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Tuesday, June 22, 2010

Impact Maximization - Incorporating the full costs of doing business


The businesses our industry is supporting are often referred to as social enterprises, social ventures, social businesses or impact enterprises. They are, by and large, businesses that not only do-no-harm, but intend to do-good[1]. Nomenclature aside, it is an industry that requires the belief that capitalism is the most effective way we know to efficiently bring products and services to the masses.

Before you label me as a Reagan Republican[2], let me also say that traditional capitalism alone (profit maximizing business models) often fails miserably when it comes to providing essential products and services to the poor[3]. This is why we support a new breed of capitalism. Impact enterprises are businesses that are impact maximizing, not profit maximizing, a distinction – we believe- that will help them correct the market failure that has expanded poverty[4] despite the lack of real scarcity[5].

Impact Maximization vs. Profit Maximization

Impact maximization, from the most basic economic standpoint, is very similar to profit maximization. In fact, it can be argued that the impact enterprise model is the real profit maximization model because it incorporates the full costs of production. It should come as no surprise then that proponents of impact enterprises are also proponents of Full Cost Accounting[6].  Let me explain.

Profit maximization occurs for most firms at the point where marginal revenue equals marginal cost[7]. The problem arises when firms fail to accurately incorporate all the costs associated with doing business. That failure leads to external costs that are absorbed by others, called externalities. Now, since externalities are not equally distributed, companies that can create more (offsetting the largest possible amount of their costs on to others) garner greater profits. This creates a competitive environment where companies attempt to achieve the greatest offset, not the most efficient production. 

A large scale example of this is the recent shift in auto manufacturing from the union controlled Midwestern states to the “Right-to-Work”[8] dominated Southern states. With a desperate need for jobs, many Southern states have offered companies offsets, such as tax-exemptions, lax environmental protection rules, and Right-to-Work legislation that dramatically limit the power of unions to seek fair wages for their members. Of course, not all manufacturers are given the same opportunity. Those that get the best deal reap the biggest profits. But the cost of building, shipping and selling a car hasn’t really changed. They have been shifted to tax payers (through tax exemptions), future generations (through environmental degradation) and workers (through low wages).  In this environment even good companies have to seek offsets or risk becoming uncompetitive.  That’s not good business… even if it is profitable.
Impact enterprises more accurately internalize their costs by incorporating indirect costs that can be attributed to the business such as environmental decay and social welfare[9]. Impact maximization is when ALL Marginal Costs (including environmental costs, social costs and public costs) equal Marginal Revenue. 

Need for Support

Economic theory suggests that impact enterprises should compete well in the market place, even dominate it. But theories are academic and reality tells us different. Traditional enterprises have deep advantages over impact enterprises. By displacing costs of production, they can provide better margins (and lower prices, conflating the two methods by suggesting an end benefit to the poor consumer. I can dispute the claim but it will take more than this post to do so). This makes them more attractive for financing and, consequently, expansion. Passive investors (most people invest passively, with very little direct knowledge of the companies they are buying shares of) compare companies by looking at their revenue and profitability. 

Socially Responsible Investing is attempting to change that by curating companies that do no harm, but in most cases these indices don’t dig deep enough to see if a company is actually doing good. And they never look deep enough to see if the company practices Full Cost Accounting. We need to do more.   

[1] We will save the details on this distinction for another post, but take our word for it, there is a big difference. In the meantime you can still check this attempt at defining the difference. http://alifereinvented.com/do-no-harm-vs-do-good/
[2] Ironically, not even Reagan himself was a Reagan Republican: http://www.newsweek.com/2010/05/10/even-reagan-wasn-t-a-reagan-republican.html
[3] Michael Moore has made a career out pointing out this failure, but this Forbes article is more accurate: http://www.forbes.com/2009/09/27/capitalism-michael-moore-love-story-opinions-columnists-michael-maiello.html
[4] I use the U.N definition of poverty, See my Investing in Development post for more details on that discussion.
[5] See: Arnold Plant, ‘The Economic Theory Concerning Property for inventions' for a discussion on scarcity created by property rights (included patents and copyright protection) and http://www.icc.ge/res/LPI_2010.pdf on the impact of logistics and poverty.
[6] Full Cost Accounting (FCA) is an accounting method that recognizes economic, environmental, health and social costs of an action or decision.
[7] Sourcing Wikipedia might be ill-advised, but when I checked this article (06/10/2010) it was clear, easy-to-understand a pretty accurate description: http://en.wikipedia.org/wiki/Profit_maximization.
[8] “Right-to-Work” is a euphemism for an anti-union agenda that has dominated Southern public policy.
[9] I’ll let someone infinitely smarter than I am explain this in more detail. Jeffery Hollender not only preaches full cost accounting, but as a founder of Seventh Generation he practices it as well. http://blogs.hbr.org/what-business-owes-the-world/2010/04/full-cost-accounting-is-the-so.html   

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