Money Profit Metric Inadequate
The value metric also important
The money profit metric is inadequate as a driver of decision making and the allocation of resources in the modern global economy. Return on investment … where return is all about money profit and money capital gain is not enough. Value adding … and its negative, value destruction … for society are also of critical importance, and maybe even more important for society and the way capital gets allocated to competing opportunities.
The value metric should not replace profit but be complementary. Much of the time value adding is consistent with corporate profit, but not all the time. The efficiencies associated with realizing profit are also efficiencies that result in improved value adding … most of the time, but not always.
The best outcome is where value adding and profit have the same profile and behavior … then very good decisions are going to get made with an outcome that is good for profit and good for society.
But not all profitable corporate activities end up with value adding … and there are places where there is value destruction. There should be as good metrics about the value dynamic as there are about corporate profit … and this is what TVM is all about!
The value metric about quality of life
Community and society are more important than the corporation in the matter of quality of life. Family and friends … social interaction … are an important part of life, and the quality of life.
A corporation can play a part … and other organizations … because they provide jobs and they provide goods and services that satisfy needs. An organization can be a good employer and a good community citizen … or not.
The analytical entity is the community
In the prevailing global capitalist market economy, the business organization is most central to economic performance metrics, and especially the money profit performance of the corporate organization. In turn this drives the valuations associated with the capital markets.
TVM uses the community as the primary analytical entity. People live in a community and this is where it is most useful to assess quality of life … and in turn to make decisions that will improve quality of life. Value metrics are related to all the issues that have impact on quality of life.
Money Profit or Loss
What is profit?
Costs and prices determine profit … cost and price make it possible to calculate margins and profits ... and this is what is done in normal corporate accountancy and financial reporting. As we shall see later, in modern financial reporting both cost and price are capable of being distorted so that the most favorable margins and profits are being reported ... something that professional accountancy was structured to avoid.
Simply stated, money profit is the difference between cost and price. There are accounting rules about how cost and price are calculated, but in essence the difference between these two measures is profit.
The modern market based capitalist economy is based on the simple fundamental idea that profit is good, and a market should result in allocation of resources to those activities that are capable of earning profits.
Compared to systems for allocating resources that are simply rule based and bureaucratic, the market system is good … but not good enough.
Money profit is at the center of modern capital market oriented economics ... while value is at the center of TVM for socio-economic metrics. Profit is a meaningful metric for performance measurement within a for-profit corporate organization, but it does not take into account the impact on society of corporate activity and any social responsibility.
In corporate accounting, the basic computation of profit is that it results from sales revenues exceeding the cost of sales. Generally Accepted Accounting Principles (GAAP) have been developed to that there are rigid rules about how sales revenues and how cost of sales are calculated.
In a simple business situation, profit is realized when revenues exceed costs, and a loss is incurred when costs exceed revenues. The idea of profit or loss does not easily translate into all economic activity … for example in the activities of government and in the activities of the not-for-profit sector of the economy.
Phony profits … ignoring liabilities!
But even in the business world much of the profit reporting is phony! GAAP rules should ensure that profits that are reported have economic substance ... but the system of rule making in recent years has preempted reality and reported profit can be meaningless. The fundamental principles of good accountancy used to require that financial reports reflect a true and fair view of the financial situation of the organization ... but this idea has been totally disregarded in modern financial reporting in case after case ... modern bank accounting ... the accounts of General Motors ... the accounts of Enron ... and a whole host of large complex organizations.
Money surplus metric in not-for-profits
A bad metric for an entity with a value purpose
A money surplus or deficit is used as a measure of performance in many not-for-profit environments … but this is only a very poor proxy for performance. The purpose of most not-for-profits is not to have a surplus of money, but to be doing something of value to society. Nevertheless the money accounting is the primary reporting system that is used in these organizations.
Value Adding or Destruction
Profit and loss ignores social impact
GAAP profit ignores social impact! Money profit, which is the key measure of performance for the corporate profit maximizing businesses, ignores social impact. This is important, because many profit maximizing initiatives have negative impact on society. Reducing costs usually increase profits, especially in the short run … and costs may be reduced by many initiatives like, for example, cutting back on environmental pollution control, relocating production to lower wage locations, etc.. GAAP rules allow the computation of costs to ignore completely the depletion of natural resources. GAAP accounting takes into account the disbursements made to have the right to exploit a resource, but there is no explicit costing for the depletion of the resource, and the fact that the resource is consumed.
Phony profits created by ignoring value consumption are a problem in money accounting. This problem is addressed in value accounting because it is value consumption and value creation that at the key determinants for value adding or destruction. Profit gets bigger while society deteriorates. This is not a good outcome ... but is never in the metrics because social impact measures are not part of GAAP accounting.
Therefore value adding or destruction
Value adding or destruction is a derivative of value creation and value consumption. Value adding happens when the resulting value … value creation … is greater than the value consumed. Value destruction is when the resulting value is less than the value consumed. TVM takes into consideration ALL the issues that impact value to society and the community. Value consumption is not only the money cost but the value change associated with the use of the resources in economic activities. Similarly value creation is the value change associated with economic activities … hopefully positive value change.
TVM uses much of the money accounting framework to understand the dynamics of value creation … and especially the idea that a powerful metric for progress is the change in the “state” of the reporting entity. In TVM the community is the primary reporting entity, and its change in state is the main measure of value adding or destruction in the community.
Value creation less value consumption
TVM things in terms of value adding being the difference between value consumed and value created.
Cost and value result in more than profit value adding. Cost and value make it possible to calculate value adding ... something that is very important for society. This value adding is more accurate than profit … but never used in the prevailing mainstream metric systems.
Value adding is a better measure of socio-economic performance because it embraces not only the money component but also the social value component. Some profit is earned by destroying social value, and simply ignored in standard money accounting and reporting. On the other had, social value adding aggregates the money profit and the social value add in a rigorous way.
Unit costs, prices and values are very informative ... they make comparison easy both over time and from place to place. There are some challenges because units of measure and currency exchange rates may confuse ... but when these issues are taken into account, unit costs, prices and values are very powerful.
The measurement of value has a large subjective component ... but it is still possible to have some useful measurement. By using the concept of standard value ... a concept rather similar to standard costs ... it is possible to compare different programs and see how one program performs relative to another.
In the case of malaria control programs, the goal is to reduce mortality and morbidity. By having a table of standard values it is possible to report that one approach had more value relative to the costs than another.
The perception of value differs from place to place, and also changes over time. The changes are ongoing. Values change over time because of the evolution of society. The TVM set of standard values makes it possible to start a process of understanding value perception better, and also to make value adding the goal of economic interventions.
What value arises from profit anyway?
Profit has a value in its own right ... the revenues are bigger than the costs ... so on the face of it there is a positive outcome. But there are derivatives of profit that are even more important that arise because a “market mechanism” values a possible future flow of profit, and a history of past profit in a way that creates a market value ... that is price ... that is more than the real value increase taking place in the business accounts. The Initial Public Offering (IPO) is a vehicle for monetizing the market value associated with a flow of business profits.
Value reporting needs to be as pervasive as profit reporting. Every organization should be reporting not only its money accounting, but also its value accounting. Capital markets should value stock based on both money profit and value.
Value in Not-for-Profit activities!
The concept of profit has no meaning as a performance measure for not-for-profit activities ... but value has a very real meaning. The TVM value construct applies everywhere in both private and public sector organizations that are working for the public good, but without effective performance metrics.
Value adding ... social value adding
Value adding is a broader concept than profit. Value adding is the difference between the ending value and the initial value. It may also be thought of as the value created less the value consumed.
Value is rarely the same as price. Many things in life with the most “value” are truly priceless ... good health, friends and family, the birth of a child, happiness, and so on. It is a challenge to associate a number with value ... but TVM does this by using a dialog around sets of standard values.
Value consumed is more than the financial costs. Value consumed reflects costs but also includes issues like the damage to the environment ... or the exploitation and consumption of natural resources that have taken millions of years to create as in the petroleum industry.
Value ... financial and social
Capital markets are all about value ... but it is financial value only. A stock has a value based on its financial profit history and profit potential. What the company does for society is not a part of the capital market computation. It is just about profit history and profit potential ... about money flows ... about risk and the safety of money capital.
Social value is much more. It is no accident that the phrase “Pursuit of Happiness” is in the founding documents of the USA and not “Chase for Money”. Happiness derives from social values that end up making life worth living. TVM embraces both the financial and the social value and puts both in the metrics of the community.
Price and value
In some cases price and value are the same. In this situation the value chain through delivery to the final consumer is extracting from the consumer a price that is equivalent to the value. The consumer does not get anything of the added value. In fact the typical business model is one that aims to extract as much revenue from the market as possible.
Value adding may be derived from corporate activities that generate profit … but value adding goes on throughout society in a not-for-profit setting as well.
Educational establishments are value adding organizations, and mostly these establishments are not-for-profits rather than being profit making organizations. The value adding associated with education is substantial.
If the example American 25 year old with a top class education and in good health with good opportunities has a $5 million value, and the African example child with little education and little opportunity has a socio-economic value of near zero two factors are in play to explain the difference:
- Education has contributed to value; and
- Opportunities contribute to value.
It is difficult to assess which is the most important … they both work together to result in socio-economic value adding.
Business adds employees and makes new jobs when there is an expectation that the jobs will create corporate profit. At the same time the creation of a job does something of value in society. For a family, the value of a job for some member of the value is not only the immediate money but also the financial security that a job provides into the future. For a community the job adds to the buying power of the population and this multiplies into other businesses in the area. In its most simple form, the change in “value” between a no-job situation and a job situation is some multiple of the income of the job.
When a society has high unemployment the value of the society is reduced … the value of society is compromised. Unemployment in a community is a little bit like empty seats in an airline. The earning potential of the seat is lost when the seat is not used for a revenue earning passenger. Similarly the value of a job is gone when a person does not work on any day. Doing a job is value adding relative to a situation where the job does not exist and a person is unemployed.
Value adding is bigger when important needs are being satisfied … less when the need is merely a want. To illustrate this idea take the case of the person with a lot of shoes, and the person with no shoes.
When an affluent person who has many pairs of shoes buys another pair of shoes, for the business there is an exchange of money and an increment to revenues, but rather little or nothing changes in terms of the quality of life of the shoe owner. In money terms the business accounting shows revenue and profit increase together with asset cash up and asset stock down.
When a poor person who has no shoes gets a pair of shoes, the economic value proposition is very different. Quality of life for the poor person is substantially enhanced and the value adding is positive.
What happens in the shoe supplier business, however, may not be money profit positive … in fact there may well be a money loss.
In TVM the money loss to the business and the value adding to the beneficiary … to society … are taken together. In TVM, a business that has an activity that runs at a money loss while producing a social value gets judged on both the money dimension and the value dimension together.
When society is driven only by profit metrics the outcome is a prosperous luxury sector that is profitable doing very little in terms of social value adding … and little or no allocation of resources into the poor sector of the global economy where needs are enormous and potential for progress ignored.
What is value destruction
Value destruction is when there is more value consumption than there is value creation … a similar idea to profit and loss which are derived from business money costs and business money revenues.
The corporate business community understands corporate value destruction. When a business does things that enhance immediate profit but at the expense of the future profit of the company, there is corporate value destruction.
Society has value destruction in the same way … arguably in a more important way and with more complexity.
Value destruction in a money economic boom
Value destruction is possible in a society even when an economy using money based metrics shows it is booming and growing strongly. The calculation of corporate profit ignores all sorts of value elements which impact on society in one way and impact corporate profit in another way
The case of outsourcing manufacturing from the USA to (say) China has a favorable impact on corporate profit, but has an unfavorable outcome on the social value metric for the USA community with some favorable offset for the Chinese community. When corporate profit is the only metrics that is being monitored by decision makers and investors, then community impact gets ignored.
Jobs and value destruction
Value destruction is pernicious … and difficult to address unless decision makers are using the right set of metrics of performance.
An American 25 year old with a top class education and in good health can look forward to a 40 year career that pays very well. The cost of the education may have been something around $1 million, but the earning potential for the person is many multiples of this. A net present value calculation will probably put the NPV of this person at around $5 million.
The example of an African child … in Niger, say … at 25 years old with little education, a lot of health problems and almost no job opportunities ends up with a NPV of perhaps $5,000.
If American job opportunities decline … not so much in quantity but in the level of remuneration, then the NPV changes from (say) the $5 million referred to above, to something much lower … say $2 million. There is very real value destruction when this happens … in this case one person represents a value destruction of $3 million.
The corporate profits that are being generated simply by moving production to low cost areas of the world from high cost areas are also changing the value proposition for both the low cost area and the high cost area. Meaningful metrics about this take all the value issues into consideration … in both places … and also around the decision makers in the corporate organizations and investors in the capital markets.
The ideas of Adam Smith and the invisible hand of the economic market should not be discarded … but the role of metrics in driving the market and influencing outcomes should be respected.
Markets driven primarily by corporate profit and individual gain will produce outcomes that have massive value destruction in high wage locations around the world … which is bad.
In the outsourcing of manufacturing, TVM value metrics will show value adding in low wage areas … and this value adding will help substantially in raising people out of abject poverty … which is good.
Corporate decision makers … investors … labor leaders … policy makers, etc. have to address the challenge of value destruction caused by the relocation of corporate activity from one place to another. Maybe some value destruction has to take place … but maybe not.
If the brain-power that has a singular focus on making the most corporate profit and the most money gain in the capital markets were to be deployed to address the dynamics of socio-economic value adding and destruction there would be a better outcome.