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Destroying company relationships

By having absurd theories, abstracts and aggregates define them.
Adding value is the oldest activity known to man and the oldest business principle. Picture: Shutterstock

SWELLENDAM – If economic theory holds true, you could have a good business selling Johannesburg Big Mac hamburgers in New York. For the latest Economist Big Mac Index shows that New Yorkers pay about twice as much than Joburgers, and that’s a healthy margin by any standards.

Of course, even the most ill-informed will protest that it is much more complex than that. It may not be the best example, but it is some reflection of how often theories, abstracts and aggregates lose touch with underlying complexities, when a macro-assumption not only does not fit a micro situation but its imposition as an absolute can cause more harm than good. The best examples we have are the dominant drivers of economic policy such as gross domestic product and the consumer price index.

Markets are messy. People are messy. They become even messier when you add to the mix those powerful intangibles and immeasurable such as hopes, fears, expectations and aspirations. These are the real driving forces behind human behaviour and simply cannot be captured by an economic model or economist’s spreadsheet. It has given birth to a recent serious field in economic study called complexity economics, which is questioning many of the assumptions of neo-classical economic theory. The driving forces behind human behaviour are not shaped by these theories, or even the way we try to construct and institutionalise them. They are shaped by relationships at many different levels and in different forms and that are seldom, if ever fully recognised in the way we understand and measure business specifically and economies generally.

Recognising, understanding and shaping the relationship dynamics in companies could hold much promise in solving many of the issues confronting them. I can remember in my early days of financial reporting being troubled by the bland way company figures were presented and the failure to reflect behaviour and relationships that were the real essence behind the figures. In the early 80s I was exposed to the UK accounting format, the value-added statement, which went quite a way in doing that, but still did not seem to appropriately reflect the relationship between the main role players or stakeholders. But a significant conclusion that could be reached was that the value-added measurement itself not only reflected a figure (income less outside costs), but a magnificent metric of contributory behaviour. To repeat a previous postulate: adding value is the oldest activity known to man. It is also the most powerful business principle.​

  • It is behind all positive transformation
  • It is the source of wealth
  • It measures contribution
  • It measures reward
  • It links contribution and reward
  • It drives all contributory behaviour
  • It is the base of GDP, the nation’s wealth
  • It is the source of profits, wages and taxes
  • It affects all company measurements

By way of illustration, I’m including the Contribution Account© that I extrapolated and indexed for the mining industry.

The full strength of this form of accounting is the way it defines relationships – first between the enterprise and its market, where it creates and receives value, and then between labour, capital and state, where that value is shared. It is in that relationship where things can be contaminated and logic lost. I was reminded of this by a comment to my recent article Debunking monopoly capital where the reader equated debt with equity to satisfy the conventional abstract of “providers” of capital and, of course, sustain the myth of the supremacy of capital. To be fair, the UK VAS format does this as well, but in the European format interest paid was moved to “outside supplies” in what became known as the Cash value-added statement.

The latter format also moved depreciation and amortisation to outside supplies. Both not only make technical sense, but even more so from a contributory relationship point of view. Allocating depreciation to outside costs is based on the logic that the item being depreciated was invariably purchased from an outsider, but the cost advanced is set-off over time through the balance sheet. Regarding debt, no one can logically see interest paid as anything but a cost. A lender’s relationship is as a supplier of a service – the use of money, and seldom, if ever extends beyond that. The risk of advancing that money is covered in the interest rate.

Equity also cannot be generalised as a single abstract called capital. It can have many forms such as owner’s money, crowdfunding, inherited funds, use of friends’ and acquaintances’ money, majority and minority shareholders, holding companies and institutional investors. All have different relationships with the enterprise. Many will take no heed of esoteric formulas such as capital or labour productivity. When these are imposed as rigid benchmarks they often disturb and sour relationships. There’s also a stark relationship difference between retained income and dividend, with the former being a commitment, and the latter a cash receipt. As a shareholder, you don’t get a debit card to draw on the company’s savings. The relationship between retained earnings and dividends, or dividend cover, speaks volumes about company intent.

I used the cash value-added statement as the basis for the Contribution Account©, simply to reflect its behavioural qualities. More recently I have moved personal income tax from labour to state, again as an accurate reflection of the relationship between state and the enterprise. One could argue that the state itself should be viewed as an outside supplier, but apart from its variable share of wealth, the state generally does not (or should not) create wealth in its own right and relies on that created by others for its income.

But here’s the exciting part – nothing prevents or should prevent stakeholders or contributors from defining their relationship with the collective and between themselves. Of course all have a specific context for their existence, but their validity and ultimate strength lie in a common value creating purpose and to be as free as possible from external prescriptions and pressures. Even then, relationships with anything or anyone are still highly manageable and flexible and are defined by expectations which in turn are self-defined. Increasingly companies are starting to see that.

What hinders this process are the absurd theories, abstracts and aggregates that we try impose upon them.

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Wow, a very interesting article. This could easily be the starting point for an MBA thesis.

Where did you get the information that New Yorkers pay 13 times more for a Big Mac than Joburgers? According to the Economist’s Big Mac index in the US the Big Mac costs about twice than in SA. I know that in places like New York prices are generally higher than in smaller cities, but google shows that New York Broadway prices are still under 5$, so it is barely double not 13 times.

Indeed!

Jerry Schuitema, so a big mac burger in SA costs R30. And the US one is $5.3 according to that index, which coverts to R68.90 (using 13), so at best it’s double the price and a bit. Where do you get 13 times?

I wonder if it was meant to be 1.3 times more?

People are messy indeed!

My apologies to my readers for the initial slip in the relative cost of the Big Mac. I have asked Moneyweb editors to correct, as it is a serious detraction from my respect for statistics, and needlessly detracts from the essence of the article.

No worries, the rest of the article is on point and well thought through indeed.

No problem Jerry

Great article….and outside the box thinking and approach from your side.

Not often one sees quality writing like this…!

The Big Mac slip aside, once again a nice concise “cutting through the clutter” article. No one is an island and mutual respect and collaboration goes a lot further than name-calling and blame shifting. Fostering that requires focus on the right metrics. Thanks Jerry.

Excerpts from the last Ace Acme Widget Corporation management meeting…I hear

CEO: ‘We are lucky to have Stan [the chairman] with us today. All murmur assent. Chairman nods sagely.

CEO:’ For the next agenda item we are going to discuss the new accounting protocols in light of the new value add policy the company has adopted in line with the recommendations of our management consultants. After all we need to define relationships between our various stakeholders and how the value thus created is shared’. We shall still present traditional statements such as income i.e. P’nL, balance sheet, changes in equity and cash flow etc mainly for the auditors, but since out focus has shifted from ‘profitability’ to ‘value add’, the contribution account will be the primary metric by which our worth as a company is measured. Profits aren’t important. To this end we are focusing on ideas on how we can increase value add. Pete?’

CFO:’ Thanks, Mike. Yes we have a number of ideas how we can increase the value add. Firstly we are going to get rid of the contractors. Having outside suppliers is a leakage of value. For example, we pay Ace Acme Electrical R60000 per month…

Chairman: ‘But wait… we need that spark on retainer to maintain the widget machines. Spiro the spark (laughs) even has his own parking bay last time I heard? Correct?’

CFO:’ Yes that is the magic of it all. Spiro is indispensable so we offered him a job and he accepted’.

Chairman: ‘So how does that add value?’

CEO:’ Well no leakage of value add to outside suppliers, you know. The value add is kept in the company a family employee kind of thing. The next item in value add is the CDs’.

Chairman: ‘ We are not going into the music industry, are we?’

CFO (laughs):’ No, the convertible debentures’.

CEO:’ We issued these when we had the working capital crunch after we put in the extension. We needed the cash injection to stay alive. A consortium of investors purchased our debt but the only way we could get a decent interest rate was to make them convertible to equity at the CD holders’ request. They said something about us partaking in risky investments and they wanted upside’.

CFO:’ Yes we got an interest rate of 8% on this basis. Now since we are doing so well and spinning off tons of cash they want to convert their debt to equity -which is good’.

Chairman:’ Why is this good? The equity of the company is now going to be diluted by 20%. More shares in issue, more to divide the dividend by… we all in this room (gestures) are all shareholders, you know. We had fantastic ROE using this gearing…’

CFO:’ Yes, but it is their right and it will increase the value add. That is critical. No more interest payments to “outside suppliers”.

Accountant: ‘ Yes agreed, interest payable is simply an operating expense to the company just like… well wages… (contemptuously) everyone knows that’

CEO (frowns, shakes head): ‘Well not really. Wages are a value add kind of expense whereas interest payable is not. Debenture holders don’t do much, not even supply capital. They just get interest for like… being there. We just use their money… if you like but they don’t add value’.

(Accountant has a Tucker Carlson type w.t.f. expression but remains silent).

Chairman:’ How will this increase value add?’

CFO: ‘Bondholders are outside suppliers. I’m not really sure of what as the consultant was adamant it was not capital. However, making them shareholders increases the value add. Think of it like this: We no longer have the interest expense, no value add leakage, thus we make bigger profits albeit shared by more shareholders and we even get to pay more tax on the profits! More total value add for the stakeholders’.

Chairman:’ And that tax is a good thing?’

CFO: ‘Yes, the ANC regime is an important stakeholder to which we need to add value’.

Accountant:’ That will kill the ROE – we have had 20 plus per cent for the last 2 years. Shareholders won’t like this’.

CEO: ‘ROE is an old style esoteric metric- simply no longer important… if the shareholders don’t like it they can sell’.

Nice parody … but a bit mischievous, Richard. You actually prove my point — the folly of blind obsession with metrics INCLUDING value added itself.

You could have gone a step further in your consultant example and suggest that ACE ACME should generate its own electricity (perhaps not so ridiculous!) to improve VA. The same goes for CD’s or even Prefs. The different relationship (easily captured in “notes”) may dictate that (as I have often advised my clients) you include under “dividend and …”). It really depends on where risk lies and how malleable the payment is. That was the thinking behind the European format. Again, you are disingenuously only examining one form of interest or capital use and a very different relationship from bank or institutional capital, which is the more common especially in non-listed or non corporates. (Another example of norms applicable in one context, not making sense in another.)

BTW on a more technical point, and macro level, if you include interest paid as part of VA of companies, you create double accounting, because that interest is included in the institutional lender’s revenue, which in turn feeds their own VA.

As there is no statutory format (yet) for the Contribution Account, the only requirement is honesty, transparency and consistency. (Within the company itself). Wider practice may create greater peer consistency, and I doubt whether bank or institutional finance can be anything else but If that time ever comes, I will happily engage ACE ACME’s CFO — hopefully get him to understand that relationships go beyond that of his love for Excel.

Jerry writes at the start of the article that by PPP measure a burger in NY costs DOUBLE (not 13 times more) than a burger in JHB!

End of comments.

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