Value, profit and risk accounting and the resource-based view of the firm

Accounting, Auditing & Accountability JournalEmerald Article: Value, profit and risk: accounting and the resource-based view of the firmSteven Toms

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To cite this document: Steven Toms, (2010),"Value, profit and risk: accounting and the resource-based view of the firm", Accounting, Auditing & Accountability Journal, Vol. 23 Iss: 5 pp. 647 - 670

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Value, profit and risk:accounting and the

resource-based view of the firmSteven Toms

The York Management School, University of York, Heslington, UK

Abstract

Purpose – This paper aims to argue that the principal components of the Resource-Based View(RBV) as a theory of sustained competitive advantage are not a sufficient basis for a complete andconsistent theory of firm behaviour. Two missing elements are value theory and accountabilitymechanisms.

Design/methodology/approach – The paper proposes a link between value theory andaccountability using a Resource Value-Resource Risk perspective as an alternative to the CapitalAsset Pricing Model. The link operates first from the labour process, where value is created but isimperfectly observable by intra-firm mechanisms of organizational control and outside governancearrangements without incurring monitoring costs. Second, it operates through contractualarrangements which impose fixed cost structures on activities with variable revenues.

Findings – The paper thereby explains how value originates in risky and difficult to monitorproductive processes and is transmitted as rents to organizational and capital market constituents. Itthen reviews recent contributions to the RBV, arguing that the proposed new approach overcomesgaps inherent in the alternatives, and thus offers a more complete and integrated view of firmbehaviour.

Originality/value – The RBV can become a coherent theory of firm behaviour, if it adopts and canintegrate the labour theory of value, associated measures of risk arising from the labour process andmechanisms of accountability.

Keywords Resources, Risk management, Labour, Competitive advantage

Paper type Research paper

1. IntroductionTo what extent is strategy framed in accounting terms and what role do accountingnumbers and techniques play in setting strategy? In both cases the answer is probablynot enough, in view of the potential contribution on offer from accounting generally,and from critical accounting in particular. In recent years, the resource-based view(RBV) of the firm, has achieved widespread dissemination in academic literature andmanagement practice (Acedo et al., 2006). It explains competitive advantage, ordelivery of sustained above-normal returns (Peteraf, 1993) or economic profit (Barney,2001), in terms of firms’ bundles of resources (Amit and Schoemaker, 1993; Rumelt,1984), which are valuable, rare, inimitable and non-substitutable (VRIN) (Barney, 2001,emphasis added). A theory linking asset value and abnormal returns is therefore

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The author would like to thank participants at the European Critical Accounting StudiesConference, University of York, 2006 and the Institute of Chartered Accountants in Scotland,whose financial support helped develop the ideas in this paper. He would also like to thank ChrisCarter and two anonymous reviewers for their very helpful comments.

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Vol. 23 No. 5, 2010pp. 647-670

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required. Because the RBV literature has placed these issues at the centre of its agenda,its neglect of the accounting literature all the more surprising.

If the strategy literature has neglected accounting, it is also fair to say thataccounting has neglected strategy. Where concerned with valuation, accountants oftenemploy theoretical stances at variance with the Neo-classical mainstream strategyliterature (Bryer, 1994, 1999; Macve, 1999; Mouck, 1994; Tinker, 1980, 2004; Toms,2006a, 2009; Toms and Bowman, 2010)[1]. A common approach of critical accounting isto begin with the restrictive assumptions of marginalist Neo-classical economics andargue that they possess logical inconsistencies, for example the tautological approachto asset valuation implied by the Cambridge controversies (Tinker, 1980), privilegeinterest groups (Tinker et al. 1982), or are not useful because the total social product iseither not recognised (Mayston, 1992) or ignored (Milne, 1991), and neglect the social“essence” beneath the surface of market relationships (Tinker, 1984, p. 61, 1980, p. 158).As a consequence, much of the critical accounting literature has abandoned economicdiscourse, including the Classical and Marxian Schools. With limited exceptions,deductive model building has become unfashionable, even though, as will bedemonstrated below, it has the potential to overcome some weaknesses of theNeo-classical School and its accounting applications. As a consequence, there areunresolved questions in accounting and strategy. First, what is the nature of value, anda theoretically consistent measure of sustained competitive advantage (SCA)? Second,can an operationalisable theory of risk be developed for the purposes of managerialdecision making?

In addressing these questions the paper will advance an agenda for strategy, andaccounting. It will address them by developing an integrated theory of value, profit,and risk. In section two the relevant literature is reviewed under three headings. First,the salient features of the RBV are analysed. Second classical theories of value areconsidered. Finally, the accounting literature is discussed, insofar as it reflects theformer two aspects. Section three develops a new conceptual framework, linking profit,value and risk as a basis for a theory of SCA. It will be shown how the labour theory ofvalue (LTV) can be extended to include risk and be used to modify the neo-classicalcapital asset pricing model (CAPM). It will do so by linking both to the underlyinglabour process. It will demonstrate how profit and asset value can be consistentlylinked by cost structures. It will show how value creation of value can be differentiatedfrom the rent. In the fourth section, the implications are discussed, first for accountingtheory, with particular reference to the Cambridge controversies, and second bycomparison with similar approaches in the strategy literature. A final section drawsconclusions.

2. Strategy, value theory and accountingStrategy and the RBV as a theory of valueThe RBV is an important idea in strategy, because it offers the potential to explainSCA, or the process of delivering long run abnormal returns to shareholders. Suchreturns can be delivered through accessing resources, including for example bymonopoly control, as in the theory of competitive heterogeneity, or the creation ofdifficult to replicate resources as in the RBV. It follows that the RBV needs a theory ofvalue to be a convincing theory of SCA. As Priem (2001) therefore suggests, the RBV isincomplete because its explanation of value must be imported from outside literatures.

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Further, as Priem and Butler (2001) propose, the RBV is tautological if the firm’spossession of unique capabilities cannot be ascertained independently of theirdescription (Carter et al., 2008). Accounting might break the tautology by providingmechanisms for understanding resource creation, their valuation and reporting. Ittherefore follows that the measurement of resource value and abnormal returns arenecessary components of the development of the RBV as a theory[2].

Of course, this conclusion has not been fully accepted in the strategy literature,which reflects more general disagreement about the RBV’s basic premises (Hoopeset al., 2003). Indeed, participants in the debate have yet to reach a consensus on thecircumstances of where, why and when a resource is valuable (Miller and Shamsie,1996, p. 539). Where recent strategy literature does acknowledge the requirement for atheory of value, it has adopted two quite narrow and largely mutually exclusiveperspectives. One strand examines processes within the organization (Denrell et al.,2003), which might be conceptualized in terms of production, transaction andgovernance costs (Madhok, 2002). Another considers value, price and cost as marketinteractions (Hoopes et al., 2003), and the market based division of value throughbargaining games (Lippman and Rumelt, 2003a, 2003b; MacDonald and Ryall, 2004;see also Brandenburger and Stuart, 1996).

In contrast with economic theory, which explains performance differentials in termsof product and market structure, the RBV focuses on the internal characteristics of thefirm (Lockett and Thompson, 2001). However, the valuation of RBV assets also impliesrelationships with a specific market environment (Amit and Schoemaker, 1993).Similarly Barney (1991, p. 105) suggests that a resource is valuable to the extent that “itexploits opportunities and/or neutralizes threats in a firm’s environment”. A connectedargument is that resources are valuable if they enable a firm to satisfy needs at lowercosts than competitors (Peteraf, 1993). Barney (1991, p. 106) also suggests thatresources are valuable “when they enable a firm to conceive of or implement strategiesthat improve its efficiency and effectiveness”. A resource has been defined as valuableif it enables customer needs to be better satisfied (Bogner and Thomas, 1994; Verdinand Williamson, 1994).

How the superior returns that arise from these activities are captured by specificstakeholder groups through accountability processes has not been resolved in thestrategy literature. Coff (1999) addresses the question with the notion of “nexus rents”,so that proceeds of superior performance are appropriated by competing stakeholdergroups. Although explaining their distribution, rents, and one assumes value, aredetermined by market processes and do not arise from the productive process,although Coff’s contribution importantly highlights the role of monitoringrelationships. Where the stakeholder approach is used, definitions of value are stillpredicated on notions of utility. For example Collis and Montgomery (1997, pp. 30-1)argue that a resource is valuable when demanded by customers, when it cannot bereplicated by competition, and when the profits it generates are captured by the firm(emphasis added). The implied reification does not sit comfortably with a stakeholderapproach. However, the principal weakness here is that value depends upon definingcustomer needs (including, tautologically, access to low priced goods) in utilitarianterms. There is also the more fundamental question of whether utility in any caseconstitutes the basis for a theory of value. It has been dismissed as a tautology by someprominent economists (Robinson, 1963), and more importantly refuted as a theory of


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capital value and the rate of profit (Harcourt, 1969). Neo-classical economics hasignored rather than responded to these fundamental criticisms (Tinker, 1980), and anyattempt to develop a resource based theory of the firm on neo-classical foundationsnecessarily faces the same problem, not least because capital values and profit rates arecentral to the RBV approach. To summarize these problems, the RBV requires a valuetheory independent of utility, or must specify a stakeholder group whose utility is totake precedence.

Strategic management researchers meanwhile are also interested in developing newrisk measures that are theoretically consistent and useful for managerial decisionmaking, achieving a suitable trade-off between concept complexity and computationalsimplicity (Ruefli et al., 1999, pp. 182-4). So far, this literature has relied on the CAPM,but has merely added to the critique in the finance literature. Bowman (1979) andArmour and Teece (1978) examined the implied CAPM relationship, finding aparadoxical negative slope between risk and return. Feigenbaum and Thomas (1986)and Singh (1986) find differing risk return relationships at different levels oforganizational performance and capacity utilisation. These studies typically reflectNeo-classical approaches to modelling risky behaviour, so that they are potentiallyundermined by the weaknesses of the CAPM highlighted by financial researchers(Clare et al., 1998, Fama and French, 1992, Wang, 2000), and although address expectedreturn, do not offer a theory of value.

Summarizing much of the above, Priem (2001) argues that existing theories dealonly with the value capture element but do not explain how value is created. ForMakadok and Coff (2002) RBV works with value capture, but does not need a theory ofvalue creation, especially not a theory based on consumer utility. Bowman andAmbrosini (2000) suggest conventional explanations of resource value (Makadok,2001; Makadok and Coff, 2002; Barney, 1986; Peteraf, 1993; Collis and Montgomery,1995) are insufficient and set out a framework incorporating value creation and valuecapture. These critics have built on Classical economists’ notion of use value, so thatnew use value derives from individuals’ actions within the organization (Bowman andAmbrosini, 2000; Bowman and Swart, 2007; Lado and Wilson, 1994; Pfeffer, 1995;Wright et al., 1994). These approaches potentially form the most useful starting pointfor the more formal integration of the LTV and theories of SCA.

Classical value theoryIn the classical LTV, human action within the productive process is the source of value.Because commodities are systematically sold at higher prices on leaving the productiveprocess in comparison to the prices at which they enter it, there must be somecommodity within the process that adds value systematically. Without this conditionaggregate profits are zero and the economy is a zero sum game. Further, labour time ispriced in the market, but labour time is transferred to the product with a degree ofintensity that is a function of physical effort and mental processes, which are notdirectly observable. Socially necessary labour time is that required to produce any usevalue under normal conditions of production with the average degree of skill andintensity prevalent in that society (Marx, 1984, p. 641).

As far the RBV is concerned, it is not a theory of value, but a theory of rent. Theserents are Ricardian (Peteraf, 1993, Teece et al., 1997, p. 513), since Schumpeterian rents(Foss and Knudsen, 2002), as synergies, or economies of scope are imitable, except in

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the short run (Barney and Peteraf, 2003)[3]. However, none of the RBV literature hasseriously concerned itself with the nineteenth century literature on rent and associatedvalue theory. Marx modified Ricardo by varying the assumption of a fixed resourcesupply, and allowing rents to arise as a function of different deployments of capital. Healso explained the proportion of profit manifested as rent as a function of theregulating price, as determined socially necessary labour. Rent therefore is regulatedby the most efficient (or least efficient) combination of resources and their productioncost, depending on prevailing conditions of competition and the order in whichresources are brought into use. In other words, Marx’s theory of rent developedRicardo’s theory in directions of potential use to RBV theorists and accountantsconcerned with asset valuation and rents. Whether useful or not, Marx’s theory of rentis unlikely to be popular with RBV theorists or mainstream accountants.

The same might be said for the LTV, although it is just as easily attributable toRicardo or Smith, or to classical economy in general. As Grant (1996, p. 112) puts it, “aphysiocratic approach”[4], locating value in a single production factor, is essential for aknowledge-based theory of value. Bowman and Toms (2010) introduce the notions ofvalue and surplus value along with the distinctions between use value and exchangevalue that have already contributed to the RBV conversation (Bowman and Ambrosini,2000). Following the above definition of socially necessary labour, firms will vary inefficiency and therefore through bankruptcy and innovation, socially necessary labouris reduced to the most efficient firm (Mohun, 1996, p. 504). For these reasons Marx ismore specifically useful for the RBV as the notion of socially necessary labourfacilitates the determination of rent elements in abnormal profits. Even so, Marx is onlya point of departure for the further development of RBV discussed in section 3.

Accounting and the RBVThere has been limited research on the RBV in the accounting literature. Studies havetypically concentrated on testing managerial accounting applications. For exampleHoworth and Westhead (2003) find that working capital management techniques differaccording to the scale and sophistication of the resource base in small firms. In anotherstudy, managerial selection of performance measures mediates the relationshipbetween strategic RBV assets and financial performance in non-manufacturing firms(Widener, 2006). Other research has examined the relationship between themanagement control system (MCS), the creation of capabilities in an RBV sense andperformance (Henri, 2006). In general research of this kind has been limited, possiblybecause as Barney et al. (2001) suggest, the MCS is not a VRIN asset due to its easytransferability[5]. In general, where undertaken by mainstream accountingresearchers, RBV research has focused on accounting practice rather thanaccounting theory.

In contrast, critical accounting research has been more directly concerned with thesefundamentals. Toms (2002), Hasseldine et al. (2005) develop an integrated frameworkfor RBV intangible asset investment and stock market signalling. Bryer (1999) arguesthat labour values are the basis of objective asset valuations. Tinker(1999, p. 655) onthe other hand suggests that Marx’s economic categories such as profit, wages andrents should be seen as socially relative phenomena. For Abeysekera(2008) accountingmeasurement is a response to commodification, or the economic logic of maximisingthe market value of a firm while dealing with the contradiction of use of labour for


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production by the firm. Another strand of critical literature has begun to address therelationship between accounting profit, valuation and the competitive process byintegrating the propositions of the RBV. Toms (2006b) integrates a knowledge basedview of the firm with theories of entrepreneurship, and extends the CAPM to integratesocial conceptions of risk (Toms, 2006a). He extends these arguments to show thepossible objective valuation measures that might be computed if social and financialrisk are appropriately integrated (Toms, 2008, 2009). Bowman and Toms (2010) showhow the RBV can be integrated with Marx’s model of the circuits of capitalincorporating different classes of labour. These ideas are now extended further toproduce a conceptual framework based on a common theory of accounting andcompetitive advantage.

3. Conceptual frameworkTheoretical dimensionsA theory of accounting and strategy is presented below, linking value theory andaccountability, using what for shorthand will be referred to as the ResourceValue-Resource Risk (RVRR) perspective. Value, in terms of labour effort transferred tothe product, is best observable in the labour process by those most closely involvedand the value capture process accordingly becomes progressively less observable (withincreased monitoring cost) by those concerned with superintendence of valorization, orrealization of use value into monetary value, and surplus appropriation. RVRR is thusconcerned with accountability mechanisms, consisting of accounting controls andgovernance arrangements.

There are several additional and important dimensions. First, is the firm’s coststructure, which refers to the degree of cost variability arising from the employmentcontract. If employee remuneration is not precisely linked to revenue, the expected (riskadjusted) rate of profit includes a rent element. Either revenue will fall and staff costsare paid anyway, in which case there is a “rent” accruing to the workforce (becausethey have produced less but are paid the same), or revenue will rise and staff costsremain fixed, in which case profit rises above normal as labour’s share in net outputfalls.

Second, if the actions of people within organisations are the source of use values, itis necessary to define such values according to some Minimum Efficient LabourRequirement (MELR), otherwise any additional labour time, no matter how inefficientand regardless of consumer requirement could still be said to create value[6]. MELRspecifically refers to the labour costs of the firm with the simplest processes and mosteasily replicable assets consistent with remaining in the market. It therefore regulatesthe market price and differential rents are set for other firms with less easily replicableassets according to the benchmark, as is analogous to the illustrations used by Marx(1984, chapters 39 [e.g. table 1], 40). The benchmark MELR firm establishes theunderlying expected normal rate of return to shareholders and the discount rateapplied in asset valuation. These relationships are developed further below to showthat such returns are systematically related to cost structures embedded in the labourprocess.

Third, there is the possibility of “rent” transfer between stakeholder groups. Rent isdefined as above, but extended to include circumstances where knowledge is unevenlydistributed within firms and between firms and their investors, so that rents accrue to

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firm insiders or financial market insiders based on access to superior information. Byextension, where knowledge is unevenly distributed within firms and between firmsand their investors, rents accrue to firm insiders or financial market insiders based onaccess to superior information. Because firm insiders are employees and managers,their realized wage is the MELR rate for the job plus or minus rent elements arisingfrom access to information asymmetries in the production process and contract relatedcost structures. Conversely, realized returns accruing to shareholders in a financialmarket reflect both the underlying rate of profit plus or minus realizable managerialand labour rents[7]. Unlike Ricardian rents in the standard RBV, these rents arise fromlabour processes within organisations and markets that are set in process by capital,and are accordingly consistent with Marx’s second category of differential rent, inwhich realized rent depends on differential employments of capital.

The fourth component is tacit knowledge. Employees hold their positions becausethe perceived value of their tacit and other knowledge exceeds their market cost[8].To develop a theory of SCA from a RVRR perspective, it is necessary to establish abasic relationship between individual knowledge, the means whereby it is embeddedin the labour process, and subsequent monitoring and valorization. Physical effortand readily quantifiable skills are resources most easily replicable. Such explicit skillsare those more easily generated through generic training and education processesexternal to the firm. As labour processes become more deeply ingrained as tacitskills, they become more difficult to replicate. As the firm invests in assets such asspecialized production facilities, trade secrets and engineering experience (Teece et al.1997) over time (Dierickx and Cool, 1989), tacit knowledge is embedded in technicallycomplex routines[9]. According to the knowledge-based view SCA arises from suchroutines (Spender, 1989, Nonaka, 1991), but recognition that individuals create theknowledge, which firms can then apply (Grant, 1996) leads in the RVRR to tensionbetween rent appropriation by individuals and team-based profit appropriation asSCA. RVRR places appropriate emphasis on the mental processes, so that seniormanagers as well as junior staff spend time creating value, specifically where theiradministrative activities are a necessary condition for productive activity to occur[10].Productive activity is activity that adds value including service provision, not justfactory production. The supervision problem intensifies to the extent thatsubordinates hold tacit knowledge. Tacit knowledge reflects value in use ratherthan market exchange value and employees hold their positions precisely because theperceived value of their tacit and other knowledge exceeds their market cost. In RBVterms, the firm that employs such individuals has a basis for SCA because acompeting firm cannot replicate the asset base through straightforward marketexchange processes.

Therefore a fifth component is that, as the labour process is not directly observable,the employer of labour and the capital market investor are exposed to financial riskarising from information asymmetry. Such problems lead to the sixth and finalcomponent, which is the process of organizational control and the mix betweenbehaviour and output controls (Ouchi and Maguire, 1975) or action and results controls(Bryer, 2006). The balance shifts from the former to the latter, to the extent that processobservation by supervisors is problematic, where accounting controls receive moreemphasis in the latter case. Each of these components is integrated in the followingframework.


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An integrated modelFigure 1 uses the Ambrosini and Bowman (2001, p. 816) continuum to include tacitknowledge as a starting point, but extends their analysis to include the additionaldimension of task complexity in the labour process, and cost behaviour, monitoringcosts, control mechanisms and appropriation in the valorization process. In other words,to consider the relationship between knowledge location and value appropriation as partof a full description of the productive process, set out in Figure 1 as a horizontalcontinuum of dimensions of value creation through to ultimate value capture.

The valorization process comprises four elements: cost behaviour, control,monitoring, and appropriation. Insofar as specific assets associated with SCA arenot valued in an external market, and are therefore illiquid and non-realizable, theygenerate fixed costs rather than variable costs. Similarly hiring knowledge intensivelabour generates fixed cost. Therefore as tacit knowledge and the potential degree ofSCA rises under RBV assumptions, so does the fixity of cost. As suggested in Figure 1,there is also a continuous relationship between the degree of tacitness and complexityin the labour process and the ability of external stakeholders to monitor the separablelabour processes that make up the firm and their joint interactions. This follows fromthe definition of tacit knowledge, because the process is less readily explainable andunderstood by an outsider and, consistent with the RBV, tacit knowledge is implicatedin SCA. External stakeholders’ two methods of monitoring, behavioural (or action)control and output control, are also implicated in the tacitness and complexity of thelabour process, and the extent of fixed production costs and monitoring costs in thevalorization process. Tasks that are simple to perform and replicate are more easily

Figure 1.The production process,knowledge location andthe distribution of surplus

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controlled through the division of labour and repetition, and more easily flexed inresponse to changes in demand, so there is greater emphasis on action control. Wherethe process is complex, difficult to observe and dependent on embedded fixed costs,rather than costly monitoring a process that is difficult to understand andunresponsive to changes in demand, output control might be relied upon, so that theproducer has to account for actions in financial terms. In the latter case, there is anadditional element in the labour process, involving transformation of heterogeneousphysical and mental inputs into homogeneous monetary outputs. Following Ouchi andMaguire (1975), behaviour and output controls may not be direct substitutes, but maybe observable in independent contexts depending on understanding of means-endsrelationships and complex interdependencies respectively. Finally, as far asappropriation is concerned, the more tacit labour processes create assets that areunique and valuable, through processes that generate difficult to monitor fixed costs,the more likely resulting abnormal profit will be appropriated by insiders. Insideappropriation is at the expense of external capital providers or of other participants injoint ventures and consortia.

Several corollaries arise from these relationships. First is the conflict between themanagerial objective of achieving SCA and the objective of maximizing shareholdervalue. Managers pursue rents rather than optimal growth (Rugman and Verbeke, 2004)and these rents arise from their role in the labour process, as supervisors andparticipants. If firms are identified as achieving competitive advantage by reference toaccounting ratios showing superior performance from a shareholder perspective (e.g.Peters and Waterman, 1982), such performance is likely based on explicit and easilyreplicable skills and that associated competitive advantage is short-term or illusory.

A second and related point is that monitoring costs in Figure 1 also lie on acontinuum suggesting that as the degree of tacitness rises, the probability of surplusappropriation by those closest to the labour process also rises. In other words themonitoring problem is not simply confined to the providers of external capital but isalso faced directly by the line managers at each hierarchical level above the labourprocess. Line managers have the incentive to externalize tacit knowledge embedded inlabour processes for which they are responsible, for example through the division oflabour, or spend organizational resources themselves on monitoring, so that rentsaccrue at their level of the hierarchy[11]. Insofar as line management itself is part of thelabour process, for example where managerial action alters the product or servicedelivered, further individually appropriable tacit knowledge arises and monitoringcosts are imposed from above on progressively senior levels of management.Ultimately the imposition comes from the capital market to the top of the hierarchy,creating a similar but separate set of monitoring issues discussed below.

A third corollary is that under RVRR assumptions the RBV is made consistent withlabour process theory (LPT)[12]. Many labour process theorists (e.g. Knights, 1990,Wilmott, 1990) stress the role of power rather than profit and, where applied to the RBV,the role of power in appropriation (Scarborough, 1998). As Nicholls (1999) has pointedout, the valorization stage of the productive process, concerned with transformation oflabour use values into realized profit, has been neglected in the labour process literature.Figure 1 suggests an integrated approach, since labour rent originates in the productiveprocess, and a valorization stage is included. In terms of labour time, capital comprisesaccumulated prior use values plus the labour time, at whatever intensity, transferred


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into output through the labour process. Capital can be conceptualized in labour hourswithout reference to valorization, but the valorization process is nonetheless the cruciallink underpinning the relationship between tacit knowledge and monitoring costs.Valorization, under RVRR assumptions, depends on the effectiveness or otherwise ofsupervisory arrangements to moderate the effects of information asymmetry.Asymmetry arises because employees sell but usually retain some control over theemployment of their labour effort, which supervision arrangements are intended tocounteract in order to achieve fuller valorization. Therefore the labour process leads toinventiveness on the one hand through the imagination of individual employees andalienation through the process of specialization on the other. In the RVRR extension, tothe extent that inventiveness and knowledge can be individually appropriated byemployees, the labour process itself becomes a risky set of activities for administeringmanagers and outside financial stakeholders.

Arising from these risks, a fourth corollary is their price impact capital markets. IfSCA is measured in terms of shareholder returns, then realization through circulation incapital markets is part of the valorization process. At the top end of the continuum whereall knowledge is tacit, it is impossible for the investor to understand the processeswhereby use values are transformed into exchange values through realization andthereby generated into profits. Even so, where there is some degree of capitaldependence (Prechel, 2000), for example in high growth sector firms, insiders will havean incentive to reserve some profit and signal its availability to outside investors insteadof appropriating it for themselves. Insofar as the labour process within one firm isunrelated to labour processes governing the average firm’s realization of profits, whichinclude many explicit processes, its variation in profit will appear random. Because thecapital market by definition can only value explicit processes, that firm’s apparentlyrandom changes in profit corresponds to the firm-specific risk from an investor’s point ofview[13]. In the limiting case where all knowledge is tacit, all share prices becomerandom. Under such conditions, following Grossman and Stiglitz (1980), share priceswould convey no information to investors. In the opposite case where all knowledge isexplicit, information is symmetrical and markets become thin, as there are no abnormalreturns (rents) and no incentive to trade (Grossman and Stiglitz, 1980). Also under theseconditions with RBV assumptions all firms possess the same easily imitable resourcesfor the same activities and there is no SCA.

These intra-firm and firm-financial market interactions provide the possibility oftheory of profit determination consistent with notions of SCA and the RVRR.Abstracting from the continua in Figure 1, a model showing the relationship between thelabour cost characteristics of tacit knowledge, task complexity, valorization processcharacteristics, and expected profits required by external investors can be developed.Figure 2 shows the rate of return required by a risk-averse external investor as a functionof the fixed cost labour ratio (FCLR). The FCLR is the proportion of fixed cost to total costfor firm i divided by the proportion of fixed cost to total cost for all firms.

Some abstraction will assist interpretation of Figure 2. Suppose a firm with a singleemployee, w, and a single shareholder, s, and that the actions of w can be made totallyobservable or explicit to s through contractual/legal arrangements so w has nobargaining power. Suppose also that s pays w only for the output actually produced (asopposed to for the time w spends at work). Under these assumptions[14], s is able toappropriate profits from the labour process under risk free conditions. If fairly efficient

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capital markets are also assumed, and other markets are perfect, the expected rate ofprofit should resemble the rate of return from risk free investment (point A in Figure 2),for example base interest rates[15]. It can also be seen that if these assumptions aregradually relaxed, so that w is able, through the acquisition of bargaining power, to fixwages in the face of varying demand conditions, then the rate of profit required tocompensate the investor will rise. Because rate of profit variability increasesproportionately to the degree of fixity in wage cost, even where diversified, investorsrequire, and should obtain where capital markets remain reasonably efficient, aproportionate increase in compensation (for the average risk firm, to point B inFigure 2). There is a systematic increase insofar as under conditions of aggregategrowth expected change in aggregate demand is positive in which case because wagesare fixed, the rate of realized profit rises.

An important reason for the positive linear association between fixity of labour costand shareholder risk is implicit contract theory, in which employees are risk averse(Rosen, 1985). In this model, the capital market absorbs the insurance element of implicitlabour contracts through a risk premium. Figure 2 is theoretically consistent with theSharpe (1964) and Lintner (1965) CAPM, in that stock return is proportionate tosystematic risk. The difference is that the risk source is related to value creation, labourprocess and value appropriation, rather than mere share price and stock market indexco-variation.

Figure 2.


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Suppose next that w has tacit knowledge and can conceal value-creating orvalue-destroying activities in the labour process, so that the effort bargain shifts infavour of w and the return to s corresponds to point C in Figure 2. Again, s facesincreased risk, but the increase is specific to the labour process and s avoids this riskby incurring monitoring costs or shifting to output control, for example setting a targetnormal rate of profit based on observable rates elsewhere. These rates reflect, and arereduced by, aggregate monitoring cost. Alternatively, s avoids risk through portfoliodiversification, but in doing so reduces capacity further for monitoring performance ofany one firm. Purchasers of other shares also run the risk of negative rents throughpremium prices charged by market makers, benefiting from inside or asymmetricinformation advantages (point D in Figure 2). In general, points C and D constituteexamples of rents arising from non RBV sources, such as monopoly power, informationasymmetry and other elements of competitive heterogeneity.

The interactions between tacit knowledge and monitoring costs are suggestive ofsome interesting contradictions within the corporate economy. Alienation, throughexcessive specialization and associated removal of intellectual content, is traditionallyviewed as a source of exploitation by unscrupulous profit maximizers. That said, inindustries where such exploitation might occur, such as cotton textiles in the Britishindustrial revolution or in modern China, although aggregate profit rates may be high,there is no basis for SCA at the level of any individual firm[16]. In contrast, where thelabour process has significant intellectual content, thereby creating entry barriers forcompetitors, the accrued profit to individual profit maximizers may be still small and therents accrued by intermediate producers and market-makers large, due to increasedmonitoring problems[17]. In short, because rent is the difference between realized priceandunderlyingvalue, if labour is thesourceofvalue, informationasymmetry is thesourceof rent. Interaction between the two tends to equalize the aggregate rate of profit[18].

Figure 3(a) shows a formal decomposition of total observed profits into profit andrent elements. Following Figure 2, there is a risk free profit element, to which is added alabour rent based systematic premium equating to the FLCR. Further rents arise fromknowledge-based asymmetries within the production process and as a residualcategory, from other non-labour based resources. Consistent with the economic theoryadvanced so far, total observed profit consists of normal profit plus rents. Normalprofit, following Figure 2, corresponds to average levels of fixed labour cost,corresponding to point A in Figure 3(a). A firm operating here would be the regulatorof market price and the benchmark for differential rents arising at points B and C. Tothe extent that the individual firm has an above average FLCR, it earns systematicallyhigher rent, which forms the first component of RVRR-based abnormal return. Thesecond component arises from knowledge-based production process asymmetries. SCAassociated with the RVRR, consistent with the RBV, is the distance B – A. Furtherrents, accrued through heterogeneous access to other physical and informational assets(C – B), are not part of an RBV story of SCA, but are consistent with competitiveheterogeneity and Ricardian rents. Where such rents are present, they will complementother categories of rent, thereby increasing total observed profit, or will increase profitin the absence of other categories. For the purposes of simplicity expected and realizedprofit are part of the same total observed surplus in Figure 3(a).

In practice, expected and realized profits are in contradiction. Figure 3(b) shows howthese interactions, including the consumption of rent by internal stakeholders, explain

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Figure 3.The determinants of

sustained competitiveadvantage and observable

profits


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the observed level of profit and when and how observed abnormal profits areassociated with SCA. Figure 3(b) shows the general case, in which profits and SCA areexplained jointly by tacit knowledge VRIN assets in the resource base and the processof surplus appropriation. The framework shows the labour and valorization processesto be in direct and dynamic contradiction. In the top row of the table, consistent withthe RBV, firms achieve SCA through their tacit knowledge resources. However,observable profits differ, so that where accountability mechanisms are effective, profitsfrom SCA are above normal and accrue to external stakeholders (quadrant 1). Whereaccountability mechanisms are ineffective, rents accrue to insiders (quadrant 2).Reported profits are normal, since insiders will report and distribute the level of profitrequired for minimally satisfying investors and preventing them from exiting theirinvestment. Remaining surplus will be consumed as rents by insiders. On the bottomrow, there are no VRIN assets and therefore no basis for SCA. Because there are noVRIN assets, rent appropriation by insiders is also impossible. Profits are thereforenormal in both quadrants 3 and 4. In quadrant 4, losses (i.e. less than normal profits)are possible if managers are not well monitored and appropriate rents, but only in thevery short-run. Because there are no VRIN knowledge assets, the normal rate of profitis well known and therefore deviations below are easy to police. Insofar as SCA andabnormal profits only occur consistently in quadrant 1, accountability mechanismscontribute to observable competitive advantage. Even here the trade-offs referred to inFigure 1 still apply, so that increased investment in VRIN assets also increasesmonitoring costs. Therefore abnormal profits and SCA are only concurrent whereaccountability mechanisms are cost-effective. In short, heterogeneous value creationprocesses and cost-effective accountability mechanisms are jointly necessary andsufficient conditions for SCA.

There are relatively few devices available to outside investors to ensure that theirfirm operates in quadrant 1. An example might be to recruit outside directors withsufficient independence from the main board but who simultaneously possess thesector-specific expertise required to monitor knowledge based assets. However, in thegeneral case, availability of such directors suggests inter-firm knowledge sharingwhich is in itself inconsistent with firm-level SCA. A possible solution is ideology, andnotions such as “shareholder value maximization”. Arguably, such notions might bemore easily shared between outside investors and the firm’s top management. Topmanagement might therefore employ ideology to mitigate apparently selfish utilizationof tacit knowledge-based wealth consumption by organizational insiders, consistentwith Penrose’s view that firms and their managers are essentially profit-orientated, andthat managerial opportunism and the agency problem constitute only a special case(Lockett and Thompson, 2004). However, there is little rational basis for managerialpursuit of abnormal profit, since it derives from a contradictory appeal to the selfishinterests of another group, i.e. the shareholders, and because normal rather thanabnormal profits are a sufficient basis for the firm’s survival. If ideology by itself isinsufficient, the use of trust in limited measure down the hierarchy in combination withideology based sanctions (Armstrong, 1991) may be necessary to achieve quadrant 1outcomes.

The trade-offs in Figures 1 to 3 explain participants’ behaviour in a dynamic systemoperating within social and technically determined limits. There is an incentive toinvest in knowledge assets insofar as the marginal product is positive net of

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monitoring costs. Because tacitness can rise to the point of total opacity there is anupward limit on the investment level. Similarly there is a downward limit to alienation,since if all processes are explicit, although monitoring costs are zero, individual firmscannot achieve SCA under RBV assumptions[19]. The realized rate of profit for thefirm, as an asset bundle, depends on the interaction of these contradictions, but isunrelated to the competence or otherwise of the firm’s management, who, whererational, will appropriate surpluses privately. The rate of surplus accruing toindividual employees and managers depends on the possession of knowledge andmonitoring cost.

4. DiscussionImplications for accounting theory: the Cambridge controversies revisitedOne of the most important potential implications of the model is for the problem of thevaluation of heterogeneous assets, or capital goods (Wicksell, 1934). Conventionally,asset value is the present value of the future cash flows the asset is likely to generate,presupposing a discount rate and therefore a rate of profit[20]. However in the RBV asin neo-classical economics, the rate of profit follows from the possession of valuable(scarce) assets. Wicksell effects and the associated Neo-Ricardian problems of capitalreversing and re-switching are important challenges to the RBV, since they implysimultaneous equilibria where firms comprise different combinations of labour andcapital at different rates of profit. If either labour or capital is a VRIN asset, theimplication is that they are only likely to hold such status within a certain range ofprofit rates. These issues were raised in the “Cambridge controversies”, but neversatisfactorily resolved (Cohen and Harcourt, 2003).

An alternative approach is to value capital assets according to cost of production.Wicksell effects also bedevil this approach, because there is a periodic need to revaluethe capital stock to reflect price and technology changes. However, from the RVRRperspective, these problems are more tractable, and capitalization rates can be derivedfrom the internal contractual structure of the firm. As Figure 2 shows, the risk adjustedrequired rate of return is a linear function of embedded fixed labour cost. Figure 2 isalso generalizable from labour to other classes of cost, using the same fixity of costapproach[21]. Moreover, corporate boards can impose these expected returns onbusiness units using output controls. Although problems of asymmetric information,possession of tacit knowledge and monitoring costs impact on individual valuations,the associated risks are diversifiable by investors and have no systematic impact onexpected returns or required capitalization rates. In general therefore, rationalvaluations for heterogeneous assets, for example RBV style intangibles, can be arrivedat by examining the underlying social relationships and associated cost structurewithin the firm.

Implications for strategic managementSuch a focus also addresses the need for theoretically consistent risk measuresidentified in the earlier review of the strategy literature. Also, the RRVR approach tosome extent parallels Madhok’s (2002) response to Williamson’s (1991) call for anintegrated approach, albeit without the restrictions imposed by the reification of thefirm and absence of shareholder-based governance mechanisms that tend to occur insuch transaction cost RBV analyses. In reality, because outside shareholders can only


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apply output controls to top management, they must rely on accountingrepresentations of results, leaving top management, crucially, in control of theprocess of transformation of heterogeneous capital resource into homogeneous cashflow equivalent representations. Therefore top management also have the ability topromote internal reinvestment of profits from innovation into perquisites at theexpense of dividend payments to shareholders. Also the way in which the firm’smanagerial hierarchy exercises surveillance is potentially important, through accesscontrol or incentivization, respectively examples of action and output controls.

There are other similarities between RVRR and Denrell et al. (2003), who assumethat all stage transformations through intermediate to finished products require onlylabour cost and that labour is undifferentiated. They also assume that all prices are inpresent value terms. It follows that the discount rate, or more precisely, therisk-adjusted rate of profit, is presupposed. If it is necessary to assume wage rates,prices and profit rates a priori, in a model with two factors of production, labour andcapital, it is difficult to see how this model rigorously adds to the theory of value.

The Lippman and Rumelt (hereafter L&R) bargaining and payments perspectivesalso have similarities to the RVRR approach. Unlike RVRR, however, the L&Rapproach lacks an underlying theory of value creation. The bargaining approachassumes a surplus (Lippman and Rumelt, 2003b, p. 1071, emphasis added).Alternatively for the payments perspective, (Lippman and Rumelt, 2003a) economicprofit is set at zero, presumably for all firms in aggregate, implying differences in priceand cost sum to zero, or revenues 8 payments. At the aggregate level, these are merelywealth transfers. In contrast, RVRR offers an explanation as to why on aggregate thevalue of purchased outputs is systematically higher than purchased inputs.

According to Lippman and Rumelt (2003b), value distribution depends on thestructure of a bargaining game. A condition is that the game should have a core[22]otherwise the participants lack the incentive to work together for a co-operativelybeneficial outcome. Where an innovative employee possesses tacit knowledge, it isunlikely that person will enter the game unless the firm’s incentive structure is suchthat the employee will appropriate a significant share of revenues. Where ex antecontracts of employment specify the ownership and rewards from innovation asproprietary to the firm, these incentives will not exist. Assets that achieve this, such asproprietary technology and large fixed asset bases, restrict access from the employees’point of view and prevent them setting up a competing firm. At the same time, theyensure inequality in bilateral bargaining gains, encouraging indirect rentappropriation. The appropriation process in this case, outlined in the RVRR, arisesfrom non co-operation by the innovative employee and imperfect surveillance of effortby the employer, so that rent arising from innovation and greater efficiency isappropriated by firm insiders through equivalent shirking. An alternative contractualarrangement, which gives the employee incentive to share information, places a core inthe game, but with the risk that the employee appropriates some monetary benefit.

A further problematic aspect of Lippman and Rumelt’s (2003a, p. 924) analysis istheir concluding objective function, that the firm should maximize its wealth and thatcompetition will induce it to maximize payments for scarce resources (PSR). PSR is aresidual category, once payments of commodity inputs (PCI) and payments forcommodity resources (PCR) have been accounted for. Because the other two categoriesare defined as commodities, they are also defined to be in perfectly elastic supply. If

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Revenue ¼ PCI þ PCR þ PSR and the firm is a price taker in two out of the threecategories, then changes in PSR can only be explained with reference to themselves,which removes any analytic properties from the identity. If on the other hand, perfectcompetition is as defined by Makowski and Ostroy (1995) and Lippman and Rumelt(2003b, p. 1071), as a condition in which individuals fully appropriate the value theycreate, then market imperfection implies transfer of surplus through rent (per classicaltheory) rather than value. It also follows that if individuals do not fully appropriate thevalue they create in a market relation other than in perfect competition, this will also bethe case in an employment relation. RVRR, which includes labour rents, does betterthan Classical theory and the sections of the RBV literature that ignore the creation ofvalue through human action.

The value price cost (VPC) framework approach differentiates between value,defined as the price the customer is willing to pay; price, which is a function of supplyand demand; and cost, which is the cost of production. The framework assumes V . P. C, which is likely to be true when individual cases of competitive advantage areconsidered, and competitive advantage might arise in individual cases of V . P and P. C (Hoopes et al., 2003). However, in the aggregate V ¼ P ¼ C, otherwise it is notclear why customers would systematically value all products and services above theircost of production. The equality of VPC in the aggregate is also consistent with thepayments perspective (Lippman and Rumelt, 2003a), but inconsistent with anunderlying theory of value creation. If V is systematically higher than C in theaggregate in price terms, then firms must be acquiring a resource for a price below itscost. The only resource all firms share common access to is human resource. As wehave seen, it is this resource in particular that not only creates value throughintellectual and physical effort, but such effort is also problematic to measure andobserve, unlike the costs of other inputs.

In similar fashion to the VPC approach, MacDonald and Ryall (2004) attempt toshow that value arises from the presence of a willing buyer. In the case presented(MacDonald and Ryall, 2004, p. 1321), the cost of production is normalized to zero andthe buyer’s utility is set at 1. To presuppose utility at a level greater than the cost ofproduction, is however, non-generalizable, since without equivalent payments toproduction factors utility cannot constitute effective demand. If the case is merelyspecific then the bargaining game is a question of rent sharing between firm and buyer,rather than value creation. Consistent with M&R, the appropriation of value dependson the number of firms and buyers. As in many interpretations that analyse at the levelof the firm, there is reification and no consideration of rent splits within theorganization. As with L&R, the M&R analysis could be extended to include theemployment relation, so that bargaining is represented as an interaction betweenemployee and employer as a buyer of labour.

5. ConclusionA common theory of value for accounting and strategy is appealing for a number ofreasons. First, the strategy literature, and especially the RBV, places emphasis on therole of human capital in the creation of competitive advantage, which at the same timeposes problems for accountants in terms of total business and intangible assetvaluation. Second, both disciplines have an interest in understanding the meaning ofnormal profit and its adjustment for risk where it impacts on performance or


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investment decisions. Third, both disciplines are interested in how, once made, profitsare appropriated. A situation where a firm is more efficient than competitors, butwhose surplus is appropriated by insiders rather than distributed to shareholderswould not necessarily meet the strategists’ understanding of SCA. Accountantssimilarly are concerned with controls which prevent misappropriation of resourcesthat ultimately are shareholders’ property. Thus, a theory of value also needs to be oneof accountability.

Accordingly, the theory developed above has attempted to integrate these elementsto the mutual benefit of accounting and strategy. The contribution of the paper is atheory of SCA, asset valuation and accountability using a consistent theory of value.The argument above has accepted the main assumptions of the RBV. It has also arguedfor the inclusion of labour process theory, asymmetric information, extension ofRicardian rent using Marx’s two categories of differential rent, and the analysis of risk,in the proposed RVRR. The combination of these elements shows that a resource-basedtheory must unite the process and content elements of strategy, through simultaneousinteraction of labour management, the determinants of SCA and relations with capitalmarkets. It has shown that by utilising the RVRR as a substitute for the CAPM, so thatthe employment of human resource creates value, but the value creation process isitself risky from the perspective of the monitoring employer and outside investor, aconsistent theory of value can be applied to explain SCA. The theory also explains thatthe roots of competitive advantage lie in the labour process, but with the corollary thatmaximizing the associated investment in tacit knowledge and associated difficult toreplicate assets is potentially inconsistent with maximizing the value of shareholder’sinvestments. Without the links, advocated above, to LTV, labour process theory andmechanisms of accountability, the RBV remains merely a view and not a theory,because it lacks a consistent basis for asset valuation and cannot explain systematicvariations in profit.

Notes

1. In similar vein, the RBV had been neglected in the industrial economics literature (Lockettand Thompson, 2001).

2. Without measurement, the RBV might still operate, but only as a heuristic, or a means ofunderstanding an organization as a knowledge system, such that the link with “value” istangential, and not as a theory of SCA.

3. Ricardian differential rent is “the difference between the produce obtained by theemployment of two equal quantities of labour and capital” (Marx, 1984, p. 649).

4. Such allusions to Classical theories of economics are rare in the strategic managementliterature notwithstanding the obvious parallels with the LTV and Ricardian rents. LTV, asthe cornerstone of Classical economics (Mouck, 1994) has been discussed extensively in theaccounting literature (for example Bryer, 1994, 2007; Toms, 2006a).

5. Henri(2006, p.539) suggests that the performance measurement system (PMS) does createRBV capabilities.

6. This definition goes beyond the debate in the accounting literature about how Marx’ssocially necessary labour time might be in an accounting context (Bryer, 1999; Macve, 1999).

7. Labour rents accrue to employees (and managers) where the wage rate exceeds the MELR.Where employees possess knowledge that is not easily replicable, particularly whenroutinized within the organization, possession of such knowledge provides workers with

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opportunities to raise real wages, if they can avoid accountability and appropriate theefficiency benefits (c/f efficiency wage theories, Katz, 1987).

8. This is an oversimplification for the purposes of model development. It extends reasoningthat stakeholders earn quasi-rents when a factor has a higher marginal product than isrequired to hold it in place (Klein et al., 1978).

9. Investment in strategic human resource assets (Mueller, 1996; Wright et al., 1994) is asufficient but not a necessary condition for realized super-normal profits, since theemployment of such assets simultaneously leads to the creation of internal rentappropriation possibilities.

10. As seniority increases managers may find more of their time allocated to non-productivemonitoring activities.

11. Although there is an incentive, it is doubtful whether full externalisation is possible. UsingDewey’s notion of productive enquiry, Cook and Seely Brown (1999, p. 391) argue thatpossessed knowledge, whether individual or group, is a set of tools to guide action. Withinorganisations, genres, such as mission statements, are used (or misused) to communicatetacit knowledge in groups. Following this logic accounting controls must monitor howindividuals and groups use knowledge.

12. RBV and LPT are from divergent backgrounds within the strategic management literature,reflecting context and process based approaches respectively.

13. Under the normal semi-strong market efficiency assumptions employed by capital marketresearchers and for which there is the most empirical evidence (Fama, 1991), explicitprocesses are public domain information and their value potential can accordingly be pricedby the market. Tacit elements cannot be known and cannot be priced by reference to genericeconomy wide factors systematically affecting all firms and therefore appear as residual orunexplained risk in the empirical form of the CAPM.

14. It is assumed that labour is the only cost and that there is a single period capital turnover (ieall the assets purchased at the beginning of the period are used up by the end of the period).These assumptions are for brevity, but the model is generalizable when they are relaxed.

15. Because labour cost co-varies perfectly with revenue, the residual, profit, is a fixed ratio ofrevenue.

16. Assuming unlimited product imitation, as a form of Bertrand competition, MacDonald andRyall (2004) reach a similar conclusion.

17. For example where abnormal returns from insider stock purchases rise as the firm’s R&Dintensity increases (Coff and Lee, 2003).

18. The lack of a consistent theory of profit equalization has been a long-running problem forclassical economics. In RVRR, differential risky profit rates arise in the productive processand are equalized through the capital market.

19. Or more precisely, removing the reification, individual capitalists or investors cannot makeabnormal returns.

20. Tinker (2004, p. 458) points out that Sraffa’s critique built on the final works of Ricardo toexpose this circular reasoning behind Neo-classical value theory.

21. See Modigliani and Miller’s (1958) example utilizing interest costs.

22. The core is defined as the set of pay-offs that ensure the sub-set of pay-offs to any sub-set ofplayers is greater than the maximum value available to that group working on its own(Lippman and Rumelt, 2003b, p. 1072).


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About the authorSteven Toms is Professor of Accounting and Finance at the University of York, UK. He is theinaugural Head of the York Management School and, with John Wilson, is Co-editor of BusinessHistory. Steven Toms can be contacted at: [email protected]

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