Ok, let’s start with the clichés first. We all know that the profit motive is at the center of capitalism, the raison d’être of an organization. So profit is the purpose of an organization, and the shareholder (to serve whom the organization exists) is the primary stakeholder. Is this reflected in most Organization Design?
Disclaimer: This article was written originally in November 2006.
The organization uses various resources to generate a profit. In economic terms, it uses Land, Labour, Organisation & Capital (LLOC), i.e., all the resources it uses can be classified in some way or the other into the above heads. If we take the 4 M’s: Man, Machine, Materials, and Method, they are merely a re-statement of the above LLOC.
Yet, most organizations I know tend to confuse this balance, i.e., they tend to focus excessively on one or the other of the above baskets. At some companies I have seen, I notice an excessive and almost myopic focus on Labour, i.e., doing things.
We have customers who tell us what to make from time to time. Through the TQM/ TPM/ 6-Sigma mindset that flows up and down the auto value chain, we all have this huge focus on the 4 M’s mentioned above. Most of the talk is about machine productivity, labor standards, (material) wastage, Overall Equipment uptime or Line Efficiency (OLE), inventory control, etc.
In other words, maximizing throughput per unit of Capital Employed. So, either you reduce the Capital Employed for a given level of output (as in stagnating markets in the developed world, where they use outsourcing and innovation to do this), or you maximize throughput for a given level of Capital (as in developing countries, where demand is buoyant, but capital is expensive and scarce).
But the companies are only focused on doing things (i.e. Labour), also called manufacturing, in layman’s terms.
Now compare this to a bank, as in, what does a Bank “do”? Is there any physical transformation in its product? A bank captures ‘profit’ by ensuring that it raises funds cheaper than what it lends (assuming it gets back all the money it lent out in the first place).
But this ‘work’ produces profit, which comes from managing “Capital”, one of the 4 economic resources mentioned above.
Organization aka Management Quality
Let’s look at Organisation, often called Management Quality in the markets. The ability to capture and maintain a near-monopoly is the key skill for Microsoft’s shareholders. Of course, the company’s PR Department will argue that this skill belongs under ‘Labour’, i.e., the ability to build the world’s best software. But ask any user of Netscape, and they will agree with my classification above. (Fortunately, this column is not read by people at Microsoft.)
Or Berkshire Hathaway. A small group of wise men are brought (and held) together, they sit down around a coffee table and understand Risk and Opportunity better than anybody we know. Why (and How) do they stay together? I don’t know, but this ability, which creates profit, must be put under the basket called “Organisation”.
Two sides of the coin: Risk and Opportunity
Under this head, I will also put the ability to handle Risk and the other side of the coin, Opportunity. A good Insurance company, for example, (or a good Derivative trading outfit, a.k.a. an Investment Bank) makes a profit because it charges more premium than it pays out, i.e., it estimates the probability of occurrence of an event better than its customers. And it keeps enough Risk Capital on standby (either on or off its Balance Sheet) to make sure that it never goes bust, especially during those sudden cataclysmic crises that happen every so often these days.
Last, let’s come to Land. Don’t take this term literally. In Ricardian terms, land used to mean anything whose supply was not controlled by human beings. The simplest example was the land itself. In those days, if you owned land, you got to charge Rent, from which came the term, Economic Rent. I believe the system exists even today, you can see it in Bihar.
These days, the concept covers every such situation where you earn ‘profit’ merely because you are there. So if Tata Steel owns some fabulous mining leases in Iron Ore and Coking Coal, it can afford thrice the labor cost of its competitors. SAIL, which also has the same quality mines in Iron Ore, can afford 4 times (the labor cost). This source of profit, a chunk of which is then lost to Organised Labour, is called Land.
In the same spirit, Infosys ‘mines’ a seam of solid, mathematical/ logical skills to give itself nonpareil code-writing capability. This is a combination of Land and Labour, a good example of a case where an organization starts with one source of profit, but goes on to build another one across the LLOC basket. Infosys started with a critical resource, code-writing skills (a generic), but has built skills to exploit another source of profit, business solutions, which is a skill layered over its generic capability.
Yet, compared to a GE for example, I have not seen Infosys use its Balance Sheet and its vast cash reserves to build a Treasury, for example. It is quite obvious that the company chooses to underperform its profit potential in this area. Perhaps it has weighed the profit potential (from Treasury activities) against the risk and decided against exploiting it. I am told that early in its history, the company lost money in the markets.
Resource-sensitive Organization Design
But to now get to the nub of my point. I don’t think too many companies examine their Organization Design, to see whether they are able to exploit all the sources of profit possible. Every external interface of the company creates an external stakeholder. Does the company examine each such interface to see how it is losing money/ value or exploiting the relationship for profit?
For example, the company I work for, is one of the best-rated auto component companies, according to a recent CNBC poll. Yet, it is my personal opinion that we give away 40-50% of our net profit, by choosing to stay with a single supplier of steel, rather than convert to multiple suppliers. One part of the management team argues that this is by choice…we need to trade off the customer’s interest against that of our own profitability. So we cannot shift to ‘multiple suppliers’ without the customer’s explicit approval.
My counter-argument is that perhaps we, as management, are averse to building “strategic sourcing” skills that allow us to scour the globe for alternate suppliers. How many vendor/ material-substitution proposals have we given to our customers in the past 5 years, for example?
So we have chosen to stay ‘ignorant’ at the vendor interface, taking the prices we are given, under the garb of ‘customer interest’. But in making this compromise, we have sacrificed “shareholder interest”.
And finally, I will establish the link with markets with yet another cliché.
Companies create wealth/ value, but markets measure them
“Companies create wealth/ value, but markets measure them”. I have often seen that markets don’t value the various streams of profit differently, i.e., the profits of an auto component company are measured on par with the profits of a bank/ insurance company. For a better understanding of the nature of profit, it is important to first analyze why (and how) the company makes money in the first place.
For example, an auto comp company makes its profits from “labor” after losing whatever it does to its suppliers, bankers, and even employees. It makes money (as in the case of my company) after over-paying its suppliers, bankers, etc. The residual profits are real and are less likely to be lost again. These profits are then redeployed into a set of real machines, plants, and buildings, which will always have value, as long as the business has any role in society.
Compare this to a bank, which makes money during the boom because it borrows cheaply and lends dear. The bank puts all its profits back into its Balance Sheet, leaving its past profits exposed to the same risk of default. Suddenly, after the recession hits, investors are left wondering how much of the past “profits” of the bank were real. The catch is that Risk levels have stayed constant (or have increased) in the bank’s Balance Sheet, while they have actually reduced in the auto comp company’s Balance Sheet.
Yet, the market would value a typical Bank at a P-E level higher than that of the typical auto comp co.
What they know is Wealth, what they don’t is Risk
So let me summarise: Profit is the objective of any organization, and it comes from the ‘management’ of 4 key economic resources (LLOC). Most organizations are good at (managing) one or the other of the above (resources). Organizations need to grow in depth, i.e., learn to ‘do’ things better, and manage one resource. And they need to grow in breadth, i.e., know enough about managing the other 3 resources better. What they know is Wealth, what they don’t is Risk.