Directors and executives who manage companies aim to combine resources (raw materials and labor) in strategic ways that create more value than they consume. Once they have developed a business model that creates significant value, a company’s managers decide how to allocate this value among stakeholders, including workers, suppliers, investors and customers. Managers are constantly making these complex and interdependent resource allocation decisions to optimize the company’s performance.

We measure a company’s performance by the value that accrues to its shareholders. In simple terms, we can think of conventional valuation methods as a ruler. We use Generally Accepted Accounting Principles (GAAP) within the US and International Financial Reporting Standards (IFRS) elsewhere across the globe to distill a company’s revenues and expenses into a single figure that represents the value accrued to the company’s owners during a given period—earnings—in dollar (or other currency) terms.

Consider an alternative way of assessing a firm’s performance that measures the total value created by the firm in multiple dimensions. Such an assessment framework may be depicted as in Figure I.

 

Figure I: A firm’s total value production is inclusive of all stakeholders

 

Here, the measure becomes two-dimensional to incorporate value beyond owners’ equity. The Y-axis represents value that accrues to owners of the company—in other words, it is the conventional “ruler” used to measure business performance. The X-axis represents value to non-owner stakeholders, including workers, suppliers, customers, the community in which the firm operates, and the environment. With owners on the Y-axis and non-owners on the X-axis, the steepness of the line from the origin to a firm’s plotted coordinates indicates the proportion of value allocated to the two groups. Assuming a common unit of measurement between the X and Y axes (a condition that will be explored in more detail in subsequent sections of this paper), one can visualize a zone on the chart around a 45-degree angle from the origin whereby a company creates value for all stakeholders and thereby earns a legitimate place in society. See Figure II for a stylistic representation of two firms that create value for the two stakeholder groups in different proportions.

 

Figure II: A firm’s choices result in differing combinations of stakeholder value.

 

A firm that draws too steep of a line – meaning a firm that captures outsized value for its owners at the expense of other stakeholders – is problematic. It may be technically legal, but it is the manifestation of the abuse of power, or greed, that has drawn increasing scrutiny and eroded public faith in capitalism’s ability to increase collective wellbeing. Traditional accounting methods that use only a single dimension to measure firms – namely financial value to owners – ignore this imbalanced distribution when it arises. Businesses that maximize earnings by exploiting non-owner stakeholders are not held accountable for doing so. The results include worker exploitation and environmental degradation.

It should be noted that non-equity stakeholders have diverse needs and the above diagram greatly simplifies the non-equity stakeholder value by aggregating it into one number. Care must be taken when aggregating impacts to not obscure material impacts to stakeholders through netting. Additionally, while the above diagram may seem to imply that there is a tradeoff between shareholder and non-equity shareholder value, it is actually quite possible that monetary valuation of inputs helps to clarify opportunities and risks, creating synergistic value creation for all constituents.

In the preceding section, we assumed that companies create positive value for their owners and other stakeholders. In the two-dimensional graph shown in Figure I, this assumption places the company in the first quadrant. However, this is not a necessary condition for a company to be viable in today’s capital markets. Some businesses deemed successful by owner-centric measures may destroy value for other stakeholders. Figure III illustrates the different positions companies may occupy on a two-dimensional map of value creation.

 

Figure III: Inclusive stakeholder value creation map.

 

To clarify this concept, consider quadrants II, III, and IV and illustrative examples of an enterprise that might occupy each:

• Quadrant II: Positive owner value, negative non-owner stakeholder value
  • Example: A company that extracts value from non-owner stakeholders and delivers it to the company owners.
  • This quadrant is the most nefarious. By conventional measures of value, this is a ‘successful’ firm because it generates financial returns for its owners (e.g., shareholders of a public enterprise). Consequently, it attracts investment from capital markets. However, this firm is destroying value for non-owners. For example, a cigarette company might be returning significant cash to owners while triggering huge public costs in the form of medical care, decreased productivity, missed workdays, and individual suffering associated with lung disease. Not every example is as obvious as cigarettes. Any business that profits via rent-seeking or by ‘cornering the market’ to fabricate scarcity and increase price is in this quadrant as well.
• Quadrant III: Negative owner value, negative non-owner stakeholder value
  • Example: A company in Chapter 7 bankruptcy, that has destroyed equity value, laid off employees, and breached contracts with suppliers.
• Quadrant IV: Negative owner value, positive non-owner stakeholder value
  • Example: An effective nonprofit whose beneficiaries cannot or do not pay for its goods and services that collects donations outside its core operations to fill a funding gap.

Understanding the potential for businesses to profit from the destruction of non-owner stakeholder value without repercussion underscores the need to hold businesses accountable for their impact. Without a measurement framework that weighs a firm’s impact along with its conventional financial value, we cannot measure a company’s true performance, its value to society. We cannot make informed tradeoffs between value-generating investment opportunities. We cannot distinguish between firms that are ‘growing the pie’ through innovative business models and those whose owners are merely taking an increasingly large slice of a stagnant or shrinking pie.

The key to understanding the total value of a company is the ability to measure its impact along multiple dimensions using the same units. In graphical terms, this means we need a way to represent impact as tick marks on the X-axis in Figures I and II. In order to determine units of impact, we need an accounting system to convert impacts of diverse nature and origin into a common currency that makes sense to evaluate alongside conventional financials and to determine how these can be meaningfully aggregated to inform decision making. Without such a transformation in business accounting, strategic analysis will continue to ignore, or at best wade through the vagaries of, both negative and positive externalities.

The momentum behind impact management is growing, but before we can manage impact, we must find a better way to measure it.