Front Page Titles (by Subject) CHAPTER 28: PROFITS AND COSTS - Economics, vol. 1: Economic Principles
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CHAPTER 28: PROFITS AND COSTS - Frank A. Fetter, Economics, vol. 1: Economic Principles 
Economics, vol. 1: Economic Principles, (New York: The Century Co., 1915).
Part of: Economics, 2 vols.
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PROFITS AND COSTS
§ 1. The broader meaning of profits. § 2. Conception of pure profits. § 3. Dual character of investment profit. § 4. Enterprise and risk. § 5. Pure profit the most variable income. § 6. Meanings of cost. § 7. Superficial view of costs and prices. § 8. Costs adjusted to prices of products. § 9. A single factor of a single product. § 10. The genealogy of value. § 11. Money cost derived from price of products. § 12. Cost an expression of consumers’ estimates. Notes On other meanings of profit and The source and cause of profits.
§ 1. The broader meaning of profits. The term profit (or profits) means broadly the residual share, the one noncontractual income in the business. It is what is left as a net gain to that person (or group of persons) who assumes the financial risk of the business, after paying off the claims of every one else for any uses or services rendered. Profit in this broad and popular sense is a complex of incomes from various sources and must fluctuate in nature (as well as in amount) from case to case for reasons that are accidental and personal.
We may see this in reviewing the examples above. In the small furniture shop profits includes all economic incomes in the business, whether from the investment or from the joiner’s own labor. It is an inclusive term for the usances of tools, shop, materials, and land, and for the services of the owner, whether as investor, manager, or handworker. It embraces all the economic yields which by theoretical analysis can be carved out of it. As the business develops, profits, as thus used, means more or less according to circumstances which must be ascertained from the context. If the investor owns all his buildings and land, machinery, and sources of materials, and has no borrowed capital, then profits includes all that is left of cash receipts after paying wages (and salaries), but wages may be more or less according as the investor takes a more or less active part in the management. If in the one business the buildings, water power, lands, etc., are fully owned, and in another business with exactly the same product all these things are hired, profits in the former would be much greater. While the business is owned by an individual or by partners, profits may include whatever is attributable to the owner for his management; or a fair salary may be estimated for this, and only the remainder be counted as profits. Like complications, or even more troublesome ones, are found in the case of corporations. The one company owns all its patents, the other pays royalties; the one has all its capital represented by paid-up stock and the other has more or less of outstanding bonds the interest of which is a “fixed charge” to be deducted before counting the residual share of profits. The possible variations are endless, but these illustrations suffice to show that profit in any such general sense is not a scientific term for the purpose of studying the forms of income; it has not even a precise practical significance.1
§ 2. Conception of pure profits. Is there then, no exacter conception of profits possible? Among these various meanings is there one not preëmpted by another term, one which expresses a sort of income found in practical affairs, which business men are constantly trying to estimate and of which economists must take account? Let us try to express such a conception in this definition: Pure profit is the income of the active capitalist as such, attributable solely to the active capital-investment in the particular enterprise. It is an investment-profit. The amount and rate of investment-profit is peculiar to each business and indeed to each investment. It is never an agreed price, or a contractual payment. It is the residual after the actual contractual dues have been paid, and the estimated value of other factors (such as the services of the manager, etc.) have been deducted. The investment profit concept is most nearly exemplified in practical affairs in the bookkeeping of a corporation. Out of gross receipts must be paid all rents, interest, maintenance and depreciation of the plant, price of materials, wages, salaries of managers and officers, fees of directors, etc.; the residue is the amount which may be paid as dividends to stockholders (or added to surplus) without impairing the capital investment.
§ 3. Dual character of investment profit. Even investment profit usually is subjected to a comparison which divides it into two elements. We have seen (Chapter 26, section 4) that it is of the very essence of the active capital function that it takes the financial risk of the outcome. When therefore at the end of the year (or income period) it appears that a certain profit has resulted (say $1000), this is compared with the capital invested (say $10,000) and expressed as a percentage on the investment (thus 10 per cent). Now this in turn is compared with the rate of interest common on the safest loans (say 4 per cent) and the remainder is the amount (or rate) by which this active-capitalist investment exceeds the current rate of passive capital investments. This merely estimated division influences further choice of investment. The rate of interest is taken to represent about what capital can do by itself (or with a negligible amount of judgment and supervision—an abstract conception) and the excess above that is attributed to the successful act of investment. Thus, however far we attempt to eliminate the personal service element of management from profits, there always remains in any active capital income this one element of investing management together with the carrying of the financial risk. There is a dual character in investment profit; it is a capital-income and a labor-income, combined. The distinctive feature of investment profit, which fastens our attention, is precisely this excess (or deficit) of income in active-capital as compared with the normal prevailing rate of time-price, which can be secured by the most conservative passive investor. It is the hope of an income more than ordinary interest that is the inducement to active capitalists to assume the risk. We may call the amount realized more or less than the imputed yield of passive investment, pure investment profit, attributable to the exercise of pure investment function. The amount may be expressed as a rate on the investment. This is the utmost point that has been attained in the analysis of the complex elements of “profits” as popularly used.2
§ 4. Enterprise and risk. To the person who exercised this function of active capital-investment various names have been applied: undertaker,3 its French equivalent entrepreneur, adventurer (especially used in former times of one who embarked in foreign trade), and enterpriser. Each of these was meant to express the assumption of the financial risk in undertaking the ownership of the various factors and of their results embodied in the products, in paying off other claimants, and in waiting for an income indeterminable in advance, but contingent on all the various fluctuations of the market.
Enterprise is the act, or function, performed by the enterpriser, and in a different but related sense is the particular business establishment, or undertaking, which is carried on by an enterpriser. Business management and enterprise are functions not embodied completely in any individuals, but diffused more or less among groups of men. The active-capitalist and the passive-capitalist are not in contrast absolutely but relatively; the passive capitalist is not, and can not be, completely freed from financial risk. Enterprise is merely in this particular business the assumption of the legal financial responsibility to the extent of the enterpriser’s credit and resources, or in other cases to the extent of the special legal limited liability, as (in most stock companies) to the amount invested, or (often in banking) to double the amount invested.
Risk is more or less everywhere in human affairs, but among various kinds of investments there is a well-recognized gradation in the uncertainty of returns. The enterpriser in a business takes the more exposed frontier of risk, and the various senior securities have prior claims. For example, if the business of a corporation goes badly the first mortgage bonds, getting a low rate of interest, are the first claim on the income and, in case of insolvency, these bonds would be paid out of any assets of the company; so in turn till we come to the common stock which gets nothing until all the other claims are satisfied but which if the business is prosperous may get dividends at any rate permitted by profits. There is thus an investment risk, an element of enterprise even in the safest investment, e.g., government bonds, but this becomes almost negligible in the case of many well-proven investments. This relativity of risk and of the enterprise function may be shown again in the interrelations of different enterprises. (See Figure 42.)
§ 5. Pure profit the most variable income. It is easily seen why the income to enterprise is the most variable from one establishment, and from one time, to another. It contains within it all the non-contractual elements of income. The laborer has taken a fixed wage, the passive capitalist has reduced his risk and accepted a fixed interest. Both wage workers and passive capitalists have taken the easy way, have “played safe,” and have left the enterpriser to bear the brunt of the financial risk. The income of each of these classes tends to conform to a general market-rate, being a medium of the gains and losses when labor and capital are applied with various degrees of risk in various undertakings. Enterprise is the most movable element. It is specialized risk-taking. Enterprise has well been called an economic buffer, which takes up and distributes the strain resulting from variations in the momentum and rate of movement of industry. The enterpriser feels first the influence of changing conditions. If the prices of his products fall, the first loss comes upon him, for the goods already made must be sold. Further loss is avoided as best it can be by paying less for materials and labor. At such times the wage-earners look upon the employer as their evil genius, and usually blame him for lowering their wages, not the public for refusing to buy the product at the former high prices. When, however, prices rise, enterprise gains through selling at higher prices the stock on hand that has been produced at low cost. Enterprise is placed between the forces of competition, between owners of resources and ultimate consumers, between laborers and the final purchasers of labor’s services. The enterpriser’s economic survival is conditioned on vigilance, strength, and self-assertion.
Profits therefore fluctuate more from industry to industry and from man to man than do other incomes. The variations of the market may sweep away not only all “profits,” but all the invested capital. As a consequence, profits may be at other times very high, for enterprise will not take the risk of great losses unless there is a chance of large gains. While the income of the salaried man is occasionally advanced, and then for long periods remains unchanged, the profits of enterprise come in waves. In seasons of prosperity profits in many enterprises swell with a dramatic swiftness while rents and wages move tardily upward. Then again for years profits fall to a level hardly exceeding a low interest on the capital invested or leave many businesses for a time with a loss. Reasons for this result will be shown more in detail under cost of production.
§ 6. Meanings of cost. The profit in enterprise results from the surplus of sales (receipts) over costs (expenses). Few words are more often heard in business than cost, or with more varied shades of meaning.
In a general sense cost always means something given up, parted with, paid, to get something else. Often this outlay takes the form of pain, fatigue, or irksomeness of labor, tho this is a psychic cost, better termed sacrifice. Thus it is said: he got it at the cost of tireless effort; it cost him his health. When the worker who is free to determine the length of his working day stops work, he reveals that his valuation of his labor just at that point is greater than the valuation of the product that will come from further labor—the one negative and the other positive in the balance. Psychic cost thus rises to the level of more or less conscious estimation at certain points and, like psychic income, has its part in many ways in the choices made by individuals. It is not, however, the objective measure of cost in the transactions of trade.
In another sense cost is applied to any objective good or any gratification which could have been chosen, but which was given up when another choice was made. This is alternative cost, called by some, opportunity cost. It is an option relinquished. One may stay at home and read a book or go on a picnic; the pleasure of reading a book will cost the pleasure of the picnic. A good dress may cost a vacation that must be given up for it. In this sense, each thing is a cost of every other thing that might be chosen in the place of it, tho the alternative cost thought of is usually the most important excluded option. Alternative cost, like psychic cost, is individual, and is significant at the moment of choice but is not the measure in which business outlay is expressed.
The sense in which cost is mostly used in business in the common phrase “cost of production” is money cost. It expresses not the pain of the laborer in doing the work, not the sacrifice of the owner of the capital in saving the money, but merely the sum of money paid out by the producer. Costs, proceeds, and profits are all in business practice reckoned in terms of money. The enterpriser invests in order to realize profits. Enterprise is investment, the putting of capital into concrete forms of wealth; and it is in turn the sale of wealth, a process which might be called divestment. The realization of profit means getting out a total sum of capital greater than was put into the business. Capital is thrown into the melting pot, and is taken out crystallized into new forms of wealth which may or may not bear a greater price than the costs. The price of the products depends on the valuations of possible purchasers. The customers may be foolish men with unwholesome desires, and profit-making may result from pandering to their vices; but in any case the enterpriser finds himself limited by this condition: to gain a profit he must produce a surplus of value (as judged by his customers) between costs and selling price.4
§ 7. Superficial view of costs and prices. It is well after this discussion of costs to consider their relation (as a more fundamental problem of theory) to prices and values. The business man, as such, is rarely interested in this question. He knows that many influences unite to determine the cost of the factors he buys, but they are distant; he cannot influence them, and in the single stage of his production his costs seem to fix the price of his products. In some purchases, however, and on the stock exchange, a remarkable power of noting and analyzing the more distant influences is displayed. But in general a superficial view of value is taken in business; it does not pay to do otherwise. The active investor simply takes the price of various factors as he finds them, and seeks to combine them and to sell them when and where he can reap a profit. Yet if he is asked, What determines the prices of goods? he probably replies, “They are fixed by cost-of-production.”5 This is the way it appears from the enterpriser’s point of view as he is deciding whether to extend or contract his production and sales, whether to raise or lower his prices.
§ 8. Costs adjusted to prices of products. But cost sets merely a lower limit of price, below which the enterprise can not sell without loss. Within or above those limits the price is determined by the bidding of the market, buyers and sellers. If any one is so situated that he can regularly get more than cost on any unit, he attributes the gain to whatever agent gives the advantage,—to his patents, his land, his own ability,—and thereafter he adds more to costs on that account. In this case we see plainly that the value (or price) of the factors (that is, the cost) is being marked up (or down) according to the price of the products, and not vice versa.
The rule must be reversed also in the case of many large classes of goods. Some things that can not be multiplied or reproduced, such as autographs, old violins, old paintings, diamonds, bring prices that are not dependent on the cost of production. The same is true of great numbers of natural resources, including all lands taken in a state of nature, whether agricultural, mineral, residential, or commercial. That leaves still to be explained the relation of costs to the prices of the great class of goods which are grown by the art of man, e.g., grain, cotton, cattle, etc., and manufactured, e.g., tools, machines, cloth, etc. Now it is noticeable that every one of these objects has a cost just because it happens to be looked at just when it is in the enterpriser’s hands at an intermediate stage of its production. The cost rule applies only to factors that have been bought at a price, and the total cost is simply the sum of the prices of the factors. But how did the factors, the various qualities of labor, the materials, use of agents, etc., get their price? That question has been answered in earlier chapters: from the value of the expected product, or uses. The business enterpriser is a middleman, buying to sell again, and his costs determine whether or not he can make a profit, but they do not determine the prices of the products. Rather they are seen to be determined by the prices, when a broad enough view of the situation is taken.
§ 9. A single factor of a single product. The tracing of the value of goods through intermediate products to direct enjoyable goods, and finally to the source of value in psychic income, gives the genealogy of value. After the goods enter into the channels of commerce and are once bought and sold, they bear a cost to the owner. In the one direction we seek the “ultimate agent,” or factor, the natural agents and laborers; in the other direction we seek “the ultimate products” or ultimate uses. A single product having a single factor shows most clearly the reflection of value directly from the product. (See Figure 43.) The discovery of a mineral spring or of a good quality of building-stone on worthless land, will cause a value to attach at once to the agent. When a great singer like Adelina Patti commands several thousand dollars for each appearance in concert, the value of the music in the minds of delighted hearers is transmitted to the salary of the singer. Her salary is not determined by cost, but it becomes a cost to the enterpriser who employs her and undertakes a concert tour.
§ 10. The genealogy of value. When the one factor yields several different kinds of products no one product alone accounts for the value of the factor. As any one wishing the factor for any use must bid against the other uses, the factor appears, on a superficial view, to have a price already determined by its other uses. But we know from our previous studies (see Chapters 4-6) that the value in any situation results from all the uses taken together, including the particular use we began to examine. To take a simple illustration: a savage finds in a wreck on the coast a number of bars of iron. He and his fellow tribesmen wish them for various purposes: to make arrow heads, spears, knives, hatchets, hoes, ornaments, nails, needles, etc. The value of a bar used to make a knife is in this case derived, in part, through the ultimate factor, from the alternate uses. Taken jointly and considered as one sum, the values of the products account as completely and exclusively for the value of the factor as if they were merged into one product. The factor (F) is distributed to each of the products in accordance with the marginal principle and therefore the value of the various products from equal quantities of any factor constantly tends to equality. Any unit of product sought for any purpose must be paid for according to a value determined by the costs of the factors under the marginal rule in all the applications. The genesis of the value of ultimate factors is found in the value of the product.
In actual life the problem is far more complex, and yet, through its settlement runs just the same principle. There is constant bidding for factors, and through their prices the claims of rival products are adjusted. A point is reached where it does not pay to use any more of an agent in a certain industry; the production of another unit results in a loss because the factors are worth more in other uses. There is a most complex relation among many different industries using the same factors. Thus in countless ways the values of products of widely different kinds mutually influence each other. The value of no one is an isolated fact, but is ultimately only the reflection of its relative importance in meeting the desires of men in view of the whole situation.
§ 11. Money cost derived from price of products. Products compete with each other for the factors that enter into them. According to location, quality of the soil, and improvements, a certain area of land has various rival uses. These uses bid for the land; that is, put in an economic claim for it. Products of a higher value outbid and exclude those of a lower. If fine wine can be raised on a piece of land, potatoes ordinarily will not be planted in it. But if there is such a supply of that quality of land that it continues to be used side by side for both products, it will have the same value and yield the same rental in both uses. The law of indifference applies. The demand for any factor entering into products is reflected, in an increased price, to its cost in all competing products. Machines are usually made for some product determined in advance, but often they are only partially specialized and within limits they can be adapted. Sewing-machine factories were readily turned to the making of bicycles at the time of greatest demand, and bicycle factories later were used for the making of automobiles. Thus, in general, machinery is used for the product in which it can realize its highest value. Any enterprise seeking it for any other use finds its “cost” affected by its various alternative uses. The same is true of all the materials and of all the grades of labor entering into products. The enterpriser’s cost is therefore the reflection of the ultimate prices of the productive agents in all its other uses as well as in the particular product he desires.
§ 12. Cost an expression of consumers’ estimates. It appears that within the limits of monopoly control prices may be fixed without reference to the costs in the particular enterprise. Even a monopoly, however, is limited by costs, in the range of its price fixing. When cost does appear as the limiting influence in the price of a particular product, the cost is itself fixed by a larger group of influences, the demand for the factor in the totality of its uses. Wherever cost asserts itself the enterpriser must bow to the situation, and must conform closely to costs or suffer a loss. The consumer by deciding to buy this or that product sets into motion waves of value. The enterpriser transmits these to the factors. He is the medium through which consumers express their estimates. The enterpriser who anticipates aright and satisfies the public taste is the good medium. He readily transmits and accurately focuses the rays of public judgment. The enterpriser who misjudges is a poor medium. The one realizes profits, the other incurs a loss.
On other meanings of profit. It is well to note for caution’s sake other loose uses of profit as any gain or advantage secured by any means in business. In retail business it has the meaning of the gross gain on a given sale, the excess of the selling price over the price at which the merchant bought it from manufacturer or wholesaler. Let us call this sale-profit. Buying an article for one dollar and selling it for two dollars, is said by the merchant to be selling at 100 per cent profit, jocularly called, “The Dutchman’s one per cent.” In different lines of goods there is added regularly to this cost 20, 30, or 50 per cent, as the case may be, as the merchant’s profit on the sale. Sale-profit leaves out of account rent, interest on capital, clerk hire, freight, and many other minor items that enter into the cost of running a store. It often happens that the Dutchman’s way of reckoning is near the truth, and that the sale-profit of 100 per cent leaves at the end of the year hardly 1 per cent of the sales as a true income to the merchant. This meaning is sometimes developed to a yearly sales-profit, the sum of all the separate sale-profits within a year, or the difference between the wholesale and retail prices of goods sold within the year.
Another meaning is given to the term by expressing yearly sales-profits as a percentage of the capital invested. The rate of profit in this case varies partly with the rate of the turnover. To illustrate: if the amount invested in a printing-office is $100,000, and the annual business done is $300,000, the capital is said to be turned over three times; if the yearly sales-profit were 20 per cent, the ratio of sales-profit to investment would be 60 per cent; but, if the capital had been turned over four times, the rate would have been 80 per cent on the investment. In none of these cases is profit used truly as an income.
The source and cause of profits in economic writings. Profits, as used by the English economists from Adam Smith (“Wealth of Nations,” 1776) to John Stuart Mill (“Principles of Political Economy,” 1848) and after, was the residual amount combining the incomes attributable to the personal management together with the capital-investment. These functions were assumed without discussion to be united in one person, as they usually were, stock companies at that time being rare outside of banking and foreign trading companies. The capital-income was assumed to be much the larger part and there was almost no thought of the varying degrees of ability in management as affecting the result. Hence profits in the older English economics often means nearly the same as yield from capital, peculiarly the income of the capitalist; tho usually it means this plus an allowance for risk and services of management. “Normal” profit was thought of as varying from one class of business to another but not very clearly as varying from one establishment to another.
Then the pendulum swung in the other direction and some writers, notably the American, Francis A. Walker, made profit mean almost solely the earnings of management, it being assumed that financial resources naturally rolled into the possession of able business managers. But, as it was assumed that they always had some capital themselves, the concept of profit still had a dual character. Capitalists were thought of as always getting a contractual income, interest, whereas the entrepreneur got an income varying from zero (or a minus quantity) upwards, according to his skill in management.
[1 ]See note, On other meanings of profit, at end of chapter.
[2 ]See note on The source and cause of profits in economic writings, at end of chapter.
[3 ]The old English word undertaker, once so used, seems to have been driven out by a rival use; perhaps after “funeral director” displaces it there, it may be reclaimed by economics.
[* ]The rates given are, of course, only illustrative of the proportions in which they might vary in a particular case. In fact the common stock might pay no dividends for years while dividends and interest on all the other classes of securities were regularly paid.
[4 ]Compare note on value vs. utility of labor in ch. 19.
[5 ]Economists long took that proposition as sound, and tried to build upon it a scientific explanation of prices and values as they are. It always has been recognized that there are difficulties in such an explanation. We shall not enter into the controversy, but briefly indicate the point of view we now take.
[* ]A factor F (it may be a concert singer, an acre of land, or a mineral spring) derives its entire value (usance and capital value) from the price of the product, is valuable or worthless according as the product is so. If two or more products (p′, p″, p″′) are attributable to it, its value is the sum of their prices (less costs, that is, the prices paid for other factors). But inasmuch as the use of F for one product takes it away from the use of another, the value of its use must be accounted as a cost whenever it is a question of increasing the output of any one of the products. Therefore, at that moment the cost seems primary and price derived.
[* ]The figure shows how the value of a unit of product at a is reflected up to the source, and through successive links to the most distant product z. The effect of this is to reduce the sale of z and correspondingly the use made of the agent in question. A higher price of leather, p″, due to the increased use of shoes (f), raises the value of hides and cattle (F) and raises thus the cost of carriage-trimmings, pocketbooks, footballs, leather belts, and every other leather product (b, c, d, e). As the price rises, substitutes for leather, and imitations of it, are used for such of the products as can not bear the increased cost of leather. As more cattle are raised to provide the leather, the value of meat (p′″) falls, and likewise soap (g) and oleomargarine (z).