What is the principal source of profits – Part Two

Continuing from my last post is the never-ending discussion of which factors drives organizational profitability. As mentioned earlier, the relative importance of industry in this context has been challenged by a series of studies in the later years.

For the sake of clarity: Such empirical studies take a large sample of firms and compare the extent to which variance in profitability is due to firms or industry (controlling for other effects). If firms within the same industry tend to bunch together in terms of profitability, it is industry that is accounting for the greater proportion of profitability and an external approach to strategy is therefore supported. The chief advocate of such an external approach is of course the well-known Michael Porter.

If firms within the same industry vary widely in terms of profitability, it is the specific skills and resources of the firms that matter most, and naturally an internal approach is most appropriate. An influential study of this was done by Richard Rumelt in 1991, and since world-famous strategists and researchers still haven’t come to some sort of conclusion, I am going to keep it all simple by comparing the two important studies done by Rumelt and Porter & McGahan.

As we can see, the two most important studies find that more of the variance in organizational profitability is due to firms rather than industries; in Rumelt’s study the organization’s resources, capabilities, structure and so on, counts for 47 % while Porter & McGagan suggest that the firm accounts for 31 %, but with higher industry effect as well (19 per cent)

It should also be noted that Roquebert, Phillips and Westfall published a meta anslysis where they compared Rumelt’s analysis up against Richard Schmalensee’s analysis from 1985. Their research does not only confirm most of Rumelt’s findings, but also suggest the existence of a corporate effect. If you have access to the Strategic Management Journal, it is a highly recommended read (Vol 17, pp. 653-664 (1996))

Such discussions will probably go on, but it will be interesting to see how the environmental changes in recent years (especially technology development, shorter life cycles and so on) will affect these factors in the future.

Is profit-maximizing finally social responsible?

Since the term was made common in the late 70s, Corporate Social Responsibility (CSR) has had its fair share of attention. It seems like we have come a long way since Milton Friedman’s statement that a company’s obligation to society is solely to “make profit, pay taxes and provide jobs”. According to a report in 2003, only one of ten adults shares Friedman’s view of corporate responsibilities. A follow-up poll actually found that over 80 percent agree that “larger companies should do more than give money to solve social problems”.

But what is really corporate social responsibility all about? Only one thing seems to be certain; whatever it is, it is not correlated to making organisational profit.

Government, activists and the media have in recent years become adept in holding companies responsible for social consequences of their activities. In order to keep such important stakeholders happy, managers have done very much to improve their companies ranking(s) among the many CSR performance-indexes. 

Simplified, the traditional view of corporate social responsibility is that you have got the profit-maximizing companies on one hand and the generous companies thinking about the future generations on the other hand

In a Harvard Business Review article from 2006, Michael Porter and Mark Kramer argue that there are four justifications for why companies should invest in CSR; first is the argument that companies have a duty to be good citizens and to “do the right thing”.

The second argument for investing in CSR is sustainability. “You should meet the needs of the present without compromising the ability of future generations to meet their own needs”, as former Norwegian Prime Minister Gro Harlem Brundtland once said it.

Third is the license to operate. Each company needs license from various stakeholder groups to operate, and an investment in CSR will help the company get this permission.

The fourth (and maybe the most common) justification for CSR; it will improve the company’s reputation. 

Last year the world’s biggest retailer Wal-Mart told its 1,000 Chinese suppliers last year that it would hold them to strict environmental and social standards. This might not be surprising in itself - a lot of companies have said that to its employees over the years.

However, Wal-Mart is not social responsible because of sustainability or because it improves the company’s reputation. They are doing it purely based of economic factors. Wal-Mart has been encouraging companies to cut down on packaging. This enables it to fit more goods into each delivery truck, not only reducing its emission, but also cutting the amount it spends on petrol!

Another example is Mars, the world’s biggest confectionery company, who announced that its entire cocoa supply will “be produced in sustainable manner” by 2020. Also Cadbury, the UK confectionery group, announced that all the cocoa in Dairy Milk, Britain’s biggest-selling chocolate, would be certified by Fairtrade.

For the fourth successive year, cocoa production fell in 2008. Mars and Cadbury are both worried about how few cocoa farmers’ children intend to go into the business. They are hoping the investment in farms that Fairtrade encourages will persuade them cocoa farming is a worthwhile occupation.

Someone please call Porter and Kramer and tell them to add a fifth justification for investing in corporate social responsibility; profits!