Optimising only for profit is a lousy strategy

I felt sorry for the woman when I heard she was going to be let go by the company. I felt even more sorry when I heard that she would be replaced by 3 graduates in China. Seriously, graduates were that cheap in China?

This reminds me of a Chinese phrase. “In the past, having a degree was a big deal. Now, the whole street’s filled with graduates.” Not all degrees are created equal.

Let’s start off with a few baseline understandings…

Infinity and beyond

John Cook said this about infinity,

Problems are often formulated in terms of infinity to make things easier and to solve realistic problems. Infinity is usually a simplification. Think of infinity as “so big I don’t have to worry about how big it is.”

(Emphasis mine)

Companies like infinity. Particularly when it comes to describing (theoretical) growths and market share. This is false. More on this later.

Basic economics

We will assume this simple generalised equation for the purpose of this article:

Profit (or earnings) = Revenue – Cost

You can think of revenue as the price of an item. Cost covers everything from the cost of manufacturing an item to storing the item, to paying employees, to paying rent (for use of space), to paying utilities.

Just keep in mind that profit is calculated from 2 components.

The gold standard and Bretton Woods

Back in the old days (way way back), the value of money was static. If you held on to a dollar, 10 years later, that dollar was still worth a dollar. That’s because the value of money was tied to gold.

Historically, a bank was legally responsible to give anyone gold in exchange for the money bill given. That means if you handed the bank 100 dollars, the bank had to give you 100 dollars worth of gold. This meant that banks had to keep large reserves of gold, just in case.

The invention of the money bill dollar note thingy just made it easier so you don’t have to carry around nuggets of gold. Gold’s heavy.

In July 1944, the Bretton Woods Agreement was signed. Basically, many countries agreed to tie their currency to the US dollar. The US dollar was tied to the gold standard, so this wasn’t a problem. (This was part of the reason why US rose to be a dominant force in the world in the early days, because practically everyone was using the US dollar as a reserve currency)

In August 1971, the United States stopped the convertibility of the US dollar to gold. It might have something to do with funding the battles of the Vietnam War. The US ran out of funds. To continue funding, the US needed to print money out of thin air. And you couldn’t do that if your currency was pegged to gold. (Note: I’m not bashing on Americans. I read this in an economics book. No I can’t remember which book… you should know me by now…).

This also “freed” the other countries from tying their currencies to the US dollar. Which (probably) gave rise to the idea of foreign currency exchange rates.

The dissolution of the Bretton Woods Agreement also meant the creation of fiat money. Meaning that dollar you have there is worth what the government say it’s worth. Printing money out of thin air also gave rise to the concept of inflation. Meaning that dollar you have there is probably worth less than a dollar a year ago.

Saturation limits

31 October 2011 was designated as the day when the world population became 7 billion. It’s a big number, but it’s not infinity.

Which is where the companies made their mistake.

In the post-World-War-2 era, everyone wanted a better life. We’ve sacrificed enough. We’ve suffered enough. We want a better life! (baby boomers, hello!)

Babies were made. Population grew. Household appliances made their ways into homes. Henry Ford created the automobile. Product categories multiplied. Industries boomed.

Revenue was up. Sales quintupled. Profits were up.

Just when local markets seemed exhausted, globalisation came and opened up the world. International trade continued the seemingly upward trend.

People started expecting growth as a natural consequence. Companies started paying more attention to Wall Street and upholding shareholder value.

“We just need to capture 1 more percent of market share!”

That started to get harder. The customers who wanted to buy your product had already bought your product.

I read that in America, there were more licensed vehicles than licensed drivers. Meaning there were more vehicles than people who could drive them. I understand there’s a surplus of 31 million of such vehicles. Supposedly, every man, woman and child in Canada could have a vehicle from this surplus.

There are probably more cell phones than cell phone users. There’s more food produced than needed to feed every person in the world (yet there are millions starving).

What happens if Microsoft succeeds in placing a computer (with Windows, naturally) on every desktop and in every home? What happens if Apple succeeds in placing an iPhone/iPad in everyone’s hands? What if everyone has already bought Angry Birds on their iPhone/iPad? What happens if McDonald’s succeeds in getting everyone to eat at their restaurants? What if everyone used an Oral B toothbrush? What if everyone used Body Shop products? What if every male used Old Spice?

What if every business person is already flying with your airline? What if every Harry Potter fan already has all 7 books? (that’s probably a rhetorical question…) What if every C# programmer already owns a copy of your C# programming book? What if every tea lover in your area is already frequenting your tea house?

What if every possible customer already has your product? What if every possible customer already maxed out his/her rate of consumption of your product?

The natural limit is population. The next limit is rate of consumption. Every company hits these 2 limits. The limits just weren’t as prominent a couple of decades ago.

Revenue started stalling

When you hit those natural limits, the company growth stalls. To give the illusion of growth, we go back to that equation again.

Profit = Revenue – Cost

The outside world (mainly Wall Street and the stock market) views growth in relation to profit. The assumption is that if a company is making a profit, it’s still healthy. As in it’s still bringing in revenue.

But if you’re not bringing in revenue, it means you’re not making any more sales. Maybe it’s because your customers switched brands. Maybe your customers switched to a cheaper version of your product (which cannibalises on your own sales, but hey at least you didn’t lose that customer).

But in today’s hyperconnected world, the reason is probably that your customer “market share” is already saturated. You might think 7 billion people is still a lot of people, but a large part of those people are in poverty. They simply cannot buy your product. Or those who can buy your product, don’t want your product.

Some new startup shows up and gets millions of users within a month. It continues at a steady pace and then… stops. The natural equilibrium is reached.

The company CEO has to do something to show that the company is still growing (because the people watching Dow Jones is breathing down her neck). So if revenue doesn’t increase as much, what can you do to increase profits? Reduce costs.

Cost reduction policies

I’d say as a broad generalisation, there’s only so much you can do to reduce costs. Rent space? Consolidate people and equipment in fewer locations. Equipment maintenance costs? Have less equipment, or more efficient equipment, or just get rid of the whole thing.

But one of the most costly line items (if not the most costly) is hiring people. (Be honest. Tell me when I said “cost reduction” you didn’t think of “layoffs”)

Let’s see. The world population is growing (albeit more slowly now). Generally speaking, more people are working (I know the current economy sucks with few jobs being created. Stay with me). Less people are dying. More people are having longer lives. Less opportunities to move up the corporate ladder (because the high level managers are still there).

Yet people still expect pay raises every year. I’m not pro-Malthusianism, but the supply of money is kinda limited… Wait, good thing the Bretton Woods Agreement was dissolved.

Since people have feelings (and machines and raw materials don’t), companies hesitate to fire people (in case of major backlashes). So something has to give.

Outsourcing (the bad kind). Mergers and acquisitions (probably where the term “wholly owned subsidiary” came from). Subtle changes in accounting books (which is illegal, don’t do it).

Anything to create the illusion of growth and profits. (And with the fiat currency system, money itself is kind of an illusion. But that’s another topic…)

It’s made people commit suicide to make an iPhone. It’s made people to over-consume (creating obesity as a problem and the dieting industry to exist). It’s made people buy houses they couldn’t really afford. It’s made people to allow those people who couldn’t afford houses to buy houses.

It’s made people look for shallower qualities in marriage partners (diamonds, big car, big house, big breasts [I hesitated on including this one], big paycheck), which caused increasing divorce rates, which increased the number of divorce lawyers needed, which increased the number of real estate agents needed (to split the property).

It’s caused the dot com bust. It’s caused tech startups to look for the fastest exit strategy, because the venture capitalists backing the startup forced the founders to do so (so the VCs could get their return on investment).

Optimising only for profit is a lousy strategy.