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Ethics and Maximizing Profit – A
Practical Approach by Paul J. Updike INTRODUCTION Most people realize there may be
conflicts that exist due to a firm’s desire to maximize profits yet still
fulfill its ethical obligations. I will demonstrate in this article that it
is possible, in fact, it is necessary to behave ethically while focusing on
maximizing a firm’s profit. But such behavior necessitates understanding the
difference between a firm’s short-term profit and a firm’s long-term
viability. Ethics, the noun, is defined by
Webster’s unabridged dictionary as “the study of standards of conduct and
moral judgment.” Ethical, the adverb, is defined by
Webster as “conforming to the standards of conduct of a given profession.” In
my opinion, whether the people in a firm act ethically is perhaps even more
important than whether the firm is profitable, in the short-term. We will
explore several business situations that different people responded to
differently and attempt to find a ‘working’ definition of ethics, as opposed
to a ‘textbook’ definition of ethics. We also need to explore and
explain what the phrase “focused on profits” means. We know that as a public
firm makes increasing amounts of profit, the price or value of its stock
tends to increase as well. Because many of the executives of today’s firms
receive a significant portion of their compensation from stock options, if
the value of the firm’s stock increases, then the value of those executives’
compensation also increases. If the value of the firm is also increasing,
then shareholders like the fact that the value of the stock is rising too.
However, when the value of the stock increases, disconnected from a long-term
appreciation in the value of the firm, then that reality can be the source of
an ethical dilemma. Since economic theory assumes that
investors are rational, we assume that every investor wants the price/value
of their stock to rise over time. This also means that capital investors
expect that the professional managers running public corporations, which are
owned by investor/shareholders, are likewise maximizing profits. However, in
order for a firm to actually maximize profits, that firm must ensure its long-term viability. My contention is that ethical
behavior actually enhances a firm’s long-term viability. A Typical Business Scenario For most of the first 40 years of
my life I was consumed by numismatics. Not only did I spend an inordinate
amount of time in the world of coins, I also spent an inordinate amount of
money. From age 10 to age 40, I spent tens of thousands of dollars buying and
selling coins. A coin’s value is determined by a
coin’s grade and its rarity. Whether the coin is rare or not is usually an
objective judgment. But a specific coin’s exact grade is a subjective
judgment, subject to the anecdote that a dishonest coin dealer buys a coin at
a lower grade than he sells that same coin. Coins in a high grade might be
100 times more valuable than the same coin (assuming same denomination, same
date and same mint mark) in a low grade. Expertise in grading takes years to
learn. I have spent thousands of hours carefully looking at tens of thousands
of different coins and I am only an informed amateur. When I was younger, I worked for a
coin dealer friend, Don McConkie, who related to me the following story. Don
was in another coin dealer’s store when a woman walked into that store with a
roll of fifty uncirculated, same date and same mint mark dimes. Upon further
conversation, the lady revealed that the death of a progenitor allowed her to
come into possession of these coins. These dimes were quite rare and in
exceptional condition. The dealer (who was an expert grader) acted moderately
interested in the coins and offered the lady $250 dollars ($5 for each dime)
for the entire roll and the lady was excited to make the trade. Ethical Choices Yet, any one of those dimes,
individually, would have easily fetched $250 apiece at that current point in time. Did the coin dealer who
made this exchange have an ethical obligation to tell the lady how rare and
how valuable the dimes actually were? The simple answer is yes, the coin
dealer bore an ethical obligation to explain to the lady that she possessed
something rare and valuable. Ethical behavior requires that the expert share
information with the untrained such that any future business transaction
between the two can happen ‘at arm’s length’. In the coin world, if two
people agree about the exact date, mint mark and condition of a coin, (therefore
they both know the approximate value) then they can negotiate an appropriate
price. The coin dealer carried the
ethical obligation to tell the owner of the rare dimes something similar to
the following: “These dimes have a street value between $10,000 and
$12,500. I typically buy at around 60% of retail value which might be $6,000
or $7,000 for the entire roll. But 50 coins of the same date and condition
might sit in my inventory for several years. Therefore, I could offer you
$5,000 for the whole lot today.” But he did not say these words, or anything
like them. In my three decades negotiating
the world of coins, I only met two ethical coin dealers that I could trust,
(one of whom was Don McConkie, noted above) though I dealt with literally
hundreds and hundreds of coin dealers. I know that I only met two ethical
dealers, because I tested them. These two dealers are people who graded and
offered me a similar price for the same lots of coins separated by many
months. Both these dealers were focused on profits, but neither one ignored
his ethical obligations. Because we are talking about maximizing profit, it
is important to note that both these coin dealers retired from the coin world
after lengthy careers. Can a Firm Choose to be Ethical? When I was asked by the Vice
President of a national firm about the ethical behavior of the General
Manager of my plant, I did not flinch. I told him exactly what happened. The
General Manager was fired shortly after my conversation with the GM’s boss. The VP then promoted the Sales
Manager of my division to GM and the new GM and I (as Controller) had a
thoughtful conversation. We committed to each other to focus on profits. We
also decided that whenever a situation arose where our honesty and integrity
were challenged, obviously or not, we would choose to behave ethically,
whether or not that specific behavior would enhance our profits at the time. The answer to the question, “How
does one behave in an ethical manner?” especially if such behavior costs
oneself or one’s firm real profit, is simply to decide beforehand how one
will act under any circumstance. If one waits until the situation
arises, with that situation’s attendant pressures and deadlines, one may not
act the way that they had hoped they would. Only if one decides now to
act in an ethical manner in any and all future business transactions that
they are party to in the future, can one hope to act in an ethical manner
when a new situation, with its attendant pressures, arises. Also, as an MBA
professor once suggested to me, always have three job offers in your pocket,
just in case the current one does not pan out. Different Incentives Often Mean Different Results A firm is simply an amalgamation
of people. If the corporate culture expects ethical behavior, then it is
reasonable to expect ethical behavior from each person in the firm. But more
than a few corporate cultures have allowed and even rewarded unethical behavior in the last few
years. Why? GE In December 2001, Jeffrey Immelt,
the new chairman of the ultra-successful (as measured by market
capitalization) public corporation GE, told assembled analysts “We give
investors a chance to sleep at night knowing that [we are] going to
outperform the S & P 500.” (Fortune, 11/11/02) On the one hand, perhaps Immelt
said these words to set the performance bar higher for his employees
than the level at which employees from an ordinary company might
perform. On the other hand, and the next year of revelations from GE bears
this likelihood out, Immelt also perhaps allowed for continued questionable
behavior by his employees. (Fortune, 11/11/02, p108-117) In fact,
during his first five years at the helm as GE CEO, the value of GE stock has
only moved mostly sideways. One economist makes the following
observation about corporations. “Why is the question of who controls a firm
important? Because economic theory assumes the goal of business owners is to
maximize profits, which would be true of corporations if stockholders made
the decisions. [However] managers don’t have the same incentive to maximize
profits that owners do.” (Colander, Macroeconomics, 4th Edition, p60) The manager of a corporation has
the incentive to maximize his or her own gain, not the corporation’s. If the corporation’s goals and the
corporate manager’s goals coincide, then corporate profit-maximizing may
happen. However, currently, the corporate managers’ concern, since government
regulations require profit disclosure of public corporations on a quarterly
basis, is that the managers appear to
have the corporate shareholders’ interest foremost in their mind. Thus we
have an inordinate concern among corporate executives to report
ever-increasing profit each quarter. This pressure creates an ethical crisis
waiting to happen. Jack Welch After Jack Welch, the prior
Chairman and CEO of GE, retired, he was quickly involved in a messy divorce
occasioned by his infidelity. His soon to be ex-wife threatened Welch that if
he did not deal with her in an upfront manner, she would reveal his
retirement income and benefits. Because she decided that he was not being
fair, she revealed to the world that Jack Welch had personally accumulated
retirement perquisites worth tens of millions of dollars a year on top of the
hundreds and hundreds of millions of dollars of wealth Welch had
been paid while running GE. Remember, a Board of Directors
typically has a compensation committee composed of people who usually pay the
CEO whatever he insists on being paid. At first blush Jack Welch’s remuneration
seemed appropriate, because during his 20-year tenure, GE had grown in
market capitalization many, many times. Shortly after retirement, the market
cap of GE tumbled by one half and GE was revealed to be another house of
cards, a house that Jack (Welch) built. (Fortune, 11/11/03, P108-117) Did
Jack Welch offer to return any of his ill-gotten gains? What do you think?
Did he behave completely ethically? What do you think? Ways to Cheat Investors by Spinning Geoffrey Colvin, of Fortune magazine, has written
several columns over the years about unethical behavior. Colvin points out
three ways public corporations manipulate accounting rules and other
regulations, to appear more profitable (in the short-term) than they really
are, by reporting profits not produced by current operations. The first way is for public
companies to treat their pension fund as a profit center. Current GAAP rules
(in 2002) allow firms with a defined-benefit pension fund invested in the
stock market to make an annual assumption about the percentage return that
the fund may earn. If you change the assumption, then you change the reported
profits up or down, whichever way is needed. The second way is to set up
reserves based on something other than reality. For instance, most companies
have a significant account receivable balance that they hope to collect. We
know that some percentage of the account receivable (AR) balance will not be
collected. Customers go bankrupt, customers dispute the AR amounts, some
portion is credited back to the customers, etc. In order to not legitimately
overstate the amount of AR that a firm might collect in the future, GAAP has
instituted a ‘contra’ asset account called Allowance for Bad Debt. Unethical
companies can over-reserve the Allowance for Bad Debt account in good years,
creating a ‘cookie jar’ and take from the cookie jar in bad years to smooth reported profits, an SEC quarterly requirement for public
companies. The third way is to play the
guidance game. Stock market analysts often ask the CEO and CFO of public
companies how things are going along the way, before quarterly results are
reported. Depending on the public statements made about current operations,
the CEO and CFO can shape expectations of their quarterly results, which often
have a dramatic impact on whether the firm’s stock price moves up or down. (Colvin, Fortune, 10/28/02, p66) Who Cares About Stock Price/Value? Why do corporate executives care
about the price/value of the stock? Because the price/value of the stock is
one important signal to everyone, including investors, of how the market
perceives the quality of current profit and how likely continued profit might
be tomorrow. But the bigger reason that managers care is because corporate
executives often have millions or tens of millions or even hundreds of
millions of dollars in stock options that they can cash in, if they can
manage (in the short-term) to keep the price/value of the stock high until
they sell. In fact, in the year 2000, just
before the stock market bubble burst, collectively, billions and billions of
dollars of value due to stock appreciation was cashed in by corporate
executives. However, ordinary shareholders were not as fortunate as corporate
executives to know the complete information regarding the quality of the
reported profit. Most people, (after all, around 50% of Americans adults
are stock market investors), were not surprised to learn later that a
significant portion of the reported profits for public firms were bogus,
especially after their own 401k plans imploded. In many situations, millions of
shareholders in Remember, we investors want our
investment of capital to be profitable. Public companies are required to
offer to the public significant amounts of operating information every
quarter. Central to this regular revelation is information about the quantity
and quality of quarterly profit. Unfortunately, what investors are
often given is an excuse by managers who treat the shareholders somewhat
like the government treats taxpayers. Whatever costly scheme or idea they
(whether managers or government politicians) want to implement is acceptable
to attempt because the managers or politicians are spending other people’s
(the shareholders/or the taxpayers) money. Question -- How do we align the
interests of management with the interests of shareholder, that is, to focus
on maximizing real profit? The simple and direct answer,
believe it or not, is to raise our (investor) expectations regarding the
ethical behavior of corporate managers. If this is not possible, then no
scheme or law will work for the long-term, period. The question to consider
again is, “How does a firm maximize profits?” CONCLUSION Maximizing profit can be defined
as when a firm operates profitably enough to allow for self-sustained, long-term
viability, ensuring an increasing value to accrue to the assets and the net
worth of the firm over the long-term. The real challenge for a firm to
maximize its profits is to realize that the managers of the firm have a
short-term planning horizon, while the investors who provide the capital,
typically have a much longer-term planning horizon. Remember when your sports coach
told you that you had to endure short-term pain for long-term gain? That
situation also applies to public corporations. The managers of a corporation
must be able to make short and medium-term decisions that are better for the
firm’s long-term health, which decisions may not be immediately profitable,
in order for the firm to be viable for the long-term, for the firm to be able
to maximize profit. We investors must stop being
fascinated by quarterly reported profit. The only way to be sure that the
interests of the corporate executives (assuming they already have sufficient
competence and experience) can be aligned with the corporate shareholders is
for the shareholders to correctly believe that the executives are ethical
people. Perhaps the best way to assure that the corporate executives are
ethical is to watch their behavior. When situations arise that call for
sacrificing short-term profits for ethical behavior, how do these managers
perform? Jerry Useem,
in the 10/28/02 Fortune
magazine, cites Bernard Lev, an accounting professor at Proposal to Fix GAAP Instead, Bernard Lev proposes what
might be termed, “Backwards Accounting”. Lev suggests chilling out for a
number of years, then looking to see whether or not the pension fund returns
hit the projected return. After a passage of time, an investor could also
look and see whether or not the bad debt reserves were too high or too low.
However, since asking for shareholders to wait around for a number of years
seems too long to wait, then just like the quarterly GDP measure is revised
once in one month, then revised again a month later, we could implement the
same ‘rolling revision’ for corporate profit, which, though it seems strange,
may get us closer to reality. (Useem, p192) Just like the best measure of
profit may be ‘Backwards Accounting’, the best measure of ethical behavior is
historical, after the fact. If certain corporate executives responded in the
past to an ethical problem in an ethical manner, it is much more likely that
when ethical situations arise in the future, and those situations will, those
same executives will respond in a similar manner. Therefore, when the interests of
the managers of the firm are aligned with the interests of the shareholders,
then the managers can maximize profits by offering some combination
of quality, price and delivery of their firm's product or service in such a
way to ensure that the firm is profitable. When a firm is truly profitable,
then it can survive today, tomorrow, and next year. Long-term viability for a
firm comes from offering to exchange a product (or a service) with consumers
profitably in the short-term, over and over again. Then, only when a firm
stays viable (both ethically and profitably) for the long-term, can a
firm harbor hope to maximize profits. I suspect there is no other way. References: Colander, D.C. (2001). Microeconomics (4th ed.). [ Colander, D.C. (2001). Macroeconomics (4th ed.). [ Fortune Magazine, November 11, 2002, p13. Fortune Magazine, September 16, 2002,
p56. Fortune Magazine, October 28, 2002, p66, p108. |
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