News item: Philips splits into two companies

In italic are the comments that I added on December 30.

In 1891, Philips started with manufacturing lightbulbs. The company became one of the world's leading technological concerns and this week, 123 years after its creation, Philips announced that the company will split in two seperate companies: Philips Healthtech (combining the former consumer lifestyle and health care divisions) and Philips Lighting.

Figure 1: source

In this post, I will try to explain the decision for this division by rationality as well as bounded rationality.

Rationality
Philips has been struggling over the last couple of years. In health care, the effects of the crisis are profound: hospitals postpone purchase of new devices and equipment, because of the large budgetary cuts they are facing. In consumer lifestyle the popular brand is suffering from severe competition and fake copies enter the markets in East Asia. In lighting, the margins on consumer light bulbs are thinner than ever, so that Philips has been forced to focus more on the maintenance and construction of complex lighting plans for public buildings or cities.

Philips' CEO, Frans van Houten, claims that this split will enable the separate firms to focus more on their core businesses, hereby creating more value for their customers and shareholders. Furthermore, the new structure of the company should lead to a saving of 100 million euros in 2015 and 200 million euros in 2016.

In decision making theory, rationality is a quite simplistic approach to explain decision making behaviour. Decisions are based on (economic) models, without any interference of emotions. You can view this kind of decision making as calculating. Philips' CEO states that he expects to save money now and earn more money in future by this decision - this sounds like a completely rational line of reasoning.

Bounded rationality

However, it might be a little short-sighted to assume that Philips acts 100% out of rationality. In decision making theory the notion of 'bounded rationality' was introduced. In this section I will first explain bounded rationality and then link it to the Philips case.

In his review on bounded rationality, Jones (2003) explains how processes that limit rationality within organizational decision making should and could be taken into account. Traditional theories of rationality do not work well with large uncertainties and imperfect information. Huge organizational decisions like the one Philips just announced can hardly be based solely on facts and calculations.

Jones explains how an organization is shaped by (unconscious) routines and structures that employees participate in. Throughout the years an employee works for a company, he or she will make decision based on earlier events, thus creating an 'organizational memory'. Parallel processing makes sure that employees can work on multiple streams of input simultaneously, thus allowing a company to expand.

However, there might be an unexpected change in the market that outdates these routines and structures. Parallel processing can than be replaced by serial processing, or centralized decision making. Serial processing allows for top-down implementation of new strategies within organizations  that are more change-averse due to this routinization. Emotional contagion, where management actively convince employees of the changed strategy, is of vast importance in the process.

This theoretical framework can be easily translated to the case of Philips. Apparantly, the old routines were not sufficient to cope with market changes. Therefore, top-down decision making took place, where Philips' CEO Van Houten emphasizes the importance of the split, in order to get the (emotional) support of shareholders and employees. This is thus an example of a change from parallel to serial processing.

Conclusion

Figure 2: source

The figure above shows the evolution of Philips' light bulbs. It's a clear illustration of the fact that the company has been able to anticipate on changes in the market for over a century. The recently announced split, that can either be explained by rational arguments or by bounded rationality in organizations, is Philips' latest strategical move. Let's see what it will mean for the survival of the company in the 21st century.

I feel that bounded rationality offers a way more advanced framework to explain decision making behaviour. Even in very simple situations, game theory has showed that human beings hardly ever behave rational. 

An organization like Philips is very large and very complex. Relationships between employees, management and other firms in the supply chain all shape the decision making process. I feel that only bounded rationality can take these processes into account.

Further thoughts on businesses and profits

Friedman's position

By addressing companies to take social responsibility, the public "harms foundations of free society" according to Milton Friedman. Relying heavily on arguments of principle - people can only be free in a free market society and governmental interference is intrinsically evil - Friedman fiercely attacks everyone in favour of companies who consider their societal impact.

Friedman's main point is that, if the leaders of stock listed company would invest in something other then financial profit, they would be spending someone else's money for societal purposes. Hereby the business man would be raising taxes, which is a problem, because a) collecting taxes is a monopoly for the government and b) the CEO would not necessarily know how to spend the money in a right manner.

My stand

To me, his argument is completely wrong.

First of all, the reasoning that firms should not act as governments can be rejected on his own free market principle. If shareholders disagree with a/the corporate policy, they can simply withdraw their shares and invest in a company that shares their values. Thus, the free market principle would actually undermine Friedman's argument. Besides, the notion that firms are not to function as a government is short-sighted. Within a firm we accept structures that remind us of a central government - firms are structured in a hierarchical manner for example -, so Friedman's argument would only be valid if he rejected the entire parallel between firms and central governments.

The other part of the argument - CEO's have been selected on their skills to lead a firm, not on their skills of honest distribution of wealth - is an oversimplification of the issue. If you don't know exactly what to do, than just do nothing. Our basic human nature is shaped through trial-and-error, so why not allow for learning in the transition from money-driven firms to people-planet-profit-driven firms?

Not business as usual

The documentary Not business as usual shows the concept of 'B Corporations'. B Corporations are labelled firms who include responsibility for the communities they are embedded in in their corporate DNA. Although this documentary slightly felt as a commercial, it showed me one huge flaw in my initial thoughts on the Friedman statement. 

Just as Friedman is unable to see the world outside his free market paradigma, I only focussed on profit in a calculable terms. I rejected the idea that only short-term financial profit should be taken into account, but I still had a rather abstract view of long-term profits for our ecosystems and the people living there. 

An important addition to my previous statement would be that people simply like to work for the 'good guys'. They enjoy helping each other and working on something way more tangible than financial profit. After all, we all want to be as happy as people in commercials.

  

Comment, 30-12-2014
In rereading my two posts on the Friedman principle (first before reading, than after reading), I can see that my opinion is way more structured in the second post. But I want to make an addition here as well. In the original posts I did not link my initial stand to my more developed opinion.

Originally, I claimed that Friedman's principle was merely a matter of definition. If one could interpret 'profit' as long term (non) financial benefits, then Friedman would be right. As I read the article, I found that the stand Friedman took was in fact based on a strong conviction that firms and the government should be strictly separated. I therefore disagree with Friedman more strongly now.

As I tried to explain above, I think this separation is not just unrealistic (in the sense that firms and the government are way more intertwined already), but also unwanted. Firms have more specific knowledge than a government within their field, which means that they have some sort of responsibility to act in line with that knowledge. Innovation, leading to more sustainable solutions than may be needed by regulations, is a process that is actually initialized by firms, even though it makes firms do more 'good' than they are legally required to do. 

To conclude, I feel my initial stand was short-sighted, but I feel that I was able to argue more clearly in my second post. Still, I feel that I did not clearly explain the development of my stand, which I tried to do in this comment.

Thoughts on businesses and profits

In this post I'll try to explore the stand that "the business of business is to increase its profits". I try to do this before I read into the subject.

Yes.

Of course the core activity of any company is increasing profit. Profits can be reinvested within the company to improve products and services and to match the (unknown) needs of clients. And profits can be seen as a reward for success as well. In that case, profits can be invested in the needs of employees besides the company (aka a nice holiday in Spain). 

In a way increasing your profits is what you do in your personal life as well. Assuming we all strive for a certain 'happiness', we constantly make choices that benefit us. We feed and shelter ourselves and we try to develop ourselves on a professional and personal level. We go to exhibitions, we meet friends, we read books; but in a way we only do it to make ourselves feel better.

No.

As a biologist, I tend to project an evolutionary framework on pretty much everything I see around, but I think in this case it makes perfect sense. The business of business is to keep existing. A company should seek ways to sustain itself, rather than always aiming at profit. 

If you try to sustain yourself, your actions will automatically focus on the long term as well. To use an enormous oversimplification: if you use all resources in year 1, you can close down your business in year 2. Therefor you need to take responsibility for the long-term effects of your business. 

I understand that this is easier said than done - if my competitor keeps his focus on the short term, why shouldn't I - but exactly this problem (aka the tragedy of the commons) is what put us in our current situation where we are using more resources than we should, causing major environmental problems.

This entire discussion might just be a matter of definition. If you see profit not just as short-term money, but as long-term benefits for all stakeholders, I can fully agree with the stand that the business of business is to increase its profits. 

Industrial ecology paradox

In italic are the comments I added on December 30.

Ten years in a row Air France KLM is the most sustainable airline in the world, according to the
Dow Jones Sustainability Index. Moreover, KLM was the most sustainable company in the entire sector transportation for the last six years. This makes KLM one of the twenty-five most sustainable enterprises in the world.

This summer I flew to Beijing, with KLM coincidentally. This added 1.24 tonnes of CO2 to my carbon footprint. Which is, according to www.carbonfootprint.com, about the same as driving 10,000 kilometers in an average car. Which is about the distance from Amsterdam to Peru. What I am trying to say is that, in short, flying is one of the least sustainable actions we perform.

So as I read that KLM was one of the most sustainable companies in the world, all I really thought was 'wow, they must have a great Corporate Social Responsibility (CSR) department'. To say the least, the news seemed paradoxical to me.

So what does my initial opinion tell me about this situation? I will not go into detail on the actual carbon footprint of a company like KLM, but I want to dig a little deeper into my own skepticism, as I feel it is shared by many others. Why am I surprised that an airline can be a leading sustainable company?

1. I'm fundamentally skeptical

I've studied ecology, so basically I have a deep understanding in how we are destroying the ecosystems around us. Add up a couple of years of watching the news and reading the papers and the simple consequence is distrust. I don't think I am the only industrial ecologist - to be - that struggles with the perception that the big companies are the 'bad guys' that drive climate change and obstruct the transition to environmentally friendly alternatives.

2. KLM is great at CSR

Maybe my skepticism is right. The Dow Jones Sustainability Index is meant as a benchmark for investors who want to take sustainability into account, therefor the largest companies in the world (2500 in the 'world-wide' category) are sent an extensive questionnaire. This questionnaire focuses on transparency and performance. 

KLM is of course investing in more sustainable alternatives to make their flights more efficient. But really the only thing this ranking says that KLM is doing better than other airlines, not that they are the greenest company in the world. KLM does just enough to be able to fully capitalize on the position as the most sustainable transportation company, but it is merely CSR.

3. KLM is a leader in sustainability

The Dow Jones Sustainability Index is created by RobecoSAM and assesses companies world-wide on their sustainability performance. They report there methodologies extensively. For the 'worldwide' category, the 2500 largest companies are invited to answer a questionnaire. For those companies who choose not to anwer, as much public information as available is inserted into the model. 

RobecoSAM has no interest in doing favours to any of the companies that are reviewed for their index, they solely want to create an accessible database that gives an overview of the most sustainable companies per sector.

As I wrote above, KLM is performing great over the last decade, according to the index. If a plane is more efficient, it needs less fuel, which makes the aircraft lighter, which makes the flight cheaper, which ultimately means more profit for KLM. And as in any company, I am sure that KLM's employees are to some extent worried about the environment.

By being ahead of its competition for a longer period of time, KLM proves that they are constantly seeking and implementing more sustainable ways within their field. It seems a little hypocritical to blame KLM for being unsustainable as long as we wish to use airplanes to transport ourselves and products we buy.

This blog has become slightly longer than I intended, as I got a bit carried away by the subject. I think that the only conclusion can be that the world is, as always, more complex. I think KLM is showing that sustainability is on their radar, at least they have managed to stay ahead of the competition for ten year. But indices never cover the full picture, so I do not feel that my skepticism was entirely wrong.

Comment 30-12-2014
This was the very first post I wrote for this course. I feel that if I had to write it now, it would be different in various ways, but the most important change that I would make is to make the content less personal. This post of course does not show a 'true' paradox, but rather a 'perceived' paradox. Even though perceived paradoxes can be of scientific interest as well, I am afraid that they are not if they are solely based on my own opinion.