Profits and Costs

Profits and costs

The myth of the evil capitalist that takes advantage of workers is false. What the situation was at Marx’s time is important only for historical reasons. What matters is how things are today. The capitalist is the entrepreneur. Many business endeavors close after 2-3 years with losses. Even the successful ones start with losses at the beginning and are “in the red”. At a certain point they break even and then profits start. After a few or many years, profits peak and from there the road is downhill. The peak may last for many years but not for ever.

There is no doubt that some businesspeople have huge profits. This is evident by the fortunes they have made. If we examine all those who started businesses, profits will be very low and there might even be losses. Something interesting would be to find the level of profits overall. That would be hard to calculate because data will be needed for everyone who had a business for even a few months.

It is wrong to see profits at their peak. The accurate measurement is ROI (Return On Investment) which is calculated with some sophisticated method in the company or investment valuation model. To make ROI simple and understandable, conceptually it could be seen as average profits although mathematically a different formula is used (it will be examined briefly later).

Smith, Ricardo and Marx all formed value theories. Profit is the mark up a company puts above all costs, including interest and taxes. Profit is the reward for putting money in the company, the return on investment. When a depositor puts money in the bank, she expects a reward which is interest. When banks loan money, they expect a reward for that, which is interest. The difference between the two interest rates is the bank’s spread. That is how banks make money. They lent at a higher rate than the one they borrow. When someone invests in the stock market, she expects a reward. Why would not someone expect a reward when investing in her own business?

Should the return of investment be equal to some bank interest rate? No because there is the risk factor involved. Bank loans often have collaterals. Even if this does not happen, in the case of insolvency, lenders take back their money before shareholders, by liquidating assets. The shareholder has a lot more risk than the lender. The higher the risk, the higher the return expected. There is a sophisticated formula that calculates the expected reward (return on investment) given the level of risk involved (it will be examined briefly later).

Let’s take the example of an entrepreneur who wants to start a software or an Internet company. This is a labor intensive industry. The proportion of labor is much larger in costs compared to capital. It is true that labor intensiveness is found mostly in less advanced countries but refers to industries that in advanced countries use a lot of capital. Services, high tech and other industries are by their nature labor intensive and does not have to do with advancement.

He estimates that he would need 6 more people for the first 2-3 years to run the company properly. They will work in production, finance, marketing, administration. He would have to buy furniture, computers, server, printers and other stuff like refrigerator, coffee machine etc. That is the initial investment. It is not very big since no expensive machinery is required like in factories but still adds up to many thousands of dollars. This is not the end of his expenses. For several months the business will operate “in the red” and he will have to cover it from his pocket. The bigger cost by far is labor and then it would probably be rent.

Now let’s assume that all 6 employees agree to become shareholders, co-owners of the business. They all probably have personal computers or laptops. Even if they do not have, they will buy their own. Everyone will chip in to buy furniture. They will need an office for company and client meetings but in this case it will be smaller with lower rent. A couple of people will have to be in the office at all times but the rest can work at home. This is also possible  in the case of a sole owner but it has problems. Having employees work in office makes supervising easier. Owners do not need supervising, they supervise themselves. Of course, there should be some precaution so that no one tries to get a “free ride”, let the others work and be lazy.

In this case, everything becomes easier. The initial investment is split. The most important thing is that the entrepreneur does not have to pay salaries and monthly expenses are minimal. Profits go to the owners. When the company gets “out of the red”, owners who are also employees will split profits.

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