Value for customers is the purpose of all entrepreneurial business. Firms big and small must know, follow, and adhere to the principles of value creation. This is pragmatic not theoretical — the consequence of a failure to do so is that the firm cannot survive.

Bartley J. Madden studied value creating firms as a co-founder of a successful investment research firm and then managing director of Credit Suisse HOLT. He is now an independent researcher and founder of the Madden Center For Value Creation in the College of Business at Florida Atlantic University.

He joins the Economics For Business podcast and shared a summary of a lifetime of research.

Knowledge CapsuleA systems thinking approach provides the best route to understanding value creation.The business firm is a sub-system within a bigger system, that of society. The effectiveness of the firm is tied to organizational learning and the evolution of dynamic capabilities. Bart Madden’s pragmatic theory of the firm treats it as a holistic system with a well-defined purpose. If it is successful in achieving its purpose, it will benefit the larger societal system.

The purpose of the firm is a four-fold composition of mutually reinforcing goals.Sometimes, the business literature is guilty of treating purpose as a PR statement, a catchphrase that can be communicated without it necessarily governing the firm’s behavior. Bart Madden’s view of purpose demonstrates much greater depth, appropriate for complex systems management. Purpose is 4-fold:

1. A vision of the value that can be realized by customers, and that can inspire and motivate employees to work for a firm committed to ethical behavior and making the world a better place through customer value. Customers consume value by experiencing it in their interactions and relationships with the firm. The customer’s experience is dynamic within their own system of competitive offerings and alternative choices.
2. Survive and prosper through continual gains in efficiency and sustained innovation. These are long term performance variables that depend directly on a firm’s knowledge-building proficiency. A firm must generate a return that is greater than the cost of capital, and as it matures, this return can be eroded away by competitors who offer lower prices or different features to customers. Building knowledge and translating it into new business capabilities is critical for long-term survival.
3. Work continuously to sustain win-win relationships in every direction. Relationships with customers are primary for value creation, and relationships with employees and managers must generate the understanding, motivation and commitment to delivering customer value, while relationships with suppliers, collaborating firms and other partners must result in their best support for value creation. It’s a way of living and doing business that engenders trust all around. Shareholders are also rewarded as a consequence of these relationships.
4. Take care of future generations. The long-term view of the pragmatic theory of the firm as a system within the bigger system of society emphasizes thoughtful concern for the future, so that return on capital can be sustained. Paying attention to minimizing waste in the earliest product and service design stages can serve the future, and this includes minimizing pollution (a form of waste) and reducing harm to the environment.

A firm that is successful in achieving its four-part purpose benefits customers, employees, partners, suppliers and shareholders, as well as society at large.

Nurturing and sustaining a knowledge-building culture is the most critical driver of long-term performance.Knowledge-building is a continuous loop:

Knowledge base, purposes and worldview: Every firm has a knowledge base that determines current perceptions or current worldview, which includes ideas and beliefs and assumptions about interacting with the world.

Perceptions: We see the world through our perceptions and construct our reality that way. We may be self-assured about some favorite ideas about the obvious way to proceed, but we may be proven wrong via future learning.

Purposeful actions and consequences: With its purpose in mind, the firm takes actions, and each action has consequences, which may or may not have been anticipated.

Feedback: Learning from actions and their consequences is consumed as feedback, a critical component of the knowledge-building loop. The knowledge base changes as a result of this learning. An existing assumption may be replaced. Humility is important when traversing the knowledge-building loop.

New understanding and new perceptions: As a result of feedback and learning we may be able to evaluate our assumptions differently and perceive the world in a new and more accurate way.

It’s hard to be skeptical about our own strongly held beliefs, and therefore a cultural commitment to experimentation — the kind that’s capable of revealing obsolete assumptions — is necessary.

Knowledge-building stems from firm culture.Knowledge-building proficiency is a culture which views everyone in the firm as a value creator and a knowledge worker who can continuously improve their own problem-solving skills. This, in turn, motivates all employees since they can take great satisfaction from their jobs.

One of the errors of the traditional command-and-control management structure is that it assumes the smartest people are “higher up”, and it takes decision-making away from those closest to the customer and to the most relevant knowledge. The higher-ups set short-term targets for the employees, which is inconsistent with treating individuals as learners and value creators.

Knowledge-building occurs, and must be nurtured, at every layer of the firm.

The correct view — and the correct measurement — of firm performance is the life cycle.All firms traverse an inevitable life cycle. Bartley J. Madden’s books and research picture it this way.

During a period of high innovation, economic returns are high, and firms can reinvest at a high rate. This inevitably fades as competitors erode the advantage. In maturity the returns approach the cost of capital, and the business model may fade to the point where it fails to make the long-term cost of capital. That’s why firms must always be investing in long term new innovation projects for continuous refreshment and to repeat the high return stage. They must demonstrate to investors a skill in making these high return long term investments. The stock price is an appraisal of this skill.

The life cycle components are the long-term cost of capital, the return on capital that results from knowledge-building proficiency, the fade rate and the reinvestment rate. The metrics of firm performance are those related to the life cycle.

Additional ResourcesThe Pragmatic Theory of The Firm and The Knowledge-Building Loop (PDF): Mises.org/E4B_199_PDF

Books by Bartley J. Madden:

• Value Creation Principles: The Pragmatic Theory of the Firm Begins with Purpose and Ends with Sustainable Capitalism: Mises.org/E4B_199_Book1
• Value Creation Thinking: Mises.org/E4B_199_Book2
• CFROI Valuation: Mises.org/E4B_199_Book3
• Reconstructing Your Worldview: The Four Core Beliefs You Need to Solve Complex Business Problems: Mises.org/E4B_199_Book4

Paper: "Bet on innovation, not Environmental, Social and Governance metrics, to lead the Net Zero transition" by Bartley J. Madden (PDF): Mises.org/E4B_199_Paper

Good Strategy Bad Strategy: The Difference and Why It Matters by Richard Rumelt: Mises.org/E4B_199_Book5

Plain Talk: Lessons From A Business Maverick by Ken Iverson: Mises.org/E4B_199_Book6