I have been thinking about something that is so obvious within conventional accounting that almost no one thinks to question it. It is the assumption that labour is a cost.
Every accountant thinks this. A business has sales, and from those sales it deducts the costs incurred in generating them. Those costs include materials, energy, rent, depreciation and, most importantly for many businesses, wages and salaries. What is left after those costs have been deducted is called profit.
But suppose we ask a different question. Suppose that the purpose of a business was not to maximise the return to capital but was instead to maximise the sustainable return to labour. What would accounting look like then?
I think the answer is that it would look very different indeed, and there is no reason why this need not be the case, and why it should not be. That is because there is unlimited financial capital in this world, and limited labour, which is why it makes complete economic sense to presume that the return to labour is what an economy should maximise.
Critically, this matters because accounting is not neutral. Accounting decides what we record, what we ignore, where we draw boundaries and, crucially, what we call income. Those decisions profoundly influence how we understand economic activity, and the treatment of labour proves the point.
Who gets the residual?
Conventional accounting broadly assumes that revenue, less labour costs and other costs, leaves profit attributable to capital. Of course, actual accounts are more complicated than that, but the essential logic is clear. Labour is treated as a cost. The payment of wages reduces profit. If wages increase by £1 and nothing else changes, profit falls by £1.
From the perspective of the owners of capital, that makes complete sense. In the currently accepted accounting framework, the worker's gain is their loss. But there is no natural economic truth in this accounting. Instead, that accounting has adopted a perspective. It has been decided that the return to labour is a cost, while the return to capital is the residual we call profit. That is a choice.
What if we choose differently? Suppose instead that the purpose of the company is to maximise the sustainable return to labour whilst maintaining the capital required for the business to continue. The calculation might then be revenue, less external inputs, less the cost of maintaining capital and an appropriate required return to capital, with what remains being the return to labour.
Suddenly, wages have a very different character. They are no longer simply a cost incurred on the way to calculating the return to capital. They are part of the return that the organisation exists to generate.
Imagine, for example, a company with sales of £1 million. It buys £300,000 of goods and services from elsewhere and pays £500,000 to its employees. Suppose another £50,000 is required to maintain its productive capital (which is the estimated cost called depreciation provided in most accounts) and to provide an appropriate return to those supplying financial capital. Conventional accounting would then say that there is £150,000 of profit left out of which a dividend might be paid over and above the return already required by those supplying capital.
But why should that £150,000 be the measure of success? Why does the £500,000 paid to labour count as a cost whilst the £150,000 left for capital counts as the residual whose maximisation supposedly indicates that the business is doing well? There is nothing inevitable about that conclusion. It only follows from the perspective from which the accounts have been prepared.
An alternative accounting could say that £50,000 is the necessary cost of maintaining and rewarding financial capital, leaving £650,000 as the return generated for labour. Of that sum, £500,000 has already been distributed as wages, leaving another £150,000 available for employees, whether as additional pay, enhanced pensions, improved working conditions, reduced working hours, better training, greater employment security or other provision for their future benefit.
Nothing about the underlying economic activity has changed. The company has sold exactly the same things, employed exactly the same people, used exactly the same physical resources and generated exactly the same amount of value. All that has changed is the question that the accounting is designed to answer, which is who is it that has a claim on this return?
Accounting as political economy
This change in perspective has significant consequences.
If the company in my example increased wages by £100,000, conventional accounting would report that its profit had fallen by £100,000. On the conventional measure, its performance would appear to have deteriorated. But if the purpose of the company was to maximise the sustainable return to labour, precisely the opposite conclusion might be reached. The company would have succeeded in distributing another £100,000 to the people whose work helped create its value.
The accounting definition of success would have been reversed.
There are, of course, limits to this argument. Labour still has an opportunity cost. A business needs to know how much labour is required to produce something. It needs to know whether resources are used efficiently, and it cannot simply ignore what it pays employees when making decisions, although it might more appropriately consider their time. But none of that requires us to assume that labour must be treated as an expense whilst the return to capital must be treated as the residual measure of success.
That assumption reflects a particular theory of the firm. More specifically, it reflects a theory in which the company exists primarily for the benefit of those who own its capital but who, in many cases, have no legal involvement in its affairs. Accounts designed around the needs of capital inevitably answer the questions that capital wants answered. They do not necessarily answer the questions that employees, communities, governments or society need answered.
Value distribution
We could instead produce accounts that began with the value created by an enterprise and then showed how that value was distributed.
They could show:
- what is required to maintain productive capital,
- what provision is required to ensure sustainability,
- what return is necessary to secure the financial capital the business requires, and
- what return is generated for labour.
That last return could include wages, pensions, benefits, training, improved working conditions and whatever surplus remains available to enhance the wellbeing and security of those who work within the enterprise.
The resulting measure of performance would not be profit maximisation. It would be the maximisation of the sustainable return to labour, subject to maintaining the resources required to ensure that the enterprise could continue to meet need in the future. The going concern principle would still, in other words, apply, which is what almost all workers desire, and have most interest in maintaining.
That point matters. No business can distribute today what must be retained to ensure that productive capacity, human capability and environmental resources remain available tomorrow. Capital maintenance, properly understood, is essential to any meaningful calculation of income and is specifically provided for in what I note above. But once that requirement has been satisfied, there remains a profoundly important question about who should receive the residual.
Conventional accounting provides an answer without ever admitting that it has asked the question. Its answer is capital.
I suggest we could answer labour instead.
Once we realise that possibility, something significant follows.
What accounting is for
Accounting would not then simply describe the economy it is presumed we have. It might also help us understand what that economy is for. If labour is always described as a cost whilst profit is described as the principal measure of success, we should hardly be surprised that businesses seek to suppress wages in pursuit of higher profits. The accounting framework tells them that doing so represents improved performance.
Change the accounting objective, however, and increasing the return to labour can become evidence of success rather than failure.
The accounts would still balance. Double-entry bookkeeping would remain entirely intact. The transactions would be exactly the same. What would have changed would be the purpose for which the information was organised and the question that the resulting accounts were intended to answer.
That suggests that accounting is considerably more political than most accountants like to admit. The decision as to whether labour or capital gets the residual is not a bookkeeping necessity. It is a choice about whose interests the enterprise exists to serve.
Maybe it is time we designed accounting systems that recognised that possibility. Maybe, in other words, we should start accounting as if work, and the people who do it, really matter, and matter most of all, because without it there could be no return to capital.
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[…] morning's post on accounting with labour as the residual is the sort of thing that happens when I take an idea for […]
” No business can distribute today what must be retained to ensure that productive capacity, human capability and environmental resources remain available tomorrow.”
Unless of course you are an English water company!
True!
Thanks to all for such outstanding lateral thinking!
Might taxation thinking and practices be modified to accept, faciliate and eccourage practicalities from this original thinking?
Yes – but that’s not for today
Many Many years ago somebody pointed out to me that Ordnance Survey maps are about travel – getting from A to B and that it would be possible to redraw them to reflect a different purpose – he suggested Pubs serving Real Ale or you might want ones with Bird Information on them.
So yes its a different version of the same theme, what else can we repurpose in the same way?
A good question
I have been working on it this week….
What does the word “ordnance” mean? The maps were originally about aiming guns.
Correct.
Now it is legacy description.
My thoughts immediately turned to those businesses whose function is already maximising the return to CEOs, & senior executives, in addition to shareholders. Eg: – banks and water companies. They already move the accounting goalposts to achieve some of what you suggest – but at the expense of sustainability, legality, their creditors, and the public good.
As examples, take Thames Water and J.P. Morgan, both currently lobbying gov’t hard to organise things so that state of affairs can continue, especially benefiting the income of their CEOs.
But they beautifully illustrate how a business and its accounts can and do already function to maximise the return to (a tiny proportion of the workforce (as long as the government keeps bailing them out).
As they already operate partially this way, there can be no objection in principle to extending the idea across the whole of their business, with a revolution in accounting. Thames Water seem open to doing their accounts in a radical new way (cancel our debts, cancel our fines, relax the regulations) , but unfortunately not for the public benefit.
In short, you are suggesting a change in accounting methods to promote public benefit. I want to remind your detractors that they already have bent, twisted and obfuscated accounting rules to their own minority, private advantage, and damaged the rest of us. What you suggest would make a pleasant change!
Thank you
It reminds me of what some American economist once said (was it Paul Krugman?) who said that ‘everyone’s wages is someone else’s wages’.
Your post underlines to me what the big issue with modern capitalism is – it’s ALWAYS about achieving monopoly – domination rather than accommodation like the Quakers/Puritans might have done.
Even when the modern capitalist has corrupted politicians and all the laws, they still think that they carry all the risk and should be rewarded for it. It goes back to pleonexia again – allowing wealth to grow so much actually destroys what is human in the rich and they disconnect – they are both victim and oppressor. The accounting you describe is just ‘machine accounting’ – looking at each quarter for more and more, with no sense of where ‘more’ is coming from.
You get it….
That has blown my mind away and made my day. Thank you Richard
Thank you
I remember my reaction to first reading about the government policies in the 1920s to reduce wages. Are these people completely stupid?! Do they not understand that their employees are also their customers?! I have since come to learn that common sense is not as common as we might wish it to be.
For the majority of businesses, taken overall, maximising the return to labour is the same thing as maximising the demand for their own products.
You pretty much get it.
A business trying to maxmise the return to labour is called a partnership. There are plenty of those and they follow exactly the same accounting principles as other businesses which can be summarized as: revenues minus costs. End of.
You are completely wrong.
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A partnership declares a return to the owners of its capital. It treats employees as a cost.
You have totally misread what I have said.
You are not alone. But anyone claiming what I have written relates to a partnership or employee conned company has missed the point. They all declare returns due to the owners of their capital.
I am saying the return should be recorded as being due to employees. It seems that this is so shocking you cannot even comprehend it.
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I’d give this 5 stars if I could. Original and mind changing, examining assumptions which shape behaviour. Next level thinking.
Thank you.
I acknowledge I discussed something like this with Prem Sikka, a long time ago
What you have described it a partnership, where every worker has a share of the equity. Or a co-operative. Or an employee owned company, where all of the shares are held for the benefit of the employees.
No, I described an accounting system.
IFRS would not permit any of them to account as I suggest.
That was my point.
RobertJ mentioned “those businesses whose function is already maximising the return to CEOs, & senior executives…”
From my position of complete ignorance about either company finances or accounting, I did wonder about that too. Is remuneration for executives lumped together in the accounts with the wages for the “ordinary” workers, and treated like them as a cost? I had the impression that senior pay packages are often negotiated individually – and given the eye-watering sums companies seem willing to shell out to “attract the best talent”, do they see it more as an investment than a cost? I suppose my question is, how would your (very commendable) labour-centric accounting deal with executive pay?
It’s also occurred to me that, with employers starting to shed workers in favour of AI, maybe the ship has sadly already sailed on this one? Though I would still like to see it put out there – now more than ever we need challenges to established ways of thinking.
Almost no company can survive without employees – unless it is about rent extraction.
My point is, if AI is universal, labour is even more important.
Would you say that the employee ownership model goes some way towards running a business with the focus your approach promotes, while continuing to operate within the assumptions of the conventional accounting framework? I’m thinking that it doesn’t directly challenge the focus on profit but, by changing the balance of who benefits from it to something more equitable, it can encourage a management ethos with a more holistic view of its purpose.
So why not change the focus on profit?
That is my whole point.
You say that every accountant thinks that labour is a cost.
Prem Sikka is an accountant and does not think this, going so far as to lament the smaller than expected number of jobs to be created by new data centres. And strangely he does not get monstered in the comments.
I think this suggestion that labour isn’t a cost has been around for as many decades as I’ve lived.
I agree.
Prem and i discussed something like this idea many years ago.
That is two then.
How many more?
Very clever (dare I say revolutionary?) idea :
“…there is unlimited financial capital in this world, and limited labour, which is why it makes complete economic sense to presume that the return to labour is what an economy should maximise”.
I’m no expert but isn’t this basically what employee ownership is supposed to be?
I wonder why it doesn’t seem to be as successful as it should be – so Waitrose employees are consistently paid less than Aldi’s and they are left waiting to see if they catch up with Aldi (or not) via their end of the year employee bonus.
Also it would take very careful rules because when, for example, you are a working sole trader with employees and providing the capital either directly yourself or via a personally guaranteed bank loan if times are bad, the proprietor can on occasions earn less then the employees…
No, this is not what employee share ownership does to accounting.
I am talking about changing IFRS to require this, whatever the entity.