Is Corporate America Too Focused on Profit Margins?

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Corporate AmericaA few days ago I penned a column in this space -- Why to Be Glad America Isn't Making TVs Anymore -- pointing out that when America "lost" the television manufacturing industry to Japan back in the '80s and early '90s, it wasn't necessarily a bad thing.

Having "won" the contest way back when, Japan finds itself struggling today to compete with lower-cost manufacturers in Korea and China. Powerhouse TV manufacturers like Toshiba, Sharp, and Hitachi are eking out a living, earning profit margins so low they'd make Walmart (WMT) blush -- that is, when they're lucky enough to earn a profit at all. Sony (SNE) and Panasonic (PC), two of the best-known brands in TVs today, expect to report a combined $17 billion loss for their consumer electronics businesses. So if America lost the TV business to Japan, I said good riddance.

Not everyone agreed.

Readers Fire Back

In fact, responses to the column were pretty heated. More than 300 of you posted comments here on DailyFinance, many challenging the notion that profits should play a role in industry at all -- especially "in this economy." One reader email was typical. I'd like to share it with you here today ... and respond.

"I happened to read your article regarding TV production and the deplorable returns those companies post. [But] considering our country's unemployment rate, even if a firm posts a modest return or even loses money, wouldn't it be preferred to have manufacturing jobs in these low margin industries? Only investors and managers whose compensation is tied to profits care about the margin..."

-- Brian G., Florida

Why Profits Matter

Now these are fair questions. But the fact is that profits do matter -- and not just for "investors and managers." Let's take a look at how profit margins affect a few other key players.

Customers: Is it good for customers when a company earns low profit margins? The answer seems obvious: Surely customers must benefit when companies sell them goods at the lowest price possible, instead of charging higher prices and padding their profit margins.

But put yourself in the place of a hypothetical manager, asked to find a way to charge these low prices, and earn these low profits. How would you go about it? Probably your first move would be to find a way to cut costs. Laying off workers. Automating more production. Offshoring jobs to China. (Sound familiar?)

You could also try cutting costs by substituting cheaper component parts. Maybe skimp a bit on quality. Tighten up the terms on warranties, and figure out new ways not to honor them.

Customer service? Expensive. That gets outsourced to India, and live customer service reps get replaced with "post a question on our customer forum" policies, and robots answering phone calls. I could go on, but you get the gist. Low profit margins ultimately lead to lower-quality products, and low customer satisfaction. Think for a moment what your impression is of Dell (DELL) (6% profit margin) as opposed to Apple (AAPL) (26%.) Who makes the better products? Who gives you the better service?

Employees: Customers aren't the only folks who lose out when companies can't earn a good profit margin. An unprofitable or minimally profitable business may struggle, for example, to maintain health benefits, 401(k) matches, and other fringe benefits for its workers.

Indeed, health insurance is probably the biggest concern. Every year, small business owners across the country see their cost of insuring employees rise 10%, 20%, and more. Minimal profits and little or no profit growth will not be able to keep up with that cost growth. For that matter, do you ever wonder how companies manage to pay "raises" to their employees? Raises come straight out of rising profits.

Management: One thing Brian G. was right about: Management also has an interest in earning high profits. Oftentimes, bonuses awarded to corporate officers are tied to how much profit their companies make. But don't go thinking that if companies agree to take lower profit margins, management will be sharing the pain right along with assembly line workers. They won't.

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When Bethlehem Steel filed for bankruptcy back in 2001, the company cut worker pensions and health benefits. Management, however, made out like a bandit. One year after Beth Steel went belly up, its CEO cashed a $900,000 paycheck. Similarly, the head of General Motors earned a cool $2.5 million in 2010, after drastically cutting that company's workforce. Bank of America, which nearly went under during the financial crisis, paid its boss $1.9 million in 2010.

These sums may pale in comparison to the payouts for more successful corporate insiders -- for example, the $400 million that ExxonMobil paid its outgoing CEO in 2006. But it goes to show: In good times and in bad, management will always make sure it gets paid.

As for the rest of us, the moral of the story is this: Profits are good. High profit margins are better.

Motley Fool contributor Rich Smith does not own shares of any company mentioned above. The Motley Fool owns shares of Bank of America and Walmart Stores. Motley Fool newsletter services have recommended buying shares of Wamart Stores and General Motors, as well as writing covered calls in Dell and creating a diagonal call position in Walmart Stores.


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