Income & Profitability of enterprise

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MINISTRY OF EDUCATION AND SCIENCE OF REPUBLIC OF KAZAKHSTAN

ECONOMIC DEPARTMENT

COURSE WORK

Theme: Income & Profitability of enterprise

Economy of Enterprise

Kazakhstan, Almaty - 2010

CONTENT

INTRODUCTION

I. Accounting of Income & Profits of enterprise

1.1 The balance sheet & The income statement

1.2 Taxing complications & Creative accounting

II. Principles maximizing the profit of enterprise

2.1 The law of diminishing returns

2.2 Multiple inputs and the production function

III. The Five Critical Factors of Social Enterprise Profitability

3.1 Five factors of profitability

3.2 Business factors & trade-off factors

IV. Positioning In The Profitability

4.1 Lessons from Business Factors

4.2 Lessons from the Trade-Off Factors

CONCLUSION

LIST OF USED LITERATURE

INTRODUCTION

Status of the market economy at the present stage involves stringent requirements for the management system of the enterprise. Permanent changes in economic conditions require a rapid response management staff to support the financial condition of the organization and profitable company to change its policy toward the situation.

The basis activity of the enterprise is profit, a source of subsistence and development, the main objective and performance indicators. The company is planed by itself to develop its activities, based on the factor of demand for manufactured products, their capabilities and the need for further development. Independently planned measure is profits and options and ways to achieve it.

One of the main requirements of the functioning of enterprises are profitability of economic activities, reimbursement own income and ensures ¬ liver in certain dimensions of profitability, cost management. The main task of the company - is the implementation of economic activities, aimed at generating income to meet social and economic interests of new members of the staff and the interests of property owners of the enterprise. In conditions of perfect competition objective is to obtain revenue and earnings ? objectively certain: not to be displaced from the market, the firm should focus all their activities on maximizing profits.

The main indicators that characterize the financial results of enterprises are the revenue and profitability. Profitability index shows how well the company, which bring profit to invest capital. In domestic practice, a factor analysis was calculated recently. This circumstance is due to the fact that our country has not fully developed stock market. With the transition to a market economy rate of profitability is becoming one of the most important factors that characterize the effectiveness of key enterprise resources.

The use of profit as one of the key indicators in assessing the effectiveness of the enterprise - a complex process based on thorough knowledge of market conditions, business opportunities, conditions and factors that determine the competitiveness of enterprises, the ability to anticipate the real way to obtain high revenues, profits.

Relevance of the topic is that in today's economic conditions for the activities of any company is profit. In my course work I consider basic elements of company's earnings perfect competitor; determine the meaning and function of profits; identify factors affecting the profit margin; analyze the behavior of firms in the short and long term.

I. ACCOUNTING OF INCOME & PROFITS OF ENTERPRISE

Accounting records report the financial position of the business enterprise, providing management with information about the business that is essential for making wise decisions. Accountants also generate reports for use by those outside of the firm, such as the financial reports for shareholders and potential investors, including the tables that appear in the corporation's annual report. Before banks will make a loan, they appraise the creditworthiness of the borrower and carefully scrutinize the accounting records of the business in order to learn how much profit the firm has been making and how much the business is worth today. And of course, the Internal Revenue Service requires corporations to le tax returns reporting their profits and related information.

The Securities and Exchange Commission was created in 1934 to establish financial accounting and reporting standards for publicly held corporations. Since 1973 the responsibility for establishing financial accounting standards has been delegated to the Financial Accounting Standards Board, a private organization. This organization promulgates the Generally Accepted Accounting Principles (GAAP), which are officially recognized as authoritative by both the Securities and Exchange Commission and the American Institute of Certified Public Accountants. Nonetheless, GAAP leave considerable room for the firm's accountants to exercise discretion in preparing the books. In deciding such arcane issues as how to measure depreciation and what inventory accounting procedures to employ, the accountant has a certain amount of leeway to manage the profit picture that will be reported on the firm's books. Accountants may be encouraged by management to adopt strategies that put reported profits in order that the firm's stock will catch the eyes of investors, push up the value of the stock, and possibly lead to a bonus for the corporation's president. For tax returns the objective is just the opposite. The accountant may adopt tax-reduction strategies that will minimize profits that have to be reported for tax purposes.

1.1 The balance sheet & the income statement ^[4]

A firm's balance sheet provides a picture of the financial posture of the enterprise at a particular date. There are three major items on the balance sheet:

Assets: An asset is something of value owned by the firm, such as its holdings of land, buildings and machinery. Inventories of raw material waiting to be processed and finished goods that are unsold or awaiting shipment to customers are also counted among the assets of the firm. Cash in the safe and funds on deposit in the bank are also assets. So are patents and copyrights. If the firm has accounts receivable from its customers, they are listed among the firm's assets.

Liabilities: In accounting, liabilities are what the enterprise owes to its creditors. Included are funds owed to the banks, the value of bonds outstanding, accounts payable to suppliers, and taxes owed to the Internal Revenue Service. New Worth: The net worth of an enterprise is the accountant's estimate of the value of the firm to its owners. It is the excess of the assets of the firm over its liabilities.

The fundamental equation of accounting states the relationship between these three concepts:

Net Worth = Assets - Liabilities (1)

As this equation reveals, Net Worth is a residual. It is what is left over for the owners of the firm after the claims of all the creditors are met. Note that the firm's creditors are those who have lent funds (i.e., granted credit) to the firm. Stockholders are not creditors; they are the owners of the corporation, sharing in the profits or losses and, at least in principle, exercising control over the enterprise.

Now let us consider the simplified balance sheet for a hypothetical firm displayed on Table 5.2. First of all, note that the Assets of the firm are listed on the left side of the balance sheet and its Liabilities and Net Worth are on the right. This is in conformity with the following modification of equation (1):

Assets = Liabilities + Net Worth (2)

Thus the sums of the two sides of the table must add to the same number, and indeed they do, 1,550,000!

The accountant's treatment of plant and equipment requires explanation.

The 800,000 listing for plant and equipment is the amount that the firm paid for the various items on the dates when it purchased them; it is their historic cost rather than replacement cost.

Table 1. Balance sheet of the Fly-by-Nite Aircraft Company.

December 31, 2000 (All figures in 1,000)
Assets	Liabilities & Equity
Cash $ 150 Inventory 500 Accounts receivable 300 Plant and equipment 800 Less depreciation (200) 600 Total Assets $ 1550	Liabilities Accounts payable 50 Bonds 350 Total liabilities 400 Net worth = Equity Common stock 1000 Retained earnings 150 Total net worth 1150 Total Liabilities & Net worth $ 1550

Because the plant and equipment are far from new; they are not as valuable as they were when purchased. The depreciation item of 200,000 is the accountant's estimate of an appropriate allowance for the wear and tear on the plant and equipment. The number is placed in parentheses, which is the accountant's way of indicating that it is to be subtracted. Subtracting the depreciation from the original purchase price yields the accountant's estimate of the current value of the plant and equipment. The Final Plant and Equipment figure of 600,000 is the value of factory buildings and equipment at historic cost adjusted for wear and tear. But the figures have not been adjusted for inflation, which means that they may grossly understate the cost of replacement.

Liabilities appear as the first heading on the right hand side of the balance sheet. As of December 31, 2000, our firm owed 400,000 to its suppliers and bond holders.

The Net Worth item on the right side of the balance sheet requires further explanation. Net Worth is a residual. It is not apparent from the balance sheet, but as equation (1) made clear, net worth is obtained by subtracting Liabilities from Assets this gives us the Total Net Worth entry of 1,150,000. The retained earnings entry is the sum of profits that, over the years, have been plowed back into the firm rather than distributed to the owners as dividends. The entry for Common Stock is the total net worth entry minus the retained earnings.

The balance sheet is a statement about the firm's financial position at a particular point of time, in this case December 31, 2000. The balance sheet does not tell us how much in the way of profit the firm has made during the year or how much it has been paying out in dividends. Profits and dividend payments are examples of owes that take place over a period of time. Just as a snapshot cannot accurately reveal the speed of a cross-country runner, so too, a balance sheet cannot reveal profits. A second type of accounting record is the income statement (a profit and loss statement) reports on what happened to the firm over a period of time, just as a video camera may vividly reveal the speed of our cross-country runner.

Table 2. Income statement of the Fly-by-Nite Aircraft Company ^[4]

January 1, 2001 to December 31, 2001 (all figures in 1,000)
Net sales (50) Less Cost of manufacturing 550 Materials 200 Labor 250 Depreciation expense 100 Less inventory increase (100) Cost of goods sold (450) Gross margin 350 Less selling cost 30 Interest expense 20 Profits 300 Less corporate tax (105) Profits after taxes 95 Less dividends (100) Addition to retained earnings 95

The income statement. Suppose that during year 2001 the following transactions are recorded on the books of the Fly-by-Nite Aircraft Company (in 1,000): Materials Purchased 200; Labor costs 250; Sales 800; Selling Cost 30; Dividends 100; Depreciation Expense, 100; Bond interest, 20; Corporate Profits Tax, 105. Further, as of December 31, 2001, Accounts Payable was 100, Accounts Receivable 200, Inventories 600. How can we determine the firm's profits from this information? Table 5.3, the income statement, lays out the information in a way that makes it easy to see what has been going on. Here are some key points to note about the income statement:

- The income statement summarizes owes that took place during year 2001. We shall find that these owes will explain why entries in the end of year 2001 balance sheet differs from the year 2000 balance sheet.

- Observe that inventories have increased during the year. That is to say, part of the expenditures of the firm on purchased materials and labor costs were incurred in accumulating stocks of purchased materials and/or finished product that will be available for future use. These expenses should not be counted as part of cost of goods sold during the current year.

- Interest costs (which are income to the firm's creditors) are an expense that can be subtracted before computing the firm's profits, which are subject to the corporate profit tax.

- The corporation pays dividends from after-tax profits, but only part of after-tax profits are distributed as dividends to the owners of the firm.

- The addition to retained earnings of $95 constitutes funds kept back by the firm for future expansion rather than distributed to the stockholders. Stockholders may expect eventual rewards whenever they sell their stock because it should sell for more, thanks to the investment in plant and equipment financed from retained earnings.

1.2 Taxing complications & Creative accounting ^[4]

Capital gains. Suppose you had purchased 100 shares of Fly-by-Nite Aircraft for 10 a share on March 10, 1996. By December 31, 2000, Fly-by-Nite stock was selling for 15 a share. Thus the value of your holdings had increased from 1,000 to1500. This increase in the value of the shares is known as a capital gain, but because you have not sold the stock it is an unrealized capital gain. Unrealized capital gains are not taxable. If you sold the stock on July 1 for, say14 a share you will have realized a capital gain. The excess of what you sell your stock for over what you paid for it, $1400 $1000 = $400 is your realized capital gain, which is taxable. You will be pleased to find when you complete your income tax return the following April that yours is a long-term capital gain because you had owned the asset for more than a year. This means that your capital gain will be taxed at a maximum rate of 15% (or 5% if your income is so low that you are in the 15% income tax bracket). If you had sold the asset for less than you paid for it, you would have realized a capital loss, which would lead to a reduction in your taxes for that year.

Why should investors pay a lower tax rate on realized capital gains than a worker pays on earned income? This hardly seems fair, but there are two arguments for the favorable treatment of capital gains. First of all, the realized capital gain may be partially offset by inflation. Suppose that during the period you owned the stock the consumer price index had increased by 10%. Then the 1400 you receive when you sell your asset is worth only as much purchasing power as 1,400=1:1 = $1,272.72 when you purchased the asset, which means that your capital gain net of inflation, i.e., your real capital gain, is only $272, but you will be taxed on the 400 nominal capital gain. The favorable treatment of capital gains provides an imprecise adjustment for inflation. The second argument for favorable taxation of capital gains is that the taxation of realized capital gains has a lock-in effect. Faced with the prospect of a substantial capital gains tax if they sell their assets, investors may decide to hang on to stocks that they would otherwise sell. Taxing capital gains at a reduced rate is one way of limiting the strength of the lock-in effect.

Step-up-of-basis-at-death. Those who invoke the “lock in effect” to justify the favorable tax treatment of capital gains do not always champion the elimination of another type of “lock in effect.” If you hold your stock until you die, both you and your heirs will avoid the capital gains tax! The “step-up-of-basis on death” provision of the internal revenue code allows an heir selling an inherited asset to compute the realized capital gain on the basis of the increase in the value of the asset from when it was inherited rather than its price when initially purchased by the deceased. This means that no tax is ever paid on the gain in value that took place during the period in which the asset was owned by the deceased.

Stock market investors often complain that they are unfairly subjected to double taxation. First, the corporation in which they have purchased stock has to pay the corporate profits tax. Second, they have to pay income tax on the dividends they receive from the corporation. Thus, their investment earnings are taxed twice. Workers may sympathize with the stockholders' lament because they have to pay both the income tax and the Social Security tax on their wage income.

The actual burden of double taxation of corporate profits is not quite as severe as it appears for two reasons. First of all, only that part of corporate profits that is paid out as dividends is taxable income for the investor. Corporate retained earnings are not immediately taxable. The hope is that the shares will increase in value because the funds are being put to good use by the corporation. Thus, the personal income tax on the retained portion of corporate profits is postponed until the capital gains are realized when the stock is sold. And when the return is finally taxed it is at a much lower rate than wage income. Second, endowment investments.

II. PRINCIPLES MAXIMIZING THE PROFIT OF ENTERPRISE

The profit maximizing level of output for the representative firm is determined by the appropriate balancing of revenue and costs. We will show how the firm's cost function may be derived from its production function. Then we will seek the profit maximizing level of output.

2.1The law of diminishing returns

The Law of Diminishing Returns is the proposition that the additional output from successive increases of one input will eventually diminish, provided all other inputs are held constant. This law," stressed as early as 1817 by David Ricardo, has been regarded as of fundamental importance by generations of economists. Point a on Figure 5.4 and Figure 5.5 marks the point where additional labor starts to reduce the average product of labor. Point m marks the point of diminishing marginal productivity.

Two exceptions to the law of diminishing returns.

While the proposition may initially appear obvious, here are two exceptions that deserve consideration.

1. Pipeline: When building an irrigation pipeline, a major cost factor is the steel for the pipe. The number of square feet of steel required per running foot of pipeline obviously depends on the circumference of the pipe: C = 2рr, where r is the radius of the pipe. The capacity of the pipe in gallons per hour, given the pumping pressure, will be proportional to the cross-section area of the pipe, which is a circle with area A = рr2. Thus the cost/capacity ratio will be proportional to A/C = 2/r. This ratio, and hence the steel required per unit of output declines with output, violating the Law of Diminishing Returns.

2. Networks: Telephone, faxes and the Internet are all examples of net-works, and they all violate the law of diminishing returns. Their common feature is that the value of the network to any user depends positively on the number of users. If you were the only subscriber to the local telephone company, the service would be of no value because there would be no one to talk to. With two telephone subscribers you can call one person, with three two, and so forth. If x is the average value to you of being able to contact someone, then the value to you of the telephone is (n-1)x, where n is the number of subscribers (including you). The value of a network to the n users is v(n) = n(n-1)x = (n²-n)x. This demonstrates Metcalfe's law," the proposition that the value of a network is proportional to the square of the number of connected clients.

So too with Email, the fax machine and any other innovation where the value to each user of the device is proportional to the number of other users one can contact.

The concept of networking explains why many innovations are slow to catch on. It does not pay to join the network when there are few users. But once the number of users reaches a critical mass, the rewards clearly outweigh the cost, and more and more users rush to take advantage of the innovation.

2.2 Multiple inputs and the production function^[4]

A natural extension of the total product curve is to include more than one input, which brings us to the concept of the production function. The production function is like a recipe book in that it shows the level of output that can be obtained by applying various combinations of labor, machinery and equipment, raw materials and other inputs.

While in reality the typical firm uses a wide range of resources in producing a number of different products, it is appropriate to narrow our attention to the essential features of the problem by supposing that our hypothetical firm produces one type of product utilizing only two inputs, labor and capital. Here we mean by capital the machinery, buildings, equipment and other durable items that are available for use in the production process. In reality there are many kinds of labor and types of capital employed by a business enterprise, but we shall neglect these complications and assume that we can talk meaningfully about the quantity of labor and capital services that are employed by the firm. Thus we shall write our production function as

q = q(L;K)

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Leverage a business-user-driven profitability modeling environment to create, maintain, and deploy cost and profitability models. Deliver a flexible allocation platform that supports multiple cost and revenue modeling approaches, and can be combined to form custom allocation methodologies. Drive rapid application design and iterations through a flexible business rules engine and intuitive interface, making it easy to build dimensions, hierarchies, metrics, and scenarios. Reveal a new level of transparency into cost and revenue allocations via traceability maps that can verify that business rules have correctly applied.

III. THE FIVE CRITICAL FACTORS OF SOCIAL ENTERPRISE PROFITABILITY

What are boards, investors and management teams to do when there is tension between the financial and social bottom lines of social enterprises? And are there ways of optimizing the financial performance of the business without negatively impacting the social performance?

This part of work describes some of the learning Social Capital Partners has gleaned from seven years of investing in employment-based social enterprises. We identify what we believe to be the five most important factors that determine whether a social enterprise will be profitable or require some form of subsidy.

Employment based social enterprises are a unique business model with 2 bottom lines - the social bottom line of helping disadvantaged populations find meaningful work that can lead to a sustainable livelihood, and the financial bottom line of running a viable, sustainable business that provides valuable products and services to an appreciative customer base for a healthy financial return.

But what are boards, investors and management teams to do when there is tension between these two bottom lines? And are there ways of optimizing the financial performance of the business without negatively impacting the social performance?

In this article we attempt to use the learning that Social Capital Partners (SCP) has gleaned from seven years of investing in employment based social enterprises to help answer these questions. We identify what we believe to be the 5 most important factors that determine whether a social enterprise will be profitable or require some form of subsidy and divide these factors into two subgroups:

1) the “business” factors -- those factors or choices that normally only affect the financial bottom- line;

2) the “trade-off” factors - those factors where optimizing the financial bottom-line will negatively impact the social bottom-line and vice-versa.

We have also provided a framework and some tools that can help boards and management make conscious choices with respect to these factors that hopefully will create better alignment between the social objectives they have and the financial constraints they must operate under. By using this framework we hope that all critical stakeholders will have more realistic upfront expectations on what a given employment based social enterprise can accomplish on each of its bottom lines.

3.1 The Five Factors of Profitability ^[5][6]

There are obviously many choices or factors that influence the financial performance of a social enterprise, but it has been our experience that the following five in particular have a disproportionate impact on its financial success:

1) The inherent business capacity of the social enterprise;

2) The complexity of the business;

3) The size and nature of the employment barriers of the people being hired;

4) The skills/training gap which is the difference between the skills of the people being hired and the skills required to make the business successful;

5) The degree of emphasis on the social mission in the day to day decision making process.

The first two of these factors we refer to as the business factors because they usually affect only the financial bottom line of a social enterprise and not the social bottom line. The last three factors we refer to as the trade-off factors because optimizing the financial performance of a social enterprise with respect to these factors will generally involve a reduction in the social outcome and vice-versa

We have attempted to illustrate the financial impact of these factors in Figure 1 below. A certain set of choices with respect to these factors will significantly increase the probability that the social enterprise will be profitable while a different set of choices will virtually guarantee that the business will need some form of ongoing subsidy. We will be referring to this diagram through out the article. Our belief is that the boards of a given social enterprise should consciously choose where to position themselves on this web given their financial situation and social objectives and make choices to achieve the desired outcome.

3.2 The Business Factors and Trade-Off Factors

1) Inherent Business Capacity. Our belief is that, all other things being equal, social enterprises with significant business capacity will perform financially better than those with limited business capacity. That seems like an obvious enough conclusions, but it is one that often is either implicitly or explicitly discounted by charities or non-profits starting a social enterprise. There is sometimes a perception in the nonprofit world that starting a business will automatically result in a profit and that management who has demonstrated the capacity to operate a non-profit successfully will automatically demonstrate that same capacity in a social enterprise. It doesn't always work that way.

What do we mean by inherent business capacity? First of all we would divide it into two component parts - the operating capacity and the financial capacity. By operating capacity we mean that management possesses all the requisite skills to successfully run the business. That means its management and personnel know how to source its product or service, how to add value to it in a way that its customers will pay for, how to sell and market it profitably, and how to recruit, train and motivate quality employees. By financial capacity we mean that the business always knows its financial situation, has good controls over its assets and liabilities and has the ability to raise capital to finance its growth. In general a social enterprise (or for that matter any business) has to be good at both in order to be financially successful.

The good news for non-profits contemplating starting a social enterprise is that even though they won't necessarily have the requisite operating capacity internally to run the business it is not that hard to acquire. It's been our experience that there is a pool of management talent that wants to find more meaning in their career and is intrigued by the idea of managing a business with a social purpose. The bad news is that often these people cost more than the non-profit is used to paying and many non-profits are reluctant to hire people from outside their organization that they might have to pay significantly more than their executive director. Unfortunately, often that means they hire people who are not as qualified and lack the relevant industry experience and then are disappointed when the social enterprise doesn't perform financially as well as they expected.

Having the appropriate operating capacity, however, will not ensure financial success. A social enterprise (or for that matter, any enterprise) must have the appropriate financial capacity as well. There is a saying that businesses are just as likely to go bankrupt from too many sales as from too few. That's because uncontrolled growth when a company does not have good controls over its assets and liabilities and is not on top of the cash flow impact can easily destroy it, even when it is producing a high quality product or service.

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An investment we made in a cafe, catering and food services social enterprise was a good example of this principle. It was managed by a very talented former executive chef from a large hotel chain who, along with his team, consistently produced high quality food offerings that its customers valued and enjoyed. It had the requisite operating capacity. It didn't however, have solid financial systems in place.

Its problems began when its growth took off. The company landed a couple of large contracts and the number of employees tripled over a three-month period. This kind of growth is challenging even for a company with a very solid financial foundation in place - it can be back-breaking for one with a poor foundation. The company did not have good controls over its assets (food being the primary one), could not produce timely, accurate financial information to aid its pricing decisions, and couldn't accurately forecast its cash flow. Management actually believed the company was doing well when in fact it was financially imploding. It didn't have the requisite financial capacity to know that it was suffering serious losses on its increased business so that, by the time the true picture was understood, the company was in receivership.

2) Complexity of the Business Model. By complexity of the business model we essentially mean the degree of difficulty involved in operating the business successfully. Does it require specialized industry knowledge or expertise? Is the quality of the product or service being offered of significant importance to the customer? Is there a high degree of customization required in making the product or delivering the service? Does it need specialized systems to operate effectively? The more “yes” answers to questions such as these the more complex the business will be to operate and the more difficult it will be for a given social enterprise to be financially successful.

An example of a complex business model in our portfolio is Inner City Renovation (ICR). ICR is a renovation company that renovates housing and commercial projects in Winnipeg. It's a complex business for a whole host of reasons. For instance, every renovation job is different and so there is a high degree of customization required; to win business involves submitting a fixed price bid which requires a significant expertise in costing a job and then executing based on those costs because the business can't afford surprises. Virtually every job involves sub-contracting portions of it to qualified electricians and plumbers that have to be priced appropriately and managed so they deliver their services exactly when required, the quality and timing of the work is of huge importance to the customer and there are significant negative repercussions to the business if these expectations are not met. The point is that this is a difficult business to operate successfully and requires specialized knowledge and expertise to do so.

This factor is strongly correlated to inherent business capacity. The more complex the business model, the more essential it will be for a social enterprise to invest in the hiring of external resources with specialized industry knowledge and expertise. It will be very risky for the business to do otherwise. At ICR, individual renovation jobs are managed on-site by foremen who have years of experience in the construction industry. This is obviously not a business where a nonprofit starting a social enterprise could simply hire some of its own best staff to operate it.

One way that some charities and non-profits have chosen to reduce this complexity factor is by partnering with franchisors. Recently we have been following that strategy at Social Capital Partners (SCP) as well. Franchising is essentially a way of turning what otherwise might be a complex business model into a “cookie-cutter”. In return for paying a franchise fee, the franchisee receives a systematized business model that they don't have to figure out themselves.

Ben and Jerry's Partner Shops are a good example of this. They offer charities that want to provide employment opportunities for at-risk youth the opportunity to operate a Ben and Jerry's franchise without being charged a franchise fee a win-win for both parties. It makes sense for Ben and Jerry's because community service is part of their mission, it enhances their reputation and they still can make money through the provision of the ice cream that's sold by the charitable social enterprise. It's also a great deal for the selected charities as the franchise model significantly reduces the financial risk by reducing the business complexity. It effectively allows them to operate near the centre of this strand of the web in Figure 1.

The Trade-Off Factors. ^[5][6]

3) Size and Nature of Employment Barriers. The social purpose of employment focused social enterprise is to employ disadvantaged groups. The mission is to enable them to acquire real-life skills that allow them to become economically successful members of society. Obviously there are wide differences in the definition of “disadvantaged” as well as huge variations in the job-readiness of different segments of these disadvantaged populations. The choice that a social enterprise makes of which type of disadvantaged population to hire and their relative job-readiness will have a large influence on whether the social enterprise will be financially successful.

For instance, it is generally harder to make a business work if the target employee group is “at-risk youth” than if it is new immigrants. Intuitively this makes sense. At-risk youth have very limited job experience and often have unstable family and housing situations. That's a difficult combination to immediately transform into a successful, productive, performing employee. New immigrants, on the other hand, often have years of successful job experience in their home country and usually more stable housing and family situations. What they lack sometimes are the necessary language skills as well as a local network to help them identify relevant job opportunities. These are often easier difficulties to overcome in terms of becoming a productive employee more quickly.

The job-readiness factor within a give target employee group is also a very important factor in the likely financial success of the business. For instance, within the at-risk youth population, there will be some that have overcome many of the barriers mentioned above and all they really need is to be given an opportunity in the form of a job to set them on the right course. There will be others who still have multiple barriers to overcome. It is obviously easier to have a financially successful business (one closer to the centre in Figure 1) if the employees hired are from the job ready segment of a given disadvantaged population rather than ones with multiple barriers still to overcome, however; it would be a greater social success story if people with multiple employment barriers were the ones being successfully employed (meaning positioning the company more to the outside on Figure 1). These are the trade-offs that stakeholders of social enterprises must think about in deciding who they employ.

4) The Skills/Training Gap on Hire. This factor refers to the inherent difficulty of the job for which the target employees of the social enterprise are being hired. The more difficult the entry-level job is, the more training that is required before an employee reaches an acceptable level of productivity. A significant training requirement obviously will have a negative impact on profitability.

This factor is a prime example of the kinds of trade-offs social enterprises face in deciding where to position themselves on the web in Figure 1. It is easier to make the business financially successful if the jobs being hired for are what are sometimes referred to as “McJobs.” In such cases, the gap between the skills of the people being hired and the skills needed to make the business work are not huge and so an employee can meet the required performance standards fairly quickly. However such jobs are not nearly as beneficial from the social mission perspective because the skills the employees are learning are not highly valued in the real world and so, arguably, they are not making significant progress towards economic independence.

In SCP's portfolio, we have examples of businesses with different skill gaps. TurnAround Couriers is a bicycle company that employs at-risk youth recruited directly from youth shelters. There is not a huge skills gap or training requirement in this business - the youth can be taught relatively quickly the skills needed to perform their jobs well. That makes it easier to make the business financially successful.

On the other hand, Inner City Renovation (ICR) in Winnipeg is a renovation company that employs urban aboriginals - the majority with limited formal education or skills training. In this business, there is a much longer training period needed before an employee can master the skills required to achieve similar productivity levels to employees in more traditional renovation companies. As a result, Inner City Renovations endured high start-up losses in its early years as this skills gap was being bridged.

Perhaps the optimal situation for a social enterprise is where it can offer entry-level jobs where the training requirements don't require a huge up-front investment as well as providing attractive career opportunities for their employees where, over time, they can learn new skills and earn significantly more income than is possible in the entry-level job.

A good example of this in the SCP portfolio is the Active Green + Ross franchises that we finance. Active Green + Ross are a car service company. An entry-level employee (in this case mainly at risk youth) does not need significant training in order to perform basic tasks like changing oil. That means that the business does not need to make a disproportionate investment compared to their competitors to make their entry-level employees productive. Yet, over time, the entry level employees can work their way to becoming a licensed mechanic which requires significant skill and provides attractive compensation and long-term financial sustainability. This is the best of both worlds scenario - attractive job opportunities without disproportionately high “skills gap” investments.

5) Degree of Emphasis on Social Mission. Employment focused social enterprises are double bottom line businesses with both a social mission (provide work for disadvantaged groups and significantly improve their long-term employability prospects) and a financial mission (generate revenue through the sale of products and services). As we have seen in the discussion of the previous two factors, the management of social enterprises often faces choices that promote one mission at the expense of the other. This final factor refers to the degree to which the management of a given social enterprise chooses to consistently emphasize the social mission over the financial mission in its day-to-day decision making (or vice-versa). Their bias on this factor will significantly affect the financial performance of the company.

There are numerous examples in a social enterprise where these tough choices come into play. For instance, how many chances should an underperforming employee receive before being let go? From a social mission perspective the whole point of the employment strategy of the business is to hire people who need extra support and training in order to be effective employees. This would dictate a very lenient policy with respect to termination. On the other hand, the business suffers if after multiple opportunities a given employee is not able to perform his or her responsibilities effectively. Moreover, if there are no consequences to consistent poor performance it sends a message to all employees that performance is not important, which is obviously not an appropriate way to prepare employees for their long term economic independence and success. This would dictate a less liberal termination policy. There are not right or wrong answers to issues like these. The point is the degree to which an enterprise has a social or financial bias in its choices will affect its profitability. An example of an issue where SCP (along with our partner Community Ownership Solutions1) was required to make a choice between the financial and social missions of a business happened with ICR. In its initial year of operation ICR lost more money than we planned. We decided in order to improve its future financial performance we would reduce the percentage of target employees in the company from 75% to 50-60%. In effect, we reduced the number of employment opportunities inside the company for the people we were trying to help. It did succeed in improving the financial performance, but, at the expense of the social mission. Strategically we wanted to move ICR more to the centre of the web and that necessitated the requirement to make choices that emphasized the financial over the social where those choices involved trade-offs.

accounting income profit business

IV. POSITIONING IN THE PROFITABILITY/SUBSIDY SPIDER WEB

The decisions that social enterprises make with respect to these five factors will determine where they will be located on the web in Figure 1. Social enterprises that are located near the outside edge of each of the five factor “strands” will require substantial ongoing subsidy if they are going to continue to operate. Training businesses or workshops that hire people with significant employment barriers and large skills gaps are examples of the types of businesses found here. The objective of these businesses usually is not to make money - it's to provide a sense of dignity, pride and purpose to people who are unlikely to be able hold a full-time job in a more conventional company. This overriding goal takes precedence over making the business financially successful and so there is a bias to the social goals in most business decisions.

Social enterprises at the centre of the web, however, can and should be financially self-sufficient. They are hiring the job-ready segment of disadvantaged populations, people who are ready to help themselves but just need someone to give them a chance. The entry-level positions are not overly challenging and thus don't require a massive investment in training and support before employees can be productive. Moreover, they have management teams with the requisite business capacity to succeed in a business that is not overly complex to operate. They are also prepared to sometimes choose the financial bottom-line over the social bottom-line when difficult trade-offs have to be made.

4.1 Lessons from Business Factors

The distinction between the business and the trade-off factors is crucial to understand because it is much easier to advise boards of directors and management teams on the best way to think about the business ones. Simply put, our advice is to do everything possible to choose businesses that are not overly complex to operate and to build management teams that have the inherent business capacity to operate them effectively. Put another way, our advice would be to try to be as close as possible to the centre of the web with respect to these two forces.

Insert background reference to Community Ownership Solutions - perhaps even an online reference.

Why is this advice easy to give? There are three reasons:

1. Unlike with the trade-off choices optimizing the financial results of the social enterprise with respect to these choices does not come at the expense of the social mission. For instance, there is no social compromise required when a social enterprise moves closer to the centre of the web in Figure 1 by improving its inherent business capacity. However, there is a social cost involved if it does so for instance by hiring a lower percentage of target employees or choosing only job-ready target employees. Any social enterprise looking to improve its financial performance should first exhaust improvement opportunities from the business forces.

2. Social enterprises are easier to scale if the business model is not overly complex and good systems are in place. A frequent implicit criticism of the social enterprise is that the business models are difficult to scale and replicate. Often the reason is because of these business forces. If a business lacks good systems, and is complex to run or has a management team without experience and knowledge of the industry it is going to be more difficult to grow.

3. Having good management with relevant industry experience in a less complex business model means that the board of directors and management can spend more time on making the social mission work. Whenever we have invested in social enterprises without those characteristics we have spent a disproportionate amount of board and management time on getting the business to work as opposed to the social mission of creating long-term sustainable livelihoods for the people employed. Ironically by optimizing the business forces more time and effort gets devoted to the social mission.

4.2 Lessons from the Trade-Off Factors

The advice we would give with respect to the trade-off forces is much more difficult because we don't believe there is a “right” answer. As we have suggested in the name, the very nature of these factors usually involves making progress on one part of the mission at the expense of the other. It is up to the board and management to determine the right balance.

The one piece of advice we do feel safe in giving is that the board can and should make conscious choices about these trade-offs and understand the likely consequences. The choice will often be dictated by the financial goals and constraints that the social enterprise is operating under. If the board determines the company has to be financially sustainable then it should make choices with respect to who it hires, the types of jobs provided and the degree of influence of the social mission consistent with the centre of the web. If, on the other hand, the business can be subsidized it can make a different, more “social” set of choices consistent with the outside.

One other critical point is that an understanding of these issues allows boards and management to check for alignment in their strategy and goals. For instance if they want their social enterprise to be profitable yet they plan to hire people with significant employment barriers into difficult jobs in a complex business without having significant business capacity, they are going to be disappointed. In effect their financial goal is to position the social enterprise at the centre of the web when an analysis of the five factors indicates they will definitely end up on the outside.

We try to illustrate these recommendations in Figure 2. The red dotted circle represents the viable positioning options that we believe the boards of social enterprises should consider when determining their strategy. Whether they are more towards the centre or the outside edge should be influenced by whether they must be financially sustainable or can be financed with some form of subsidy.

What a board wants to avoid is positioning their social enterprise in the green circle. This can happen almost inadvertently with a complex business model and where the management team possesses limited business capacity. Often this leads to the board trying to improve their disappointing financial results by financially optimizing the trade-off choices by hiring fewer target employees with fewer employment barriers into less skilled jobs. They effectively dilute the social returns of the business instead of improving the financial performance by improving their business capacity and or simplifying their business model.

CONCLUSION

I hope we have conveyed in this article, that as in conventional business, the financial results of an employment focused social enterprise are not random. Instead, they are significantly influenced by the choices related to five critical factors that every employment focused social enterprise must make. We believe one of the most important responsibilities of social enterprise boards, investors and managers is to make choices with respect to these factors wisely and consciously.