2. Profit creation

Profit is the underlying goal for most business entities. But what does it mean to achieve profits in the economy and how such recurring success impacts our financial system? To understand consequences of this process, we have to have a look a bit into very simple accounting rules. Nothing complicated, just necessary basics: Every company that achieves profits has sales which are higher than its costs. Easy, why not?

What constitutes the sales part is not important for now, it is each businessman decision where he/she is going to make business.

What interests us is the costs side.  Costs consist from wages, material, subcontractors and capital costs. It is simplified view but sufficient. Let´s have a closer look at particular costs. If the material is being priced, where is its price coming from? Raw materials, either natural or manufactured are delivered by companies that have employees of their own, are consuming their own subcontractor’s services, material and trying to achieve profits. How the price of coal is determined? Corporation must pay its employees, subcontractors and determine a price that is higher than these costs so it can incorporate also some profit. The same applies for companies providing services, energies and capital as well. The price must be always higher than the sum of costs, including costs for capital.

We can describe it like this


So we can see that all other costs are in fact transformed wage costs and profit. Under subcontracted costs we can understand the broadest category which includes material, services and capital. Costs of subcontract B consists from wages of company B, profit of B and subcontracted costs of other companies allocated for this subcontract. The same way costs of C are made from similar components and so on until the end of the pyramid.

Yes, even the price of capital is in reality determined by cost of labor (bank officials of all kind) and profit (as determined by difference between interest rates for customers and costs of capital from savings or interbank market)

The final effect is that the profit of any company is the difference between sales and wages of people participating on these sales in the broadest sense and profit margin of all subcontractors

For company A to achieve profit it must be so that sales are greater than costs, which means that overall wages, cooperating on such production must be lower than sales.

And here is the catch!!!  If this is the equation of a successful company, how can this production be realized? How can you sell the production when the buying power of all employees, participating on its making is lower than planned sales? If you total all wages paid in the production process associated with this particular production (not just direct wages but also wages of all subcontractors, apportioned to this and providing input like materials, services and machinery) they will be lower than planned sales by exactly planned profit.

The example: 

Company A uses own workers and pays them 100$.
Apart from labor it buys material worth 30$ form company B and uses machinery produced by company C worth 40$ which is planned to be used over 4 years, so its costs are calculated as 1/4th of 40$ = 10$ per year.

So total costs of A are: 100 + 30 + 10 = 140$

If they plan to achieve profit of 10%, A has to sell whatever they produce for 140 x 1,1=154$

Company B as supplier of material has to make profit as well and if we say the expected profit margin will be as well 10% their paid wages allocated on this delivery cannot be more then 30 / 1.1 = 27$.  If they paid more in wages, they would not achieve their planned margin 10%.

Company C as producer of machinery of longer life span if planning profit has to take into account that the wages paid to their workers have to be calculated in line with expected turnover. So they cannot pay their workers more then 10 / 1.1 = 9$ per year if expected profit margin is again 10%. They will not sell new machine in this micro economy until the old one is fully depreciated and new one is needed by company A. 

The resulting buying power distributed through wages is following:

AD (aggregate demand=buying power) =  100$ (A) + 27$(B) + 9$(C) = 136$

The aggregate supply of products of company A is:AS = 154$.
The difference between AS and AD is 18$, which consists from 14$ (profit A) + 3$ (profit B) + 1$ (profit C)

So the production of company A is going to have some problems being realized as there is simply not enough buying power distributed through wages as is expected to be achieved in sales. This simple example describes the problem with profit and its effects on diminished buying power. The higher the profit margin, the bigger the end difference between available demand and offered supply.

You will say, and correctly that sales are achieved mainly through customers which are not employees. Correct. But these people are employees of some other company as well - and their employer is guided by the same equation. He too wants to achieve profit. Therefore he too, logically sets his prices in a way that his planned sales are higher that collection of his own and transformed wages. Therefore, we can transform the equation of one company into one global equation, describing sum of all sales of all companies in economy:

We can add additional company D which produces some another product with 1000$ wages and plans profit at margin 20%, so is expecting sales of 1200$.

The available buying power distributed through these two companies is now
1000(D) + 136(A+B+C) = 1136$

The supply is represented by two set of productions valued at 154(A) + 1200(D) = 1354$

Even the second company added substantially more buying power into the system, its collective customers are not able to buy what is offered. The difference between AS(1354) and AD (1136) is again in the profit: 18$(A+B+C) + 200$(D) = 1354$ - 1136$

It could be that well paid employees of company D would buy all production of company A, but in that case there would be insufficient remaining demand(1136 – 136 = 1000$) to satisfy sales of company D. At least not with any profit. If all employees participating in production tree A+B+C would use their wages to complement buying power of employees D, they would be able to buy nearly 95% (1136 / 1200) of production D while maintaining its profit margin but company A would realize no sales at all and end up bankrupt.

The result is striking and surprising for some:

If all people had only employee’s income and sales would be derived from this source only, it would not be possible to achieve it with planned profit as buying power distributed through companies as wages is lower than planned sales.

People are able to buy only as much, as they get through wages and other resources which we call additional. As wages are planned and paid lower as aggregate sales, these sales are not possible to achieve only from the volume of salaries. It is mathematically impossible. How can the system be functioning then? (Because it is functioning, or at least looks so).