Moral Profit Motive in Management Compensation

Proposition:  The managers of a business enterprise are morally obligated to create profit.

This moral obligation extends beyond the simplistic notion of creating shareholder return. It's all well and good to create dividends that are paid back to the investors, but that is not enough. Investors expect more than simply the money generated by dividends. Investors expect management to continue to build a thriving concern that grows its position in the marketplace.

There is more than one application for the profits a business creates. Last in line will be the dividends. First in line should be the money reinvested into the enterprise to create innovation and the marketing required to sell that innovation. Profits must also build the cash reserve—the working capital reserve the enterprise uses to fund ongoing operations in revenue-lean conditions.

There is no universal calculation for the profit required to sustain the growth of a company. In order to grow, all businesses must invest money and effort into innovation and marketing, the cost of which varies from industry to industry, and from business to business.

Innovation Payback Impacts

Some enterprises require a great deal more research and development than others. Consider any of the technology companies, which invest large amounts of money to develop the gadgets we use every day. Apple Computer innovates as part of its core DNA, constantly developing new versions of the iPad, the iPhone, and all its computers. This focus on innovation makes customers willing to pay to replace perfectly serviceable equipment with newer versions. This is an example of a virtuous circle, in which profits are reinvested into research and development to create even greater profits. The faster the cycle, the more money the business creates.

Pharmaceutical companies must invest substantial capital into researching diseases, developing compounds, and testing those compounds to see how they can arrest or reverse the diseases. The research and development cycle in computers and software is rapid, and does not involve the extensive human testing or regulatory approval the pharmaceutical industry faces. Innovation in the pharmaceutical and biotechnology industry requires a long maturation time to bring the drugs to market. A typical R&D investment involves a wait of seven to fifteen years before the drug is even FDA approved. Once it is approved, it takes even longer to market a drug into a profitable blockbuster.

The regulatory challenges and the associated risk of failure slow the innovation cycle and increase the profit needed to sustain the business. The success of a new drug is determined by its safety and efficacy (as established in clinical studies) and a favorable benefit-to-cost ratio compared to current therapy. Society rightly requires pharmaceutical and biotechnology companies to thoroughly test their inventions and prove them safe. The computer industry doesn't face any of these challenges.

Both the computer and pharmaceutical industries depend on patent protection for their innovations. The computer industry is able to bring innovations to market several orders of magnitude faster than the pharmaceutical industry. By the time a pharmaceutical company is able to start marketing an innovative product, the remaining window of patent protection is only a few years, after which the compound can be used by generic companies like Forest labs and Teva pharmaceutical.

The pharmaceutical industry is dependent on billion-dollar blockbuster products, and the large profit margins in those few blockbusters, for its survival. The profits from those blockbusters have to cover the inevitable R&D and market failures, fund future R&D investments, pay employees, cover the costs of operations, offer financial incentives to executives and dividends to shareholders, and fund philanthropy and charity.

Which industry has the greater risk?

A Different Example Within the Supply Chain

Now apply this same logic to the supply chain. To many people, there is no difference between a wholesale distributor and a 3PL. They both operate warehouses. They both have to make investments in physical plants and equipment. They both employ warehouse workers. They both invest in systems to manage the processes in the operation. They both engage in marketing and sales activities.

There are fundamental differences between a wholesale distributor and a 3PL. A wholesale distributor must invest a significant amount of working capital in the inventory that supports the enterprise. The distributor faces the cost of procuring and insuring that inventory. The distributor must support a substantially larger sales and customer service effort. A wholesale distributor potentially can have tens of thousands of customers. The sales, marketing, and service costs of keeping those customers is substantial.

A 3PL faces none of these challenges. A 3PL serves a smaller population of customers. Its marketing efforts are nowhere near as challenging. A 3PL doesn't own inventory and does not incur the risk of loss. The 3PL does not need to procure inventory, so it avoids that cost. The customer service and sales management requirements for a 3PL are much lower than for a distributor.

Fundamentally, while both businesses use warehouse operations as a tool to conduct business, the wholesale distributor is far more complex, and the distributor faces a greater risk of failure.

Which has greater complexity and risk, the 3PL or the Wholesale Distributor?

Risk and Complexity Define Leadership Compensationhomer simpson big money.jpg

Ultimately, the scope of risk and the complexity of the business must be a consideration in the compensation of the leadership of the enterprise. As organizational complexity increases, so does risk.

The more complex the business, the greater the burden on its leader. The greater the burden on the leader, the greater the compensation the top man will demand for the job.

This issue of complexity scales from the largest of global organizations to the smallest of businesses. Consider a sole proprietor—say, a plumber.

A plumber may have a complex trade, but the one-man business of providing plumbing service is not complex. The owner is the plumber himself. That same one-man plumbing service is limited in size by the time and effort that can be expended by a single man.

This business owner, this plumber, wants to increase the money his company makes. He has several options. He can innovate to improve his productivity, enabling him to do more work, by investing in new tools. He can take a new training class to learn new techniques that improve productivity, at the cost of the training. He can hire a business assistant, someone who answers the phone and does the accounting work, creating productive time, at the cost of the assistant’s labor. He can hire more plumbers, or helpers, to increase capacity at the cost of the labor and his time to manage that labor.

In this example, every option the plumber has to increase revenue carries an investment cost, or an additional ongoing cost. Each adds a layer of complexity. Two of these options involve investment in tools or training, increasing the productivity of the individual plumber. Some investment cost and minor complexity. Adding the office assistant requires no investment, but increases ongoing costs and adds complexity to the business. Adding more plumbers may require additional investment, will add ongoing costs, and drives the complexity of the business higher.

The more complex the business becomes, the less the plumber can practice his trade, and the more time he must devote to running a business. At some point, the plumber stops being a plumber and becomes a business manager. Now that this man is no longer fitting pipes and installing sinks, what measures do you use to determine how much he should earn? The only real measure of the success of the business is the operating cash the company creates.

How Should We Compensate the Managers of a Business?

If the moral obligation of the manager of an enterprise is to create profit, then the performance measure must include the profit the operating company generates. This is just one factor in the compensation question. There are two others.

Proposition:  The managers of an enterprise are morally obligated to take actions that grow and sustain the life of the business entity.

Proposition:  The managers of an enterprise are morally obligated to respect and strive to meet the expectations of the society in which the enterprise operates.

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