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The sum is less than its parts...

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The sum is less than its parts...

Tapping his inner geek, Rohan Martyres proposes a social corollary to the 2nd Law of Thermodynamics.  The implication for VCSE managers is that they should balance their investment in ‘disruptive innovations’ and ‘value-add initiatives’ with careful impact measurement and good old-fashioned virtues of simplicity and prudence.

 

The leading UK community charity Locality will take a ‘local by default’ campaign to this year’s general elections, calling for an overhaul of public service delivery in the UK.  One aspect of their campaign is based on a thought-provoking publication that asks whether local service provision could address the issue of diseconomies of scale.  The basic idea is that large, national bureaucracies delivering standardized human services invariably introduce significant wastage  and inefficiencies to the detriment of their beneficiaries and end users.

Defying the contemporary belief in ‘economies of scale,’ Locality argue that services involving ‘people helping other people’ are more likely to be effective and efficient ‘first time around’ if they are delivered by small, local providers working in collaboration, rather than large-scale, standardised services.

This is a very interesting train of thought.  But if we take it further, the results are not a simple good news story for voluntary, community and social enterprise (VCSE) organisations that seek to scale their activities.

 

 The problem with too much scale

How many of us in the social sector think that we can create exponentially greater social value by ‘scaling’?  By scaling, I don’t just mean adding a new geography to an organisation’s existing footprint, but also expanding the type of beneficiary groups served or adding more options to the ‘service menu.’ 

When it comes to designing interventions for social good, I dare say that most of us believe that the larger or more ‘holistic’ our organisations, the more good we can deliver; the more services we can coordinate and align within an organization or consortium, the greater our impact. 

As the chair of Global Fund for Women put it on their recent merger with a smaller organization in a recent edition of Alliance Magazine, “it’s a matter of multiplication not addition.”  In short, we tend to believe that the ‘sum is greater than its parts.’

Of course, any organisation needs to have a certain amount of scale before it can substantially invest in innovation and R&D, and thereby remain relevant to the evolving demands of its stakeholders.  However, research on the private sector demonstrates that being bigger is not always better.  For example, many if not most mergers and acquisitions actually destroy value rather than create it, yet over-confident CEOs persist in believing that that theirs will be different.  In fact, to bring in something apparently unrelated, fundamental physics suggests that the sum is never greater than its parts.

 

Lessons from the physics lab

The concept of ‘Entropy’ has been recast in many ways over the past 200-plus years, with such definitions as the ‘inevitable loss of momentum’ in a system of interacting objects, the ‘statistical distribution of energy’ within a system, or even the ‘increase in the amount of information needed to understand’ this system.

The main aspect of the concept I want to pick up here is that every change made to a physical system of interacting objects will waste energy.  This is encapsulated in the Second Law of Thermodynamics, which more or less implies that the only way to maintain a constant amount of usable energy in any given system is to add energy from a source outside the system.  However, this just replicates the problem on a wider scale: the larger system which includes the new energy source itself needs energy from another source to stay on a par.   This means that if we change how a certain group of objects are aligned within a system to make it more ‘efficient’ in some way, there will be a net loss in total usable energy in the system.

Obviously, the rules of fundamental physics cannot be applied directly to the activities of VCSEs and the creation of ‘social value.’  For the sake of clarity, by ‘social value’ I mean “change in the lives of individuals, communities and society at large, which those stakeholders experience as sustainably positive.”  (The point on sustainability is needed otherwise we would have include things like addictive drugs, which are only experienced as positive by their ‘beneficiaries’ in the short term).  However, the laws of physics are used to study ecological systems and even cities (see here for one leading physicist’s thoughts on scaling).  To boil the vexed issue of physical laws vs. social ‘laws’ down to a sentence, I’d say that social interactions require material resources to be sustained, and physical resources obey physics, so there is probably a correlation between ‘physical energy’ that is available and usable in a social context and the amount of ‘social value’ that can be created. 

These caveats on direct applicability notwithstanding, I’d like to propose two social corollaries to the 2nd Law of Thermodynamics.

  1. Everything an organisation does to create positive social value is a net destroyer of usable energy. 
  2.  The greater the number of resources we seek to harness within a system for social benefit, the quicker we deplete the net usable resources – and therefore potential benefit – available in that system.

If valid, my corollaries have far reaching implications both in theory and in practice.

First the theory.  These corollaries imply that if we take every externality into account, an organization will never ‘break even.’  Or to put it into ‘social value’ language: if a cost-benefit or SROI study treated the environment and its resources as ‘stakeholders’ in their own right, every £1 invested in a given service or intervention will always result in less than £1 in value created.

I know this is radical, but it doesn’t mean we should do nothing.  Quite the contrary, as no matter how bad the situation, there are both moral and pragmatic reasons for improving everything we do as much as we can.  So what are the real-world implications?

 

Efficiently seeking impact

A quick reprise of those private sector mergers and acquisitions is useful at this point.  M&A activity is generally thought of as a way for companies to increase profit for shareholders.  Less foresighted executives may add on new product lines and acquire other businesses in the belief that the bigger their profit, the more successful they are.  This is not quite accurate.

As any fundamentals-based investor could tell you, what actually matters is not the size of a company’s profit, but how efficiently it is produced.  This idea is captured in financial ratios like return on equity (ROE) and return on capital employed (ROCE).  So company executives motivated not by ego but shareholder return often do the opposite of M&A: demergers and divestments.  They deliberately reduce their overall profit by shutting down or sell profitable business units, but thereby increase their ROCE. 

Although this may be hard for some to stomach, I believe some part of this thinking is applicable to the social sector.  Specifically, when a VCSE’s management is considering whether to expand their footprint or services, they should not simply seek to increase the ‘amount’ of social value they produce.  Rather, this value production should be weighed up against the costs involved, to find the sweet spot just before ‘economies of value’ become the ‘diseconomies of value’ warned of by Locality. 

This is illustrated in the chart below, modeled on the economic ‘law of diminishing marginal utility.’

     
  The diminishing returns of scale  
   

 

 

 

 

The blue line depicts how much ‘social value’ organisation can create from the resources available.  As per my second corollary, this blue line shows diminishing marginal value:  at point A, every additional unit of resources invested creates less and less additional value.

Point B is the moment when diseconomies of scale outweigh economies of scale, and the amount of value created by an organisation actually goes down.  Careful impact measurement which incorporates all externalities and negative outcomes is central to identifying this point.

 

More fundamentally (and this is my extension to the Locality argument), the green dotted line represents the situation if ‘value created’ exactly equals the value of the resources invested.  My first corollary to the 2nd Law implies that any curve of value created by an organisation (the blue line) can never breach this green ‘entropy barrier.’

 

A revival of older-fashioned values
 

The 2nd Law of Thermodynamics raises a formidable challenge for all of us:  can we ever leave the world a better place than we find it?

 Yes, a certain amount of scale and innovation is vital to ensure the continued relevance of any organisation.  But if VCSE managers truly believe in the idea of sustainability, they should respond to the 2nd Law by partly reviving older-fashioned values; they should balance the drive for novelty and experimentation with the virtues of simplicity and prudence.

Simplicity will ensure that we don’t voraciously seek more resources and scale than is absolutely necessary, and keep as close to the ‘entropy barrier’ as possible.  However, if we care for ourselves and society more than we do the physical resources at our disposal, we must and should be empathetic enough to do something rather than nothing.  So we will need prudence to help us be brave enough to invest for scale without tipping over into a foolhardy wasting of limited resources. 

In sum, we need empathy for each other, as well as an understanding of impact founded in the laws of physics and social values.  We need passion for growth and innovation, but tempered by the virtues of simplicity and prudence.  In this way we can temporarily buck the long-term dictates of the 2nd Law of Thermodynamics and work as efficiently as possible for society’s benefit. 

 

Rohan Martyres is Head of Impact & Investment Strategy at CAN.  The views expressed here are his own.

 

 

Category: Invest