The Social Responsibility of Business Includes Profits – ProMarket

Profits these days are often seen as a dirty word, but it is wrong to demonize profits. A company’s responsibility is not to sacrifice profits by donating them to charity, but to create profits only through creating value for society.

Responsible business is the order of the day. Policymakers, investors, and executives themselves correctly believe that companies must stop focusing exclusively on shareholder value, instead turning their attention to social issues such as climate change, biodiversity loss, and inequality.

These problems are very serious, and businesses can and should use the vast resources they’ve been entrusted with to solve them. But one responsibility is often ignored—generating profits for their investors.

Profits are often seen as a dirty word—as something that shareholders extract, that could have otherwise gone to society in the form of wages to workers, taxes to the government, or fairer prices to customers. But the demonization of profits is flawed for two main reasons. First, profits play a crucial role in society. Without profits, companies can’t fund the innovation needed to address society’s challenges. As Merck CEO Kenneth Frazier points out, to explain why drug companies sell life-saving medicines for a profit: “The price of [a] successful drug is paying for the 90%-plus projects that fail. We can’t have winners if we can’t pay for losers.” 

In addition to being reinvested within a company, profits can also be paid out to shareholders, which is perhaps the most controversial use of profits. Shareholders are seen as nameless, faceless capitalists—they are “them,” while society is “us.” But shareholders are part of society—they are “us.” They include parents saving for their children’s education, pension schemes investing for their retirees, and insurance companies funding future claims. Any responsible business must take shareholders seriously. And investors are needed to finance companies in the first place, which they’ll only do if there’s the prospect of a return. 

Second, rather than being the deliberate outcome of value extraction, profits can be the by-product of value creation. The traditional view of profits is based on the pie-splitting mentality. This sees the value created by a company as being a fixed pie, which can be given either to shareholders in the form of profits, or society in the form of “stakeholder value” such as taxes, wages, and fair prices. Under this view, the only way that a company can increase profits is by lowering the slice given to society—and so high profits are something to name and shame. It’s “them” vs. “us,” either shareholders or stakeholders, and the only way that you can be with “us” if you’re against “them.” To repurpose capitalism, and take back the pie, we must weaken shareholder rights—redefine directors’ duties away from shareholders, allow non-shareholders to appoint their representatives to the board, and hinder shareholders from proposing resolutions. 

But the pie-growing mentality stresses that the pie is not fixed. The only way that a company can make profits—at least in the long-term—is if it grows the pie by actively creating value for society. A company may improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company may develop a new drug to alleviate a pandemic, without considering whether those affected are able to pay for it, yet end up successfully commercializing it. A company may reduce its emissions far beyond the level that would lead to a fine, due to its sense of responsibility to the environment, yet benefit because customers, employees, and investors are attracted to a firm with such values.

All of the above actions are likely to be driven by the desire to create social value. It’s difficult to justify them with the traditional net present value (NPV) approach used to maximize profits. If a company adopts a generous parental leave policy, there’s no way to calculate—even roughly— how much more motivated employees will be and how much this will boost future profits. But even though the higher profits couldn’t have been predicted at the outset, they often manifest anyway. The fact that a company ultimately profits from serving society does not detract from the value it creates by doing so. Sustainable profits are the sign of a responsible company. 

“rather than being the deliberate outcome of value extraction, profits can be the by-product of value creation.”

In my book Grow the Pie: How Great Companies Deliver Both Purpose and Profit, recently updated for the pandemic, I highlight the shift in thinking that arises from adopting the pie-growing mentality—a practice I call Pieconomics. The implications are profound. A company’s responsibility is not to sacrifice profits by donating them to charity, but to create profits only through creating value for society. The “only” highlights how its primary duty is to solve social problems, not to create profits—but if it succeeds in the former, it will be profitable. Delivering high profits need not be shameful; failing to create profits by creating social value is. While Milton Friedman is wrong that profits are “the one and only social responsibility of business,” the social responsibility of business does include profits, alongside social value. 

The idea that we can have “win-win” outcomes, where both shareholders and society can simultaneously benefit, sounds too good to be true. So the book backs this up with rigorous evidence. One study investigates the list of the “100 Best Companies to Work For in America,” which assesses how well a company treats its employees—covering dimensions such as credibility, respect, fairness, pride, and camaraderie. After comparing the Best Companies to other stocks in the same industry, or with similar characteristics (e.g. size, value, and recent performance), and controlling for other factors, I found that they beat their peers by 2.3-3.8 percent per year over 1984-2011, or 89-184 percent compounded.  Moreover, their future profits systematically beat analyst expectations, attenuating concerns of reverse causality or omitted variables. Simply put, investing in your employees isn’t at the expense of profits—it grows the pie, ultimately generating profits. 

Yet, it’s critical to stress that the evidence isn’t all one-way. While win-win outcomes are indeed possible, there remain important trade-offs. It’s popular to claim that doing good always leads to companies doing well, and such claims are often accepted uncritically due to confirmation bias. However, they’re not supported by the data. One inconvenient truth is that companies that release more carbon emissions (regardless of whether they’re Scope 1, Scope 2, or Scope 3), generate higher shareholder returns. A second is that companies with high ESG ratings don’t beat their peers. Instead, outperformers are ones that do well on only the stakeholder issues most material to their business model, and scale back on the immaterial ones. 

The existence of these trade-offs means that any responsible business requires a framework to help evaluate them.  A company can’t cheerfully abandon NPV calculations and just try to “do the right thing.” Since doing good is costly, a company needs to know when to do good, and critically when not to. If “anything goes,” then a company might be so focused on social value that it forgets about profits and fails, as James O’Toole explained in his book The Enlightened Capitalists: Cautionary Tales of Business Pioneers Who Tried to Do Well By Doing Good. 

In Grow the Pie, I propose three principles to help executives decide whether to take an investment that can’t be justified on pure NPV grounds. One is the “principle of multiplication,” which says that $1 invested in a stakeholder must create more than $1 for that stakeholder. Providing employees with a free on-site gym isn’t responsible if there are adequate local gyms. It would be better for the company to pay higher wages and allow its employees to spend them on gym memberships.  The second is the “principle of comparative advantage,” which states that $1 must create more value than someone else could by investing in that stakeholder. Donating to charity doesn’t satisfy this principle, since employees could donate the same money themselves if corporate philanthropy was reallocated to wages. But investing to reduce plastic packaging does, as it has a much greater impact on the environment than if the company instead paid higher wages, which employees then donated to Greenpeace to lobby for a tax on plastic bags. The third is the “principle of materiality,” according to which the benefits from a stakeholder’s activity must be material to the enterprise.  This is supported by the research showing that addressing only material stakeholder issues ultimately boosts returns. 

Taken together, these principles mean that a company’s responsibility is not to solve all of the world’s problems or box-tick all 17 of the United Nations Sustainable Development Goals. Instead, it’s to focus on the issues that it has a multiplicative impact on and enjoys a comparative advantage in addressing, and that affect its most material stakeholders. Advocates of responsible business argue that companies should have a purpose, and “purposeful” is often seen as a synonym for “altruistic.” But that’s not what the word “purposeful” actually means—it’s about being focused and targeted. A purposeful meeting is one with a clear agenda; if you do something on purpose, you do it deliberately. Purpose is as much about knowing what not to do as what to do, and resisting the urge to jump onto whatever social issue happens to be the order of the day. 

Pieconomics as a Middle Ground

Thus far, we’ve explored how the pie-growing mentality shifts our thinking on the role of profits. There are two quite separate, but equally important implications. The first is the role of government. While free-market capitalists argue for minimal intervention, and stakeholder capitalists lobby for heavy regulation, Pieconomics argues for a middle ground. It stresses how responsible behavior varies wildly across companies depending on the three principles, while regulation takes a one-size-fits-all approach. But it also acknowledges that many effects a company has on society don’t feed through to profits, and it’s a government’s responsibility to address these externalities through either taxes (so that the firm internalizes them) or outright bans. The more profits and social value are aligned, the more it will be in companies’ own interest to create social value. 

The second implication is that responsible business is feasible even in difficult times, such as a pandemic.  Traditionally, responsibility is seen as splitting the pie more fairly, by donating to charity or pay higher wages than you need to. But doing so is impossible in a pandemic, when you don’t have pie to give. Thus, it seems that responsibility is a luxury only for good times. 

But if a company’s primary responsibility is to grow the pie, this is possible even in difficult times. The main investment required is not money, but rather thinking innovatively about how a company can repurpose itself to solve social problems. A responsible leader asks herself “What’s in my hand? What resources and expertise does my company have, and how can I deploy them innovatively to serve society?”

Such a mindset can inspire some great ideas. Chelsea Football Club in London doesn’t have anything obviously relevant in a pandemic. Soccer tickets and replica merchandise aren’t going to save lives. But what’s in its hand is its hotel, where it allowed doctors and nurses to stay for free, saving them a long commute after a day of fighting on the front line. LVMH’s luxury perfumes are indeed a luxury during a pandemic—but what’s in its hand is a production facility that uses alcohol, which it redeployed to manufacture hand sanitizer. Many of JetBlue’s planes were grounded as passenger numbers plummeted, so it partnered with charities such as the Red Cross and Médecins Sans Frontières to use these planes to transport medical professionals, devices, and supplies to where they’re most needed. 

And thinking of responsibility as growing the pie is relevant not only in bad times as well as good, but also for small companies as well as large. Entrepreneurs often think that their primary goal is to start turning a profit—only once they’re consistently in the black can they afford to think about responsibility. 

But if responsibility involves leveraging resources, not spending money, this unlocks the potential for small businesses to play their part. Take Barry’s, the boutique fitness studio. What’s in its hand is fitness expertise, which it used to offer free livestreamed workouts—particularly valuable when citizens are locked down at home. Now, it might seem not particularly innovative for a fitness studio to provide fitness classes, albeit online. The real creativity was in how it redeployed its office and desk workers. Some of them also had jobs as actors; since acting can be volatile, they also worked for Barry’s to provide a stable income. If you’re an actor, what’s in your hand is that you’re entertaining. How does that help in a crisis? Barry’s launched a “Barry’s Cares” program, which included their staff reading stories and providing entertainment to children over Zoom—taking the load off working parents whose kids were at home due to school closures.

These inspiring examples give us hope, even in bleak times. If there’s any silver lining to the crisis, it’s that it will permanently lead to a shift in thinking about what responsible business entails—from splitting the pie by spending money to growing the pie by innovatively using what’s in our hand. Doing so need not always require the investment of profits, and in the long-term may enhance profits—allowing a company to fulfill its social responsibility.    

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