Identifying and proposing a solution to rectify the root cause of many of our economic problems.
The root cause of many of our economic problems is an inappropriate measurement standard. There is general acceptance that we need a more balanced perspective than that provided by our Accounting Model. Consequently, we’ve seen the development of “solutions” like The Balanced Scorecard, plus many others, but none of them work, and are definitely no solution. Here I explain why, and suggest what my research has revealed, in the first of a number of articles on the subject.
Understandably, most of us are deeply concerned about our under performing world economy, issues of sustainability, unfair wealth distribution, disproportionate executive remuneration, unethical business practice, and greed, together with resource exploitation, increased stock market volatility, and increasing business risk.
These are all the symptoms of an underlying root cause – an inappropriate measurement standard.
We are all aware that what we measure is what we get and what we don't measure is what we don't manage, so the importance of our measurement standard in shaping outcomes, becomes self-evident. As money makes the world go around, the economy is central to everybody’s life and that of the environment. If our measures are inappropriate, we produce inappropriate results, which lead to all the undesirable socioeconomic problems mentioned in my introduction.
The first step in solving any problem is to identify or acknowledge it, otherwise we go around chasing our tails. Only when identified can the requirements for a solution be articulated.
The problem lies with our Accounting Model. It’s not that it’s a poor financial measure, but because it’s our sole, universally applicable standard for measuring business performance. Consequently, businesses are encouraged to produce strong “financial” as this is how the outside world (bankers, investors, creditors) measure them. As a financial measure, it only provides a one-sided, myopic, historical perspective. However, there is considerably more to business than backward-looking financial data, but by concentrating on producing strong “financials” other important measures are overlooked, thereby skewing results unfavourably.
The inadequacies of our Accounting Model were identified almost two decades ago. As a result, “solutions” such as “The Balanced Scorecard," the “Triple Bottom-Line," and “Intellectual Capital Measures," to name just a few of the more popular “solutions," were introduced to help provide a balanced perspective of business performance.
Unfortunately, none of these, including all the lesser know “solutions” work. The reasons for this will soon become apparent.
The need for balanced measures has wide acceptance. Critical to implementing such a philosophy is that all measurement standards must be of equal stature. There can be no “balance” if one measure dominant's others; they must all be of an equal standing.
The advantages of using the Accounting Model is that it’s universally applicable, allowing comparisons across different sectors, irrespective of business size. This is of critical importance. Our entire investment / management approach is based on making comparisons on a like-for-like basis. Therefore, if we are going to introduce other measures, then they too must be universally applicable, just as the Accounting Model is. If a measure does not offer universal applicability, don’t even consider it – its missed the point.
Now you can see why all the “solutions," proposed in the past, like the popular “Balanced Scorecard," failed to identify the most fundamental consideration of all in providing balanced measures – universal applicability. As a proprietary, internal measure, it has no significance outside the business (irrespective of how good, it is), because the business will be judged on its financials (as our sole universally applicable measurement standard.) Consequently, the business is encouraged (or obliged) to produce strong financials, which may be counterintuitive to the suggestions of the “Balanced Scorecard." As a result, its effects are watered down until it doesn’t really matter if they follow the model or not.
Having acknowledged the problem (i.e. the need for a balanced approach), and identifying a prerequisite for the solution (i.e. universally applicable standards), the question is what do we need to measure to provide this balanced perspective?
Our requirement, in my opinion, is particularly simple. To start and run a business you need two primary resources – money and people, or financial and people capital. You then apply these two primary resources to processes within your business, called the “value creation processes” to add value to your two primary resources. Therefore, it makes sense that we measure these three major components to provide a balanced perspective.
While providing additional measures, and acknowledging their equal importance, there also needs to be a fundamental shift in focus away from “backward-looking” financial results towards “forward-looking” measures. Financial measures are important, but no successful business faces the future looking backwards at historical financial results. Businesses need to look ahead and consider how their “forward looking” value creation processes, and people capital assets, are positioned to produce favourable results.
These changes represent a fundamental, grassroots change, affecting every business and everybody within business. It represents a complete paradigm shift in measurement and management, where we have three measurement standards of equal importance, but where the focus shifts from “backward” to “forward-looking” measures and where such measures are radically different to the absolute financial measures we have become accustomed to. Nothing will have a greater impact on business than changing its measurement (and therefore, management) standards. This represents the biggest change in business since the introduction of the Accounting Model over 500 years ago.
This is an area where I have spent the past fifteen years researching and understanding, and I would like to share some of my understand with you in future articles. If you have any questions or queries, please email me at the address shown below.
Our Accounting Model is the root cause of many of our socioeconomic problems, but it's not failing us because it’s a bad financial measurement standard, but because it’s used as our exclusive measurement standard. There’s a lot more to business than financial measures, but if we continue to measure business only in terms of its short-term financial results, the problems will worsen. I list the top ten problems caused through using the Accounting Model as our sole measurement standard.
1. Inhibits business achieving sustained, long-term profits.
When our primary measure is short-term financial results, we encourage strong financials, which are often achieved at the expense of the value creators (e.g. R & D and marketing investments,) as well as investment in staff development. Investment in these activities impacts negatively on short-term financial results. Consequently, these value drivers are not fully developed, favouring “good quarterly financial results” instead. As a result, businesses struggle to achieve long-term profits.
2. Increases business risk.
Financial measures show only a small part of a much bigger picture. Furthermore, they relate to “backward-looking” historical data, not forward-looking indicators, which show how well placed the business is to create future wealth. Limited information in a competitive, rapidly changing market increases risk substantially.
3. Contributes to stock market volatility.
Stock markets are driven mainly by financial data. As this data is extremely limited, risk is high. There is a direct correlation between risk and market volatility. The higher the risk the more volatile the market. Only when a better measurement standard is introduced, which provides a more balanced and detailed view of business, will market volatility subside.
4. Encourages poor decision making.
On what basis does management decide to invest in the so-called "Accounting Intangibles," which make up more than eighty percent of business value? Financial measures can only be used to evaluate financial results; they cannot tell you where you should invest, which is the most important decision of all. Without a method for quantifiably identifying investment opportunities within the murky depths of the "intangibles," the probabilities of investing in the wrong projects increase substantially.
5. Leads to concerns about sustainability.
The consequences of being unable to determine accurately business performance and underlying value, together with a short-term profit focus, means critical, finite resources (i.e. financial, people, materials and the environment) are being ineffectively employed in our economy; scarce resources are being ineffectively directed.
6. Masks value creation activities.
What's the relationship, if any, between financial profit and value creation? We all know it's possible to make a financial profit yet destroy value, and we also know it's possible to create underlying value yet show a financial loss. So, from this we can conclude that there is no correlation between financial profit and value creation. Financial profit masks our value creation activities, yet it is these value creation activities which build underlying business value, which supports and sustains future profit.
7. Contributes to unethical business practices.
As our Accounting Model is geared around creating short-term profits, it "incentivises" senior executives, on short-term tenure, to cut costs "below the bone" and to shun medium to long-term investment opportunities to make “excellent quarterly results” for their own personal benefit, at the cost of the business. It’s very easy to gut value and generate profits without the markets being any the wiser, because we don’t have a balanced perspective of the business, which would immediately identify the problem. Because the system encourages strong financials and rewards them through disproportionately high executive remuneration, and because we cannot easily identify value destruction in pursuit of profit, then expect unethical business practice to be on the increase.
8. Supports a “profiteering” approach.
Our Accounting Model does not distinguish between profit and rent-seeking activities (as defined by Adam Smith in his book The Wealth of Nations.) It fosters a short-term “profiteering” attitude - optimise profits in the short-term through any means, at any cost. Destroy long-term value as “tomorrow's another day," exploit rent-seeking opportunities, it doesn't matter as long as you return a good profit this quarter! This is what the Accounting Model encourages, (evidenced through the long list of current business scandals, of short-term profiteering by major banks and corporations.) Long-term profits cannot be achieved through any form of exploitation. You cannot exploit, or destroy, what ultimately sustains you. Long-term value creation is all about mutual benefit - customers, shareholders and all stakeholders must benefit from their mutual interactions, including the environment. This is a fundamental cornerstone for long-term, sustained value creation.
9. Encourages poor wealth distribution.
Greater business ownership and involvement by the masses is the key to sustained prosperity for all. Concentration of wealth in the hands of an elite group only benefits them. It’s better to have broadly distributed wealth, but the Accounting Model inhibits this in two ways.
a) The “profiteering” approach of the Accounting Model is in complete contrast with a long-term value creation approach which encourages mutual benefit for all those involved in business (whether directly or not.) The Accounting Model, has inadvertently, set up an adversarial form of management where the interests of shareholders, and the executive are pitted against all other parties involved. The objective is to make them rich at the expense of other parties, and to hoard such riches.
b) Stock market involvement becomes an “art” more than a science when limited data is made available to make decisions. Access to the stock market by the masses is difficult, limiting to it to a “knowledgeable” few.
10. Restricts / inhibits marketing’s strategic input.
The dominance of the Accounting Model has lead to another disturbing phenomenon. Boards are predominantly composed of those with financial backgrounds, to the exclusion of those with marketing backgrounds. The reason for this is that marketers are to a large extent involved in the process of value creation, and as the Accounting Model is inappropriate for measuring value creation activities, marketing has been marginalised as their performance cannot be fully evaluated in financial terms. Their apparent lack of “accountability” has forced them out of boardrooms. This narrow financial perspective is inhibiting marketing from contributing to the future direction and strategy of their organisation to their organisation's and economy's detriment.
We have to supplement our Accounting Model with both People Capital and Value Creation Process measures, but these new measurement standards have to be universally applicable to facilitate measurement across sectors, irrespective of business size.