Thursday, October 22, 2015


At work we ... // Nope.

I'm retiring at the end of this year, two, two and a half months from now. More time for writing, I hope. Anyway:

At work we have very specific terminology for the things we do. Use a piece of wood one way, it's a "scab". Use it a different way, it's a "splice". Used a third way, it's a "waler".

Our terminology is important because, as long as we're careful to use it when we talk, it's easy to convey meaning. I do drawings for a living, drawings of things to be built. I can always draw a sketch to show what I'm talking about, what my question is, or like that. But I don't need to always draw a sketch, because we have the terminology.

Words are important.

I went back to Angry Bear to read Ed Lambert's post again, then checked out Robert Waldmann's How Many Equations Should There be in Macroeconomic Models?

Who could resist a title like that??

I started getting out of my depth in the second half of it, but the part I understood I thought was great. Waldmann writes, for example,
Standard DSGE models still contain no housing sector. So the profession is attempting to understand the great recession while ignoring housing completely.

I should say, too, that this was the easiest read I've ever had in a Waldmann post.


There was a comment by William Ryan on Waldmann's post. In part:

What is important to you may not be important to me depending where you stand in the profit margin department. It becomes a matter of how we see things...

I think I know what "profit margin" means. But I looked it up anyway. Profit margin is "the amount by which revenue from sales exceeds costs in a business", Google says. Profit margin is an amount (as opposed to a rate).

Yeah, profit. You spend money to make money. After the money comes in, you subtract out how much you spent, and the rest is profit.

"Profit margin" is the same as "profit" I guess, if we go by the Google definition. I'm not comfortable with that. Terminology is important. Maybe "profit" and "profit margin" are the same. I don't know. So I did a little more digging.

I found a page from Chron -- some relative of the Houston Chronicle apparently. Hearst newspapers. The page is What Is the Difference Between Profit Rate and Profit Margin Ratio? Seemed like it might be useful.

It's garbage. I want to go thru it a piece at a time. First, the opening:
Understanding the difference between profit rate and profit margin ratio is critical for a small-business owner.
The rest of that paragraph explains why it is important to you.

Not off to a good start here.

Next, the Profit Rate:
Your profit rate is the percentage of your income that is profit. You can calculate this by deducting your total expenses from your total income, and taking the amount remaining as your profit. Divide the profit by your total costs, and the result will be the rate, or percentage, of profit that you make on your sales.

"Deducting" means subtracting. So, total income - total expenses = profit
And then, profit / total costs = the rate of profit. Profit ratio. (For percentage you have to multiply the ratio by 100.)

But terminology is important. I don't care if we say "total expenses" or "total cost". But we should pick one, and stick with it. Pick and stick. So
income - expenses = profit
And then,
profit / expenses = profit rate

To make matters worse, they introduce the topic by saying

Your profit rate is the percentage of your income that is profit.

Percentage of income they say, not percentage of expenses. To figure percentage of income, you have to divide by income. But they don't want you to divide by income. They want you to divide by total expenses. To be consistent, they should have introduced the topic by saying

Your profit rate is your profit as a percentage of your costs.

I don't know if that's correct. But at least it would have been consistent.

What the Chron article is doing is like if I went to work, learned my definitions for "scab" and "splice", and then started using the two words interchangeably, as if they were the same. Oh my god, it defeats understanding! and it defeats the purpose of having a terminology.

There is a word for that: Stupid.

Next, an Example:
A home-based, small business brings in $5,000 a month in sales of dog clothing and accessories. The cost of goods sold, including the purchase of materials and wholesale products, the cost of labor to make and sell the products, and the business overheads add up to $3,500 a month. Deduct the total expenses from the total income, and the profit is $1,500 a month. To calculate the profit rate, divide $1,500 by $3,500 and the result is a profit rate of 43 percent.
Forty-three percent. Oh, that's realistic.

"Overheads" -- plural?

I hate examples that are full of words. I don't need to know it is "A home-based, small business". (And they don't need that comma.)

I need to know we're looking at "$5,000 a month in sales". I don't need to know about dog toys. Dog clothing and accessories, whatever. (Hey -- "dog clothing" is funny. But it is buried in so many mistakes that I didn't even see it till now.)

Maybe I do need to know all of

The cost of goods sold, including the purchase of materials and wholesale products, the cost of labor to make and sell the products, and the business overheads add up to $3,500 a month.

I'd be happy with just "expenses add up to $3500 a month". But expenses are technical, too. Very, very well defined by the IRS. Not clearly defined, perhaps, but defined in many, many words.

But really, the article shouldn't be explaining the tax code. So really, I just need to know we have $5000 in sales and $3500 in expenses. (I don't even need to know "a month".)

Expenses = $3500
Income = $5000

Income - Expenses = Profit
$5000 - $3500 = $1500

Profit = $1500

$1500 / $3500 = 43%

Profit Rate = 43%


Next, Profit Margin Ratio:
Profit margin ratio is the ratio of the business's gross profit in relation to sales. Using the example above, your net income is $1,500 a month. Divide this figure by the total income of $5,000 a month, and your percentage of income that constitutes profit is 30 percent. This means that the profit margin ratio is 0.30:1, or 30 percent of each dollar earned. This tells potential investors that 30 cents of every dollar you make in sales is profit, which helps identify whether your business is profitable.

... helps identify whether your business is profitable.

Yeah -- because you couldn't tell whether your business is profitable from the 43% number you got before.

Good grief.

So what else do we have here? New terminology: "gross profit" and "net income". Neither has been used before in the article. So you've got new, undefined terms. Does that help the understanding? Does it convey?


"Gross profit" is the same as "net income" and both are the same as the word "profit" as used in the Example paragraph and the Profit Rate paragraph. So: Profit margin ratio is profit in relation to sales. Oh, and "sales" is the same as "income" -- but gross income, not net.

So how does "Profit Margin Ratio" differ from "Profit Rate"? The one is profit divided by income. The other is profit divided by expenses.

That's all they needed to say.


I have no confidence that what I learned from the Chron article is right, because the article is so badly written.


Greg said...

Good find Art

Whats particularly interesting to me is that the sector which is left out of DSGE models is THE primary sector by which the predominate macroeconomic policy lever (monetary policy) does its magic. Monetary policy mostly works via the housing/real estate sector as Mike Sankowski has pointed out more than once.

So the tool which is used (DSGE model) to examine and make prescriptions for macroeconomic policies leaves out the sector via which your main tuning mechanism works............. no wonder we're screwed.

The Arthurian said...

Thanks Greg. Waldmann has a whole list of flaws in DSGE models. The one I quoted really stood out. But I was only thinking of housing as the source, no, as the vehicle that brought on the crisis.

As you point out, that vehicle was driven by policy!