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You're reading: Digital Tonto: The profit paradox

Profits, after all, are the engine that drives the world of commerce. Any idiot knows that.

Unfortunately, idiots who do know that go out of business all the time. The US auto industry, integrated steel giants and many others who failed were extremely profit driven and, in fact, it was their quest for profits that was their undoing.

That’s because making money means nothing without competitive advantage. Companies who chase opportunities in the name of profitability often find they can’t compete, while others, like Wal-Mart, Southwest Airlines and Nucor are able to be consistently profitable in tough industries with thin margins. Profits aren’t what always what they seem.

True profitability is more than just making money, although the two concepts are often confused.Richard Rumeltillustrates the point nicely in his bookGood Strategy/Bad Strategy, where he gives the example of an imaginary silver machine.

He asks us to imagine a silver machine dropped from a UFO that can create $10 million dollars of silver per year out of thin air with no costs. There are also no taxes and the interest rate is 10%. A profit seeking company buys it for $100 million. Did they make a good investment?

The not so obvious answer is no. Their return on the silver machine was 10% – exactly their cost of capital. There’s no way for them to improve on the machine, it already produces silver at no cost. They might be betting on the increase in silver prices, but then they aren’t creating any value, just investing in a commodity and hoping it will go up and not down.

It’s a very simple concept, but one that few managers understand. You are only truly profitable if you earn money in excess of your cost of capital, otherwise, you’re better off with money in the bank (unless, of course, they are chasing their own profits in real estate), and the only way to consistently do that is to build advantage.

Why are so manyresource rich countries so poor? Why are resource poor countries like Japan and Singapore so rich? That’s the essence ofDutch disease.

When a country earns lots of money from selling commodities, it does more than just bring in money. It also drives up wages and currency values. Generally, that’s a good thing, but it also has a downside. Products in high skill, value-added industries become uncompetitive.

Many corporations fall into a similar trap. They see a high growth industry and rush to get in on the windfall. Of course, other companies see the same opportunity and do the same. Investments are made, salaries go up (labor tends to be scarce in high growth industries) and focus shifts.

Inevitably, growth in the target industry slows and by that time there is overcapacity from all the companies rushing in. The “great profit opportunity” has done nothing but take resources from the core business.

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