10.24.2012

When ROI and SROI Diverge

http://www.socialfirmsuk.co.uk/imagebrowser/view/imagecache/1027/advert_images
It wasn't very long into my Wharton undergrad days that my classmates and I got schooled in the way business works: if there's profit to be made, you do something, and if there isn't, you don't.  Whether you want to call this ROI or NPV or MR=MC, it's not actually that unique to the world of commerce, since humans think like this all the time: if something will get me more benefit than it costs, I will do it, and if it won't then I won't do it.

We may not think in dollar terms but we think like this nonetheless, whether it's buying an iPad (will my happiness exceed the $599 that it will set me back?) or taking up a hobby (will I gain more than the time and money it will cost me?).  That being said, sometimes this calculation is more straightforward than others: as you start talking about more and more abstract things, it becomes easier to grossly undervalue or overvalue them, leading to decisions which end up being poor choices for you and others.

A little later in school, we learned about externalities, both positive and negative.  That is, this notion of costs and benefits gets a little skewed sometimes, because costs and/or benefits sometimes are generated to other actors besides you.  The classic positive externality is education: we pay for schools to educate our kids, but in addition to us benefiting, society benefits from a more educated populace.  The classic negative externality is pollution: a business makes and sells a product, but generates pollution in the process that we all have to pay for in the form of dirtier air/water. 

Therein lies the twofold dilemma, from a public policy standpoint.  Absent some outside mechanism, we will end up with too much of some things and too little of other things than is socially optimal.  Now, I want to be careful here, given that I have just used a term, "socially optimal," that makes me sound like a Soviet central planner.  Many choices are matters of opinion, and in a diverse and democratic society there is going to be great disagreement between whether we have too much or too little of something.  I raise this not so much to complain that we are worse off as a society as a result of our choices, but rather to explore the way in which make those choices and what consequences result.

Let's go back to business decisions, which is what I think about a lot.  If I am a business, and I have the opportunity to invest 100 units in order to earn 200 units, I will do it in a heartbeat.  But what if, in the process of converting 100 units of investment into 200 units of earning, I generate negative 50 units of costs to society?  One can argue that there should be some fair mechanism to transfer units from the business to some entity that will offset the negative costs to society with some positive benefits to society.  And, if, instead, in the process of converting 100 units of investment into 200 units of earning, I generate negative 500 units of costs to society, one can argue that there should be some way that society can organize itself to prevent me from proceeding.

Let's flip this now.  If I am a business, and I have the opportunity to invest 100 units in order to earn 50 units, I will not do it ever.  But what if, in the process of converting 100 units of investment into 50 units of earning, I generate 500 units of benefits to society?  One can argue that there should be some fair mechanism to transfer units from society to the business, so that the transaction becomes worth doing for the business, so that society can enjoy those benefits.

Of course, we do this all the time in our society, through government taxes, subsidies, and regulations.  We tax some things to draw out their negative externality (ex: sin taxes), we subsidize some things to make them happen when they won't happen absent government help (ex: energy efficiency tax credits), and we forbid some things outright when they are bad for society (ex: no dumping toxic waste into rivers).  But, in theory and in practice, the logic is fuzzy and the results are mixed.  Even at a simpler, philosophical level, you can disagree with how involved government should be in adjusting the marketplace.  And, when you get down to specific transactions, it becomes even murkier as to if, how, and how much government should insert itself: how do you value societal benefits and costs, what government tool is best for adjusting the market outcome, and will there be any unintended consequences?

For a while now, there has been talk in the business world about SROI: social return on investment.  This is exactly what I'm talking about, that to a business, ROI is about comparing return to the business with investment by the business, whereas to a society, SROI is about comparing return to the business plus return to society against investment by the business and investment by society.  Fair enough.

What, then, happens when the ROI tells you something is a go but the SROI tells you no-go?  Or vice versa: what happens when the ROI tells you something is a no-go but the SROI tells you go?  I think even the most ardent believers in government are sober about government's ability to properly insert itself into these transactions and to accurately size the tax, subsidy, or regulation that will move us to a more optimal solution.  And, I think even the most ardent believers in business are sober about business' ability to make choices that are in society's best interest and not just their own narrow interest.

One promising development in this realm is the rise of the informed consumer and the enlightened employee.  Increasingly, both consumers and employees are making decisions - with where they spend their dollars and where they want to work - based on these social factors.  Aiding these consumers and employees is the explosion of media coverage - from traditional sources to individual blogs, social networks, and word of mouth - to elevate good corporate behavior and uncover bad corporate behavior.  As a result, businesses are thinking twice about doing things that are good from an ROI standpoint but bad from an SROI standpoint (or vice versa), because they know that they might lose consumers and employees as a result.

Of course, losing consumers and employees means that, at some point, ROI and SROI might converge: things that are good from an ROI standpoint but bad from an SROI standpoint will actually be bad (or at least less good) from an ROI standpoint when factoring in the losses associated with boycotting consumers, employee attrition, and bad publicity.  This may be even more true if government becomes more aggressive in its taxing, subsidizing, and forbidding (I say "may be" because of course there is the possibility that government gets these things wrong and we end up with a bunch of unintended consequences).

Maybe you can tease out where I personally stand on how this all should work: how businesses should behave and what role government should play.  If you can, let me know, because I don't think I've figured out where I stand!  But I know it is helpful for me to explore these concepts, and I hope this has been helpful for you as well.








Post a Comment