What is Profit?
< A Story of Three Builders (Taken from "Running a Successful Construction Company," by David Gerstel, Taunton Press 2002)
Three Builders put up identical small additions. Each of them worked 125 hours at project management and carpentry. After paying for labor, materials, and subcontractors, each had $5,000 remaining, but they viewed their $5,000 very differently.
The least experienced divided his 5k by 125 hours, came up with $40/hr and concluded he had made a "good profit" on the job.
The midlevel builder looked at the $40/hr and concluded "at least I broke even." He figured that, though he had made no profit, at least he had $40/hr to show for his work on the project.
The veteran builder looked at the 5k and concluded, "I lost my butt on this one." He realized that he had lost money three ways:
#1 The $40/hr was $20 less than he would have had to pay (in wages and labor burden) to a good lead to work in his place on the job. Therefore, he had lost about $20 of the value of the labor for every hour he had worked.
#2 He had incurred $1,000 in overhead, none of which he had recovered.
#3 He had no profit to show for the job. He had taken on all the risks and responsibilities of building the addition without any compensating profit at all.
Though only the veteran builder recognized it, all three builders had lost money three ways. They had lost part of the value of their labor, their overhead costs, and a fair profit.>
The first time I read this, I got hung up on the “least experienced” builder scenario. The guy made $40/hr, what’s so bad about that? I finally figured it out and moved on. I was knee-deep in business management, and Gerstel made sense. It still makes sense, but only if you assume this “profit” idea.
Let’s do the math a different way. 5k minus 1k for overhead (cell phone, office, truck, license, etc) = 4k. I will grant Gerstel the overhead point, you need to charge for that. So, let’s add the 1k in overhead and say he charged 6k for the project. 6k minus 1k= 5k/125 = $40/hr. That covers all the expenses that the builder had, and means he took $40/hr home (before his taxes). If he made that wage 40 hrs/week for 50 weeks out of the year, he’d take 80k home for the year. Almost no matter where you live, 80k is nothing to sneer at. It is a very, very nice income.
And here’s another thing, there was a directly proportional relationship between what was done and the money that it cost the homeowner to have it done.
Let’s do the math again, Gerstel’s way. If the guy charged the $60/hr for the wages + labor burden he would have had to pay a good lead, he would be at 7.5k. Then he would need to tack on overhead, 7.5k+1k=8.5k. Then he would need to figure in his profit. Gerstel offers a range of percentages for different types of construction, but 10% is on the low end of his recommendations for the sort of work this project entails. 8.5kx1.1=9.35k.That means that this project, if the veteran had charged what he ought to have charged, he would have taken home $66.8/hr. Do the yearly math again, and you get 133,500k/year.
And the other thing; there is an indirect relationship between what was done and the money that it cost the homeowner to have it done.
The reasons for charging profit, Gerstel says, are:
1 Estimating errors
2 Project delays and disruption due to:
A Extreme weather
B Man-made and natural disasters
C Loss of key employees
D Subcontractor failure
3 Equipment failure and loss
4 Uncharged or unchargeable change order
5 Callbacks and warranty work
6 Difficult and labor-consuming clients
7 Litigation
8 Management errors
9 Recession
When I read this list, several thoughts come to mind. I am a contractor and I know the risks we take first-hand and they are real. But honestly, I just can’t get the risks to justify the profit numbers. #’s 1,5 and 8 are mistakes the builder made, not the homeowner, as is #2D. #’s 4 and 6 are risks that the contractor can either mitigate or simply charge to the client if and when they occur. #’s 2B (the first part), 2C, 2D (Whatever isn’t covered by the above mentioned 2D) and 7 are almost entirely avoidable by certain business practices. That leaves us with #’s 2A, the latter half of 2B, and 3, acts of God and broken tools. In an alternate setup, those could be charged to a customer if and when they are realized. But let’s not think about that yet.
So let’s figure those in. The guy that made 80k could lose 10% of that/year and still make 72k/year. In reality, the guy that made 133,500k/year is going to either: lose 50k of that in the risks Gerstel mentions and still clear 80k or get smart, minimize his losses, and take home 120k (after he loses 10% due to the acts of God and broken tools).
Hot Damn, I want to be a builder! Really though, how can we justify this idea of profit-beyond-wages if we can’t justify it with risks? Why am I entitled to more money than my wages? What is this idea of profit? Where did it come from and why is it built-in, assumed?
This arrangement looks a lot like an insurance policy that the homeowner is paying for. The money all goes into the builder’s pocket until something happens, then it goes to any number of other parties listed in Gerstel’s risk lineup. Let’s say it’s a given that something does happen and the builder loses all that insurance money every year. That’s 50+k every year going to something that has nothing to do with the homeowner’s addition. In this scenario the cost of doing business far exceeds the cost of building. It just seems downright wasteful.
Gerstel’s other point that I get stuck on is #1 in his story. The fact that it would have cost you $60/hr if you hired someone else (I desperately need to figure out how to do italics in this posting setup) = you should charge $60/hr for yourself, even though it does not cost $60/hr for you to do the work. YOU are doing the work, so charge what it costs YOU. Unless this whole thing is based on you not wanting to actually do the work, but to sub it out. If so, then we create a beast where the best-paid guy is the one who figures out how to get other people to do work he could do himself. That beast devalues the worth of the guy who actually does the work. Hmm, this sounds way too familiar. What’s more, in this scenario a sizable chunk (30-50%) of the $60/hr goes to parties that have nothing to do with building (insurance, taxes, workman’s comp, payroll, etc).
Someone will no doubt object to my saying that the builder pockets 70k or 120k. He won’t pocket it because he will take his wages out of that amount and then put the rest back in to the company. That sounds right, but the company is him and he is the company. Otherwise there is this entity out there that Chris described as “pathological,” it has no one’s interests in mind and does no one’s bidding. It’s just out there, making money for itself. This just isn’t the case. Companies make money for people.
So, how about this for a setup: I work for a homeowner, building him an addition. I arrange with him to build it for 10k. I came up with 10k by figuring out how long it will take me to build it at a wage that will support my family, and the materials/subs it will take to complete the project. I also arrange with the owner that he cannot take over my project, and I will charge more if he does. If acts of God slow us down, he pays for it. I also stick to my bid, if he changes anything, I charge for it. But, if I screw something up, I eat it. This means that if I’m good at what I do, I will bring more money home at the end of the job. In a scenario like this, the homeowner doesn’t pay for something he doesn’t get. If it doesn’t snow and take me longer, he doesn’t pay for it. If it does snow and I take a day longer because of it, he pays for it. This setup still gives me incentive to work hard and get better at what I do. The faster I complete the job (due to skill and hard work), the more I make per hour.
I only bring this scenario up to provide an alternative. Maybe it’s not a good one, but I’m sure there are others.The main question I have is the notion of deserving profit-beyond-wages.
Donny, and 
Donny 7:57 pm on February 20, 2010 Permalink
A lot of these principles factor into web design I think, so I appreciate the post; it’s interesting. I’ll just kind of go stream of consciousness here. These are so much points I think you don’t understand, just stuff I’m working through myself.
I think the real issue boils down to how much value there is outside the product itself. In other words, does the customer just care that his addition gets built, that his website gets created, or is there more to it?
With construction, what immediately hits me is customer relations. When I get a bid on some improvements on my house, I don’t just want a number, with a promise it can be done. I also need to know what needs to be done. What kind of windows do I need? What kind of flooring should I install? The same goes for web design. It’s not just about building the website; it’s about helping the customer figure out what they need.
Management is similar. Management removes a lot of the burden from the client. With a good manager, the client doesn’t have to talk to the electrician, the plumber, the carpenter, and the drywall crew, hiring them all at the right time to get the job done. He talks to one guy, and he manages all the workers, which is a huge load off the client. And this even means he might be making money off work that other people are doing, work he could or couldn’t be doing himself, because he needs to be payed for all the work and stress that’s involved with managing a crew, and communicating with all the sub-contractors.
Web design is the same way. There’s a skill to being able to organize and communicate with all the people involved. Someone who can talk to the client, figure out what they need, then go the design, the developer, the photographer, and the host to get it all taken care of is taking a huge load off the client’s mind, and should be rewarded for it.
This is because management is a different skill than the technical work itself. Some people don’t have it, and shouldn’t ever head up a job. Instead, they love the technical work itself, and would rather have someone else deal with all the custom relations/management stuff. And that’s good.
As far as why they get paid more, I don’t know. Maybe it’s because they have the control. The whole question about fair wages, and who should be making what, is really interesting, but I don’t even know where to begin.
Books like the one you’re talking about seem to take all this division of labor a step further, though. It’s not just that management is a valuable role, but that this is a business, and, as you pointed out, businesses are there to make big profits. Successful “businessmen” are people who notice all this about a certain business, get to the top, and manipulate things to make a good profit. I’m exaggerating things, but that’s the feeling I get. Businessmen become middlemen, squirming into every crack they can find hidden profits. There’s still a value to all the work “above” or “around” the actual technical work itself (management, entrepreneurship, customer service, marketing, etc.), and it should be rewarded, honestly and well, like any other work. If a businessman is a manager, that’s great. If a businessman is someone who’s good at working the numbers, I’m skeptical.
G 8:42 pm on February 20, 2010 Permalink
Donny, I understand what you are talking about regarding management. I have been doing that part of construction for several years now. Here’s the thing: in Gerstel’s scenario, he includes all the management time in his 125 hrs. So the guy got paid for doing what you are talking about. It is a skill, and it’s a skill that not a whole lot of people have, but that’s what wages compensate for. Profit is an entirely other thing…as I understand it.
C 12:28 am on February 21, 2010 Permalink
Gaberull,
Briefly, if I am able. I can’t speak specifically to your math. I can say though that profit is not a bad thing in itself. I’ve toyed for some time with the idea of considering “profit” as rather a type of sabbath. A man works for provision, and this is true, but God has fashioned the world in such a way that if we work for six days, he provides for a seventh. In Leviticus 25, he promises his people that if they work the fields for six years, he will provide not only enough for the Sabbath year, but for for the two additional years (one for sowing, one for reaping) that are required to get production going again. Then we have gleaning laws and other forms of prescribed charity; God gives us not only rest for ourselves, but rest for our neighbors and for our land.
In this scheme, we work for six years and get yet three more of yield because God is kind to his people. If one were being inexact (and I must be for the sake of my pretended brevity), one could say that $80,000 per annum in wages is acceptable and one might also expect that another 50% (or $40,000 for a total of $120,000) is right by God’s math so it should be right for ours. It is assumed of course that this additional $40,000 will be spent on mercy, and one might rightly ask why $80,000 is not enough for living and for mercy, but the point I’m making is that profit is not a bad thing in and of itself.
There is yet another reason to defend this idea of Profit, and here I borrow from F. Schumacher, by all accounts a good Catholic and capable economist. For the businessman, profit is the clearest and surest sign of a properly ordered business. If a business does not yield profit, it does not yield Sabbath, and this means that something is wrong. In your example, a Manager who is not able to earn a profit and still remain competitive should consider this a problem to be fixed. His workers may be lazy, his materials may be overpriced, or his gifts and calling may lie in some other line of work.
Schumacher does not apply the profit test woodenly: some types of business are necessary but not very profitable, and there are some forms of profit (usury is one) that are unjust and sinful. In the case of the first, charity from others is prescribed by God. In the case of the second, we have repentance. It seems plain to me that what you are writing about is the second kind of profit, and I would agree that excessiveness and greed are at the heart of many of our problems. But you should not discount the first. God, the author of both justice and mercy, has intended some forms of profit to be quite natural.
C 12:36 am on February 21, 2010 Permalink
Also, please excuse the somewhat affected tone of my comment. I recently watched the 6-hour BBC version of Pride & Prejudice with my wife. I’m likely to be insufferable for a few weeks.
Boogers. There, that’s better.
Donny 9:28 am on February 25, 2010 Permalink
Gabe,
Okay, then, I think we’re on the same page. It’s the distinction between manager and businessman that’s throwing me.
Chris,
I’m not sure I understand the distinction. Salaries workers get wages, but business owners get wages and profits? It seems that the profits are just the “wages” an owner is getting for taking the rick, funding the business, etc. I’m not sure I understand the distinction. But that’s also probably because I know almost nothing about business.
C 12:30 pm on February 27, 2010 Permalink
@Donald,
“Profit,” can be a squirrelly word. There’s a meaning in economics, and then a meaning in accounting. Gabe seems to be focusing on the accounting definition. Most basically, it’s the money a business earns in excess of costs. This money belongs to the owners of the business. Depending on the structure of whichever company we’re looking at, “costs,” “owners” and “profits” can be defined in various ways; the tax code in the US contributes to quite a bit of this tinkering.
Gabe obviously had a set of definitions in mind when he approached the question. I’ve here suggested that “wages” and “profit” really aren’t the first principles to which we should be looking. We should focus on things like work, provision, and plenty about which God has spoken much rather than EBIT, PBIT, or other accounting conventions about which God has spoken nothing. For instance, it seems to me that
Now that we understand this, we can define wages and profit a million different ways to achieve any number of favorable tax outcomes, and the conversation hasn’t shifted.
As for risk, I think that warrants an entirely different post. For starters, I don’t think risk is anything new or remarkable. In more agrarian societies where ownership and production are more widespread, “risk” isn’t something that only investors endure that entitles them to profit margins. Risk is just a fact of life. Crop failure, equipment deterioration, and crappy clients happen to everybody; wage-earning is a state of servility, and owners should not look at profit as a reward for taking risk but rather as benefit of the already exceeding privilege of ownership. “Risks” that are realized sure do cut into their profit margins, but owners do not make profits because they are taking risk. They are making profits because God promises Sabbath yield from work.