Cooking the Books: Profitability

Every quarter the Office for National Statistics (ONS) publishes figures for the ‘profitability’ of UK non-financial companies. The latest are for the third quarter of 2011. They showed that the “net return on capital employed” for all companies was 12.9 percent. For manufacturing it was 5 percent, for services, 15.9 percent and for North Sea oil and gas companies, 60.5 percent.

Over the last ten years the annual average has been around 16 percent for services and 9 percent for manufacturing.

Why the difference between these two sectors? Surely, according to the way that the competitive profit system that is capitalism works, capital should flow out of manufacturing and into services until the rate of profit is the same for both, as Marx explained in the section of Volume III of Capital on the averaging of the rate of profit.

The explanation lies in the fact that the rate of profit used by the ONS is not the same as in Marx.

There is no problem with the definition of ‘profits’ which are defined as “that part of a company’s income which arises from trading activities” less depreciation but “before payments of dividends, interest and tax”. It’s “capital” that is the problem. Here’s how the ONS calculates ‘profitability’:

“Profitability is defined as the net rate of return on capital employed. That is, it is the value of profits (allowing for depreciation) divided by the value of fixed assets (allowing for depreciation) and inventories.”

In other words, “capital” is defined as fixed assets, i.e. buildings, machinery, office equipment and the like, or “fixed capital”. But this is not the only part of capital as it excludes “circulating capital”, i.e. the capital invested in what is entirely used up in the course of production (material, power, labour).

Marx divided capital in another way. That part whose value was only transferred, whether wholly or gradually, to the product (which he called “constant capital”) and that invested in employing productive labour (which he called ‘variable capital’ because, besides transferring its own value, it added new value).

So, the rate of profit in Marx is the ratio between profits and total capital while the ONS’s rate is the ratio of profits to fixed capital only. This is not even how companies calculate their rate of profit and its only usefulness would seem to be to record short-term variations in profits.

The different rates that the ONS formula results in for service and manufacturing companies does, however, neatly illustrate another point Marx made.

Marx argued that because the tendency under capitalism was for constant capital (mainly fixed capital) to increase more than variable capital (productive labour) – in economic textbooks, ‘capital intensity’ – and because variable capital alone generated profits, there was a tendency for the rate of profit to fall. This could be shown mathematically but wouldn’t necessarily happen in practice since there were counter-acting tendencies, notably an increase in the exploitation of labour and the cheapening of fixed capital.

Since manufacturing is more ‘capital intensive’ than services, if you compare profits to fixed capital you would expect this ratio to be less in manufacturing. Which is precisely what the ONS figures show.

How explain, then, the huge ‘rate of return’ on fixed capital in North Sea oil and gas which is a more capital intensive industry than most? It’s that most of their ‘trading profits’ are ground rent rather than profits proper.

Oil and gas have the same price on the world market wherever they are extracted but the difficulty and so the cost of extraction varies depending on geological conditions. The price is set by the most costly oil and gas fields, which means that the less costly ones get an extra, windfall profit that is actually ground rent. In Saudi Arabia and the Gulf States it goes to enrich the despots there. In Russia, it has created oligarchs. In Britain, it is largely taxed away by the government.