An excerpt from the first chapter, "Bad Profits, Good Profits, and the Ultimate Question."

Too many companies these days can’t tell the difference between good profits and bad. As a result, they are getting hooked on bad profits.

The consequences are disastrous. Bad profits choke off a company’s best opportunities for true growth, the kind of growth that is both profitable and sustainable. They blacken its reputation. The pursuit of bad profits alienates customers and demoralizes employees.

Bad profits also make a business vulnerable to competitors. Companies that are not addicted—yes, there are many—can and do zoom right past the bad-profits junkies. If you ever wondered how Enterprise Rent-A-Car was able to overcome big, well-entrenched companies to become number one in its industry, how Southwest Airlines and JetBlue Airways so easily steal market share from the old-line carriers, or how Vanguard soared to the top of the mutual fund industry, that’s your answer. These companies just said no to bad profits, and their revenues and reputations have flourished.

The cost of bad profits extends well beyond a company’s boundaries. Bad profits provide a distorted picture of business performance. The distortion misleads investors, yielding poor resource decisions that hurt our economy. Bad profits also tarnish the position of business in society. That tarnished reputation undermines consumer trust and provokes calls for stricter rules and tighter regulations. So long as companies pursue bad profits, all the noisy calls for better business ethics are so much hot air. The only way a company can truly live by the Golden Rule—treat others as you would like to be treated—is to avoid bad profits entirely.

By now you’re probably wondering how in heaven’s name profit, that holy grail of the business enterprise, can ever be bad. Short of outright fraud, isn’t one dollar of earnings as good as another? Certainly, accountants can’t tell the difference between good and bad profits. They all look the same on an income statement.

While bad profits don’t show up on the books, they are easy to recognize. They’re profits earned at the expense of customer relationships.

Whenever a customer feels misled, mistreated, ignored, or coerced, then profits from that customer are bad. Bad profits come from unfair or misleading pricing. Bad profits arise when companies save money by delivering a lousy customer experience. Bad profits are about extracting value from customers, not creating value. When sales reps push overpriced or inappropriate products onto trusting customers, the reps are generating bad profits. When complex pricing schemes dupe customers into paying more than necessary to meet their needs, those pricing schemes are contributing to bad profits.

You don’t have to look far for examples. Financial services firms, for instance, like to throw around terms like fiduciary and trust in their advertising campaigns, but how many firms deserve these monikers? Mutual funds bury their often-exorbitant administrative fees in the fine print, so that customers won’t know what they’re paying. Brokerage firms slant their research to support investment-banking clients, thus bilking their stock-buying clients. Retail banks charge astonishing fees for late payments or bounced checks.

Or take health care. Too many hospitals won’t reveal the deals they have cut with insurance companies. Too many insurers do their best to exclude people who might actually need the coverage—and if you do have coverage, they’re sure to drown both you and your doctor in a deluge of complicated paperwork. Many pharmaceutical companies pay doctors to push their drugs, while carefully quashing studies suggesting that a potentially lucrative new drug may be ineffective or dangerous. And many health-maintenance organizations promise to provide cradle-to-grave coverage, yet balk at paying for many procedures their own physicians recommend.

Travelers face their own set of inhospitable tactics. They must pay most airlines $100 to change a ticket and $80 for an extra piece of checked baggage. If they are so foolish as to use a hotel phone, they may find they have run up charges larger than the room rate. If they return most rental cars with less than a full tank, they will be charged more than triple the market price for the fill-up. Of course, they also have the option of buying a full tank at the beginning of the rental and then trying to manage their mileage so precisely that only fumes remain—they get no credit for unused gas.

At times, customers must conclude that businesspeople lie awake nights thinking up new ways to hustle them. Most airlines change their prices hundreds of times a day, so nobody can know what the “real” fare is. Banks develop algorithms that process the largest checks first each day, so that depositors will be hit with more insufficient-funds penalties. Many mobile-phone operators have created pricing plans that cleverly trap customers into wasting prepaid minutes or incurring outrageous overages.

Ironically, the best customers often get the worst deals. If you are a patient, loyal user of your telephone company, your mobile-phone provider, and your Internet-service company, chances are good that you are paying more than disloyal switchers who signed up more recently. In fact you’re probably paying more than you need to, regardless of when you signed up, just because you didn’t know about some special package the company offers. Customers who discover an extra charge of $20, say, for using text messaging find that unlimited text messaging is available for $5 per month—if only they had asked for it in advance.

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How Bad Profits Undermine Growth

Bad profits work much of their damage through the detractors they produce. Detractors are customers who feel badly treated by a company—so badly that they cut back on their purchases, switch to the competition if they can, and warn others to stay away from the company they feel has done them wrong.

Detractors don’t show up on any organization’s balance sheet, but they cost a company far more than most of the liabilities that traditional accounting methods so carefully tally. Customers who feel ignored or mistreated find ways to get even. They drive up service costs by reporting numerous problems. They demoralize frontline employees with their complaints and demands. They gripe to friends, relatives, colleagues, acquaintances—anyone who will listen, sometimes including journalists, regulators, and legislators. Detractors tarnish a firm’s reputation and diminish its ability to recruit the best employees and customers. Today, negative word of mouth goes out over a global PA system. In the past, the accepted maxim was that every unhappy customer told ten friends. Now an unhappy customer can tell ten thousand “friends” through the Internet.

Bad profits—and the detractors they create—strangle a company’s growth. If many of your customers are bad-mouthing you, how are you going to get more? If many of your customers feel mistreated, how can you persuade them to buy more from you? Right now, churn rates in many industries—cellular phones, credit cards, newspapers, and cable TV—have deteriorated to the point where a typical company loses half of its new customers in less than three years. Many airlines have created so much ill will that customers are itching for an alternative. For a while, US Airways dominated the Philadelphia market. The company’s fares were high and its service mediocre, but the routes into and out of Philadelphia were highly profitable. Then Southwest Airlines entered the market with lower fares. US Airways dropped its prices to match Southwest, but travelers flocked to the new carrier anyway—they had had enough.

True growth is hard to find these days. How hard? A recent study by Bain & Company found that only 22 percent of the world’s major firms achieved real, sustainable growth of even 5 percent a year over the ten-year period from 1994 to 2004. It seems like no coincidence that so many companies are having trouble growing and so many companies are addicted to bad profits. To change metaphors, business leaders have become master mechanics in siphoning out current earnings, but they fumble for the right wrench when it comes to gearing up for growth.