What “profits” means.

The general dialog often refers to company profits. This is especially true when the discussion turns to minimum wage and corporate taxes. A common belief is that companies require profit in order to remain in business. There appears to be a bit of misunderstanding of what “profit” is, precisely. This lack of precision leads to mistaken conclusions.

There are to fields of study from which to draw a definition of “profit”. These are economics and business accounting. The two yield the same final understanding though alone they both are a bit lacking. The reason is simply that the precise definition often depends on what the point is. Economics, when concerned with profit maximization, isn’t concerned so much with taxes. Business accounting can be all over the map with revenues, earnings before taxes, earnings before interest and taxes, earnings after taxes, and on and on.

The best precise definition that gets to the point of profit is that it is the final amount of monies remaining after all costs, interest, salaries, and taxes have been paid.

The math goes like this;

Costs = wages*labor_hours + rents*equipment.

equipment includes facilities and capital equipment. Wages includes all wages, hourly or salary.

Revenues = price * quantity.

Earnings = Revenues – Costs

Earnings are before taxes and interests which is referred to as EBIT in business accounting. Typically, interest is deductible from earnings before the tax rate is applied.

EBIT = Revenues – Costs

EBT = Revenues – Costs – Interest

Earnings After Taxes = Profit

Profit = (1-t) * EBT

What is significant here is that if EBT is zero, there are no profits and no taxes. It is obviously necessary for a business to be able to cover costs. At the very least, revenues need to equal cost plus interest. But, when all is said and done, as long as revenues cover interest and costs, there is no necessity that a company earn profits or even end up paying taxes.

And, in fact, this is how businesses do tend to operate. Of 25 million companies operating in the US in 2012, they paid a total of about $191 billion in taxes. This amounts to about $7000 per company in taxes. With an effective tax rate of about 26%, the total per company profits amounted to about $21,000. $21,000 per company is pocket change. It doesn’t even cover the income of one minimum wage worker. It is, for all practical purpose, insignificant.

This is not unexpected as it is exactly what is predicted by basic classical economics. In a free market, any profit attracts competition. Competition drives down prices which quickly drive profits to zero.


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