Do Family Businesses Make a Profit?

              I am reading Anthropology, Economics, and Choice, by Michael Chibnik, a professor of anthropology at the University of Iowa.   For forty years, Mr. Chibnik has conducted anthropological studies, in both the U.S. and third world societies, trying to analyze economic choices by viewing them from both economic and non-economic perspectives.  He studied how Iowa corn growers in Van Buren County chose whether or not to try no-till farming methods.  And he’s studied how subsistence corn growers in the Peruvian Amazon decide whether or not to participate in the government agricultural loan program.  In both of these studies and many others, he found that most real world decisions generally involve some important element that is beyond simple economic gain or loss.  For example, [my example, not his] if your employer offered you a promotion to a position in another state at a higher wage, you might easily refuse this job for any number of reasons.  There might be economic reasons; such as, you would have to sell your house at a huge loss in today’s market. There might be social reasons; such as, someone has to look after your aging parents, or perhaps you have a special needs child who might not adapt well to a new school situation.  There could be cultural reasons; such as, you come from a family of scientists, but the school system you would be moving into teaches “Creationism.” Could your family really adapt to living in such a culture, and would you even want them to try?  And of course, your reasons for refusing the job could be psychological and personal.  This would be a risk, and perhaps you are uncomfortable with risks. 

            Mr. Chibnik gives the example of how corn farmers in Van Buren County decided whether to try no-till farming.  They considered the variability of yields, the impact of droughts and floods, the change in fuel consumption, and the increased cost of additional herbicide and pesticide use.  But they also worried about the possibility that the increased chemicals used would eventually get into the well water, possibly exposing their families to increased risk for cancer and other diseases. So how would you put a price on that?  Yet they also worried that continued conventional tillage would cause so much topsoil loss that within a generation, there might be no topsoil at all.   Could you put a price on that either? And worst of all, these possible disasters are not risks—they’re uncertainties.  According to Chibnik, a “risk” has a probability that is knowable and calculable.  An “uncertainty” does not.

            Mr. Chibnik explains that economists using “rational expectations” theory actually try to assign a price to such things.   They assign prices to such imponderables because if they did not, it would be impossible to complete their equations. They simply define such choices as “preferences”, i.e. we would “prefer” to have live children—as opposed to having dead ones. We would “prefer” to have farmland that can still feed us—as opposed to having mass starvation.   And how do they assign numerical values to these preferences?  They make a guess.   The main thesis of Mr. Chibnik’s book is that any numerical analysis which includes even one element which is merely an arbitrary guess will produce a final answer that is no more reliable than that guess, which explains why such analyses have not, historically, had much predictive power in real world situations.  He feels that while a careful study of the immediate economic inputs and rewards is still worthwhile, only a careful ethnographic study of the culture and history of the people involved allow us to draw any conclusions about how their decisions are being made.

            He gives us this quote from Duesenberry (1960): “The difference between economics and sociology is very simple.  Economics is all about how people make choices. Sociology is about how they don’t have any choices…”      

            I must warn you; this is the kind of book where you sort through four or five pages of often impenetrable jargon—and then find one paragraph which gives you a wonderful insight.  One of his best insights is his analysis of the choice between running a family business, or working for wages.  Interestingly, the same elements of choice apply for the Peruvian farmer choosing between being a subsistence farmer or wage worker on a plantation, and the Silicon Valley engineer agonizing over whether or not to quit his job and open some high tech family business. 

            In his second chapter, “Choices between Paid and Unpaid Work,” Chibnik quotes Russian scientist A.V. Chayanov whose studies showed the difficulties in using classical economic models to analyze peasant farm situations where money is not used. But even in societies which use money, comparing the paid labor of commercial farm operations to the unpaid labor of family subsistence farms may not always be reasonable.  Chayanov says that on commercial farms where all work is paid for, any increase in labor inputs without a matching increase in income would be disastrous, because profit equals gross income minus material cost and labor cost.  So every new worker has to produce as much as he costs. Family subsistence farms are not tied to such a standard.  Since the labor is unpaid, a decrease in income without a decrease in the number of workers does not result in bankruptcy.  So subsistence farming is more resilient, and less fragile than commercial operations. For this reason, a family operation which is technically unprofitable if the value of labor inputs and production outputs are compared, might still feed a family for generations.

              But assessing the market value of unpaid labor on a family farm, or any family business, is no straightforward matter. On a commercial farm, any worker who cannot yield a standard day’s work is fired—because he has to be fired. But you don’t fire your family.  Chayanov says that many family operations regarded as operating at a loss might actually be considered profitable if the non-standard quality of labor is considered.  And Chibnik points out that the value of the produce grown on subsistence farms should not be reckoned at the wholesale market price derived if these crops were sold, but rather at the retail price of the food which would have to be purchased if these things were not grown.  But even so, it’s likely that most family operations would be considered unprofitable by any classical economic analysis. Of course, the usual method of valuing family labor, the “opportunity cost,” meaning the cost of forgoing the opportunity to sell one’s labor by working “off-farm” for others, may not apply when no such opportunity for off-farm employment is available.  Many a family business, in both the third world and here, has been started simply to provide jobs for family members at a time when they would have otherwise been unemployed and unemployable. But are family businesses really profitable? The acid test of whether a business is profitable, I suspect, would be whether an investor can be found who will pay anything for it. 

            A few years ago, just before the crash, I had a talk with one of my cousins; we’ll call him Pete.   Pete is an engineer who was down-sized from a large corporation during the farm crisis of the 80s.  Not wishing to re-locate to obtain work, he started a small business, producing small, custom items of industrial electrical hardware. He had a number of corporate clients, probably including his former employer.  This production required a lot of work and a variety of skills. But like all members of that branch of the family, he was hard working, competent, and multi-talented.  And like some members of that branch of the family, he liked people and could relate to them effectively.  So he could personally handle the sales, as well as the engineering, drafting, and all aspects of production. His wife, an intelligent and competent woman, managed the office, and the teenage kids delivered the products.

            For many years, his operation produced a middle class income stream that allowed him to pay off a nice house, put the kids through college, and generally continue living in the manner to which he had become accustomed. He did not, during those years, accumulate much in the way of retirement savings. He assumed that as his business grew, this business would in itself be an asset of sufficient size and fungibility to guarantee a secure retirement.

            As he approached his mid-sixties, it occurred to him that it might be time to sell out.  He would not need a lump sum in cash.  If he could find a reliable person with the proper skills, he could accept a reasonable down payment and carry the contract himself.  The income stream from the principal and interest payments would support him for life.   And then a funny thing happened.  There were no buyers—not at any price.  Several people looked at his operation. But when they saw how many hours of labor were needed to produce the income he was getting, they had little interest.  He could easily have sold the physical assets—the building, assuming he actually owned it, the vehicles, and miscellaneous shop equipment—for about what they would bring at an auction. But this trivial sum could not support his retirement.

            His explanation for the lack of buyers was that people are all lazy nowadays. No one wants to work.  I said, “Pete, let’s take a look at this.  If you are trying to sell this operation to an investor, then you have to look at it as an investor would see it.”  I told him that in a recent article by financial columnist Malcolm Berko, Mr. Berko was asked by a reader why he was having so much trouble selling his small, family business. Mr. Berko replied that most family businesses actually operate at a loss, but stay in business because they are subsidized by unpaid or underpaid family labor. And this includes the hours of underpaid labor contributed by the entrepreneur himself.  He said that any potential buyer should consider all labor inputs at market value, that is, the probable labor cost if strangers were hired to perform all tasks.   Even if the buyer plans to supply only his own labor, he should still price that labor at what it’s worth—the market value.  Having done this, the buyer should then subtract this labor figure, along with all other operating costs, from the gross revenue.  What’s left, if anything, is the net profit.  Typically, small businesses sell for about three times the annual net profit.

            “So tell me, Pete,” I asked,  “if an entrepreneur were to hire a part time salesman, who was as effective at selling as you are, and a part time engineer and draftsman, whose engineering and drafting skills were equal to yours, and a fabricator with shop skills comparable to yours, employing him full time and probably many hours of overtime, and also employ a full time office manager as competent as your wife, about what would this cost?” 

            I haven’t seen Pete since then, so I have no idea whether he managed to sell his operation.  Frankly, I doubt it.  I assume he’s still working, and he’s nearly 70. I was disappointed by this outcome. I have always liked Pete, and I think it’s unfair that anyone who worked so long and so competently should have so little security in his old age.  But this is something to consider when becoming self employed. There are many occupations that can support a man well during his working years and still leave him with nothing.  Arthur Miller’s play Death of a Salesman awakened a whole generation to the way Western society uses salesmen and then discards them.  But this same fate awaits most of the self employed. Unfortunately, the Willy Lomans and the Petes of the world aggressively consent to their own entrapment.