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Buying and selling: two sides of the same coin

There is a programme on Radio 4 early on a Sunday morning, repeated late in the evening, called “Something Understood”.  Originally presented by Mark Tully, who as the BBC’s correspondent provided for many years a most wonderfully insightful window on India for the domestic British audience, it generally provides a reflective and gentle introduction to the day of rest for those cursed to wake early and be incapable of rolling over and returning to sleep.  A catholic mix of music and literary extracts, it is generally a pleasurable experience, but one morning in early July 1999 it strayed into dangerous territory.  Selling was its subject, or rather its target.  And when Charles Handy, sometime corporate man, then business school professor, and finally purveyor of folksy philosophy joined the fray, I found myself with hands clenched in fists of rage.  Worse still, I switched the radio late in the evening to find something to lull myself to sleep, only to find the late evening repeat.

For what the programme failed to understand, and Charles Handy, who should know better, was that selling is merely participation in an exchange, in which both parties are selling.   One may be selling goods or services, the other is also selling, at the very least selling cash that can be converted into other goods and services.  The cash being exchanged is merely a more flexible and fungible form of goods or services, superior to a primitive barter exchange in that it leaves the party receiving the cash able to acquire and services that they need.  Handy seemed to suggest that he felt guilty if he was able to sell something for more than its value to himself, in other words to make a profit.  But, he seemed to forget that sometimes he might have bought something for less than he would have been prepared to pay for it, in other words for less than its value to himself.

Life is about exchange, about transactions.  Most obvious in the commercial world, it is well recognised also in social, political and emotional domains.  Without this exchange, these transactions that create value for the participants in the transaction, there would be no advantage in love, no evolution beyond the primitive amoeba, no advantage in community.  For these transactions take place because they create value for the participants.  What the editor of “Something Understood” clearly did not understand, but which I am sure that Handy if challenged would demonstrate that he does, is that it is not the transaction that is the potential problem, nor that fact that the transaction gives rise to a surplus in which at least one of the participants and possibly both feels that they have come out ahead  but there are potential imbalances in that mean that one side or other may secure a great deal more of the value created than the other, and that this means that those who start weak and vulnerable generally find themselves selling their goods and services for only just enough to justify their participation in the transaction and those who start advantaged capture most of the surplus value.  These are the consequences of what classical economics would describe as the imperfections in markets (ie without which you have “perfect markets” ) and of the unequal endowments of the conditions of our birth.  But this is not the basis for saying that selling is worse than buying, or denying the value created by the transaction.

1993 Tomorrow’s Company paper and latest paper for Cranfield Renewing Capitalism project

Two papers setting out some of the key ideas in the framework have been added to the site.  A paper written for Tomorrow’s Company, when in its initial phase under the sponsorship of the Royal Society of Arts, can be found on the Origins page.  A recent paper written for the Cranfield Institute’s Renewing Capitalism initiative can be found on the home page.

Marketing, not just about consumers

At some point in the late 1990s, I wrote a short piece for Word on the Street, the Brackenbury Group’s client newsletter, which demonstrates one of the core propositions behind the Escondido Framework very clearly.  The relationship between the organisation and all its “stakeholders” is at its heart a marketing relationship:

Marketing is too important to be left to the marketing department.  Marketing departments address only the consumers of the products or services that a company sells to those it thinks of as its customers.  But the truth is far wider than this.

Companies should apply the marketing way of thinking in all the markets in which they operate.  This means not just the “downstream” market, but also to the “upstream” markets: funding, labour, bought in goods and services.  The company is marketing an investment opportunity to its shareholders and debt providers.  It is marketing careers and contracts to existing and prospective employees.  It is providing opportunities to its suppliers with markets and channels to other markets. 

The marketing mindset involves understanding the differing needs of differing customer segments, thinking about how to adapt your offer to meet the needs of your target customer and then doing it consistently, understanding the trade-offs they make between different attributes of the product or service you provide – of which price is only one dimension, determining where you can achieve an advantage over your competitors.  It also includes what most non-marketing people understand as “marketing”, communicating these benefits to customers in ways that lead eventually to a profitable sale.

In most companies, marketing activity occurs sporadically in the functions that face “upstream”.  Presentations are given to investors and financial PR consultancies are returned to put a positive gloss on results.  Advertisements are placed, glossy brochures and upbeat web pages prepared, and roadshows taken round campuses to attract prospective recruits.  Invtitations to tender and requirements lists are circulated, and subscriptions taken to web-exchanges as part of the sourcing process, whether for services, real estate, or components and real estate.

But in few companies does marketing explicitly underpin the way in which directors and managers in finance, HR, buying and purchasing, IT, property approach their responsibilities.  They need to think about their “customers” in the same way that their downstream facing colleagues do about the people or businesses that are customers for the products and services the company sells.  Applying tried and tested approaches from the downstream markets to the upstream markets to dealing with the financial markets will yield precious basis point reductions in the cost of capital and reduce paranoia about awkward investors or even takeover.  In HR policy, it will reduce total employment costs – not just outlays on wages and salaries, or even improved retention, but also through enhanced productivity.  And in purchasing it will translate into competitive advantage through lower total costs of supply, higher service and priority treatment. 

A new way of looking at the firm

The Escondido Framework starts from the assumption that the company (in common with many other forms of organisation) is defined by its interfaces with the various market places in which it operates, in the simplest form the markets for labour, raw materials, capital and finished goods or services. These are, in effect, its boundaries.  And while there are differences between markets, in essence they all reflect an exchange between two parties for mutual benefit – the employee receives payment and other non-financial rewards for his labour; the supplier of raw materials payment for the goods provided; the supplier of funds either interest or dividends and the prospect of capital growth for forgoing use of those funds for his own short term benefit; and the customer goods or services in exchange for payment.  The Framework also reflects the view that being a party to the exchange does not of itself mean that the other party has a “stake” in the company or “own” it in any absolute sense.  There may be a contractual relationship between the party and the company which reflects the terms of the exchange and provides structure for enforcement but essentially this is a mutually beneficial relationship in which both parties have duties to deliver their side of the bargain.

Within the Framework, there is no assumption that any of the providers to the company – of labour, raw materials, capital or revenue – any superior rights or claims over the company, in traditional parlance, “ownership”. Legal devices may be put in place by the state, or may exist in the form of contractual agreements that provide these other parties with rights, for example: in the form of wages and employment rights; to payment for goods at a particular point in time; to payment of interest or dividends; and to return of capital under prescribed terms and with differing degrees of confidence. The contracts and legal frameworks may also define mechanisms under which these other parties may enforce these rights, but enforcement is also be a function of other considerations that reflect market conditions rather than the law, for example: what alternatives are available to a workforce with a specific set of skills and ties to a particular geography; what other customers are available for the raw materials, and how much  are they willing to pay; what will other prospective providers of capital pay for these shares or bonds, and how easily can we replace the existing board and executive team; and how often do customers in consumer markets consider, let alone read terms and conditions.

The Framework suggests that the company can be considered as a “virtual space”, existing between these market interfaces.  The location and shape of each of the market interfaces reflects what economists think of as the demand function and marketing academics describe as indifference curves, i.e. how customers make trade-offs between the various attributes of a product. These are also shaped by the competition that the company faces: when recruiting from a limited pool of skilled employees; for sourcing scarce raw materials; seeking funding from a limited capital market, or seeking the custom of consumers who can buy from other companies or who may be able to substitute one item for other goods. Remove the competition and the market interface or boundary moves outwards, increasing the volume of the “virtual space” available to the company. Improve the operating efficiency within the company or secure a competitive advantage over other participants in one of the markets concerned and the volume of the “virtual space” will also increase.

At any particular point in time, for any particular product or service it sells, these interfaces will be brought together, or resolved, at a single virtual point at which of each of the providers is rewarded at prices that are, all things considered, satisfactory to them. In perfect market equilibrium, all prices would be at market clearing levels, no-one would realise economic rents, and there would one point at which the interfaces would be resolved.  No self-respecting economist has ever viewed the perfect market paradigm as anything other than a useful benchmark for understanding a world which is dynamic and virtually always distant from the paradigm, and in this the Escondido Framework is no different. In reality, the “virtual space” is just that, an available set of points at which the price levels may be resolved. Depending on the scale of the external market failures that allow for the internal organisation of economic activity to generate greater efficiency, there is potential for the management of the company to elect where to set prices and where on the indifference curves to locate the marketing proposition to each of the other parties (suppliers or labour, raw material, capital and custom), and how to allocate the economic surplus that the absolute volume of the “virtual space” represents.

The allocation of income and wealth: power versus marginal productivity

John Kay has written a fine account of the distribution of the rewards created within an economic enterprise in his FT column today.  Reflecting on the rewards of looters in the London riots, and allocation of resources in professional services (“eat what you kill”), he comments:

“Two broad economic theories describe the allocation of income and wealth. The power theory states, broadly, that people get what they grab: from the forest, the markets, or the shop window. The distribution of income reflects the distribution of power. For most of history, this was plainly true – the landlord took what he could from the tenant, the baron what he could from the landlord, and the king what he could from everyone. The sixth Duke of Muck was rich because the first Duke of Muck had been an especially successful gang leader. The alternative theory is that what people earn reflects their marginal productivity – how much they personally add to the value of goods and services. The marginal productivity theory has many attractions, especially to those who are well paid: if what they receive is a product of their own efforts, their rewards are surely well deserved.

“Collaborative organisation was only occasionally necessary in an agricultural society in which there were no asset-backed securities and no electrical goods in the shops. But in a complex modern economy, as in the deer forest, production requires the involvement of many. Adam Smith marvelled at the resulting efficiency in his description of a pin factory. But if, as Smith described, one man wrought the iron and another stretched it, who could say what was the marginal productivity of each? And what was the marginal product of the chief executive of the pin factory, or the person who hedged the foreign exchange exposure on the unfinished pins, whose contributions the Scots savant unaccountably failed to mention?

“If the pin factory really did increase the productivity of the factory by a factor of at least 240, as Smith claimed, there was likely to be a surplus when the wage earners had received whatever their marginal product was. And when it came to dividing that surplus, the distribution of authority within that pin factory would be crucial. That distribution would surely favour the CEO. Since the CEO wrote – or at least commissioned – the pin factory’s annual report, the moral and economic argument could be turned on its head. If you were paid a lot, that showed that you contributed a lot. What the recipient earned was, by that fact alone, justified. So the ethic of just reward through effort gave way to the culture of present entitlement from possession.”

So how does this relate to the Escondido Framework?  After all, the Escondido Framework is about organisations and is underpinned by the idea that organisations are defined by their external market interfaces.

The market defined the minimum reward that must accrue to the wage earner, or the CEO for that matter, since if the rewards are insufficient the wage earner will move to alternative employment (after due allowance for the frictional expense of changing jobs, issues surrounding risk and uncertainty about joining an unknown organisation).  But given that the Escondido Framework recognises that most markets are imperfect, the firm that operates more efficiently than competition (so that Adam Smith’s pin factory enjoys at the very least an experience curve advantage over competitor pin factories) for whatever reason may be able to generate returns above and beyond those required to pay the market clearing prices in its markets.  Who gets the additional return: investor (only if he remains sufficiently engaged to address the agency problem of relying on a manager), the manager (whose position mirrors that of the investor), a monopolist supplier exploiting the leverage from his control over scarce resources, the wage-earners (particularly if their skills are in short supply or they organise into a union), or perhaps the customers if the pin factory if has high fixed costs, spare capacity and no alternative markets to serve, or if the company’s strategy is to defend market share by keeping prices low to discourage competition?

John Kay’s observations about the privileged position and likely hold on power of the “CEO” of the pin factory are characteristically perceptive.  All that is needed to reinforce the upwards pressure on rewards arising from the circular argument that high pay must indicate greater contribution is a remuneration committee displaying the Lake Wobegon effect and setting out to pay top quartile in the believe that those with the highest pay deliver more than those of their peers on lower salaries.

 

The dumbest idea in the world?

In an article in today’s FT Michael Skapinker describes how the debate around shareholder value is turning. He notes that Richard Lambert, his former boss now at the CBI, has suggested that the era “Jack Welch capitalism” – the elevation of shareholder value – was drawing to a close, but that the celebrated Jack had marked this himself last year when described shareholder value as “the dumbest idea in the world”, adding that “Shareholder value is a result, not a strategy … Your main constituencies are your employees, your customers and your products.”

Skapinker notes that Unilever’s chief executive, Paul Polman, has recently said the said same to the FT: “I do not work for the shareholder, to be honest; I work for the consumer, the customer. I discovered a long time ago that if I focus on … the long term to improve the lives of consumers and customers all over the world, the business results will come.”

Skapinker’s own observation on these comments, and what has been going wrong, are worth repeating in full:

“I am sure these leaders did not mean shareholders did not matter; rather that they were best served by businesses that performed well over the years. That meant selling goods and services to customers who were happy to come back, and employing staff committed enough to encourage them to do so. Doing that, and doing it profitably, would, over the years, be reflected in the share price.

“The problem has been the rise of shareholders who are not prepared to wait years, but who want a return now, so that they can sell their shares and repeat the trick elsewhere.”

He observes that the focus on shareholder value has resulted in the design of the executive remuneration packages that were designed to address the “agency problem” and to encourage them to do what was best for shareholders. However, any scheme designed to reward a manager will reflect the relatively short time horizon of the individual – unlikely to be in post for more than ten years and probably a great deal less, so in due course retired and on their way to satisfying Keynes’s “long-run” condition. In contrast, companies or, for that matter, their investors, particularly institutions like pension funds and life insurance companies have very long term, even unbounded, time horizons. It is also worth reflecting on the time that it can take to create a great corporation – building a Unilever, a GE, a McKinsey or BCG, one of the great universities, or even one of the sustainable technology companies (Microsoft is now 45 years old and Apple 44 years old), is a matter of generations.

The second issue that Skapinker refers to is interesting.  It is hard to see a moral argument for the promiscuous shareholder who trades shares on short term price movements having pre-eminence over the other constituencies (to use Jack Welch’s terminology). With well-developed equity markets, the investor has a far more fungible stake in the company than most employees, suppliers or customers. However, there are parallel issues to executive pay in the rewards in the fund management industry. Many fund management remuneration packages encourage short term trading rather than long term active engagement with investee companies. This is despite mounting evidence (probably best illustrated by the success of an even more iconic figure than Jack Welch – one Warren Buffet, sage of Omaha) for the superiority of long term investment strategies over playing short term market movements.

Skapinker completes his challenge to the primacy of shareholders by observing that “it is the customers who provide the revenue, the employees who produce the goods and services and society that tolerates the company’s presence. It is hard to reward one when the others suffer.”