In Conversation with Hermann Simon

In his interaction with Marcel Hülsbeck and Kai Thürbach, Hermann Simon gives his definition of profit and its many characteristics, applications, and effects. Marcel Hulsbeck: How do you define profit? Hermann Simon: Profit is what the owner of a company can keep after the company has fulfilled all obligations towards employees, suppliers, banks, and the state. All other profit definitions, such as EBIT, EBITDA, and extensions are not profit. This is the only true definition of profit. Whatever the owner can keep after having fulfilled all his responsibilities is profit. Marcel Hulsbeck: What do you mean by economic profit? Hermann Simon: Economic profit is a more demanding benchmark. It is the profit that exceeds the cost of capital, the so-called weighted average cost of capital. It can be said that only economic profit is real entrepreneurial profit because if you don’t exceed your costs of capital, you better invest your capital elsewhere and not in your own company.Hermann SimonHERMANN SIMON: Economic profit is a more demanding benchmark. It is the profit that exceeds the cost of capital, the so-called weighted average cost of capital. It can be said that only economic profit is real entrepreneurial profit because if you don’t exceed your costs of capital, you better invest your capital elsewhere and not in your own company. Kai Thurbach: What significance does profit have for business in times of crisis? Hermann Simon: The crisis brings the hour of truth, and it is exactly now. Companies that weren’t profitable in the past and have no reserves are the first to fail. After the crisis, profit will become even more important than ever because it is critical for recovery, to payback incurred debt, for instance. That will be the second hour of truth. Profit always depends on the combination of the three profit drivers, which are price, volume, and cost. Kai Thurbach: Could you share some empirical evidence about the actual profit situation of companies? what is the people’s perception of the same? Hermann Simon: In Germany, people believe that the net profit margin is 23%, but the real margin over many years has been 3.4%. Similarly, in the US, the belief is 32 and the reality is 4.9%. Italians think that the margin is 38% when the reality is 5%. Thus, there are two messages: Real net margins are 5% or less typically, and people overestimate profit margins by 600%. Kai Thurbach: In your research, does there seem to be significant differences in profitability between countries, between industry sectors, and between different companies? Hermann Simon: Yes. The differences are staggering. Switzerland is very profitable with an average net margin of almost 10%. At the very bottom is Japan with 2.4%. The margins in larger countries tend to be lower, and one example is the US. It is probably due to more intensive competition. On the other hand, we are economies of scale, but the net effect is that margins are lower in larger countries. When it comes to sectors, pharma is usually one of the most profitable industries with net margins of 20%. Automotive is rather average with around 5%, and airlines are really bad; in the hundred years of their existence, their accumulated profit is around zero, and probably even slightly negative after Corona. Kai Thurbach: What are some typical reasons for low profitability? HERMANN SIMON: The main reasons are the wrong goals: market share, revenue, sales orientation instead of profit orientation. This is exacerbated by conflicting goals between functions, like between finance and marketing, for instance. Wrong incentives such as stock options or sales-based commissions are closely related. Being in the wrong sector is also detrimental to profits. Airlines is an example. Also, overcapacities are a very effective profit killer. Social values play a big role, too, which is one reason for the differences between countries. For example, in Germany, profit is somewhat a social taboo. In other countries, it is highly valued by people. That effects the real behaviour Kai Thurbach: Are large corporations more profitable, or are there drivers of profitability other than size? HERMANN SIMON: Large corporations are not more profitable. The median of the net margin of the Fortune Global 500 is 4.49%. This indicates that half of these giants earn less than 4.5%. Most likely, they do not make an economic profit, meaning that they don't recover their cost of capital, and that is half of the Fortune Global 500. The public perception is misguided by a few profit stars like Facebook that makes 39% net after cost and taxes. Facebook, Apple, and Alphabet are rare exceptions. Kai Thurbach: What is your key message relating to profit for founders and start-up teams? HERMANN SIMON: Profit always depends on the combination of the three profit drivers, which are price, volume, and cost. Attention must be on all three and their interrelations, and should not be confined to one driver. Stars like Facebook and Google have a unique combination of high prices due to a quasi-monopoly, low marginal costs, and huge customer numbers, which is dream profitability. Many start-ups are proud that they have many customers, but they don’t earn money from these customers. The number of customers is useless if there is no margin per customer. Marcel Hulsbeck: Are there profit stars among older incumbent firms? How do they differ from not-so-good older firms? Hermann Simon: We cannot make a general statement, but we can make some specific observations. Margins are generally low in Germany, but there are quite a few profit stars, the so-called “Hidden Champions”. These are midsized, little-known global market leaders. Their margins are about three times the German average and they often dominate their global markets. So, there are profit stars in all countries and usually, they are characterized by strong market positions and a good combination of the three profit drivers.Hermann SimonHERMANN SIMON: We cannot make a general statement, but we can make some specific observations. Margins are generally low in Germany, but there are quite a few profit stars, the so-called “Hidden Champions”. These are midsized, little-known global market leaders. Their margins are about three times the German average and they often dominate their global markets. So, there are profit stars in all countries and usually, they are characterized by strong market positions and a good combination of the three profit drivers. Long-term profit orientation largely eliminates the conflict between shareholder and stakeholder value. Marcel Hulsbeck: How can “Hidden Champions” cope with the crisis? Would they be better off after that? Hermann Simon: They can cope because firstly, they have a very solid, strong financing. They were profitable in the past, have high reserves, and an equity ratio close to 50%. The second reason is that their products are often indispensable. Marcel Hulsbeck: In your view, what drives profitability for our companies? Hermann Simon: Since there are three drivers of profitability, the question is which one is the most effective? In other words, by what percent does the profit increase if the driver improves by 1%? This is the so-called profit elasticity. For an average 1% price improvement, profit increases by 10%, making the profit elasticity of price as 10. For costs, it is 6, and for sales volume, it is 4. This implies price is the most effective profit driver, followed by costs and sales volume in the third place. These averages are typical for industrial products and services. Marcel Hulsbeck: Do you see a conflict between your call for profit, and the social embeddedness of a company and its business ethics? Hermann Simon: This conflict exists mostly or even only if the company is short-term oriented. Long-term profit orientation largely eliminates the conflict between shareholder and stakeholder value. Of course, a company must satisfy its employees, its customers, its suppliers, and not only its shareholders. A company must remember this Peter Drucker quote, “Without profit, no company will survive, because profit is the cost of survival.” Another thing to remember is that no company ever failed from making a profit. Kai Thurbach: A recent study quoted by McKinsey says only 7% of Fortune 500 CEOs believe their companies should mainly focus on making profits and not be distracted by social goals. Hermann Simon: I hope that this finding is not true or not valid, because it sounds more like a tribute to the spirit of the times than as a statement to be taken seriously. To quote Nitin Nohria, the Dean of the Harvard Business School, “The first ethical responsibility of a business leader is to make a profit,” to which Peter Drucker added, “There is no conflict between profit and social responsibility. It is not a business that earns a profit that rips off society. It is a business that fails to do so.” Kai Thurbach: How would you summarise your ideas on profit? Hermann Simon: Freedom, ethics, and profit orientation are inextricably linked. They are the pillars of each free-market economy. “We want to educate leaders who make a decent profit decently,” says Wallace Brett Donham. Marcel Hulsbeck: How much time horizon does a company need to become profitable? If we talk about long-term profit, what would you classify as long term? Hermann Simon: Short versus long term is a very fuzzy issue and there is no general definition to it. A family company, which is not exposed to the pressure of capital markets, can afford to have a longer-term view than somebody who has to report on a quarterly basis. In case of pharma, companies need a time horizon of 20 years because that is the patent period; 10 years to bring the product to the market and 10 years to harvest the profit. So, the definition of short and long term is a very difficult question without a clear answer. If businesses are built on customer needs and not on technology, the chances of survival are big because customer needs do not disappear. Marcel Hulsbeck: If you take profit as a key benchmark, what do you think of innovation? Hermann Simon: Deciding on a budget for innovation requires anticipation of the life cycle, the duration of the life cycle, and some kind of cash flow and margin prediction. I would only start an innovation project or launch a product when it is developed where I have a positive discounted cash flow and a positive profit expectation. This does not mean that I have to make a profit in the first three or five years, but it is difficult to make a profit even in the longer term if marginal costs are high. Marcel Hulsbeck: What are the characteristics of the “Hidden Champions” that make them so indispensable? Hermann Simon: There are three main pillars of their strategies. The first is very ambitious goals. They strive for market leadership; they strive to be the best in their markets and very often they do that very early in their development. They achieve this by focusing. However, focus makes a market small, so they make a market large by globalization. The three essential pillars then are: ambitious goals to be the best, and focus, combined with globalization. Marcel Hulsbeck: Do you have any more thoughts on the question of purpose versus profit? Hermann Simon: The purpose of companies is not to make a profit, but to serve all kinds of stakeholders, customers, community, etc. Of course, any reasonable company or manager does not confine his view and his activities towards the shareholders but tries to satisfy customers and even suppliers. There have been cases where suppliers have discontinued the business relationship because there was too much pressure on them, so a company always has to serve the constituency of different groups, build a business relationship that is satisfying for them. This will lead to profit. Profit is the main goal because it is a condition for survival, but it is also the result of what we do. Marcel Hulsbeck: There are many movements, especially in the European Union right now, that are trying to engage a new green deal in the European Union. They say we should not only report our economic profit but also the social or ecological profit that we produce. What do you think of this project? Hermann Simon: We have had these reports on ecology, human resources, etc., for about 15 to 20 years now. So far, we do not have an overriding indicator of these activities, which makes them comparable across companies, across industries, across countries. These reports do not change the world. The activities change the world, but the reporting has limited relevance. Marcel Hulsbeck: What about the Shared Value Initiative with FSG and Michael Porter? Hermann Simon: That relates to the purpose issue as well. Profit is not the purpose, but we need measurable, quantifiable indicators in business. The ultimate indicator of the success of each business is profit. Whether somebody likes it or not, and it is, as I said repeatedly, the condition for survival. No company ever failed from making a profit, but many, many companies failed from not making a profit, and from having the wrong goals and the wrong measurements. Marcel Hulsbeck: What would a shrinking economy post-COVID do to the margin pressure? Secondly, are there specific differences between B2B and B2C companies? HERMANN SIMON: To answer the first part, it will be very tough. Many companies have already announced bankruptcy or insolvency. In many cases, there will be more price wars, where companies fight for market share, so costs and smart price moves will get higher importance. On the price side, I advise companies to give discounts in kind instead of cash, during this crisis. It has several advantages. Usually, customers accept an offer of a discount in kind. It gets more work for the employees and the company is better off with regard to margin because the discount in-kind costs only the marginal cost, but the customer gets the full perceived value. Marcel Hulsbeck: Would you say the sustainable value chains are antecedent to profit? Or, how can you make a profit in a world of disruption? Hermann Simon: This ties to the short term versus long term debate. As per research, the relationships to vendors and suppliers have been lasting on average for 20 years. If a company has such a relationship based on trust, they do not exploit a short-term emergency need of their customer or vendor. This is a good example to illustrate the difference between short-term and long-term profit orientation. Many of the established family businesses have a relationship based on trust and avoid short-term exploitation of emergency situations. Marcel Hulsbeck: Do you think this crisis will be at the expense of the employees? Hermann Simon: It will of course put pressure on the employees, but the pressure on suppliers in the various stages of the value chain will mostly be tougher. In the case of Germany, people are obsessed with productivity and that does put pressure on wages, but it puts more pressure on the labour force to be productive. Marcel Hulsbeck: Do you think we will see a de-globalization? If so, what will it do to the “Hidden Champions”? Hermann Simon: We have seen a kind of de-globalization for 10 years now. In the last 10 years, the growth rate has been identical. It just happened after the financial crisis. The longer-term consequences of Corona are still not very clear, but there will be changes. Those changes will not be driven by Corona; Corona only exacerbates existing trends to rearrange the global value chains. Marcel Hulsbeck: If profitable organizations are streamlined to efficiency, where do we build resilience in these companies? Hermann Simon: There are often conflicts in goals between finance, sales, marketing, production, etc. and building resilience should start from there. There is an acceptance, a sharing of common goals at the top level, so starting with unifying the goals from the very top is one step towards resilience. Indeed, resilience, as agility is a very complex project or complex challenge, and it ultimately starts with customer needs. Customer needs do not disappear, and only the way they are satisfied changes. If businesses are built on customer needs and not on technology, the chances of survival are big because customer needs do not disappear. Marcel Hulsbeck: What do you think about government support for companies that are not profitable? Hermann Simon: I would distinguish between a normal situation and the current crisis. Under normal circumstances, we should not subsidize companies that are not making profits. The market has to decide. In the current short-term situation, it is very difficult because we don’t know whether a company is on the verge because of these fundamental issues or because of the current short-term situation. If it is because of the current situation, the state has to do something. Marcel Hulsbeck: What do you think about building better antecedents for profits? What are your views on the public investments in education and training? Hermann Simon: Yes, public investments in education and training are necessary and highly productive. To take the German vocational training system as an example, it consists of a private-public partnership. Apprentices are employed by private companies and get a modest salary. They work for three days per week in the company and attend a government-run vocational training school for two days. After 3-3.5 years, they pass their exam as qualified workers. Germany has the best-qualified workers in the world due to this system. This system would not work without government support. Marcel Hulsbeck: Would you like to add anything else that we did not touch upon? Hermann Simon: The emotional aspects of profit. It is very important for each entrepreneur. Some of the biggest frustrations faced by entrepreneurs and sometimes founders who come close to retirement and have no followers in the family, are that they want to sell their company, find an investor, etc. They don’t find one because it turns out that they have not been profitable for years. That's about the biggest frustration an entrepreneur can experience, that his life work is devalued because he or she did not pay attention to the profit markers. On the other hand, some people are motivated and satisfied because they have observed the profit mandate and so they successfully conclude their career. So, profit is not only an economic matter; it is a deep matter of emotions, of personality, of reward for your life's work, and for survival, duration, and succession in family firms. .

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