Business is an organ of society.

“Asked what a business is, the typical businessman is likely to answer, ‘An organization to make a profit.’ The typical economist is likely to give the same answer. This answer is not only false, it is irrelevant.” – Peter Drucker

Almost four decades ago, Peter Drucker, one of the most highly-regarded writers on business and the role of business in society, described a business as an organization set up to fulfill a need which is significant enough that a group of people is willing to pay for it to be addressed.

But why are many people’s mental models for a business so different? It seems that the popular conception of a business is of a profit maximizing organization.[1] Economics textbook treat firms as profit maximizing entities for theoretical simplicity, abstracting away essential qualities. Press coverage favors juicy but often exceptional stories, from record profits to scandals to boost profits. Moreover, in the last two decades, there’s been a growing obsession with covering the daily ups and downs of stock markets and financial metrics. In this context, you wouldn’t fault someone for viewing business simply from the lens of profit-making.

I think that’s the wrong mental model to have. Here’s Drucker again:

“It is the customer who determines what a business is. It is the customer alone, whose willingness to pay for a good or for a service converts… things into goods.”

Think about that for a second. Customers provide the financial commitment that enables a business to create, build, and improve products and services. Without this dynamic, we wouldn’t be able to do many of the things we care about today–from blazing computing power in our hands to robotic prostate surgery to an all-electric luxury car with no tailpipe pollution.

And this dynamic is only getting stronger as a deeper understanding of customer needs has become a source of competitive advantage. In the venture-backed startup world, Steve Blank and Eric Ries have advised startups to use a “get out of the building” approach called customer development. In healthcare, Kaiser Permanente, my wife’s employer, is innovating around patient-centric care. By better understanding households and families, Nest has created a self-programming thermostat that actually gets programmed and saves energy.

So what is the role of profit? Let’s go back to The Essential Drucker:

“[All the objectives of a business] require effort, that is, cost. And they can be financed only out of the profits of a business. They all entail risks; they all, therefore, require a profit to cover the risk of potential losses… Profit is, therefore, needed to pay for attainment of the objectives of the business. Profit is a condition of survival… Profit planning is necessary. But it is planning for a needed minimum profitability rather than for that meaningless shibboleth ‘profit maximization.’ The minimum needed may well turn out to be a good deal higher than the profit goals of many companies.”

So there you have it. Profits fuel a business. Society, as represented by customers and their needs, determines the flight path.

What does your experience tell you? Fire away in the comments.

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3 comments

  1. Praveen Ghanta

    I think the economists’ model is correct within its context – businesses generally are profit maximizing, if one looks at profit in the right way. Small family businesses may view profit in terms of total family payroll, and total benefits accruing to the family from the company – while the P/L shows a 0 for profit every year. Public company execs often view profit as increase in share price, as that may put far more dollars in their pockets than actual GAAP profits.

    While the societal perspective is also correct – a business can only exist if people are willing to pay for its product – I think it’s important to view the motivations of the businessman or entrepreneur. More often than not, that turns out to be maximizing the net after-tax dollars in their pocket – and perhaps that’s a better way to look at profit maximization.

    • Vivek

      Praveen,
      Here’s how I might frame what you’re saying consistent with Drucker. Let me know what you think.
      1) Businesses succeed only when they meet a need people are willing to pay for.
      2) Entrepreneurs and many (most?) business leaders are motivated day-to-day by meeting this need and expanding its scale.
      3) Profit is a metric established by investors and management to align (and reward) all involved, around covering costs and risks and enabling reinvestment in growth.

      I think my point, and Drucker’s, is that profit is an effect not a cause. Growing profits is not the essence of what a business is. It is an outcome of how its setup in order to ensure sustainability.

  2. Niklas

    Hi Vivek,

    This framework makes logical sense, however it is really only theoretical. This is analogous to the Economic Calculation Problem that the Communist ruling parties struggled with. In the case of our social system, if profits are how a business is measured, then profits will be what that company tries to attain. Profits occasionally reflect benefit, though not always, and this is clearly seen in lots of data that displays huge growth of GDP but also shows widening inequality, erosion of public institutions (or faith in), and others.

    Moving on, the basis of this discussion is that if what we want to see something done, we need to create measurements or rules or something to guide us towards that goal. The argument put forth by Drucker states that profits are an accurate proxy measurement, however I would argue, once again referencing the data I mentioned in the last paragraph, that often a profit measurement (and therefore motive, as it is usually the main criterion) is not consistent with benefitting the public or consumers.

    I would be happy to discuss this further; I think it is an interesting discussion that needs to be addressed– and is being attempted with CSR, Happiness Indices, B Corps, etc.

    Thanks

    Niklas

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