Current measures of economic success
ICAEW’s thought leadership project ‘So what is economic success? Going beyond GDP and profit’ focuses on two measures that dominate current discussions of economic success: GDP at the national level and profit at the organisational level.
This page provides some background on these measures, explains why we have chosen them as our focus, and outlines how they relate to one another.
We have posed some questions for you to consider in an accompanying discussion forum. We welcome your comments on these questions and the other ideas outlined here.
What do we mean by profit?
Whereas GDP refers to a single number in the national accounts, company accounts provide multiple profit figures such as gross profit, operating profit, net profit and retained profit, which may be stated before or after exceptional items. For the purpose of this project, we will typically use ‘profit’ in the loose sense of the financial ‘bottom line’ of an organisation’s income statement.
The equivalent of ‘profit’ in not-for-profit organisations like government bodies and charities is ‘surplus’, often calculated using the same financial reporting standards as companies (suitably adjusted). This project is interested in measures of economic success for all types of organisations, not just companies, so ‘profit’ should generally be interpreted as shorthand for ‘profit or surplus’.
Many aspects of this project, particularly the parallels between national and organisational accounting systems, are relevant whether or not the organisation operates on a for-profit basis which is why the project is described in terms of organisations and not businesses. However, despite the similar calculation, the emphasis on profit/surplus differs between commercial and not-for-profit organisations. Whereas businesses often have profit maximisation as a primary objective, the primary focus of not-for-profit organisations typically lies elsewhere. Subject to ensuring that surplus is non-negative, they will tend to focus on the efficient use of incoming resources in pursuit of their public service or charitable objectives. Not-for-profits therefore tend to make more extensive use of alternative success indicators more than businesses and are already ‘going beyond profit’ to a greater extent.
What is GDP?
In simple terms, GDP (Gross Domestic Product) measures the quantity of ‘final’ goods and services produced by an economy, ie, those that are purchased by an end-user rather than as an input for other production. For example, it includes the food you buy from a supermarket, but not the ingredients or packaging bought by the food’s producer. GDP also includes public services like healthcare and education. It does not include welfare benefit payments or the proceeds from buying and selling houses and company shares, as these involve transfers of money not production of goods or services.
GDP can be calculated in three different ways, each of which gives the same answer (subject to statistical error). It is the sum across the economy of:
- ‘final expenditure’ on domestically-produced goods and services by consumers, firms and government (as outlined above); or
- ‘gross value added’ by domestic producers (their gross output less non-durable inputs purchased from other producers) plus taxes less subsidies on products (eg, VAT); or
- ‘income’ to those who provide the inputs to domestic production (employees’ wages, firms’ profits, taxes).
GDP figures form part of an extensive set of national accounts which provide a wealth of supporting information such as GDP’s split between sectors of the economy and between households, firms and government. The accounts also provide related figures such as NDP (Net Domestic Product, equal to GDP less an allowance for ‘consumption’ of fixed capital) and GNI (Gross National Income, which is similar to GDP but allocates economic activity according to the initial destination of the income generated rather than the location of the activity).
As in the case of company profit, the calculation of GDP requires numerous assumptions and the application of judgement. The calculation is constrained to a large extent by the UN System of National Accounts (SNA). This provides a set of internationally agreed concepts, definitions, classifications and rules for calculating national accounts, and increases comparability between countries. However, the SNA is the subject of ongoing debate and periodic revision, in the same way that financial reporting frameworks for organisations are.
More information on GDP can be found in the Office for National Statistics publication UK National Accounts – a short guide.
What is the relationship between GDP and profit?
Discussions about national and organisational economic performance tend to be conducted separately, with fairly loose references to the contribution that businesses make to national economic statistics (through investment, job creation and payment of taxes). It is not immediately clear how business headlines such as increases in revenue and profit affect national headlines such as GDP growth statistics.
If GDP is thought of in terms of end-users’ expenditure on goods and services (see the definition of GDP above), then there is a clear link between increases in the revenue of consumer goods companies and increases in GDP. But what about increases in business-to-business revenues? An alternative way of looking at the connection between businesses and GDP is to think in terms of the value added by each business in the supply chain. An increase in the ‘gross value added’ by a company or other producer within a region (or in the taxes applied to their products) results in a corresponding increase in the region’s GDP.
For the purposes of GDP and the national accounts, an organisation’s gross value added (GVA) is calculated as:
- Gross output (total revenue)
- less Cost of non-durable inputs purchased from other producers
Equivalently, an organisation’s GVA can be calculated as:
- Employee costs
- plus Taxes net of subsidies (excluding those applied to products)
- plus Gross operating surplus
GDP, GVA and gross operating surplus are all ‘gross’ in the sense that neither capital expenditure on durable inputs nor depreciation of those inputs is deducted.
In simplified terms, an individual company’s contribution to GDP can therefore be thought of as broadly ‘revenue less cost of sales’, so is less than its revenue but more than its profit. This is illustrated in the diagram:
In practice, there are methodological differences between national accounts and corporate financial statements, so the figures presented in a company’s accounts do not directly correspond to the components of GVA. An important difference is the reporting boundary: national accounts have a geographic boundary so companies that operate cross-border contribute to the GDP of more than one country.
The goods and services produced by not-for-profit organisations such as government departments and charities are typically not sold in markets, so their total income is not analogous to a company’s revenue. Their GVA is instead calculated as total production costs, including a notional charge for capital consumption (broadly equivalent to depreciation), less the amount spent on inputs produced by other firms. Their ‘gross operating surplus’ is therefore assumed to equal capital consumption, so that their ‘net operating surplus’ or profit for national accounting purposes is zero.
Why are we focusing on GDP?
GDP is widely used to describe a country or region’s economy and is of central importance to the analysis and management of the economy in developed countries. It is heavily used by government treasury departments, central banks and other political and financial institutions. In particular, it is frequently employed as a measure of success, for example:
- total GDP is used to rank countries in terms of the size of their economy, sometimes interpreted as an indication of their international importance;
- GDP per capita is often used to rank countries in terms of their living standards (although it is at best a proxy for them); and
- increases in GDP (after adjusting for changes in price levels) are assumed to indicate economic improvements over time.
The last of these is particularly important because a real increase in GDP is what is commonly meant by ‘economic growth’, a central policy objective in many countries around the world.
Other economy-wide measures of economic success are also used extensively, particularly employment levels and inflation, but also measures such as household income and income inequality. Nonetheless, GDP is probably the most widely-used measure at present and so has been adopted as the national-level focus of this project.
Why are we focusing on profit?
Organisations use a wide range of measures of their economic success and there is not a clear front-runner like GDP at national level. Important measures for businesses include revenue, profit, free cash flow and shareholder value (dividends plus increases in share price).
The reason for selecting profit as the organisational-level focus of this project is that profit broadly parallels GDP in the sense that they are the ‘bottom line’ of their respective accounts. GDP is the most frequently used figure in the national accounts and (some form of) profit is arguably the single most important figure in company accounts. Certain aspects of this project will focus on national and organisational accounting systems, rather than the headline figures of GDP and profit. In particular, we want to compare the two accounting systems to help us identify ways to improve both measures, as well as to identify wider lessons for national, corporate and not-for-profit accounts. Hence profit is a more relevant measure for the project than (say) shareholder value.
This project will draw upon ICAEW’s other thought leadership work on profit and related topics, particularly the Financial Reporting Faculty’s Information for Better Markets (IFBM) initiative. For example, the 2013 IFBM conference considered questions such as: At what point should you recognise profit? How is this information used to evaluate companies? How should you structure, present and analyse this information? How can stepping outside the standard reporting regime help you to communicate a company’s economic success more effectively? The 2012 PD Leake lecture discussed how the target we choose to measure (eg, profit) can affect our behaviour. And the 2012 IFBM conference provided relevant context by looking at the objectives underlying financial reporting and how financial reporting can meet wider social needs.
Our thought leadership project So what is economic success? Going beyond GDP and profit is exploring what we mean by economic success, the role that GDP and profit play in this, and the potential of broader measures of economic success to help us balance our economic priorities, our social goals, and the constraints imposed on us by the natural environment we live in.
We are considering: