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19. Per Bylund: ACT! How To Apply Austrian Capital Theory In Modern Organizational Design, Contemporary Business Structure, and A High Response Business Model

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Austrian Capital Theory (ACT) sounds arcane, academic and complicated. In fact, it’s the key to modern organizational design, cutting edge business structures, and the high-response business models leading entrepreneurs deploy to win in today’s business environment.

Show Notes

Austrian economics recognizes that capital and resources are so varied and different today that agile entrepreneurs can combine them and recombine them in ways that are highly differentiated – even unique. Every firm is a capital structure that is in continuous flux, as the entrepreneur changes and adjusts to create new value in response to marketplace and environmental changes. Therefore, the whole economy is a changing, rapidly evolving capital structure, generating economic growth. It is the appreciation of the need to continually shuffle the firm’s capital combinations, and the mastery and agility in doing so, that marks the Austrian Entrepreneur. He or she is an orchestrator of capital, buying and selling capital goods and combining them with new and retrained workers to change production processes, scale up to new levels of efficiency, and to solve customers’ problems in new ways.

The purpose of the orchestration function is to achieve the highest return on capital by creating the most customer value. The value of capital is the future revenue streams it generates from customers, and revenues are a reflection of value created. Entrepreneurs examine every piece of capital, and every capital combination, to measure how much value creation it contributes. Could it do more? Can the entrepreneur render the capital more productive in maximizing value at the end of the production chain?

How can entrepreneurs assess whether their combination of capital assets is right? The managerial accounting of Austrian entrepreneurs is not identical to formal financial accounting. A conventional balance sheet is not going to tell the truth about the money-value of assets, since it is not based on assessing future revenue streams. And this year’s P&L is of little use since it is static and backward-looking. How can entrepreneurs differentiate between assets that it merely feels good to own and assets that genuinely create consumer value and future revenue streams? It’s not easy, but there are two useful steps, both of which focus you single-mindedly on the consumer.

  • Root out those assets that clearly do not contribute directly to consumer value, or clearly contribute very little. An office building might be one such example. It’s nice to have a central office, but couldn’t your employees contribute as much from a remote location, so that you can eliminate the cost of centralization?
  • Examine capital combinations that could contribute more if they are rearranged. A server + software + trained personnel is a productive combination. What if the entrepreneur could ditch the server and rent computing power from AWS? What if the savings could be reinvested in more training for the person or better software? Would this rearrangement contribute more to consumer value? Renting rather than owning assets is one way to add dynamic flexibility to the firm.

Austrian Capital Theory Diagram

The entrepreneur should focus the firm on what it alone can uniquely do for its consumers and customers. Outsource everything else. The firm is a necessary vehicle for the entrepreneur to take ideas to market to earn a profit. It is at its most efficient when it is 100% focused on what it does uniquely: its unique brand, its unique processes, its unique recipe, its unique design, its unique functional and emotional benefits for the consumer. Everything else should be stripped away. The necessary infrastructure can be rented or outsourced. If you own 10 computers and have 10 people sitting at them every day, it’s hard to identify what productivity you are getting out of each of them every day. If you don’t own them, and you are thinking rigorously about the future streams of consumer value your firm is producing, you won’t feel locked in to your current capital structure.

A “capital-lite” structure in no way reduces the market value of the firm – in fact, it can increase it. In the past, companies were valued based on the assets they owned, as captured on the balance sheet. But this valuation method was based on an assumption that the assets were owned because they produced consumer value and contributed to profits. What if the assets are not contributing to future profit? They become a liability. Firms like GE are finding this out today – they own a lot of non-contributing assets and face major transaction costs in shedding them.

There is no need to own consumer value-producing assets. You need to control then and have the rights to utilize them to produce value, but not to own them. In venture capital markets, it is common to see firms change hands at a price that represents a high multiple of revenues or of earnings, even if the traditional capital base is insignificant. Assets that don’t appear on the balance sheet, like brand and a loyal customer base, are more important than those that do.

ACTIONABLE INSIGHT: The Austrian Entrepreneur reviews combinations of capital and labor and non-capital resources at every moment, seeking ways to improve that combination for the consumer’s benefit.

The single-minded focus is on consumers and their changing preferences and the consequent implications for responsive change in the capital structure of production.

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18. Steven Phelan on How To Assemble A Winning Combination Of Resources

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Austrian Capital Theory holds that capital assets are heterogeneous and complementary. In business language, that means an entrepreneur can assemble set of assets that are special to his or her firm and combined in such a way that the combination is unique, or at least hard to copy. If the assets generate consumer value, and hence a revenue stream from consumer purchases, then the entrepreneurial firm can be said to have marketplace advantage – it is unique or advantaged in its creation of consumer value.

The Resource-Based View (RBV) of the firm came from this thinking. The marketplace advantage available to any firm results from its assembled resources (synonymous with assets for the purposes of our discussion). We talked to Professor Steven Phelan, Distinguished Professor at Fayetteville State University, an expert in this field.

Note: The conventional language of RBV is competitive advantage. At Economics For Entrepreneurs, we prefer the idea of the search for uniqueness, where the point of reference is the consumer rather than the competitor. Therefore, we’ll use terms like marketplace advantage and commercial advantage.

Show Notes

Resource-based strategic thinking guides entrepreneurs in the identification, assembly and use of resources in unique (or at least differentiated) ways to create sustained marketplace advantage. The use of resources is how entrepreneurs create revenue flows from consumers. The money-value of the resources – and hence the market value of the firm – derives from these revenue flows. The goal is to align the resources as perfectly as possible with consumer wants and preferences. Entrepreneurs who combine consumer-valued resources in unique ways can establish an advantage in the marketplace. If their combination of resources is unique, or at the very least hard to copy, then the advantage is sustainable and the revenue flows can be anticipated to continue absent changes in consumer preferences.

What kind of resources are we talking about? All kinds, both tangible and intangible, and both physical capital and human capital. It’s the combination that counts. A handy acronym for the kinds of resources available for entrepreneurs to combine is PROFIT: Physical, Reputational, Organizational, Financial, Intellectual and Human, and Technological resources. It’s a good exercise to review your resources under each of these headings and question whether they are unique and hard to copy.

Reputational, Organizational and Intellectual (Human) resources are the most usual sources of uniqueness (in the VRIO framework, “unique” translates into valuable, rare, hard to copy / inimitable and non-substitutable).

Reputational resources can include brand, customer satisfaction levels and trust.

Organizational resources can include processes, methods, and culture, and also includes the bundles of resources we call capabilities.

Intellectual resources include people (always unique), teams, decision rights, as well as patents and recipes.

Sustainable advantage is reinforced when other firms can’t see inside the “black box” of the combination of resources and can’t reproduce the “secret sauce”. It might be the case that your Physical, Financial and Technological resources are not differentiated, or even rare. The “secret sauce” is in how you combine them, and especially how you combine them with Reputational, Organizational and Intellectual resources. If outsiders can’t see inside, and can’t decipher the combination or copy the recipe, you can separate yourself in the consumer’s perception as a unique choice.

How you deploy the resources can also be a source of advantage. Operational excellence can be differentiating and value-creating. If you can guarantee customers and suppliers that you’ll operate with excellence in all directions – on time, on budget, high responsiveness – you’ll create an advantage over other firms that don’t keep their promises. Think of this as a bundle of resources that you deploy really well. The business literature sometimes calls it “core competence”. High quality, consistent operations do not come easily. This capability is also a resource.

Dynamic flexibility can be thought of as a bundle of capabilities around detection of and action in response to the need for change. Austrian economics stresses marketplace dynamics and the role of entrepreneurs in detecting and responding to changes in consumers’ wants and preferences. Such agility does not come easily to the firm. It requires “sensing” the uneasiness of consumers and using empathic diagnosis to identify the source of the uneasiness, and creativity and imagination in rearranging resources to produce new offerings. Organizationally, the entrepreneur must make the change occur – ready the organization for the adjustment and orchestrate individuals and functions to shift. It’s a rare capability.

Implementing the resource-based strategy is a continuous activity. Winning entrepreneurs shuffle and reshuffle resources continuously. Professor Phelan urges entrepreneurs to ask this question every day: what can we do better? Ask it in every resource area of the PROFIT framework. Gather information that tells you where you need to improve or change. (You can use a template like SWOT – Strengths, Weaknesses, Opportunities, Threats, but make sure your use of it is deeply analytical and not just a laundry list of what you do.) And then execute the hard part of dynamic flexibility: taking rapid action. This is the advantage of small companies and entrepreneurs.

Useful books mentioned by Professor Phelan:

Entrepreneurship Strategies and Resources; Marc J. Dollinger

The E-Myth Revisited; Michael E. Gerber

Crossing The Chasm; Geoffrey A. Moore

 

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Per Bylund’s Tweet Stream Explains The Concept Of Economic Cost And How It Directs Investment To The Highest Return Projects.

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The concept of economic cost seems to confuse people. It is not the price you pay for a good, but the reason you pay it. The cost of one action is the value you could otherwise have gained, from taking another action. In other words, if you have $100 and you have the choice to buy two goods, each at a price of $100, you’ll naturally choose whichever is more important (valuable) to you. The cost of it is not the $100, which you give up to purchase it, but the value of the other good, which you can no longer purchase.
That other good is the opportunity foregone by your action, the ‘true’ cost of your action–the economic cost. Why does this matter? Because our actions are intended to create value, and we always aim to maximize that (subjectively understood) value. The economic cost concept brings to our attention what we *actually* give up to get a value, and thus why we choose a certain course of action.
An economy, which is a system of economizing on scarce resources, is the systematic allocation of resources to maximize value. It is not about minimizing price paid, which is something different. It is about value. While this may seem like an academic point, the implications are enormous. Those who are ignorant of this concept focus on the outcome of action only–the “net gain”–rather than the cost. Doing so means we end up wasting enormous resources while not getting the value that was well within reach.
Examples of this include arguing that there were massive gains from, for example, World War II or the US space program in the 1960s. Both were enormously wasteful, but also generated tangible benefits. WW2 led to the discovery of artificial rubber, freeing us from costly and time-consuming rubber production. Yes, that’s a benefit. And there were plenty of technologies developed as part of the space program. Those were also benefits. But at what economic cost? That’s the real issue: what *other* benefits did we never see because we instead pumped in enormous resources into war and the space race? What other discoveries and innovations were within reach had those resources been used differently?
The WW2 example should be obvious, since the war itself was hardly productive. But the space program is exactly the same issue: what opportunities did we, as a society, forego because the government preferred to invest billions of dollars into the prestige program of beating the Russians to the moon? We don’t know what we didn’t get, of course. But this doesn’t mean we cannot say whether it was the right thing to do. The fact is that in a market system entrepreneurs compete with each other not to minimize cost, but to produce value. Naturally, this means *net* value: what actual benefit is provided in the eyes of the consumer. The entrepreneurs don’t know what consumers will value, but they bet their livelihoods on what they think will benefit consumers most. The result is a variety of goods and services from which consumers can choose, and they will choose what is the best option from their point of view.
What is not produced cannot be chosen. But what is not produced also does not seem to be worth it to the numerous entrepreneurs engaging in value facilitation for consumers. Note that this is not a matter of whether entrepreneurs can “afford” the capital investment needed. It is about the rate of return: whether the value is high enough above the outlays necessary to produce the good/service (the production cost). With a sufficiently high ROI, relative to other possible and attempted projects, entrepreneurs can always find the funds needed: investors are looking for a return on their funds, after all. So the argument that “only the government can” invest in something because it requires capital is bogus. It asserts problems that don’t exist, and often fails to properly apply the concept of economic cost (as in the examples above).
Economic cost tells us what is expectedly most important to people, regardless of the capital investment magnitude. Higher ROI means greater value, which means a higher price can be charged–and more profit earned. This is where economic cost is essential to understand the workings of the economy. Because if a project envisioned by an entrepreneur appears to be highly profitable, regardless of initial investment needed, s/he will pursue it. This means, at the same time, that other entrepreneurial projects, which are expected to provide a lesser return on investment, will *not* be pursued.
What matters for society and the economy is that the greater value is pursued, because it makes all of us better off. This is why, through competition, the swift weeding out of entrepreneurs with projects that do not actually produce much value is important: they literally waste our resources because the value foregone–the projects that were not undertaken because the resources were bound up in these lesser projects–is higher than the value produced. It is an economic loss regardless of what benefits came out of it.
Consequently, we can conclude that the space program, just like war, was a wasteful act. The government stepped in because no entrepreneur was willing to undertake it, which is because its expected ROI (if any) was much lower than other projects entrepreneurs could pursue. We don’t know what we lost, but it could have been cures for nasty diseases, doing away with poverty, or whatever. The fact that consumers were not expected to spend their own money on the space program, and the fact that no entrepreneurs expected that they would, at
least not to the extent necessary, means it was not considered valuable enough. Its economic cost was expected to be higher than the economic value!
Now, does this mean that nothing good came out of the space program? Of course not. There were innovations and technologies discovered that have served us well. But they were, at the time of investment, either not expected (at all) or not expected to sufficiently serve people. There are certainly examples of flukes that ended up creating beautiful things (like Arpanet becoming the Internet), but who in their right mind would argue that we should waste resources on grand government projects because there might be unintended consequences that we’d benefit from? Considering the economic cost, what we could have gained from that investment was expected (by everyone!) to be higher than the project pursued by the government.
That’s the reason the government did it: Government is in the business of wasting scarce resources at high economic cost, i.e. without sufficient expected value. No matter how one looks at it, this is wasteful.
Unless, of course, one ignores the concept of economic cost: the higher-value opportunities that are foregone–lost–because we’re instead pursuing the lower-valued ones.
To simplify, it is a matter of picking the low-hanging fruits first, because there is much higher return–greater “bang” for the buck–from doing so. It makes no sense climbing to the top branches “in case” there is some other and unexpected benefit from putting in the extra effort.