Corpus compilation and processing

There is plenty of scope for disagreement among those managers whose objec-tives can be characterised as profit maximisation; these disagreements revolve around the appropriate measure of profit making. However, there is another body of thought which takes the view that companies should have objectives which are much broader in scope than simply maximising profits. These objec-tives might include the minimisation of pollution and creating employment opportunities for the disadvantaged and for those who live in depressed areas.

This view was strongly criticised by Friedman,³who argued that not only is any other goal than profit maximisation bad for the company, but it can result in a misallocation of resources so that everyone ends up worse off. This, of course, is consistent with the view of Adam Smith, that the interests of society as a whole are served by the self-seeking actions of individuals, while the undesirable side effects of the market can be tackled through collective action using elected gov-ernments; attempts by individual companies to shoulder the role of government are misguided.

The arguments against incorporating social objectives into company objectives are, first, the lack of efficiency criteria. The most obvious difficulty which a company faces when attempting to incorporate objectives relating to civil rights or ecology is the determination of how much of its scarce resources to devote to any particular end. The next problem is to determine whether this allocation

of resources is efficient. Given the difficulty managers have in determining the efficiency of resource allocation within the company itself, such a venture is bound to be frustrating. It may be that there is a real return on being associated with a ‘green’ approach to production, and in this case ecological concern is really a form of marketing expenditure; furthermore, these returns may only be achieved in the long term. In the extreme, the attempt to achieve social objectives may generate a paternalistic attitude in large companies which is contrary to the concepts of freedom of action upon which the notion of the market system is based. It may also lead to an allocation of resources which an elected government would not agree with; if the government’s view is an expression of the will of the majority, it could be argued that society is less well off than if the government had been allowed to make the choice. The second argument relates to the self-interest of the shareholders. Any company pursuing social objectives which incur costs which the company would not otherwise bear has to compete against rivals who are pursuing a purely profit maximising set of objectives; this means that the company will have higher relative costs. If the end result is that the company goes out of business and shareholders lose their wealth, the attempt to achieve social objectives becomes rather pointless and self-defeating.

However, it may be the case that the pursuit of some social objectives incurs trivial costs. In that case the issue of whether to use social objectives is a matter for the owners of the company. The problem is that managers are likely to be unaware of the costs involved, and this is an area where shareholder wealth analysis could be put to use. Attention could be focused on the likely impact of pursuing social objectives on expected cash flows, with the consequent implications for shareholder wealth.

The underlying issue here is what is referred to by economists as ‘efficiency versus equity’. The efficiency issue is concerned with maximising the output of goods and services. The equity issue is how the output should be distributed among members of society, bearing in mind that different distribution systems themselves have implications for incentives and hence for efficiency.

A generally accepted view now is that managers should not attempt to achieve social objectives directly. Once profits have been made, attempts can be made to discharge social responsibilities which are consistent with the interests of those whom managers represent, i.e. the shareholders in the business. Managers who feel that they should follow their social conscience in the general process of resource allocation may well be doing net harm both to their own company and to society as a whole. This is an example of what the Austrian economist Hayek referred to as the ‘unintended consequences of human action’. While there is no absolute right or wrong concerning which course of action should be taken, managers should be aware of the practical dangers which a non profit maximising approach can generate.

3.14 Stakeholders

3.14.1 Stakeholder Interest

A variety of individuals and groups have an interest in the organisation and the way in which it is managed, and those individuals and groups are categorised as the stakeholders. The notion of stakeholder extends well beyond the share-holders, or owners of the company, to include managers, employees, customers, suppliers, creditors, the local community and the government. Each stakeholder has a different type of interest in the company, for example the shareholders are concerned with the return on their investment, and the safety of their capital, while customers are concerned with the quality of the product they purchase and after sales service. Thus each stakeholder has an expectation of some return from the company which is not necessarily expressed in financial terms.

An outline of the various stakeholders and their interest is shown in Table 3.5.

Table 3.5 Stakeholders and their interests Stakeholder Interest

Shareholders Return on investment Risk

Managers Salary

Advancement

Employees Salary

Advancement Security Fair treatment Suppliers Prompt payment

Repeat orders

Customers Relative value for money Quality

Availability

Creditors Cash flow

Financial stability

Local community Lack of negative externalities Employment prospects Government Payment of taxes

Lawful operation

The main characteristic of this classification is that the interests of the different stakeholders are completely different. This raises the possibility of conflicts of interest, therefore the issue of stakeholder influence needs to be pursued in some detail. There are in fact two distinct issues to be addressed when analysing stakeholder interests and expectations:

• which interests are most important;

• the influence which stakeholders have on the operation of the company.

The first of these largely relates to how stakeholders feel the company should be run, while the second relates to how the company is actually run.

3.14.2 Stakeholder Interests: The Priorities

It could be argued that this is really a discussion about how society should be run, for example, in a general sense should employees or shareholders be regarded as more important? An individual’s judgement on this is likely to be affected by which group he or she is in, for example it is quite natural for an employee to consider that his day to day involvement with the company is more important than that of the shareholder who may never have been inside the door.

It is important to be explicit about the issue of shareholder priorities because it has implications for the efficiency with which the company can be operated. The following are the type of arguments you will encounter on stakeholder priorities, but it is important that you keep an open mind on the issue. Furthermore, this discussion is conducted in terms of a commercial organisation; the not-for-profit sector, which includes education, health provision and charities, will differ in many respects.

Shareholders

The shareholders can be regarded as the most important because they provide the capital for the company and if it does not operate efficiently shareholders can withdraw their funds and invest it in something more profitable. In this respect the shareholders provide a service to the rest of the economy in that they direct resources to those operations which provide the highest financial returns;

in that sense everyone benefits from the freedom of choice to pursue the best return on their money.

On the other hand it can be argued that shareholders tend to take a short term view of company prospects and it is not safe to leave the destiny of companies to their discretion. This in turn becomes an argument about how efficiently capital markets work, and the fact is that no method has yet been discovered which is as effective as capital markets in directing the allocation of resources in the economy as a whole. Central planning was exposed as a failure with the fall of communism; variations on free market operations have been tried, but these amount to attempts at influencing the way the market works rather than replacing it.

So far as the company is concerned, it needs to be recognised that shareholders control the supply of capital, and if their interests are not met in the form of a rate of return which is comparable to other investment opportunities then the company will most likely cease to exist. It is because of this that it is often concluded that shareholder interest is the highest priority stakeholder and companies ignore this at their peril.

Managers

Managers comprise the group which is charged with determining the direction, scope and effectiveness of the business. They are responsible for the allocation of resources, and it is largely upon them that the stakeholders depend for their

returns. In addition, if managers make the wrong decisions the employees lose their jobs and customers are deprived of the company’s products. It can thus be argued that managers are the most important stakeholders and therefore should be rewarded accordingly.

While this is true, there is also a market in managers, and so long as the company treats them at least as well as companies which might compete for their services then they do not need to be singled out for special treatment. Their stakeholder priority is high, but it need not be at the expense of shareholder or employee returns.

Employees

It is on the productive effort of employees that the success of the company depends. But exactly the same argument applies in the case of managers: there is a market in employees which determines the conditions under which they are employed, and again it is unnecessary to single them out for special stakeholder treatment above and beyond that dictated by the market.

Suppliers

The stakeholder priority depends on the number of suppliers which the company uses. The five forces model discussed at 5.12 highlights the bargaining power of suppliers, and when the company is greatly dependent on one supplier it follows that its stakeholder priority is relatively high. But before assigning too high a priority to suppliers it is necessary to determine whether the company can substitute for other suppliers, or increase the number of suppliers. If there is a high degree of dependence with a supplier then this may be a case for vertical integration, but typically recourse to the market will reveal that there are plenty of other suppliers.

It may be that a long term relationship has been developed with certain suppliers which provides security of supplies, flexibility and so on. But it has to be recognised that there are costs as well as benefits in such a relationship, and if dependence on particular suppliers is found to have an unjustified influence on the management and direction of the company then the stakeholder priority must be reconsidered.

Customers

It is clearly important to provide customers with what they want, but this is because they can take their custom elsewhere in competitive markets. Other than the obvious fact that the company sells to customers, it is difficult to see what priority should be accorded to customers as stakeholders.

Creditors

As capital markets have become increasingly competitive the interests of indi-vidual creditors has diminished. If the creditor has made a realistic estimate of the client then it will be reasonably confident that its debts will be serviced and need have no other interest in the company.

Local community

Companies depend on their local community for employees, services, land, plan-ning permission and so on; the local community depends on the company for employment and the creation of wealth. Both sides benefit from the arrangement and in this respect it is important for the company to live in harmony with the local community.

There is no doubt that the local community has a valid stakeholder interest, and these need to be taken into account in company decision making.

Government

So long as the company pays its taxes and acts according to the law there is no need for the government to figure in its decision making. In a market economy the role of the government is to set the rules of the game and monitor that they are being adhered to. The government really has no stakeholder interest beyond this for market companies. In government run organisations such as the civil service this is not the case, but here the government acts as a shareholder and it is in that sense that it has a high stakeholder priority.

3.14.3 Stakeholder Influence

While it can be argued that in principle some stakeholders should have little interest in the company, the existence of legislative, institutional and historical factors can imbue stakeholders with a significant degree of influence; for exam-ple, a strong trade union can result in employees having a significant impact on major company decisions. In the not-for-profit sector there are typically many interest groups who have to be consulted.

It is not only the degree of influence which is important, but the fact that the interests of stakeholders are often in conflict; this leads to the principal agent problem discussed in section 3.8. While the profile of stakeholder influence varies among different companies, the following indicates the factors which determine how important that influence is likely to be.

Shareholders

Despite their importance, shareholders usually exert little influence on major company decisions or how the company is run from day to day. Large companies typically have many shareholders and they are geographically isolated, coming together, if at all, only for the annual general meeting. Power rests with the executives, and it is only in exceptional circumstances that CEOs are censured or dismissed at the AGM; this is an aspect of the principal agent problem discussed at 3.8.

In some cases large financial institutions, which manage portfolios for pension funds and investment trusts, may have a significant shareholding in a particular company; if the institutional shareholders together take a similar view on a particular issue they may wield some power over company executives at the AGM. However, it must be recognised that these financial institutions are really the representatives of the individuals whose money they manage, and there is

no guarantee that they will act in accordance with these individuals’ wishes.

In smaller companies, which are family owned or have a few partners, the shareholders wield a direct influence on company operations. But in this case they typically play the dual role of shareholders and managers, and this negates the principal agent problem.

Managers

By and large the influence of managers increases with the size of the company, as the influence of the shareholders diminishes. The independence of managers also depends on the type of remuneration package – whether it is related to absolute profits, growth in sales, successful acquisitions, or whatever. Ideally, the management incentive structure would be aligned with shareholder interests, which are largely profit maximisation, but this is notoriously difficult to achieve.

There are many examples of CEOs receiving huge salary increases at the same time as company fortunes are falling – this is usually because remuneration is lagged and is related not to current but to past performance.

One method of attempting to align the two is to make the CEO a shareholder by giving stock options instead of direct remuneration. While the outcome of this should be the maximisation of shareholder wealth, the CEO has an incentive to cash in the options at the most opportune time, and this may not be consistent with long term profit maximisation. In principle, the role of the non executive board members, and an independent chairman, is to provide the countervailing power which will balance up the interests of managers and stakeholders, but given the limited time which the non-executives spend in the company, and the fact that directorships are often interlocking, the non-executives often wield little real power.

Employees

There was a time in the UK when trade unions had sufficient numerical strength, and the backing of legislation, to ensure that employees had a significant impact on company decision making. The changes in the legislation in the 1980s, cou-pled with an absolute decline in trade union membership led to a significant reduction in this form of employee influence. In some countries, such as Ger-many, employee influence is much higher because of labour legislation which is more favourable to employees than is the case in the UK. Thus much depends on the individual country and its legislation.

However, employees wield influence in a different way. At the simplest level, it is not feasible for a company to replace its entire workforce at a stroke. Even if it were, the new employees would start off far down the experience curve and productivity and competitiveness would be severely undermined. Thus the company is to a great extent dependent on the skills and attributes of the current employees. In this case it is not so much the direct influence of employees on company decision making which is important, but the extent to which they are able and willing to collaborate in the changes which strategic decision making involves. This in turn depends on the company culture, organisational structure, incentives and so on. The more specific the employee skill sets are to the individual company the more important this factor is likely to be.

Suppliers

As discussed above, the important considerations are the number of suppliers and the availability of substitutes.

Customers

Again, the five forces model reveals that the number of customers or customer groups largely determines customer influence. On the other hand, if there are few substitutes for the company’s products this power will be greatly diminished.

Creditors

Companies tend to build relationships with sources of credit, such as banks, so that they can rely on a fast and fairly sympathetic reaction to credit requirements.

Some companies have representatives of creditors on the board; this is usually the outcome of venture capital being provided by banks for high risk start ups who wish to monitor their investments. But typically this involvement diminishes as the management establishes a track record.

Some companies have representatives of creditors on the board; this is usually the outcome of venture capital being provided by banks for high risk start ups who wish to monitor their investments. But typically this involvement diminishes as the management establishes a track record.