I believe that this is based upon a naive view that everything has an intrinsic value, and therefore that selling anything above that value amounts to profiteering. I'd like to explain just why that isn't so, based upon my own experiences.
Nearly 20 years ago, together with 3 colleagues with whom I had been working for the previous decade, I co-founded a small business. The business was entirely self-funded - we were in the position to do so, because our previous employer had closed down the place where we were working, and we had decent redundancy settlements due to our length of service - in my case, it amounted to about 9 months net take-home pay.
Where we had been working together previously, we specialised in the development of data communications products for PCs, which were used particularly in the financial arena, using a type of networking that was widely employed in the days before the internet, namely X.25. Despite the advent of the internet, there was still a market for X.25 products - but sufficiently small that the big players were no longer interested. The products of our former employer were designed for the old ISA-bus, which had just been superseded by the PCI-bus. This gave us our target market.
We therefore developed new software from scratch, and to start off with, while were proved out our solution, we bought in off-the-shelf PCI hardware on which to run it. We couldn't devote all of our time to software development - we also had to find a way of earning a living - so we did some contract work, consultancy and worked on projects for other companies. We also managed to negotiate a a deal to sell the hardware made by our former employer on licence, with a royalty on each sale, for which there was a ready if limited market (there was one customer buying maybe a couple of hundred or so products each year), which our former employer was no longer able to support.
On balance, I don't think things could have gone a great deal better to get us up and running, but even so, we earned enough cash to be able to pay ourselves salaries for only 7 of the first 12 months, thereby burning through up a sizeable chunk of my redundancy settlement.
Our basic costs were about £250k per year, with the cost of the employees (i.e. ourselves) being about £50,000 per person per annum, taking into account gross salary, employer's National Insurance, pension contributions, etc. We were renting an office for maybe £20k per year including business rates; electricity, phone and internet charges added still further, plus the cost of running our web-site. And then each of our employees needed at least one computer at about £1,000 each, but that was not something that was required every year - their useful life was more like 5 years.
Of course, not all of our time was spent on product development, being engaged in other revenue earning activities, so you could probably say the overheads were more likely to be about £125k per annum for the product side of our business. So, given we spent about 2 years developing our product, (total costs a quarter of a million pounds), and given that the hardware on which it was based cost us about £300 each, what would be the fair value of each product?
We would get back our investment if we sold 500 units at a margin of £500, or 1000 units at a margin of £250. Which of those is a more fair value? And if we continued to sell the product in the future, after recovering our investment, would that amount to profiteering?
Of course, we needed to make a total of £125k each year of accumulated margin simply in order to continue trading. And in fact, we needed to make more money than that for cash-flow reasons - payment terms are typically 30-90 days, during which time we would need to pay our suppliers, overheads and our own salaries.
We also needed to hold stock, partly because it is much cheaper to buy from your suppliers in volume, but also because customers sometimes want the product in a hurry and if you can't supply it quickly enough you might not just lose that particular sale but also future business. Furthermore, we needed profit to invest in future product development, and to be able to expand and employ other people.
At every step, there is risk. There is no guarantee of selling the target amount, and there is no guarantee the customers will pay in a timely fashion. Or indeed, at all. How does one value the risk when trying to calculate a fair price?
Even the salaries we were paying ourselves were somewhat arbitrary: what we were paying ourselves (when we actually had some cash in order to do so at all) was rather less than we could collectively have expected to earn if we were employed elsewhere at that time.
How could we therefore work out a fair value for our product?
In fact, we didn't have a great deal of the freedom to determine the selling price for our product; comparable products to ours existed, and being a new entrant into the market we couldn't price ours at a premium.
Typical customers, however, do not expect to pay list price - a 10% discount is usual for multiple units, with repeat customers getting 25% or so. When purchasing the 3rd party hardware at about £300 per unit, if we set the list price at £800, we would be making a margin of £500 per unit, but after discounting it would be more like £300 per unit. Thus, in order to earn enough money for the company to be able to continue to trade, we would need to be selling well in excess of 400 units every year.
We needed to reduce the cost of the hardware we were selling, so despite our financial position being a little precarious, we employed a couple of engineers to develop our own hardware, in order to get our cost per unit down to about £200, increasing our margins to £400 per unit.
Then we had had an enormous stroke of luck: we managed to sell our newly developed hardware to a Canadian company who had won the contract to sell Lottery terminals in the Netherlands. This involved some 4500 units, a huge step up from volumes we had been shipping up to that point.
Substantially increasing volumes presents problems of its own: it is a major cash-flow headache. Obviously we didn't manufacture anything ourselves, but subcontracted that out to a specialist manufacturer with whom we had already managed to establish a relationship. We didn't have anything like the amount of cash necessary to fund the purchase of 500 units, let alone 4500, but fortunately they didn't all have to be delivered in one go. We managed to agree a delivery schedule with several batches, over a period of 2 years, with part payment in advance from the customer funding the purchase of the hardware from our supplier for each batch. But if something had gone wrong at any stage, we would have been horribly exposed, and it could have seen the demise of our business.
So, if making a profit is immoral, how should have we handled this situation? Should we have reduced the price specially for the Canadians? Would that also have meant price reductions for our other customers?
Of course we had to give a larger discount - over 50% on list - for the volumes we were shipping, but even so our customer paid rather less than they would have done had they gone elsewhere. In the end we made a profit of about £500k spread over 2 years, enough to pay ourselves the salaries we missed when we were getting started and to fund an small expansion of the business - we employed 2 more staff and moved to larger premises, and retained a buffer of cash within the business to fund future operations. And of course, we had to pay corporation tax. As it turned out, we needed that buffer - sales returned to more like their previous volumes, and we struggled to break even for the next couple of years.
The only way to establish a value is via the market: the selling price is constrained by what people are prepared pay, but everyone's circumstances differ. In some cases, a customer might need a unique feature of your product and be able to get such value out of it that they would be prepared to pay a substantial amount, but these customers are few and far between. More commonly, they might be able to use an alternative product. Some may not have a business case at all if they can't get your product cheap enough, and so just won't buy it if the cost is too great.
The only thing you can is work out how much you have to pay to buy in the components, and add a reasonable margin to pay a contribution to running costs, taking into account any discounts, and then gamble that you will sell enough to cover costs. If you get that gamble wrong then you are in trouble.
The same sort of issues applied to our suppliers' pricing: the subcontract manufacturer's costs didn't bear any resemblance to the price we paid per unit, because they were also manufacturing for a number of other clients. They had substantial overheads such as staff costs and rent, and the capital cost of the equipment they used. Then there were one-off tooling costs when producing a product for the first time in addition to the cost of the components. They could order some components in large volumes because they could also be used for products for other customers, but other more specialist components they purchased only for our product. They didn't make the circuit boards themselves; in high volumes it was economic to get them made in China, but that made no sense in lower volumes, due to shipping costs.
How would we know whether we were paying them a fair price? There are so many variables involved, it is just impossible to say that a product has an intrinsic value - profits are determined by the volumes in which something is sold, over which a company has little control.
In the 10 years in which I was a director of the company, we had a few other successes, sufficient indeed that we qualified for the Queen's Award for Enterprise, but we also developed products that didn't give us a return on our investment. Overall, I didn't earn significantly more than I would have done had I been employed elsewhere. In the end, I decided that the risks outweighed the rewards, and that in any case maybe on a personal level I wasn't cut out to be an entrepreneur, so I left (thereby improving the viability of the business now that the proceeds only had to be split 3 ways instead of 4). Hence I have returned to being a salary-man, as the Japanese put it.
I believe, however, it is quite fair to say that I more than deserved to profit from my win on the Lottery!
