Before he died, Peter Drucker debunked the use of quantitative analysis to attain maximum profitability. The philosophy behind this well-known pricing technique was that if you charged “as much as the market would bear” (i.e. the highest price possible), you would maximize profits, at least temporarily.
According to this theory, you can always reduce the price later should a competitor emerge and, with the money you obtained from your high price, you can invest more in advertising than your competitors, thus maintaining your market dominance.
Profits, not maximum profitability, are essential to business success
Drucker agreed that profit for a company is like oxygen for a person, vital for survival. Profit, not maximum profitability, is the essential element to business success. There is a big difference between the two. In fact, maximum profitability, is not only not essential, but may not be desirable or possible.
For example, to treat a life-threatening sickness, potential buyers of a medicine may be willing to pay almost any price for a product if it is the only treatment available. That might result in high profitability, but it is hardly beneficial financially for those who require the product or for society. Moreover, it is unethical to demand an unreasonably high price for products such as a cancer medicine even if legal restrictions do not restrict the price.
Pricing high temporarily to confirm the quality of your product versus a competitor’s may be acceptable, but pricing as high as “the market will bear” will eventually attract competition and displease customers.
Guess who invented and introduced the transistor radio?
Pricing the product for maximum profit attracts more competitors than other strategies and some of them may have advantages unavailable to you. For example, many people believe that the transistor radio was invented and popularized by Sony. The truth is that AT&T built and sold the first transistor radio, not Sony or any other Japanese company. AT&T dominated the U.S. market long before any Japanese company sold a single transistor radio. Yet Sony still gets the credit.
In 1952 Sony was a small company with less than ten employees. At that time, AT&T had invented the transistor radio and was selling for the highest price possible to maximize profits. AT&T was also licensing their product to other companies to produce additional income.
Masaru Ibuka, the founder of what later became Sony, and his partner, Japanese physicist, Akio Morita, could not afford the US$25,000 that AT&T demanded for a license. After securing a loan from the Japanese Ministry of International Trade and Industry (MITI), Ibuka traveled around the United States and examined features from different transistor radios on the market. They reversed engineered the best of these features and incorporated them into the design of a new, improved transistor radio.
Not only was this new transistor radio more sophisticated, it was also less expensive. Manufacturing costs in Japan were lower at that time and Sony rejected the notion of maximum profitability. Despite the radio’s new, innovative features, the price remained competitive for those reasons.
Within five years, Sony had captured the whole market and sold sufficient transistor radios to expand from seven employees to over five hundred. Sony did nothing illegal or unethical, but they captured the entire American market by providing a better product at a lower price, not by seeking maximum profitability
Drucker’s analysis on maximum profits
After years of studying business cases such as this, Drucker realized that charging high prices and striving for the maximum profits that could be squeezed out of a market will not lead to long-term business success. Instead, businesses should strive to deliver superior products at a lower price.
From this knowledge, Drucker laid the framework for “management as a liberal art” or MLA. In his book, The New Realities, Drucker, wrote that since management is a liberal art, it should be practiced more as an art than a science. Drucker, however, was not the first to make this discovery.
Einstein’s amazing year in his first job after earning his PhD
E=MC², the equation for energy which is called the world’s most famous equation, was derived by Einstein during his “miracle year”. It came not from computer calculations or mathematical analysis, but MLA techniques.
In 1905, Einstein was one year out of school and working as an entry level patent examiner in the Swiss patent office in Bern. During this time, Einstein published three major scientific papers, including the theory of relativity, that would later earn him a Nobel Prize for Theoretical Physics.
He wrote these groundbreaking papers without a slide rule, computer or white-coated assistants. Instead of using quantitative analysis, he leveraged the liberal arts to explore highly technical questions in theoretical physics.
The fundamentals of management as a liberal art (MLA)
Based on extensive research into successful product introduction, Drucker specified four necessary fundamentals plus two essential co-practices.
The four fundamentals are:
- general knowledge of the liberal arts
- self-knowledge of limitations and capabilities of people and resources available
- wisdom based on past experience and one more.
- ethical leadership, the most important element, is responsible for about 50% of the results achieved on any project
The two essential co-practices: high ethics and social responsibility.
Society expects more from businesses than maximum profitability
Drucker believed that a business cannot exist without making a profit. Society, furthermore, expects businesses to assume social responsibility and deliver value to their customers, employees and the public.
Corporate philanthropy and social responsibility activities may not directly increase profits or drive growth, but they do contribute to long term success. Drucker’s favorite example was Julian Rosenwald’s, the Chairman of Sears Roebuck and Company, eponymous charitable fund that donated over US$70 million to schools, museums, Jewish charities and African American institutions. The Rosenwald Fund did not generate direct profits (nor was it intended to), but it established Sears as one of the most innovative and influential businesses in American history.
The evolution of MLA
Five experts from the Drucker Institute at Claremont Graduate University in California (Minglo Shao, Bill Pollard, Bob Buford, Dr. Joseph Maciariello, Dr. Karen Linkletter) further developed the concept of MLA. According to them, principles and actions that might deliver short term results can, unintentionally, cause long term harm.
Drucker, as early as 1936, openly criticized companies that violated laws and human rights as well as governments that ignored ethics, social responsibility and basic human rights. In his is academic paper, The Jewish Question in Germany, Drucker condemned National Socialism and bravely identified himself as a German citizen of Jewish origin. Written in German, it was promptly banned and burned by the Nazis. A year later he published his first book in English, The End of Economic Man. An examination of totalitarianism and its devastating effects, the book was a best seller and acclaimed Winston Chuchill.
After World War II Drucker began to cite other examples of how dictatorships and the unethical, defective leadership that define them, usually lead to chaos and disaster. In the same vein, Drucker argued that ethical leadership and business practices are not only just as important as profits, but deliver more value that maximum profitability ever could.