Definition of Profit: The return received on a business undertaking after all operating expenses have been met. (thefreedictionary.com)
Note: The wages and salaries of all workers, including a working owner, are not considered to be profit.
The Dynamics of Compound Profit:
For any product or service that you can think of, if you break it down into its components and then trace each of those components back to the Earth, you will quickly see that labour and profit are really the only two costs in the whole production process. All other operating costs like raw materials, parts and supplies, buildings and equipment, energy and utilities, packaging, transportation and marketing services, etc. are really just complex combinations of natural resources, human labour and profits.
When we take natural resources from the Earth, we do not pay Mother Earth anything for them. We don't throw money into the sea when we catch fish and we don't bury money in the ground when we extract oil or minerals. Ultimately all of our natural resources are free. We do pay the costs of extracting and processing them, but the natural resources themselves are totally free.
Human labour + natural resources produce tools; human labour + natural resources + tools produce machines; human labour + natural resources + tools + machines produce everything else that we desire, including all of the goods and services that we include in operating costs. Tools and machines (and all products for that matter) are really just forms of stored human labour and natural resources.
But wait a minute, if natural resources are totally free, shouldn't prices simply be equal to human labour costs? How do profits creep into prices?
Every good or service offered in the marketplace relies on a complex series of interwoven supply chains. Every producer requires the goods and services of many other producers to operate their business. If all producers are trying to recoup all of their operating costs, plus are adding a profit, on top of their costs, to their own selling price, then the total amount of profit that is embedded into the selling price of every good or service that we buy compounds continuously as it moves along the chain of production. Now that globalization is so entrenched, raw materials, components, manufacturing and assembly operations, shipping and distribution routes, criss-cross the world many times before goods enter local retail channels. Production interdependencies alone can often loop through 10 or 20 levels. The table below reveals how dramatically embedded compound profits increase the selling price of everything we buy and indicates how far prices could fall if all profits were eliminated.
Step 1 represents the first business in a supply chain. For each and every $1 of his costs (call this the initial unit), he adds a 10% profit to his price. In Step 2, the second business in the chain purchases output from the first. For each and every initial unit purchased from business 1 (which now costs $1.10), he adds a 10% profit to his price. Each and every $1.10, however, includes the 10% profit that was already added to prices by the first business. So the $0.11 profit added in step 2 is added on top of the $0.10 profit that was already imbedded in the selling price of the first business. At the end of step 2, a total profit of $0.21 is now embedded in the selling price of each and every initial unit. This process of compounding profit is repeated in each successive step along the supply chain.
The effect that compound profits have on prices is identical to the effect that compound interest charges have on borrowing costs. Compound profits, however, are much more harmful to consumers. Compound interest charges take years to inflate consumer costs, compound profits inflate costs immediately. Financial advisors often use a Rule of 72 (or Rule of 70) to estimate the approximate future value of an investment. This is how it works. If you divide the rate of return, or the interest rate, into the number 72 (or 70) the number you get is the approximate number of years that it would take for your investment to double in value. For example, an investment that earns 6% per year would take about 12 years to double in value (72/6=12). An investment that earns 10% per year would take only about 7.2 years to double in value (72/10=7.2). The table above shows that the Rule of 72 can also be used to calculate how many levels of compound profit would cause prices to double at a given profit rate. The rightmost column reveals how much lower retail prices could be if all profits were eliminated entirely from the supply chain.
With an average supply chain profit rate of 10%, it takes only 8 levels to double the selling price of a product and only 12 levels to triple it. Many products produced in the labour ghettos of the Third World have profit margins that are much higher than just 10% of the selling price. At level 12, all of the wages and salaries that were paid out to workers are sufficient to purchase only one-third of the production ...and this is before taxes reduce their purchasing power even further. The remaining two-thirds of the production pie is only available to corporations and individuals who have profits, dividends, capital gains, or other non-labour income to enjoy. This two-thirds fuels the vast inequality in the distribution of wealth in the world and explains why corporations and the super rich own (or consume) a perpetually growing share of the assets that workers produce.1
Real estate & commodity speculation, leveraged trading & investment schemes, and compound interest add only profits to the selling price of the products that they touch. Totally unproductive themselves, these power tools of modern greed are only useful for extracting income from the economy. Profits and interest expropriate the earnings of workers and usurp the fruits of their productive labour. Profits siphon away current earnings, interest feeds on future earnings. With so much of Capitalism working against them, is it any wonder that most people are simply exhausted by the struggle to survive?
1 If two-thirds seems too high to be reasonable, consider this. According to data published by Statistics Canada, (Financial & Taxation Statistics For Enterprises, Table 187-0003) from 1980 to 2006, for all industries combined, wages and salaries represented only 16% to 20% of all corporate operating expenses. All of the domestic wages and salaries of all domestic supply chains are already included in this total, so the remaining 80+% of operating expenses must be a combination of imported labour costs, embedded profits, interest, or capital accumulation.
Profit and Debt - Part Three explains why Capitalism can't prevent the Boom/Bust Cycle from re-occurring.