uses various resources to generate a profit. In economic terms, it uses land, labour, organisation and capital (LLOC). If we take the 4 Ms: man, machine, materials and method, they are merely a re-statement of the above LLOC.

Yet, most organisations I know tend to confuse this balance, i.e. they tend to focus excessively on one or the other of the above baskets. In some companies, I noticed an excessive and almost myopic focus on labour i.e. doing things.

We have customers who tell us what to make from time to time. Through the TQM/ TPM/ six-sigma mindset that flows up and down the auto value chain, we all have this huge focus on the 4 Ms mentioned above. Most of the talk is about machine productivity, labour standards, (material) wastage, overall equipment uptime or line efficiency (OLE), inventory control etc. In other words maximising throughput per unit of capital employed. So either you reduce the capital employed for a given level of output (as in stagnating markets in the developed world where they use outsourcing and innovation to do this), or you maximise throughput for a given level of capital (as in developing countries, where demand is buoyant but capital is expensive and scarce). But the companies are only focused on doing things (i.e. labour) also called manufacturing in layman terms.

Now compare this to a bank, as in, what does a bank do? Is there any physical transformation in its product? A bank captures 'profit' by ensuring that it raises funds cheaper than what it lends at (assuming it gets back all the money it lent out in the first place). But this 'work' produces profit, which comes from managing capital, one of the four economic resources mentioned.

Let's look at organisation, often called management quality. The ability to capture and maintain a near-monopoly is the key skill for Microsoft's shareholders. Of course, the its PR department will argue that this skill comes under labour i.e. the ability to build the world's best software. But ask any Netscape user and they will agree with my classification. (Fortunately, this column is not read by people at Microsoft.)

Or Berkshire Hathaway. A small group of wise men are brought and held together. They sit down around a coffee table and understand risk and opportunity better than anybody we know. Why and how do they stay together? I don't know, but this ability, which creates profit, must be put under the basket called organisation.

Under this head, I will also put the ability to handle risk and the other side of the coin, opportunity. A good insurance company, for example, (or a good derivative trading outfit, aka an investment bank) makes profit because it charges more premium than it pays out i.e. it estimates the probability of the occurrence of an event better than its customers. And it keeps enough risk capital on standby (either on or off its balance sheet) to make sure that it never goes bust, especially during those sudden cataclysmic crises.

Last, let's come to land. Don't take this term literally. In Ricardian terms land used to mean anything whose supply was not controlled by human beings. The simplest example was land itself. In those days, if you owned land, you got to charge rent, from which came the term economic rent. I believe the system exists even today as you can see it in Bihar.

These days, the concept covers every such situation where you earn profit merely because you are there. So if Tata Steel owns some fabulous mining leases in iron ore and coking coal, it can afford thrice the labour cost of its competitors. SAIL, which also has the same quality mines in iron ore, can afford four times the labour cost. This source of profit, a chunk of which is then lost to organised labour, is called land.

In the same spirit, Infosys 'mines' a seam of solid, mathematical/ logical skills to give itself nonpareil code-writing capability. This is a combination of land and labour, a good example of a case where an organisation starts with one source of profit, but goes on to build another one across the LLOC basket. Infosys started with a critical resource, code-writing skills (a generic), but has built skills to exploit another source of profit, business solutions, which is a skill layered over its generic capability.

Yet, compared to a GE for example, I have not seen an Infosys use its balance sheet and its vast cash reserves to build a treasury. It is quite obvious that the company chooses to under-perform its profit potential in this area. Perhaps it has weighed the profit potential (from treasury activities) against the risk and decided against exploiting it. I am told that early in its history, the company lost money in the markets. But to now get to the nub of my point. I don't think too many companies examine their organisation design, to see whether they are able to exploit all the sources of profit possible. Every external interface of the company creates an external stakeholder. Does the company examine each such interface to see how it is losing money/ value or exploiting the relationship for profit?

For example, the company I work for is one of the best-rated auto component companies, according to a recent CNBC poll. Yet, it is my personal opinion that we give away 40-50% of our net profit by choosing to stay with a single-supplier of steel rather than convert to multiple suppliers. One part of the management team argues that this is by choice…we need to trade-off the customer's interest against that of our own profitability.

So we cannot shift to multiple-suppliers without the customer's explicit approval. My counter-argument is that perhaps we, as management, are averse to building "strategic sourcing" skills that allow us to scour the globe for alternate suppliers. How many vendor/ material-substitution proposals have we given to our customers in the past five years?

So we have chosen to stay 'ignorant' at the vendor interface, taking the prices we are given under the garb of 'customer interest'. But in making this compromise, we have sacrificed shareholder interest.

And finally, I will establish the link with markets with yet another cliché.

"Companies create wealth/value but markets measure them". I have often seen that markets don't value the various streams of profit differently i.e. the profits of an auto component company are measured on par with the profits of a bank/ insurance company.

For a better understanding of the nature of profit, it is important to first analyse why (and how) a company makes money in the first place.

For example, an auto component company makes profits from labour after losing whatever it does to its suppliers, bankers or even employees. It makes money (as in case of my company) after over-paying its suppliers, bankers etc. The residual profits are real and are less likely to be lost again. These profits are then redeployed into a set of real machines, plant, building, which will always have value, as long as the business has any role in society.

Compare this to a bank, which makes money during the boom because it borrows cheap and lends dear. The bank puts all profits into its balance sheet, leaving its past profits exposed to the same risk of default. Suddenly, after the recession hits, investors are left wondering how much of the past "profits" of the bank were real. The catch is that risk levels have stayed constant (or have increased) in the bank's balance sheet, while they have actually reduced in the autocomp co's balance sheet. Yet, the market would value a typical bank at a P-E level higher than that of the typical autocomp co.

So let me summarise: profit is the objective of any organisation and it comes from the management of four key economic resources (LLOC). Most organisations are good at (managing) one or the other of the above (resources). Organisations need to grow in depth, i.e., learn to do things better, manage one resource. And they need to grow in breadth i.e. know enough about managing the other three resources better. What they know is wealth, what they don't is risk.

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