Customer-Centric Capitalism

What is the primary responsibility of a business?  Renowned management professor and writer Peter Drucker gave a succinct answer to this question in his 1954 book The Practice of Management:  “A company's primary responsibility is to serve its customers . . . Profit is not the primary goal, but rather an essential condition for the company's continued existence.”

For the last thirty years, maximizing shareholder value has replaced customer value as the key objective of many companies.  But, a number of experts are now raising questions about this widespread business practice and the extreme preoccupation with short term profits that inevitably results from putting shareholders over customers. 

A 2006 study co-sponsored by the Business Roundtable and the CFA Institute  concluded that: “the obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the unintended consequences of destroying long-term value, which decreases market efficiency, reduces investment returns, and impedes efforts to strengthen corporate governance.”  It is quite possible that this short-term oriented business culture was a leading cause of our global financial crisis.

The issue of shareholder versus customer value was the subject of a recent excellent article in the Harvard Business Review: The Age of Customer Capitalism, written by Roger Martin, dean of the Rotman School of Management at the University of Toronto.

 
For about a decade now, Professor Martin has been advocating the need to teach business students to think more holistically and creatively, as much as we need to teach them discrete skills like finance, accounting and marketing.  He believes that to become successful general managers, students need to learn how to think about the complex problems they will encounter in business from many different perspectives, which will better help them find innovative solutions to whatever immediate problems they are facing, as well as to formulate the overall strategy of the business.

The central premise in The Age of Customer Capitalism is that: “For three decades, executives have made maximizing shareholder value their top priority.  But evidence suggests that shareholders actually do better when firms put the customer first.” 

In the first paragraph of the article, Martin gives us a historical perspective:

“Modern capitalism can be broken down into two major eras.  The first, managerial capitalism, began in 1932 and was defined by the then radical notion that firms ought to have professional management.  The second, shareholder value capitalism, began in 1976.  Its governing premise is that the purpose of every corporation should be to maximize shareholders’ wealth.  If firms pursue this goal, the thinking goes, both shareholders and society will benefit.  This is a tragically flawed premise, and it is time we abandoned it and made the shift to a third era: customer-driven capitalism.”

The basic idea underlying the shift to shareholder value capitalism was that the best way to manage a business was to align the interests of senior management with those of shareholders through stock-based compensation.  Martin believes that while sounding good in principle, this premise turned out to be flawed in practice.  He uses historical stock prices from the S&P 500 to show that shareholders actually earned lower returns in the shareholder value era of the past thirty years than they did over the previous several decades. 

Shareholder value capitalism encouraged the management of the company to take actions to increase the price of the stock in the short term, both to satisfy investors and to help increase their own compensation.  But the better the stock does, the more you raise the expectations about the future performance of the company.  This can only work for so long.  Stock prices cannot continue to rise indefinitely to match shareholder’s increasing expectations.  “The harder a CEO is pushed to increase shareholder value, the more the CEO will be tempted to make moves that actually hurt the shareholders.”

The shareholder-value movement was most strongly advocated by Roberto Goizueta, CEO of Coca-Cola from 1981 to 1997, and Jack Welch, CEO of General Electric from 1981 to 2001.  These two prominent CEOs were outspoken advocates of increasing shareholder value through higher and higher growth, mostly achieved through acquisitions, including a number of companies outside their original core businesses.  According to Professor Martin, once Goizueta and Welch retired, their successors have struggled with their legacy of rapid growth and diverse acquisitions, and “it is questionable how much shareholders benefited in the long term.”

If not through a focus on profits, growth and acquisitions, what then is the best way of increasing shareholder value?  Martin has a simple answer to this question:  “To create shareholder value, . . . you should instead aim to maximize customer satisfaction.  In other words - and nobody should be surprised by this - Peter Drucker had it right when he said that the primary purpose of a business is to acquire and keep customers.”

He cites Johnson & Johnson as an example of a company that has done quite well by its shareholders while explicitly putting customer first and shareholders last in its credo, which was personally created by then chairman Robert Wood Johnson II in 1943:

“We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services . . . We are responsible to our employees, the men and women who work with us throughout the world . . . We are responsible to the communities in which we live and work and to the world community as well . . . Our final responsibility is to our stockholders . . . When we operate according to these principles, the stockholders should realize a fair return.”

The credo helped guide the actions of CEO James Burke during the 1982 Chicago Tylenol murders, in which seven people died after taking Tylenol capsules that had been tampered with and laced with potassium cyanide.  While the deaths occurred only in the Chicago area, Burke and his management team promptly recalled every capsule of Tylenol across America without any government prompting, much to the consternation of Wall Street.  They only returned Tylenol to store shelves several weeks later after they had quickly pioneered tamper-resistant packaging, all the while keeping the media and public informed of their actions.

“In the long run,” writes Martin, “that decision didn’t hurt J&J at all.  In fact, loyalty toward Tylenol soared after the company demonstrated that customer safety came first and also introduced the world’s first tamper-resistant packaging for over-the-counter health products.  In September 2009, J&J’s market capitalization was $167 billion, the ninth highest in the world. J&J seems to have indeed provided long-term shareholders more than a ‘fair return.’”

“Why is it that companies that don’t focus on maximizing shareholder value deliver such impressive returns?”, asks Martin. “Because their CEOs are free to concentrate on building the real business, rather than on managing shareholder expectations.”  This is a particularly important point when you consider that in today’s short-term obsessed Wall Street culture, not all shareholders behave like true owners and have the long interests of the company at heart. 

Clearly, money managers and individuals who hold stock for the long term are owners, and their interests are aligned with those of the company's employees, customers and communities in which they do business.  But, what obligations does a company have to traders who view its shares as chips in a casino, even if they are, strictly speaking, owners for the short time they hold the stock?

The article concludes:

“Managers like profits just as much as shareholders do, because the more profits the firm makes, the more money is available to pay managers.  In other words, the need for a healthy share price is a natural constraint on any other objective you set.  Making it the prime objective, however, creates the temptation to trade long-term gains in operations-driven value away for temporary gains in expectations-driven value.  To get CEOs to focus on the first, we need to reinvent the purpose of the firm.”

This is what customer-centric capitalism is all about.

Comments

[Alvis Brigis]

Nice post. Lots of great data. I wholeheartedly agree with your analysis of the system and the need to return to more customer-oriented businesses. It's a due shift.

I'd also suggest expanding the concept of a customer to that of a prosumer (producer + consumer), aka a customer that gives back to X extent. This seems like a logical next step that many companies, particularly social media and other data driven businesses, are already getting started on.

http://socialnode.blogspot.com/2010/05/prosumer-centric-capitalism.html

Keep up the great posting!

[Mervadrian.wordpress.com]

Important ideas articulately delivered. Thanks for raising the issue. It seems particularly appropriate in the tech industry, where I spend my time (as you have). It seems likely that the cash hoards some firms are sitting on will drive a new round of portfolio building for revenue accretion - as opposed to strategic value as defined by serving customers better. Let's hope not.

[Markmadsen]

Very good points raised. I think short term thinking about business and investment performance has been a known issue for a long time. The problem is that executives are forced to manage for the short term according to investor desire, and the desires are primarily from large institutional investors. Their incentives and the incentives of most executives are aimed at short term performance. With their tenure of a few years and the tight interlacing of corporate boards, systemic support for longer term investing is not going to happen. Until we shift away from treating stock trading as gambling rather than an investment with a long term payoff, the overall system will continue to constrain corrective actions.

[toronto marketing services]

A very nicely written post – anyone who plans to learn what makes a successful blogger should keep these in front of them all the time.

[Meilinfung]

Congratulations, you have written a "tipping point" article.... the term Customer-Centric Capitlism has a great ring to it. There has been so much talk over the years about Customer Centricity especially in the technology world of "CRM" or customer relationship management. Those of us in the field have watched what started out as lip-service to customer centricity, emerge as the aligning sense of purpose that could bring people together to overcome challenges and work together through conflict and obstacles.... to the benefit of the larger organization. BUT only if the organization took the care to nurture this spirit. In all too many cases, it died on the vine, as short term bonus-driven behavior took back the steering wheel... the crazy world of Dilbert.

By taking it all the way to the underlying system of capitalism, amplifying the reach of the term: Customer Centric Capitalism Martin and Wladawsky have done the world a great service and brought the heart back to business.

Thank you both!