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Appropriate business rules for competitivity & growth

Hector McNeill1
SEEL

The Real Incomes Approach is designed to encourage a sustained effort in increasing the productivity of economic activities as the driver of growth in real incomes.

This article discusses a topic that is often not part of the macroeconomic policy domain, that of business rules. If economic policy provides incentives for increasing real incomes then business rules can be aligned with this objective to provide managers and workforces with decision guidelines that secure good corporate returns and levels of competitivity. An important aspect of achieving this is the optimization of the deployment of tacit and explicit knowledge to make effective company pricing and production allocation decisions. A key management strategy should also be to reduce the amount of investment that depends upon debt and to augment the amount of investment based on earned equity.

This article is the sequel to article, Tacit & explicit knowledge and explains the significance of these considerations.

Cost-volume-profit (CVP) analysis

Cost-volume-profit (CVP) analysis has been widely applied in profit planning and decision making. It has been extended to incorporate uncertainty, non-linear cost and revenue functions, income tax effects and inflationary costs and prices. However, little effort has been made to trace the effects of learning on CVP analysis. However, Woody M. Liau of the University of Houston has explained the effects of learning on CVP analysis in his paper2 entitled, "The effects of learning on Cost-Volume-Profit analysis". These can be summaries as follows:

  • by taking into account that costs of production are declining in a predictable fashion it is possible to determine the break even points fairly accurately
  • break even points occur sooner than would be the case when calculated without taking learning into account

However, conventional macroeconomic theory is based on the Aggregate Demand Model (ADM) of the economy and this presumes that the profit motive is the driving force of economic activities. As a result the ability to take advantage of the characteristics listed above incurs risk because reducing unit prices is associated with reduced unit profits. In spite of this, conventional policies provide no incentives to encourage companies to take advantage of the characteristics listed above and also provide no means of reducing the risks involved. This state of affairs is exacerbated by the legal and regulatory frameworks governing accountancy and corporate taxation which create conflicting business rules for management in resources allocation in promoting business performance and maximizing profits and more critically provides a positive incentive for management to constrain wages (See: The profit paradox). As a result the macroeconomic outcomes of conventional policies are the typical generation of winners, losers and those unaffected by policy. Conventional KMS policies (Keynesianism, Monetarism and Supply side economics) attempt to deploy centralized state monopolistic impositions of single valued instruments such as interest rates and tax rates (one size fits all) to a diverse economic and social constituency and as a result there is a systemic and structural problem characterized by inconsistent outcomes on individual constituents including prejudice, benefits and neutral impacts.

Positive systemic consistency

In order for policy to promote the effective application of the learning curve and tacit knowledge by companies there is a need to align microeconomic objectives with macroeconomic objectives. Rather than use policy instruments that cannot be attuned to the conditions of each enterprise, such as interest rates or taxation, it is more practical to establish a single objective. In the case of Real Incomes Policy the common macroeconomic and microeconomic objective is the maintenance of growth in real incomes (See: Why real incomes?). The significant difference between conventional KMS policies and, for example, Price Performance Policy is that the impact of the policy instruments (See: Price performance ratio and also Price performance levy) remains under the complete control of individual companies according to their circumstances, capabilities, resource availability and objectives. As a result the outcome is a positive systemic consistency (See: Positive systemic consistency).

The Price Performance Policy (PPP) environment


The Real Incomes Approach is a different paradigm providing business with the incentive and the business rules that support a greater degree of freedom to innovate and secure a higher lower-risk performance that enhances national growth.

The mechanics

A short description of the method of PPP without reference to theory can be accessed here: "Bare Bones Price Performance Policy"

Notable aspects of the policy

In the context of the British economy with relatively complex and onerous corporation taxes and legal and regulatory accountancy framework, the Real Incomes policy Price Performance Policy is quite distinct from conventional policies through the elimination of corporate taxes and, in addition, having the following key differences:

No corporation tax - corporation tax is widely abused as a result of the profit paradox and resources allocation is distorted by considerations of corporation tax. Companies can achieve far higher levels of productivity if corporation tax is eliminated with the bulk of this cash flow being added to investor, owner and employee salaries and personal income tax paid on the basis of pay as you earn (PAYE).

A Price Performance Levy (see "The price performance levy") is paid by companies according to their actual Price Performance Ratio (See "The price performance ratio")- This Levy can have a base rate of a nominal sum, say 20% i.e. set at a rate to provide a positive incentive for companies to lower their Price Performance Ratio to lower the Levy, if possible to zero.

Managers can allocate resources in response to exogenous input price rises to alter the price performance and reduce the Levy, even to zero - improvements in price performance are compensated by Price Performance Levy discounts that are treated as bonuses, paid pro rata to all people associated with the company with corporate performance being based on the generation of income of personnel (ownership, shareholders, managers and employees) against investment
The policy incentive

In order to encourage management to make decisions on resource allocation optimization to secure unit price moderation or reduction there is a need to provide a positive economic incentive. Under the profit motive moderating unit prices in the face of rising unit costs will lower unit margins and raises risks. However, the elimination of this motivation by substituting profits by investments in technology and human resources and substituting the profit motive by a real incomes motive can reduce these constraints and reduce risk on the basis of the identification of optimized resource allocations. Thus an incentive that lowers the risk of unit price reductions can help companies gain market penetration and increased income. This would secure simultaneously the microeconomic and macroeconomic objectives of enhanced real incomes both of those who own and those employed by companies as well as their customers.

The degree to which a company achieves price moderation can be measured by the price performance ratio (PPR) (See "The price performance ratio"). The PPR value achieved by any economic unit is established directly by management decisions and actions. Rather than bear down on companies with centrally-established rate for interest and taxation these instruments can be substituted by a positive productivity incentive in the form of a Price Performance Levy (PPL) (see "The price performance levy"). This can be applied by selecting from a very large range of optional formulae. By way of example a power function can be used where the main variable that determines the value of the Levy is the PPR. Thus the PPL can be of the following form:

PPL=L(PPR)2    . . . . . (1)


Where:
PPL is the levy applied to the company
L is the base rate Levy,
PPR is the price performance ratio.

Assuming a base rate Levy of 20%, Table 1 shows the range of values of the PPL according to the PPR achieved by a company.

Table 1

Price Performance Levies associated with different Price Performance Ratios

PPR
Base rate Levy
PPL
Bonus
l.00
20%
20.00%
0.00%
0.75
20%
11.25%
8.75%
0.50
20%
5.00%
15.00%
0.25
20%
0.63%
19.37%
0.00
20%
0.00%
20.00%


As can be seen under a fixed policy-related base rate Levy of 20%, management can allocate resources so as to come up with the PPR they desire and thereby pay a Levy varying from 20% to zero. Naturally managers will try and avoid paying the Levy and the only way to do this is to lower their PPR by improving demonstrable productivity. Companies can easily manage their PPR values by carrying out incremental investments in technology and human resources which will raise unit costs in addition to any rises associated with purchased unit input variables. However, the resulting gains in efficiency must be recorded in the form of moderated unit output prices. In other words the benefit to the economy becomes immediate (short term impact), real and demonstrable. The amount of PPL avoided that is based on increased productivity and sales is a bonus category paid pro rata to all salaries and wages of all associated with a company.


Source: The Real Incomes Approach - The main theoretical principles & policy options


Elimination of the profit paradox - by substituting profits in accountancy norms by investment in technology and human resources and transferring corporate returns to the real incomes of those associated with each firm resource allocation can achieve higher rates of return

Manipulation of PPR - because profits have been substituted by investment in technology and human resources, modified accountancy norms (see below) enable management to manipulate the PPR downwards (See "The price performance ratio") by raising unit costs in association with stable or lower unit output prices

Companies do not contribute to government revenue - Where Levies are paid, these do not count towards government revenue, but become "reserve equity" for the future use exclusively in investment in technology and human resources by the company; this also reduces dependency on loan finance.

These procedures do not involve any subsidy since the funds involved all come exclusively from current corporate cash flow and this enables conditionality of payment to be against actual performance. This avoids the typical problems of failure associated with lack of effective control of conditionality associated with supply side subsidy initiatives.

The public sector is subject to same PPP regime as the private sector - this introduces the same incentives for increased productivity within public service operations thereby attaining operational performances equivalent to the private sector and reducing the cost of provisions.

How PPP works

As outlined in "The Real Incomes Approach - The main theoretical principles & policy options") (a summary can be found here "Bare Bones PPP") the operation of Price Performance Policy requires modified accountancy categories.

In the article Schumpeter and Keynes by Peter Drucker, a section describes Joseph Schumpeter's view on the role of profits as the foundation or guarantee of future activities and employment. The significance of this view arises from the fact that Schumpeter's role for profits, bears little relationship to their currently perceived role but, in my view, it presents a key to straight thinking; an imperative. By limiting the role of profits to that identified by Schumpeter it is possible to alter the accountancy norms, on a rational basis, so as to terminate the contention between business success and wages as well as to ensure government revenue rises to realistic levels. This requires changes in accountancy regulation details. The current corporate taxation and accountancy framework are so divisive that significant efficiencies can be realized by eliminating corporate taxation from the decision analysis model. This is not to say government revenue raising is not an essential requirement in a modern economy but corporation tax is a very inefficient and disruptive way to raise government revenue. The objective is to facilitate resources allocation so as to achieve the highest feasible return to operations supported by investment in technology and human resources. By eliminating corporate tax considerations we are left with six basic categories of quantifiable accounting aggregates:
  • Corporate revenue from sales
  • Income of individuals associated with the company
  • Current operational costs
  • Cash
  • Assets
  • Profit
As mentioned, the profit category can be redefined as investments in technology and people (in the Schumpeterian sense). So the accounting categories can be expanded to seven:
  • Corporate revenue from sales
  • Income of individuals associated with the company
  • Current operational costs
  • Cash
  • Assets
  • Investment in technology
  • Investment in human resources
Creative transformation

Margins in excess of distributed real incomes and operational costs represent funds that can be invested in innovation or expanded operations, saved or used to purchase assets.

M = CR - (dY + oI)

Where M is the margin
CR is corporate revenue
dY is distributed income
oI is operational inputs


The margin net of the Price Performance Levy is given as follows:

nM = M(1-PPL)

Where nM is the net Margin
M is the Margin
PPL is the Price Performance Levy (expressed as a decimal e.g. 12% = 0.12)



This formula can be altered to embed the two accountancy categories of investment in technology and human resources as follows:



M = CR - (dY + oI + dT +dH)

and

nM = M(1-PPL)

Where dT is the incremental investment in technology
dH is the incremental investment in human resources.



The Price Performance Ratio (see "The Price Performance Ratio") dominates the formulae that estimate the PPL (see "The Price Performance Levy"). A company can lower the PPR by moderating output prices in response to rises in unit input costs. The unit output price response can be made more competitive by reducing the PPR and minimizing the PPL by making marginal investments in technology and human resources. This will raise unit input costs but this will secure the PPR and PPL desired.

This adjustment will require a reduction in margin so the unit prices need to be set at the level that maximizes corporate revenue (CR) and/or the margin (M). The optimized unit output prices will be established as the price reduction that maximizes revenue and/or margins which will be determined by the price elasticity of consumption (pEc) that results in the best degree of market penetration combined with revenue compensation.

Sustainability depends to a large extent on the degree to which


In addition to CVP analysis, making a more effective use of the PPP business rules requires the application of well-established optimization techniques facilitated by computer processing. Pre-emptive pricing requires a sound knowledge of the propensity of consumption arising from the price elasticity of consumption. This is not new but under PPP it can be turned to more effective advantage for producers and consumers; a new and exciting frontier for business.
investment is geared towards a creative transformation that improves efficiency and productivity through investment in technology and human resources so as to maintain a sustained income and employment (see "The PAC Model of the economy").

Business rules

The accountancy framework changes relating to profits, investment in technology and human resources and real incomes and the two policy instruments (PPR and PPL) are designed to provide business with transparent business rules. These are fashioned to enhance the ability of companies to benefit from Cost-Volume-Profit analysis that takes into account learning. The added benefit of Price Performance Policy is that companies can achieve a lower risk and higher real income return through their steps to minimize their PPR and resulting PPL.

An important difference in the microeconomic decision-making is that market prices are not presumed to be relatively fixed which is an assumption that underlies conventional marginal cost pricing.

Under a Real Incomes Policy companies are encouraged to become more proactive in price setting (preemptive pricing) so as to lower their PPR and therefore the amount paid in PPL. The degree to which it is rational or feasible to lower a company's PPR is dependent upon the relative movements in unit costs and unit prices on the one hand and the associated volume of sales, on the other. The response of sales to different unit prices can be measured by the price elasticity of consumption (pEc) (See: pEc - Price elasticity of consumption). Sound information on the values of the pEc provides important tactical advantages which can result in the reduction of initial unit prices to below current unit cost levels so as to accelerate market penetration. The process of accelerating market penetration increases the rate of cumulative throughput and this intensifies learning and, as a result, the rate of cost decline also accelerates. Where inputs are accessed from the national markets this same process can result in falls in unit costs helping augment the income that can be extracted from future revenue, based on an increasingly positive margin gained on the basis of far larger throughput.

Minimizing investment based on debt

It is often not acknowledged that the financial crisis arose, not as a result of government debt but rather because of private debt and the uncontrolled issuance of money by the private banking system as well as the generation and sale of derivatives that turned out to have been sold on the basis of fraud and to be worthless. The derivatives saga impacted local authorities who lost a considerable amount of money creating problems for governments.

The fraud & malpractice iceberg

The extent of financial fraud and malpractice reported in the media apprarently is linked to the insistence by financial intermediaries that compensation be subject to "gag clauses" in legal settlements. This has created a fraud and malpractice awareness iceberg which hides a large proportion of cases.
In terms of transactions between banks and other financial advisory practices and the private sector, some class actions are now being brought forward that involve cases where banks worked in collaboration with their own consultancy organizations specializing in "corporate restructuring" who purposely degraded the corporate valuations leading to them being sold to the banks who in turn then sold them on at their true value. Such fraudulent activities also permeated the LIBOR quotations affecting contracts worldwide and there have been other issues associated with prejudice created by the unethical behaviour of "debt or interest-based financial intermediation" (see box on left).

Since 2007 private debt has risen and is now higher than it was before the crisis. In addition interest rates for private investment in the productive (real) sector are higher than they should be whereas most money has, under quantitative easing and low interest rates, been applied to fixed assets such as housing, commodities and stocks and bonds. An increasing proportion of stocks and bond values have been increased, not as a result of higher productivity and business prospects, but rather as a result of manipulation by companies buying back their own shares so as to push up the value of executive share allocations, often making up part of bonus packages, and increasing so-called "shareholder value". In the corporate sector the relatively low interest rates have increased the precariousness of borrowers whose "cash flow" has been increased by loans and debt leading to a "real incomes illusion". This has been assisted by an increasing use of credit cards in an attempt to alleviate the cost of living crisis, for some, by also providing them with a "real incomes illusion".

The Real Incomes Approach provides firms with a higher probability of increasing income levels and the generation of equity which can be used to invest and thereby reduce the need to rely on loans and debt. The transfer of corporate funds away from corporate taxation into wages (See, Getting rid of corporation tax), also helps reduce the need to resort to the use of consumer credit thereby reducing debt and, in general, the overall reduction in unit prices helps augment real incomes in the economy as a whole, thereby reducing the pressure to rely on the real income illusion based on debt.

Competitivity

One of the assumptions made by those who remain doubtful of the value of PPP and its associated business rules is that by removing profits from consideration in business accounts it is not possible to be competitive. The reality is that under current profit-based operations and corporate taxation structures, it is virtually impossible to attain the level of competition that can be achieved under a PPP business rule regime where the measure of return is real incomes as opposed to profits. Paradoxically, the PPP business rule regime achieves a higher price competitivity in association with lower business risk and, on balance, the generation of equity is higher and therefore the need for finance and debt is lower.

The underlying attraction of PPP and associated business rules will depend upon the specific corporate structures and internal contractual arrangements with those working in a company. This is an important topic and this is covered in the article in preparation and that is concerned with beneficial work contract frameworks.


1 Hector McNeill is the director of SEEL - Systems Engineering Economics Lab.
2 Liau, W. M., "The effects of learning on Cost-Volume-Profit analysis", Cost & Management, The Society of Management Accountants of Canada, December 1983,

Updated: 16th October 2015: Added section entitled "Minimizing investment based on debt"

Updated: 17th October, 2015: Added box entitled "The fraud & malpractice iceberg"

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