Peter Drucker: What Is A Business?

We have to start with its purpose, which lies outside the business. A business organization is an organ of society. There is only one valid definition of a business purpose: to create a customer. This leads to two and only two basic functions – marketing and innovation. All the rest are “costs.” Marketing is the distinguishing, unique function of the business. The uniqueness of the enterprise is that it markets a product or service. The economic revolution of the American economy since 1900 has been in large part a marketing revolution. He gives the examples of Sears (the book was published in 1973) and Japan after 1950. Marketing is so basic that it cannot be considered a separate function.

Despite the emphasis, marketing practices are more often rhetoric than disciplined. When managers speak of marketing, they often mean effective selling. They start with their products and look to their market. But selling and marketing are antithetical rather than synonymous or complementary. There will always be a need for selling, but the aim of marketing is to make selling superfluous, such that the product or service “sells itself” in the view of the customer.

The second function of a business is innovation – the provision of different economic satisfactions that are better and/or cheaper. Innovation may be finding new uses for old products. Innovation is not solely invention. Nontechnical innovations – social or economic – are at least as important as technical ones. (Management: Tasks, Responsibilities, Practices 61-66).

“However important the steam engine was as an invention, two nontechnical innovations had as much to do with the rise of modern economy: the mobilization of purchasing power through bank credit, and the application of probability mathematics to the physical risks of economic activity, that is, insurance. The innovation of limited liability and the subsequent development of the publicly owned limited-liability company were of equal importance” (66).

“Innovation can be defined as the task of endowing human and material resources with new and greater wealth-producing activity” (67).

There are three kinds of innovation: product or service, marketplace and consumer behavior or values, or of the various skills or activities used to bring the product or service to market. (107).

Peter Drucker on Communication #2

2. Communication is expectation. We see/hear largely what we expect to see/hear. The unexpected is usually not received or it is ignored or misunderstood. The human mind attempts to fit impressions and stimuli into a framework of expectations. It resists vigorously any attempt to make it “change its mind,” that is, perceive what it doesn’t expect to perceive.

Before we can communicate, we must know what the recipient expects to see/hear. Only then can we know whether there is a need for an “awakening” that breaks through the recipient’s expectations and forces him to realize that the unexpected is happening.

3. Communication makes demands. It demands that the recipient become somebody, do something, or believe something. In other words, if communication fits with the beliefs, aspirations, values, or purpose of the recipient, it is powerful. If it goes against them, it is likely not to be received or be resisted. At its most powerful, communication affects a change of beliefs, aspirations, values, or purpose.

4. Communication and information are different and indeed largely opposite—yet interdependent. Where communication is perception, information is logic. The more information can be freed of the human component – of emotions, values, perceptions, and expectations – the more valid and reliable it becomes. Information is always encoded. To be received, let alone be used, the code must be known and understood by the recipient.

Similar to my comment in #1, I don’t entirely agree with this. I believe his ideas about many other things are stronger, and plan to make several more posts about them. 

Peter Drucker on Communication #1

Peter Drucker (1909-2005) was a management consultant, educator and author (Wikipedia).  I read several of his books many years ago. He was philosophical yet practical about business. He had many insights. One of them was Management:Tasks, Responsibilities, Practices (1973). I recently recalled he had written about communication.

His four fundamentals of communications are:

1. Communication is perception.

2. Communication is expectation.

3. Communication makes demands.

4. Communication and information are different and indeed largely opposite—yet interdependent.

In this post I will only expand on the first one.

“Is there a sound in the forest if a tree falls and no person hears it?” The correct answer is: No. There are sound waves, but no sound unless someones perceives it. Drucker makes this a segue to communication.

It is the recipient who communicates. The so-called communicator, the one who emits the communication, does not communicate. He utters. Unless there is someone who hears, there is no communication. There is only noise.

Perception isn’t logic. It is experience. The “silent language” of gestures, tone of voice, and the context – including cultural and social referents – can not be dissociated from what is said.

One can communicate only in the recipient’s language or his terms, using terms that relate to his experience. The connection between experience, perception, and concept formation – that is, cognition – is much subtler and richer than earlier philosophers imagined.

Fanatics aren’t convinced by rational arguments, because they do not have the ability to perceive a communication that goes beyond their range of emotions.

I believe Drucker's description of the recipient is correct in general, but I personally wouldn't say it is only the recipient who communicates. I think it's a two-way thing. Maybe he had this one-way view due to his work with higher-level managers. Indeed, he writes later in the same chapter about downward communication from managers to subordinates. He writes: [A]ll one can communicate downwards are commands, that is, prearranged signals. One cannot communicate downward anything connected with understanding, let alone motivation." That doesn't sound fully real to me. For example, what about communicating between peers from different work areas? Teachers and students? Client and consultant?

Four Kinds of Capitalism

According to GoodCapitalism, Bad Capitalism, a book written by Baumol, Litan & Schramm, there are four kinds of capitalism. They all have in common the private ownership of (business) property.

The first is state-guided capitalism, in which government tries to guide the market by supporting particular industries. This model has been favored in Asian countries, where the state controls the banks and other financial institutions. The states underwrite low wage export oriented businesses to produce goods primarily for the world market. The problem with this kind of practice is that governments tend to overinvest in favored industries and underinvest in those needed for their domestic use. States are also notoriously slow in responding to the demands of a changing marketplace.

The authors distinguish state-guided capitalism from centrally planned economies, in which the state owns the means of production, sets wages and prices, often cares little about what consumers want, and provides no incentives for innovation.

Secondly, there is oligarchic capitalism. The economic system is nominally capitalist, but government policies mostly promote the interest of a small and usually wealthy part of the population. Economic growth is not a central objective, the main goal being to keep or enhance the position of the oligarchic few.

Along with oligarchic capitalism there is often informality. Individuals and firms do things that are constructive but technically illegal, such as lacking licenses, but without being outright criminal. Informal operators get much less access to legal protection and credit. The oligarchs do not consider more formal rights for informal operators to be in the oligarchs' narrow economic interest. The oligarchs don't want the competition.

Thirdly, there is big-firm capitalism. The big firms operate mainly in well-established markets and deal in large volumes. They often innovate incrementally with product and process refinements but usually not in radical or revolutionary ways. Many incremental improvements over a long period of time can amount to radical, comparing the start and end of the interval. Big firms are essential to mass-produce some of the innovations that radical entrepreneurs are unable to do by themselves. On the other hand, big firms may become lazy or influence government to help them or hurt the competition.

Lastly, there is entrepreneurial capitalism. Entrepreneurs can be radical or replicative. The majority are the latter. They more or less copy other business successes, usually in a new location. The authors do not mention franchises, but they surely fit this pattern. (McDonald’s is a great example.) The great breakthroughs in technology are usually brought to market by the radical entrepreneurs, individuals or small firms. This type of organization -- free of the constraints of big firms -- is better at creating new markets and opportunities.

The authors say the most successful economies are those that have a mix of big-firm capitalism and entrepreneurial capitalism. The more established firms -- often multiple generations removed from its entrepreneurial founders -- refine and mass-produce the innovations that entrepreneurs bring to market.

In China, Trump-Style Infrastructure Partnerships Are Used to Hide Debt

The title is the title of this Wall Street Journal article dated Dec. 6. The link may allow the reader to see only a little of the article online, but some excerpts follow.

"The 400-foot JinQing Harbor Bridge under construction in this small seaside city [Wenling, China] is being financed not by bank loans or bonds but by a Chinese twist on the public-private partnerships that the president-elect has proposed to fund infrastructure projects in the U.S.

The city, like many in China, faces budget constraints after years of expansion amid warnings from central authorities that debt is already too high. So to pay for the $1.2 billion highway project that includes the new bridge, Wenling’s government teamed up with Bank of China Ltd. to create an “industrial fund” that pulls in money from ordinary investors.

Ultimately, the city is on the hook to pay back the money with a preset return. Critics of the structure say it is merely a way of disguising debt to pile more obligations on already straining government entities."
..............

“We’re seeing continued proliferation of off-balance-sheet channels to help banks extend and mask credit,” said Jack Yuan, a Shanghai-based analyst at Fitch Ratings. “Much of this is going to infrastructure and other local government projects, sometimes in the guise of funding for public-private partnerships.”

End excerpts.

This doesn't exactly parallel what I wrote in Pied Piper Finance? on Dec. 1, but it is very close. I note two minor differences. The Bank of China is government-owned, whereas the banks in my scenario are privately owned. The source of money is "industrial funds" rather than loans. A major likeness is that a big part of the money is not recognized as official government debt. In other words, it's "off-balance-sheet" like the WSJ article says.

Investment Or Durable Good? #3

There are some business expenses that are clearly investment expenses, e.g. all the parts and labor that go into an auto-maker producing a car or truck. When the car or truck is sold, there will be revenues. Some other expenses aren’t so clearly linked to revenues, so they might be regarded as for durable goods or services or even non-durable goods or services. Consider accounting. Paying for an accountant is an ordinary, necessary business expense, except perhaps for very small ones, but it is not a revenue maker for the firm. (It is a revenue maker for the accountant who is paid.)

A similar sort of analysis holds for claim adjusters for insurance companies and lawyers hired by many businesses. They typically don’t get the company revenues, but using them may indirectly boost the company’s profit (or reduce losses).

What about education? If somebody pays the expenses to attend a technical school or college for an education tailored for a particular kind of job after graduating, that is investment spending. If the parents of such person, the student, pays the expenses instead, I think it is still investment spending.

When parents pay for the education of their children for grades K-12, that is paying for a durable good. The same seems to apply in some other cases, e.g. pursuing a college liberal arts degree with a very unspecific career goal. That would especially be the case of a trust fund child who wants to go into the Peace Corps and do even more volunteer work after that. In other cases it could be a mix.

What about labor? If I rake all the leaves in my yard, that is a consumer good. Most people with an opinion would probably say it was non-durable, since it will need to be done again in about 12 months. That doesn’t change if a pay somebody else to rake all my leaves. However, if I hire somebody to do it, there is income to the yard guy. Most of his income for doing so is for labor, but he does a little investment spending or recouping prior investment spending – the cost of the gasoline he uses in his leaf blower and a little of the cost of the tools he uses.

Trump’s Impulsive Tariffs

I applaud President-elect Donald Trump’s proposals to cut the corporate tax rate and reduce regulation on business, especially smaller businesses, on whom they are most burdensome. His impulsive statements about tariffs are a different matter.

Donald Trump Warns of 35% Tariff For Companies That Move Abroad

"Despite the Carrier deal, the company still plans to close a plant in Huntington, Indiana, moving about 700 jobs to Mexico."

This plant makes microprocessor-based controls for the heating, air conditioning and refrigeration industries, i.e. parts that are probably used in the plant that Carrier is going to keep in Indiana. So what does Trump believe the tariff should be imposed on? And wouldn’t it be a cost for the plant that Trump claims to have helped save?

Further, suppose a foreign company, e.g. Honda or Toyota, has plants in the USA. The company with good economic reasons decides to replace a plant or part of it with one in another country. So legislation signed by Trump imposes a 35% tariff on the company's goods coming into the USA. The parts issue is pertinent again. Also, foreign businesses might wonder, "If I build a factory in the USA, what happens to me in the future if I want to relocate or merely shift part of production elsewhere? I don't want to take that chance. So I think I'll pass on building that new U. S. plant [and creating more American jobs]." (Hat tip to Gralee for this point.) Does that sound great for Americans in general?

Trump has threatened to impose tariffs on imports from China because he feels that the Chinese have stolen American jobs. He has ranted against the USA’s trade deficit with China. But imports from China aren’t solely made in China.

“On trade, although the headline data shows China accounted for 50% of the U.S. trade deficit last year, that number gives a highly distorted view since around 37% of those exports consist of imported parts, mainly from Japan, South Korea and Taiwan, according to Deutsche Bank Chief Economist Zhiwei Zhang. In value-added terms, he calculates, China accounted for just 16% of the U.S. deficit, slightly ahead of Japan and Germany.

        A trade war with China, Mr. Zhang notes in a report, “would be a war against all participants of the global supply chain, including U.S. companies.” Link.

Indeed, Almost Everything Trump Says About Trade With China Is Wrong.

Consider tariffs on a smaller geographic scale. Suppose a USA company wants to shut down a plant in state X and move production to far-away state Y. So the government of state X imposes a 35% tariff on goods shipped from a new plant in state Y back to customers in state X. Would Trump as President approve that tariff? (It's probably illegal, but I'm only questioning a principle.)

And why not a similar principle -- a 35% tariff on all imports? Oh, I get it. Trump companies import a lot of stuff.

Of course, imposing tariffs creates a host of other problems, e.g. higher consumer prices, enforcement, and retaliatory tariffs. Effects outnumber intentions here.

The Golden Triangle-Yokohama Deal

Sean Hannity talked with Paul Ryan on Fox News. Ryan talked about public-private partnerships to rebuild infrastructure. Link. The Golden Triangle and Joe Max Higgins were mentioned.

Part of the Sunday, December 4, 2016 CBS's 60 Minutes show was about The Golden Triangle and Higgins. Link. Higgins has worked hard to bring manufacturing jobs to Mississippi, which lost a lot of manufacturing jobs over the past few decades.

There is more detail about what has been done here, from which I quote.

To win the Yokohama tire plant Joe Max Higgins "installed water and sewer systems on the proposed site for the plant, and he secured $30 million from the state for a new access road so trucks could reach the factory."

That doesn't sound like public-private funding to me.

"Yokohama agreed to build the $300 million plant in the Golden Triangle. Higgins secured about $100 million in incentives and an estimated $200 million in tax breaks from the state of Mississippi and the counties that make up the Golden Triangle."

The incentives and tax breaks are worth as much as the cost of building the plant. Is that crony capitalism? The devil may be in the details. The plant is expected to bring 2,000 jobs. Assume a generous $100,000 wages per job, a figure given for one worker in the 60 Minutes show. State income tax = $4,660 for single and $4,470 for married. I'll use $4,565. 2,000 x $4,565 = $9.13 million. 200/9.13 = 21.9, the number of years to offset the $200 million in tax breaks. (A lower average wage would lead to more years.) That doesn't include the $30 million for a road, whatever the water and sewer system cost, or $100 million in incentives. Hmm, that suggests crony capitalism to me.

Of course, the people who get those jobs are going to be very appreciative. But it doesn’t sound to me so great for the rest of the people of Mississippi.

Milton Friedman wisely observed that we spend our own money on ourselves very carefully. We spend other people’s money on ourselves less carefully. But the least carefully spent money is other people’s money on other people.

Cafe Society

Last night we saw Woody Allen’s Cafe Society on DVD. I liked it as I usually do Allen’s films and his humor. Some humor from it follows.

The lead character is Bobby Dorfman. Most of the movie is about Bobby and his romances. His family is Jewish and he has a gangster brother Ben. His parents are Rose and Marty.

Ben is apprehended, imprisoned and sentenced to death. Dismayed that the Jewish faith doesn't have any provisions for an afterlife, he converts to Christianity, and he's buried in a Christian cemetery, much to the chagrin of some family members.

Rose Dorfman: First a murderer, then he [Ben] becomes a Christian. What did I do to deserve this? Which is worse?

Marty Dorfman: He explained it to you. The Jews don't have an afterlife.

Rose Dorfman: We are all afraid of dying, Marty! But we don't give up the religion we are born into.

Marty Dorfman: I'm not afraid to die.

Rose Dorfman: You're too stupid to appreciate the implications.

Here is bit of Woody's philosophical humor: “Socrates said the unexamined life is not worth living. But the examined one is no bargain.” 😊

The Carrier Deal

President-elect Trump’s claiming to save 1,100 jobs at Carrier in Indiana was all over the news. A closer look says that it isn’t that many. Of course, Trump tried not to say anything about Carrier’s tax break.

A Wall Street Journal article says the number of jobs saved was 700. “The Indiana governor was offering $7 million over 10 years to encourage the company to keep in the state roughly one-third of the 2,100 jobs it planned to ship to Mexico” (link). 

A Chicago Tribune article says the number of jobs saved was 800. “Carrier, he said, had agreed to preserve 800 production jobs in Indiana. (Carrier confirmed that number.)” Link. 

Does this tax break make sense for Indiana? I will use the Chicago Tribune’s number of 800 jobs.

Assume $50,000 income per worker. That's very close to the that of the Carrier workers. State income tax =$1,617 = 3.23% for single, $1,584 = 3.17% for married. I’ll round the midpoint. 800*$1,600*10 = $12,800,000.

So at first glance Indiana gains about $5.8 (=12.8 - 7) million in tax revenue. (700 jobs implies a $4.2 million gain.) However, this assumes the 800 workers would otherwise vanish from Indiana's workforce such as being unemployed or moving out-of-state. Therefore, it is clearly an unrealistic assumption. If that were true of only 200 jobs, Indiana has a net loss of $3.8 million (= 200*1,600*10*10^(-6) – 7.0). Indeed, if that were true up to 437.5 (=(7*10^6)/(1600*10) jobs, Indiana has a net loss.

One thing that could justify the state government's decision -- one I didn't think of when I first posted this -- is unemployment benefits that Indiana could pay if these 800 workers were laid off. $7,000,000/800 =  $8,750 per worker. A few months unemployment benefits could cost the state  government that much. Beyond that I can only guess. Also, how much such benefits might be (hypothetically) could be diminished by severance benefits from Carrier.

Regarding Carrier’s decision its parent, United Technologies (symbol UTX) is relevant. UTX is a huge defense contractor. Perhaps the high-level executives at UTX considered saving those jobs in Indiana – rather than saving costs by having the work done in Mexico, estimated at $65 million – creates good will that will pay off when UTX deals with people in the Trump administration regarding defense contracts in the future. $65 million is not a lot for UTX; 2015 revenues were $56 billion and net income was $7.6 billion. Of course, it's a good deal to those who keep their jobs. Nevertheless, prima facie, it doesn’t look like a good deal for the Indiana state government and hence for the people of Indiana in general.

Investment Or Durable Good? #2

In this post I will apply the concepts in #1 to some other examples where their application isn’t as clear or is mixed.

What about airports? “The vast majority of airport revenues come from fees paid by passengers using the airport, landing fees and space rental fees paid by airlines, parking charges and sales of food and goods at the airport. Though not well understood by many Americans, commercial airports receive almost no taxpayer-funded support from state or local sources. Federal grants that help pay for airport construction projects come from a portion of the travel taxes paid when you buy an airline ticket or ship a package and fuel taxes paid by general aviation” (link).

So to the extent there is no taxpayer-funded support, building an airport is investment spending. Ditto to federal grant money which is recouped via the taxes as described.

What about housing? Next consider somebody who buys a duplex, half to live in and half to rent out. It is half durable consumer good and half investment by the meanings in #1.

The reader may have thought by now that my meanings are confusing, since it can make the identical entity a consumer good or investment good. That is true, since the focus is not on the physical nature of the entity, but on the purchaser’s intention or use. For example, a car dealer buys a car in order to sell it at the dealership. The car is an investment good. For the person who buys the car from the dealer, it is probably a durable consumer good. On the other hand, if the person buys it to use it half the time as an Uber driver, it’s half investment good and half durable consumer good. It’s similar for food. Food purchased by a restaurant to prepare and fix for its customers is an investment good. The same food purchased to take home to eat is a consumer good.

Affordable Housing

This post will compare two affordable housing programs, one by the government and one in the private sector.

The government one began when the US Department of Housing and Urban Development (HUD) was given authority under 1992 legislation to undertake an affordable housing program. HUD imposed goals on mortgage providers, especially Fannie Mae and Freddie Mac to make it easier for medium and lower income people to get a mortgage and buy a home. (Of course, pushing only buying neglects rentals.) HUD pursued its goal by promulgating weaker underwriting practices – lower down-payments, lower credit scores, accepting higher ratios of house and house-related expenses to income for buyers, and weaker documentation of the buyer's income. They were usually called subprime mortgages. Some were called Alt-A mortgages. Over the next 16 years or so this led to a housing bubble, then a crash in house prices, much higher mortgage defaults, and foreclosures. All this spilled over into the wider financial sector that enabled the mortgages, resulting in the Financial Crisis of 2007-8. Advocates of government activism and government apologists say the financial crisis was created by the private sector. Of course, there were some problems there. However, the primary cause was these affordable housing goals, and they made possible the problems in the private sector.

If you want to read more about this, see Hidden In Plain Sight. This government affordable housing program unwittingly led to a “train wreck.” The fix took multi-$100 billion bailouts with taxpayer money. 

The private sector one has only begun, but I bet it will turn out far better. The key elements are in a Wall Street Journal article, from which I cite. “[Facebook] announced Friday it will spend about $20 million in Menlo Park and East Palo Alto, Calif., two cities that surround its campus, to create a fund to build new housing, support job-training programs and provide legal assistance to tenants in danger of eviction.
      Some $18.5 million will go to a fund to build new housing, primarily targeted at low- and moderate-income families, with consultation from community groups."

Why are they doing this? I attribute it to the very high price of housing in Silicon Valley. (This shows all single family homes under $800,000 in Palo Alto). Also, Facebook, Google and other companies in Silicon Valley are already running buses from distant areas like San Francisco where their employees can find cheaper housing. You can read about it here and several other places on the Internet.

After the Facebook housing is built many employees will find more affordable housing near work and thus shorter commutes, distance and time. A side effect will probably be that housing will be made more affordable in the areas from which they move. It will probably work out pretty well. And it will not lead to multi-$100 billion bailouts with taxpayer money. 

I have described a government-created affordable housing program that led to a “train wreck” and a private-sector affordable housing program. Which do you prefer?

Pied Piper Finance?

Assume a government wants to do a big infrastructure project – resurfacing a major highway and repairing bridges along the route. This is not a toll road and that will not change. The government finds a contractor who will do the work. However, the government does not want to pay all the cost upfront. Therefore the government’s overseer of the project – call him “pied piper” -- finds a private investor (PI), who will borrow a large part, say 85%, of the money to cover the construction cost. PI will put up the remaining 15%. The pied piper promises to pay PI enough over several years so that PI can pay back the loan, plus some more. How much more might depend on meeting deadlines and how much actual construction costs turn out to be compared to the amount budgeted. If construction is done in less time and/or costs come under budget, PI will receive more from the government. If construction is done in more time than expected and/or there are cost overruns, PI will receive less from the government. In other words, incentives are attached to PI’s 15% equity stake.

Since the government doesn’t borrow – PI does that – the project will not increase the government’s debt or any deficit it has initially, under current cash-based public accounting practice. However, it probably will over time when the payments to PI come due, whenever the government does not have enough cash on hand at the time to make said payments.

This is off-budget treatment by the government. It is what the federal government does already regarding Social Security and Medicare. It is obligated to make payments to beneficiaries of these programs well into the future in excess of incoming revenue. But there is no corresponding debt for the excess of future outgo over future FICA tax revenues on a federal government balance sheet. The federal government doesn’t even publish a balance sheet. The only item that the government prominently presents that is a balance sheet component is the national debt. Cash deficits for the programs become debt as they materialize.

Is the scenario described above what Mr. Trump has in mind when this webpage says his infrastructure plan will be deficit-neutral? (This document by two Trump advisers had more detail.) Of course, it will be deficit-neutral early on when PI puts up the money, borrowing 85% of it. But when the government payments to PI commence, I will bet that it won’t remain deficit-neutral. The government will likely issue more Treasury debt to offset shortfalls, and that debt will be added to the national debt, which is now about $20 trillion. Depending on how the pied piper’s deal with PI is structured, those payments may not start coming due, and some may not be due anyway, until after Trump no longer occupies the oval office. Then they won’t be “his debts”; they will be the next president’s … and ours.

Or maybe much of the $1 trillion infrastructure plan would be pushed onto state and local governments. They already pay for a lot of infrastructure and get earmarked revenues to do so, e.g. fuel taxes for roads and bridges. Whatever is so pushed would be off-budget for the federal government. It might even be done selectively with strings attached. The state or local government is told it must contribute some of the money, e.g. raising it by issuing bonds. If they don’t, then they get no federal money.