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The Firm's Mission And Purpose

The author considers Medtronic as a firm with a clear sense of purpose: the firm began in 1949 as a repair facility for hospital equipment and began in 1957 to manufacture its own, including he first wearable pacemaker, and is presently a $35 billion corporation. (EN: Checking today, its market cap is closer to $40B.)

The author presents the firm's mission statement, which, in brief, is: to contribute to human welfare, to focus on practical application of its strengths as opposed to experimenting in areas where it is unlikely to make "unique and worthy" contributions, to uphold standards of quality and reliability in products, and to "maintain good citizenship as a company."

Specifically, the primary goal of the company's founders was not merely to make money, but to improve the human condition" and this resounded through the directives to management and the culture of the organization. There are even a few quotes from executives that specifically underscore this: that focusing on financial goals cause people to lose site of the purpose of the business, and the "companies can only survive so long as they serve their customers better than their competitors do."

It was also believed that the criteria for success was serving all parties who have an interest, and that these were ranked in order of importance: customers, employees, shareholders, suppliers and communities.

The author suggests this as an example of a firm that has its perspectives and priorities squared away, and as a result, one that suffered little in recent crises.

(EN: Another author considered this a bit further. By his perspective virtually every company starts out with this same sense of purpose and service, but eventually loses sight of its original goals and pursues other ones, namely money, which cause it to fail at its original purpose. I have a sense this author will come around to the same conclusion.)

(EN: I also have the sense the author may be aiming to high, with an intent to influence boards and C-level management. I don't doubt that there are firms that are corrupted at the very top, but my sense is it more often happens at a lower level of the organization. That is, the annual reports and executive speeches of many firms reflect the proper service orientation, but there is a blockage between the C-level who speak of service and the front-line employees who fail to deliver it - and that it is often a mid- or low-level manager who is misguided and is working at odds with the purpose, often while paying lip-service to it.)

The Need to Rethink the Firm's Purpose

The economic systems based on free enterprise - on private ownership and the freedom to produce, invest, buy, and sell by one's own volition - has proven to be far superior to every alternative. During the twentieth century, it was clearly evident that socialist systems in Asia and eastern Europe have failed to be efficient at producing anything except poverty and misery, while the western economies based on free enterprise have flourished during the same time, and their peoples have enjoyed unparalleled wealth, security, and happiness.

Although the current financial crisis, as well as others that have periodically arise, have shown some flaws in the system, they have merely been setbacks in a record of success.

(EN: This is perhaps too superficial a statement, as it's a subject of much conjecture. Free-market enthusiasts have provided a great deal of evidence that the major crises in the commercial sector were not originated by the commercial sector itself, but often by the sector's reaction to government and regulatory encouragements and restraints. Their opponents typically fail to present much in the way of facts to support their notion. In truth, there's blame on both sides, the politician who uses the law to facilitate and encourage irresponsible behavior and the businessman who then does exactly what he has been encouraged to do without pause to consider the ethical or practical consequences of yielding to the temptation.)

The rightful goal and purpose of a company is one of the most debated aspects of free-market economics. Some suggest that the company's primary goal is to increase its profits, and any other goal would be contrary to its purpose and neglectful of its core responsibility. If this is the sole standard, then firms may engage in practices that are detrimental to their employees, customers, and society at large in order to make money for their owners, and such a viewpoint condones and encourages serious infringements on basic ethical rules.

Discourse on the subject of the firm has largely been dominated by two fields: economics and accounting. These fields have much to contribute, but do not have a monopoly of explaining the theory of business. Moreover, they are based on hypotheses that seek to explain numerically how companies work. These fields are very limited in scope and need to be considered in the context of the firm's many other dimensions. Worse, if taken alone, economics and accounting are misleading, "the seed of terrible mistakes for companies and societies at large."

Most economists consider the firm to be simplistic, and considers profit to be the sole motivation of entrepreneurs. Some acknowledge that the entrepreneur might also pursue other goals, but they tend to be dismissive of them. They are not easily quantified and do not fit their models, "and so they generally ignore them."

Institutional investors are also dismissive of any non-financial goals of an organization: they are under pressure to manage their portfolios to achieve specific financial goals. As such, they drive firms in which they invest to deliver better profits in less time, and select investments based on financial information alone, generally based on an expectation that a firm will continue to follow trends, either based on their own historical performance or that of similar firms.

The problem with the economic/accounting approach is it tends to confuse the ends with the means: a firm exists to serve the needs of its customers, and profit is the result of doing so successfully. When a firm makes decisions to pursue short-term economic gain, it often neglects factors that interfere with its true purpose, and harm the firm in the long run. It jeopardizes the function of the company and undermines its effectiveness at accomplishing its purpose for an unsustainable short-term benefit. "Perhaps unwittingly, it is killing the goose that lays the golden eggs."

The economic crises that have arisen under the economic/accounting approach should be evidence enough that this approach cannot and should not remain dominant if the free market is to function reliably and properly. Instead, it is vital to consider a more comprehensive theory of the purpose and goals of the firm if it is to survive as an institution.

Rationality and Profit Maximization

A basic premise of economics is an individual seeks to achieve efficiency by applying himself (and his capital) to the functions that produce the greatest return. The same assumption applies to companies, such that if management guides a company to achieve maximum profitability, it coincides with achieving the maximum productivity and social benefit.

There are a few flaws with this theory:

The issue is not merely theoretical, but relevant to actual corporate governance: when a firm is guided toward profit maximization, the flaws in theory become serious issues, even crises, as a result.

While the mission statement, company description, and other boilerplate often describes the purpose of a firm in broad and holistic terms, the performance assessment of top management is often exclusively financial: and where compensation and continued employment are driven to short-term financial goals, all other considerations are abandoned.

The idea of profit maximization dates back to Adam Smith, who linked economic outcomes to societal benefits. Smith suggests that the capitalist "neither intends to promote the public interest, nor knows how much he is promoting it," but that the benefit to society is nonetheless achieved as a byproduct of pursuing individual and private interests. Many economists since have echoed this notion.

However, Smith's principle applies to markets, which achieve equilibrium between buyers and sellers, guiding sellers to produce what buyers want at a price they are willing to pay. It does not apply to the internal workings of a single company, which has little knowledge of the entirety of the market, especially of the intentions of competing firms.

(EN: The author doesn't provide much further detail, but it has been remarked elsewhere that Smith' approach to markets is indifferent to the owner, employees, and shareholders of any given firm - where a firm burns brightly for a short time, then collapses, the market rolls merrily along. In the modern economic situation, where regulation pushes many firms in the wrong direction, the mistakes and the damage is more widespread.)

Two other common counterpoints is that markets are imperfect (people are no driven by logic and rationality) and that the information available to decision makers is often incomplete or incorrect (a sound decision based on poor information has unforeseen results).

As such, the author regards profit maximization as a useful approach to considering the historical activity of markets, but "it cannot be easily translated into a workable criterion for decision-making."

The Profit Maximization Hypothesis: Limitations and Alternatives

Economists generally accept that consumers seek to maximize their utility (the benefit they receive for the cost of obtaining a good) and producers seek to maximize their profits (the payment they receive for providing a good) and that both sides are rational agents who seek the most efficient way of allocating scarce resources. These axioms are very easy to use in formal analysis, to quantify cost and benefit an apply basic mathematics to suggest the course of action that leads to the most favorable ratio. However, there are significant limitations.

The first limitation is that there is no concept of time: an option that provides short-term benefits may be less beneficial than an alternative option over a longer period of time. When managers are assessed on a firm's financial performance, they are driven to seek results that have an immediate impact and disregard the long-term perspective.

Some may realize that their decisions will have a negative long-term interest, but recognize that they are going to be punished or rewarded in the short-term: they will receive a bonus for what they can achieve this quarter, a raise for what they achieve this year, and don't expect to be around five or ten years in the future when the damage will be recognized.

The second limitation is precognition. A decision is made in the present that requires a prediction of what shall be in the future, and there is no way of knowing, with accuracy, how events will actually unfold. In some instances, decision is by uninformed gut-feel; but even in instances where a firm is diligent about modeling and predicting, it is prone to inaccuracy: information may not be available, or it may be inaccurate, or models may point in the wrong direction. The false sense of security given by sophisticated statistical analysis are not necessarily more accurate than gut-feel guesswork, though they do tend to create a stronger sense of confidence that lead to bolder and more dramatic actions.

Another problem is that profit maximization causes us to cede logic to mathematics: as a rule, a decision is assessed and compared to other decisions according to its net present value (the ratio of return on the financial investment) and this is often the sole criterion. It is quite a long and dangerous leap to assume that the decision with the highest return is the best decision for the sustainability of the corporation and that, more importantly, any factor that cannot be quantified is regarded as insignificant.

The author cites a number of economists who have criticized the maximization hypothesis for this very reason: that maximization and sustainability do not coincide. That is, what is most profitable is not necessarily the most important to the sustainability of the firm - and conversely, that those options that are important to the sustainability of the firm are not the most profitable.

When evaluating a decision, profitability is a binary test: an action is or is not worth the cost of obtaining an expected benefit. If so, it is a good action, even if there are other actions that generate greater profit. But not all benefits are financial - some are qualitative, and the inability to quantify the outcome does not render it less important. Further, it is precisely because decision makers cannot identify and quantify factors that will have detrimental outcomes that profit maximization should not be relied upon as the sole or even the chief criterion.

(EN: This all seems abstract. An example to concretize: using cheaper materials to reduce production cost is a decision that often serves as a straw-man because it feeds the notion of profit maximization by ignoring other consequences: the cheaper material damages production equipment, or results in an undesirable product, which is not discovered until later, and would not yield to accurate calculation even if it had been foreseen.)

The last consideration the author intends of present is that successful business leaders often de-prioritize profit. The examples are too numerous to be dismissed as exceptions or outliers - and their existence in such numbers should lead us to question whether profit maximization is "an empirically proven fact." It certainly fails to account for the success of firms that disregard it. As such, we must regard profit maximization as a hypothesis that can lead to success, but does not unfailingly guarantee it.

Disregard for profit is evident in many of the statements made by the founders of companies. The founder of Merck pharmaceuticals maintained that "medicine is for the patient ... it is not for the profits" and that if the firm remembered its purpose, profit would be a natural consequence. Another founder is quoted as stating "profit is a cornerstone of what we do ... but it has never been the point in and of itself." There are no shortage of such sentiments in documents that describe the purpose, mission, and values of businesses - and no shortage of examples in the day-to-day decisions made by the custodians of successful companies that are completely contrary to its stated values.

This is not to suggest that a firm must abandon the notion of profit. A corporation and even a nonprofit must generate sufficient revenue to sustain its operations and if profitability is entirely disregarded, a firm would not survive for long. It's obvious that a firm must make a profit and use resources efficiently - but this does not necessitate the extreme of maximization. Again, sufficient profit is not maximum profit, and companies that pursue immediate maximization often fail at achieving sufficiency over a longer period of time.

The profit maximization hypothesis, individual behavior and trust

Adam Smith's theory presupposes the concept of the economic man, driven by self-interest. As a producer and a consumer, he assesses each opportunity as a trade of cost for benefits and seeks to gain the most he can by applying a limited amount of resources: his capital and his labor. This is where the notion of profit maximization was seeded, and it is the source of some of the most serious problems.

A primary problem is that this assumes that individuals know what actions will be of the greatest benefit to themselves - when in reality, there is never an instance in which a person has complete and accurate information to make such a decision with certainty. Even were this possible, it ignores the possibility that the situation may change: especially over the long term, one cannot say for certain that things will remain unchanged and proceed on a plan without being attentive to the environmental factors - to continue to discover and learn. As such, the suggestion that "this is most optimal" is based on incomplete information and a poor assessment, and the declaration that "this will be optimal in future" is to pointedly ignore the possibility that it will not be.

Profit maximization also assumes that a person seeks to maximize his own benefit - but fails to identify what benefit he seeks to gain. It presumes that "benefit" equates to "money" but it is not always so. (EN: Moreover, Smith himself did not suggest money as a benefit, but rather indicated people seek to obtain "the necessities and conveniences of life" and pointed out that, in the role of consumer, we spend money to gain other things that deliver value that cannot be quantified.)

It also tends to focus too narrowly on a single benefit. The most obvious and immediate consequence of a decision to act, and does not consider the entire scope of the consequences of a decision - and thereby avoids, sometimes purposefully, the ethical criteria of a decision to act.

The author uses trust as an example: it is an intangible and unquantifiable value that is essential to society: people cannot cooperate or achieve mutually compatible goals in a society unless they have trust in one another. For trust to grow, an individual must expect that others will consider his interests - they will consider his welfare, at the very least avoiding doing him harm - or else he will withdraw and refuse to interact with them.

(EN: My sense is that trust and self-interest are incorrectly placed at odds in a black-or-white fallacy, which wrongly suggests that social interaction is combatant rather than collaborative. A person who pursues their self-interest isn't necessarily harming others and, to the degree that he values or depends on cooperation, cannot do so - he must consider the welfare of others to gain their continued cooperation, which is of greater value to him than the immediate profit he might make by cheating them. To go a step further, you can in fact trust that people will pursue their self-interest, and identify points of conflict, and negotiate a mutually beneficial outcome.)

Trust is particularly vital to organizations, which are by definition an arrangement in which people work together to achieve mutually beneficial outcomes. Where people within a firm trust one another and work cooperatively, they are more efficient and effective. This applies not only to a sense of teamwork among employees, but the trust between constituent bodies within and outside of the organization (customers, shareholders, management, employees, suppliers, partners, etc.) Where trust is lacking, success is difficult and failure is practically inevitable.

Understanding this, self-interest must be guided to the long-term as well: serving immediate and short-term self-interest is damaging to trust in the relationships on which we depend to achieve a greater long-term benefit. Maintaining a relationship with others, professionally or personally, often requires us to trade the immediate benefit we might achieve to serve the interests of others to gain the greater long-term benefit of the relationship.

In conclusion, the author does not dismiss self-interest as being necessarily harmful, but if short-term self-interest is the criterion by which options are assessed, it becomes detrimental to effectiveness and efficiency over a longer period of time.

Ethics and markets

Smith contended that self-interest alone was a sufficient condition for efficient market functioning - but the author disagrees. Self-interest is likely an important factor and the primary motivation to engage in commercial exchange, but it overlooks the necessity of ethics.

The market is merely a collection of transactions - in a physical space or otherwise - and in order for two people to agree to enter into a transaction, each must have trust for the another, and that trust requires adherence to moral principles such as honesty and fairness. And so, where there is no ethics, there is no trust, no transaction, no market.

(EN: This seems reasonable, but sets up an all-or-nothing argument for complete trust or complete mistrust - so it's likely that it should be considered as sufficient trust. There are honest mistakes, and some purposeful violations, and it seems that most customers and sellers recognize this but, taken all in all, still have faith in the ethics of others and still participate in the market.)

If an individual in a market deceives others - he makes false representations about his goods, uses counterfeit currency, fails to deliver the good promised, or otherwise betrays the trust of another - others refuse to trade with him further. The greater the number of individuals who do so, the less suppliers or consumers are interested in engaging in trade in that market - the market ceases to function efficiently, and eventually ceases to function altogether.

Aside of honesty and fairness in transactions, markets also require certain basic rights of the person to be recognized: their right to own property, their right to use their property in an unrestricted manner, their right to the product of their productive acts, their right to enter into an agreement, their right to refuse to enter into an agreement, etc.

Therefore, the proper functioning of the market depends upon certain cultural and social values, and certain institutions that ensure adherence to these values. Without this, the economic function of a market is hampered or entirely prevented.

An Alternative View of the Firm

As markets and organizations became more established, there was a shift in the perception of the role of management: whereas they were once the stewards of the firm, they were reduced to the mere agents of the shareholders, following the orders of those who owned the company. This idea has changed the notion of professionalism, reducing it to service to one set of stakeholders to the exclusion of all others - and other to the detriment of all others.

Mission and purpose of the firm: some business leaders' perspectives

Following the profit maximization hypothesis, Friedman and Friedman suggested that "There is one and only one social responsibility of business: to use its resources and engage in activities designed to increase its profits" with the only limitation being that the firm must obey "the rules of the game." This perspective has become dominant in many firms, but is not without opposition.

The author asserts that top executives "of well-known companies" desire to define a mission for the firm that is beyond mere economic goals. It should consider its purpose as an organization, the ethical values it espouses, an the way in which it proposes to serve its customers.

He considers Bill George, chairman and CEO of Medtronic, who suggested shareholders should be the third priority of a company, after its customers and employees.

In particular, the firm's first duty must be to customers, as the core of its function is to deliver a benefit to them and its revenue originates from its fulfillment of this function. They are not motivated to purchase from a firm that seeks to make as much profit as possible, and generally regard this to be contrary to their interests. It is to be taken as a premise that a firm will survive only so long as they serve their customers better than their competitors do.

The employees are ranked as second because they create and deliver that value. People seek to gain something more than mere financial reward for their service, and are not attracted to employers that are likewise motivated primarily toward profit, as this is also contrary to their interests.

Shareholder return is ranked third, as their investment furnishes the capital resources used by the employees in the process of production. When you consider the economic benefit that a firm creates as a whole, the value of their contribution to their customers and employees far surpasses that of the value returned to shareholders.

Daniel Vasella, chairman of Novartis, suggested that evaluating the performance of a firm by its profitability, as indicated by quarterly and annual reports, can have "a poisoning effect" on a firm. While there is nothing intrinsically wrong with using financial results as a metric to evaluate progress toward certain goals, focusing on financials without considering the cause of performance leads a firm to seek short-term profit rather than long-term success.

If financial indicators are the sole measurement of success, it discourages innovation and the development and introduction of new products on the grounds that they may not produce short-term profits. Vasela particularly objects to the use of quarterly reports as a method of evaluation. A short time-frame puts managers under intense pressure to achieve immediate results, and they may not have the ability to act on plans that will take a greater amount of time to generate a return on investment.

It also places evaluation of corporate performance in the hands of those who know very little about the operations of the firm: financial analysts and the media can be very imaginative in suggesting causes for the evidence they see in the financial reports, without having any sense of what is really going on with a firm. It's most evident when he numbers tell a story of success while customers and employees are extremely unhappy with the firm and may even be defecting in drives.

Since the investors of a firm elect and appoint managers, they must take their expectations seriously - but they should not put short-term investor satisfaction first. As crises past and present have demonstrated, doing so entails sacrificing the efforts required for long term success merely to satisfy those who have a short-term financial interest.

Jeff Immelt, chairman and CEO of General Electric, considered the problem from a perspective of ethics. His argument is that a company must be good in a moral sense in order to achieve profitability and growth: the brightest and most productive people are drawn to work for a company that enables them to be a part of "something that is bigger than themselves." While they want, and need, an income from working, their high-order desires is to help society on a grander scale - to "solve some of the problems of the world."

Immelt's conception of values is that are demonstrated in the way in which other people are treated: whether a firm is fair in its relationships with investors, employees, customers, partners, and other stakeholders. When a firm fosters mutually beneficial relationships, it wins the loyalty of others: devoted employees, enthusiastic customers, supportive partners. When a firm is parasitic in its relationships, it is abandoned and it fails.

David Packard, one of Hewlett-Packard's founders, dismisses financial reward as the sole reason that a company comes into existence - and sees the firm as an entity created by a desire for people to work together "to accomplish something collectively that they could not accomplish separately." Money is involved, but it is merely the fuel that feeds the machine, and the underlying drive is to do something else - to make a product, render a service, or do something that is of value to many others.

An alternative notion of the firm

The author returns to his working definition of a company: it is a group of people who work together to offer goods and services that are useful to its customers. Profit is a necessity for its continued operation but is the result of success at accomplishing that purpose, but it does not surpass or supplant the purpose.

This definition of the firm places it in the broader context of society and considers the benefit of its customers to be the primary motivation. The investors remain important as they are some of the people who work together to achieve the purpose, but they are not given preference over the other people (employees, suppliers, partners, etc.) who participate in the operation of the firm.

To the author's way of thinking, a firm is differentiated from a nonprofit merely by the way in which it manages its finances. Many nonprofits rely upon donors rather than customers (though nonprofits often sell things as a means of generating revenue) and some of the profit is generally extracted from the company rather than reinvested in it, distributed to employees and investors.

A company can, for a period of time, fail to generate profit but still serve its purpose. It cannot, however, succeed in generating profit except by serving its purpose. If it fails to produce a product or service that is attractive to consumers, it will very quickly cease to exist.

Failing to produce value for other groups of people is also a shortcut to disaster: treat employees poorly and they will leave; treat suppliers and partners poorly and they will find other clients; treat the public poorly and the regulators will react; treat any third-party poorly and there will be a lawsuit. In that way, socially destructive behavior will destroy a firm - its collapse may be slow or fast, but it is inevitable.

The recent economic crisis by global companies demonstrated that even large organizations are structurally very weak: in the recent crisis, many massive financial corporations were devastated in short order while other companies that had resisted the allure of highly profitable but shady practices and remained focused on more conservative and long-term goals, were comparatively unaffected.

The author proposes a model of the firm that has the following core components:

  1. Customer satisfaction and customer service as the purpose of the firm
  2. Employee retention and development
  3. Economic efficiency, including profitability
  4. Consideration of all the people who collaborate freely
  5. Contribution to society at large

There's an oblique point about valuing people as human beings - a person has value, and deserves some measure of respect and consideration for their dignity and rights as an individual. Both religion and philosophy agree upon this point, and regard as unethical any behavior that fails to acknowledge the value of other persons. It is unacceptable to treat people as a means to serve your own interests. The author's notion of the firm as an organization that serves the needs of people supports that principle; the notion of the firm as a profit generator does not support it, and often leads to its violation.

Some Final Thoughts

The concept of the company as an organization that is geared strictly toward earning a profit for the contributors of capital is clearly dysfunctional and unsustainable.

The author has presented a model of the firm based on its social function, which is primarily to provide a benefit to its customers, and has considered its duty to other stakeholders: employees, partners, suppliers, investors, and the public.

His intention is not to dismiss the importance of shareholders or to dispute their claim to a share of the value generated by the firm, but merely to put it into the proper perspective. Shareholders are only one group, and they contribute only one thing: capital.

He has further described profit as the result of a firm's achievement of its primary purpose, and contrasted the consequences on deviating from this principle: firms that place their primary emphasis on service enjoy financial success for long periods of time, whereas those who focus on financial success fail in very short order.

And yet, the problem remains that firms subscribe to the notion of profit and motivate their employees, particularly senior management, to seek to generate short-term financial results to the long-term detriment of the firm.

As such, the main challenge faced by firms today is in aligning the perspective of investors and management to those of the long-term interests of the firm, its employees, its customers, and society in general.

It is not about ignoring profitability to do social good, as this is the character of nonprofit organizations. It is, however, about prioritizing long-term benefit over short-term and setting reasonable and sustainable goals.

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