Category Archives: Finance

The Process – Simplicity Paradox

The known world is full of paradoxes. Paradoxi? Whatever. Having studied Physics in school I am somewhat familiar with a couple of scientific paradoxes that changed the way we look at everything. Prior to these changes the world was viewed through the lens of what was called Newtonian Physics. That is the mechanics of the motion of objects of non-zero size. Beach balls bouncing, planets orbiting, that sort of thing. It worked well until technology progressed to the point where people could examine smaller and smaller objects, like “particles”, electrons, and protons and such. Then it didn’t work anymore.

It was at this point in time that a new branch of Physics had to be created. It had to work for the macro-world of bouncing balls and the micro-world of sub-atomic nuclear particles. It was called “Quantum Mechanics”. It had to address the paradoxes that were now visible.

It had to address the paradox that sometimes light behaved as a wave and sometimes it behaved as a particle, when in reality it had to be both a particle and a wave all the time. If that was truly the case then everything had to exhibit the same characteristics of waves and particles. This is called the wave-particle duality.

There were other paradoxes that Quantum Mechanics had to address. The idea that physical quantities such as speed and energy (and others) changed in only discreet amounts, sort of like going up and down steps as opposed to the idea of smooth slopes like slides. It also had to explain why the very act of observing these things changed their behavior and made observing other aspects of the same objects that much more difficult.

So, as usually the question now is: What does this introduction have to do with anything associated with business. I think it is pretty simple. I think we have been working in a business management model that for analogy’s sake is the seventeenth century equivalent of Newtonian Physics. It has worked, or not worked as the case may be, on a somewhat macro-scale, but as we have tried to drive it further down on a micro-scale into the organization, it seems to no longer provide the solutions and value businesses need.

As we have introduced more process into the business system in order to try and drive more and more order into the system, I think we are starting to see a breakdown in the results we are expecting to see. Instead of getting better we have gotten slower. We don’t get the results that we expect. So what have we done? We have attempted to introduce still more and more process on a smaller and smaller level in order to achieve the predictability and order that we desire in our business universe.

I think we may have reached the same metaphorical boundary in business that Newtonian Mechanics Physicists had to cross in order to get to the new Quantum Mechanics model of the world.

As we layer in more and more process in order to try and simplify, streamline and make our business universe more predictable, we are also adding in more complexity to the business system through the application of the process itself. Herein lies the paradox: The very act of adding incremental process in order to simplify the business adds complexity to the business. We may actually end up simplifying the business a little, but it takes more effort in the process than we save in the business.

This incremental process complexity manifests itself in the time it takes to accomplish simple tasks. It can be seen in the number of conference calls that are now required before any actions can be taken. It can be seen in the increased desire for consensus instead of action. All of these complexity symptoms can be seen as the result of trying to drive the increased application of complex process into the business structures.

Extending the Quantum, Mechanical and Measurement metaphors a little farther into business could also give us some of the solutions to the paradoxes that business is now facing. If the very act of trying to simplify adds complexity, and if the very act of measuring modifies the behavior of how the business behaves, what do we need to change?

I think one of the first things we need to do is change what we measure. As we have seen in the quantum mechanical world, the more specifically we try to measure something the more we modify some of the targets other characteristics or attributes. This is actually called the “Uncertainty Principle” (It was actually introduced in the early part of the last century by the German Physicist Werner Heisenberg, and is also known as the Heisenberg Uncertainty Principle).

The same behavior is noted in organizations and is defined by the phrase “Expect what you inspect”. This generally means that by merely measuring something in an organization, whether it has value to the organization or not, you can change the behavior of the organization with respect to what you are measuring. If you measure the wrong things you should expect the wrong behaviors.

So perhaps we should reassess the value of ever more specific metrics and measurements. This thought seems to run almost entirely counter-intuitive to the directions that many organizations are going today. Instead of looking for ever finer and more specific things to measure we may want to take a step back and focus on the organization as a whole.

There are many metrics that the market looks at when it puts a value on the whole of a company, but the primary ones are financial: Orders, Sales, Profit, Earnings and Cash Flow. There may be others, but these should work for this argument’s sake. It is through the application of these metrics that the market usually establishes a value for the business. We might want to add Customer Satisfaction into the business metric mix, but I actually think that metric will sort itself out through the other financial metrics. If you don’t have Customer Satisfaction, or Quality or any of those derivative topics, you eventually won’t have the financials either as your customers will leave and take their business elsewhere.

So the simple baseline metric for every process, project, strategy, product or program should be: Is there a Financial Business Case that improves one of the five financial metrics that justifies the activity? By forcing the creation of that business case you have created the business representation in numbers and also the accompanying metrics for measuring the activity’s success. You can then see if the activity actually generated the beneficial behavior for the business that was targeted. If the value of the proposed activity cannot be defined, then there is a pretty good chance that the activity probably doesn’t need to be given a high priority.

Measurements against any other type of criteria will yield nothing more than some sort of a track against a non-critical objective, and will most probably drive a behavior that is not in alignment with the objectives of the business.

The Process versus simplicity paradox may be a little more difficult to counter, but again I think we can get it down to a business case. I think the idea for all those that would like to create, add to or extend a process is again to ask them to quantify what they are trying to correct or improve, and what resource they expect to expend on the improvement. In other words we need to create a Process – Simplification equation:

Man Hours required to implement the process
Less
Man Hours saved / removed from the business because of the process
Equal
Net Business Simplification.

The nice thing about physics is that it can be clearly expressed in terms of numbers. Postulates and theories can be readily proved or disproved via experimentation or observation. I think we need to look at returning business to this sort of practice as well. There is the proposed theory to reduce and align the metrics with the financial value metrics in the business so that all members of the organization are clearly working towards the same goals. This will make sure that the behaviors on the macro-organizational level are fully aligned to the individual or quantum level within the organization.

I believe and agree that some process is required for the proper running of an organization. The question is when do we start experiencing the law of decreasing returns when it comes to adding more process? By requiring at least a business case proposal and defense of the quantified value of each incremental process I think business can begin to regain the focus on the value that each process is supposed to deliver and start to move away from the current approach that appears to be more process as the solution to every issue.

Business like Physics is a numbers oriented discipline. Good processes in business are like good theorems in physics. People may like to believe in them, but they need to be proven out in the numbers and measurements before they become accepted as natural laws.

Do The Math

I can’t tell you how many times I have kept myself, my team or my business group out of trouble by doing something as basic as simple math. You know, adding, subtracting, multiplying and dividing. The sort of math that we were all supposed to learn starting in elementary school. It seems many of us think that we now have computers or other people who are responsible for this sort of activity. In just about every business that I have been in, it has always been brought home to me that knowing and understanding the numbers is everybody’s job. In almost every instance where this tenet has been forgotten or ignored, things have turned out badly.

I think part of the issue may stem from the fact that we don’t seem to use real numbers anymore. In the spirit of speed, or simplicity, or possibly laziness, we leave all the appropriate zeroes off of our numbers when we work with them for business. So now when we are working with say, twenty four million, six hundred thousand dollars (a reasonably large sum by just about any standards), instead of writing out $24,600,000 we put down $24.6 M. I know and you know they mean the same thing. However, I probably have $24.6 in my wallet. I know I don’t have $24,600,000.

Perhaps this trend has promoted a more relaxed attitude toward the numbers. Twenty four point six as opposed to twenty four point seven is only point one difference, right? It’s a rounding error. In reality its one hundred thousand dollars. How many more people could you hire or what more could you do if you had an extra hundred thousand dollar rounding error in your budget or in your wallet?

This example is just one of many possible reasons why people and businesses may have evolved this tendency toward what seems to be a more lackadaisical view of the numbers. There are probably many more. The point here is that the numbers and the math behind them represent the scoring system for the business game. It has been my experience that business eventually always boils down to the score.

In most other games you get to start tied with your opponent at zero and start counting upwards. The scoring only goes one way. Those that score the most usually win. The one exception that comes to mind here would be golf. It seems I never miss the opportunity to mention golf. In golf everyone starts at zero and starts counting and it is the one with the lowest score that wins. The point here is that you cannot do worse than zero. That is not the case in business. In business you can in fact end up with less than you started with.

This is called a “loss”, as in you have lost money.

Here in comes that math thing I mentioned at the start. Not only are there things that add positively to your score (this is called “Revenue”) unlike other games, in the business game there are things that can be and are subtracted from your score (this is called “Costs”). In sports you have a “loss” if your opponent ends up with a higher score than you. In business you end up with a loss if costs you more to provide your good or service than you get paid by customers for the good or service.

Here’s the kicker: the numbers don’t lie.

Bill Parcells, the famous football coach is credited with the following quote, when asked if his team was actually better than their record indicated. He said: “You are what your record indicates you are.” If you lost ten games and had a losing record that meant you were a ten game loser with a losing record. It didn’t matter how well you played. The numbers didn’t lie.

Any time you are looking for ways to improve your or your team’s performance, start with the numbers. Do the math. Look at the revenue (value) that you or the team generates or is responsible for. Don’t generalize regarding what you affect. Don’t try to take credit for associated work. Don’t claim “enablement” of someone else’s revenue. Be specific. Math is about specifics, not generalizations. Games have specific scores. Look at the costs you or your team generate as well. These are going to be the reductions to the score. You can’t hide them. They too must be figured into the score.

Leadership is about recognizing what needs to be done before it needs to be done.

Anyone can recognize that something needs to be done when the score indicates that the business is losing at the game. It is the leader who will have already done the math that will anticipate that something will need to be done. They will plan for it so that they can take full advantage of any potential opportunities and minimize and mitigate any potential risks.

The math is really pretty simple. If you want to change the business score there are basically two things you can do: Increase the positive score (revenue) or reduce the negative score (costs). Just about everything you can do to affect the business will fall into one of these two categories.

The usual seduction occurs when the manager focuses on only one or the other category. It is very difficult to grow an unprofitable business into a profitable one. Costs tend to grow along with the growth in revenue, hopefully at not the same rate, but they do grow. If you started out unprofitable and tried to grow without changing anything else, chances are you would still be unprofitable after any growth.

On the other hand it is impossible to cut costs all the way to prosperity. You can reduce costs to profitability (hopefully) but you cannot reduce your way to growth. However, a business left unchanged will continue on in the same direction, in the same manner that it has before. I have referred to this phenomenon in the past a business momentum. There have been too many instances in the past of managers not taking or delaying appropriate actions on the cost side in either the hope or expectation that something would change of its own accord.

It usually doesn’t and the score only gets worse.

It takes both the “pluses” and the “minuses” to change the score in a business. It takes looking at what has happened and using it to anticipate what will happen next. It takes the numbers. And if you are going to utilize the numbers you are going to have to do the math.

Investment firms have a wonderful disclaimer that states that past performance is no guarantee of future success. This is true. However in business it is a good indicator that without a change to the elements that make up that business’ scoring system on both the plus and the minus side of things, of what can be expected. When you start changing the factors that affect the score, you definitely need to first do the math.

Surprises


As we enter the fourth quarter and approach the end of a year, greater attention will be focused on the business performance financials. We see this type of focus at the end of every quarter to a certain extent, but at the end of the year it peaks. Sales commissions and staff performance bonuses are paid based on annual numbers. Personnel ratings and reviews are conducted based on annual numbers. Business forecasts are to be completed in preparation for the next year during this time period as well. Predictability of business performance is now at a premium. It is also the time when businesses most try to avoid surprises.


 


Surprises are those unexpected events that materially affect both the performance and the measurement of the performance of the business. Surprises can be viewed as both positively impacting and negatively impacting to the company. However when surprises are viewed against the three basic limitations that all businesses must deal with, Resources, Money and Time, we see that at the end of the year, time is in very short supply when it comes to dealing with surprises. That means that incremental money and / or resources will be expended on surprises, both good and bad ones.


 


Good surprises usually come in the form of unexpected sales and revenue opportunities. A large un-forecasted order can come in. A product shipment scheduled for next year can be pulled forward into this year. Good surprises are normally associated with opportunities to increase the top line and via the financial flow through, increase the bottom line as well. However, even good surprises normally come with an additional cost. A large unexpected order will stress both the supply chain and production capabilities for delivery. Overtime and expedite costs may be required to meet the year end time frames. In short, because there is now limited time, it will take incremental resources and money to deal with even good surprises. No business leader wants to deal with problems, but if they are going to have problems, these are the types of problems that every business leader wants to deal with.


 


Bad surprises on the other hand are normally associated with issues that unexpectedly reduce sales or revenue, or alternatively increase business costs or expenses, and again via financial flows reduce the bottom line business performance. Expected orders being cancelled or not materializing would be the primary example of a top line bad surprise. A reduction in sales will turn into a reduction in revenue, and all other things being equal, a reduction in predicted earnings.


 


Top line bad surprises normally come about as a result of an overly optimistic sales team, or a sales team that is under engaged with the customer. Either way, it was not clearly known that the customer was not going to be buying, when everyone was predicting that they were. When the business is counting on the sale, the sales team needs to be fully engaged with the customer, as well as possibly a little conservative in their forecasting. It is far better to present the good surprise of an unexpected sale and the problems it presents than the bad surprise of the loss of a sale that was counted on to make the yearend forecast.


 


 Other types of bad surprises can affect both the top and bottom lines. Component shortages can cause unexpected production limitations precluding shipment and revenue recognition, changes to government regulations can add unexpected costs to products and unexpected legal or labor provisions can eat directly into margins to name just a few, are just a few examples of bad surprises.


 


The point here is that these surprises are issues that can and should have been readily identified as potential risks to the business. If they are risks, then the need a risk mitigation strategy if they occur. If they are not identified, then the business team needs to understand why they were missed and take corrective actions, as well as examine the business for any other unidentified potential risks. If they were identified and mitigation was neglected, then the business team must address this management failure appropriately as well in order to avoid future similar situations. Again in either event, it is the business leaders’ responsibility to identify and either avoid or mitigate these types of bad surprises.


 


Predictability of business performance is a key to the business’ success. As the end of the business year approaches it takes on a heightened importance. Good surprises can help bolster the numbers coming into the close of the year, but even good surprises usually come with the requirement of increased resources and financial costs since there is usually limited time to deal with them. Bad surprises on the other hand can cause problems with the business’ financial performance that there is not sufficient time for the business to recover from before the year ends. Bad surprises are normally the result of human error where either sales’ over optimism or management’s lack of attention to fundamental business practice has contributed to the business failure. In either instance the “surprise” needed to be identified well in advance of the event occurring so that the business could more accurately predict how it was going to perform.

Know the Numbers and Sales

Once I had attained executive level, I was frequently asked to conduct new hire orientation classes. I didn’t know if it was because no other executives wanted to do it or if it was because of the way I had come up through the ranks. Looking back I suspect it was because no one else would do it.


Regardless, I did take the responsibility seriously. At the end of the session, I would always ask for questions. The question I got most frequently was: “How did you become and executive so quickly, and what do we need to do to accomplish the same?” I came up with a two part answer. I think it still applies.


First I would tell people that they needed to spend some time in sales. It is hard to understand just how difficult it is to compete with other sales teams to get customers to give you money (orders) unless you have done it for a while. It will give you a perspective on the market from the inside out.


The second thing I would say is learn the numbers. As you progress up the corporate ladder, more and more of your communication and information revolves around the tabulated financial data. You have to understand how the metrics interrelate and how to affect them.


Doing this won’t guarantee your success in the corporate world, but it will help you to understand why it works and acts the way it does, and that is the first step to success.

Involve Finance Early

It seems too many times we end up asking our finance teams to total up the score for our businesses, after the fact. We make all our plans, execute them and modify them when they come in contact with reality. We move. We react. At the end of the month, the quarter or the year, finance tells us how we did.


This management structure breeds an adversarial relationship with finance, and casts them in the role of being the “money police”. The oversight check-and-balance needs to be there, but it needs to be there at the front end of the process. Finance needs to be an integral part of the planning process, the sales process and execution team from the beginning.


Understanding the financial ramifications of each move before you make it is critical. It will help avoid mistakes and missteps. It also builds finance into the team, instead of casting them in an external watch-dog role.


And the truth be known, finance would like to be involved earlier in the running of the business as well. Invariably finance is also compensated on the performance of the business as well, and they would like to have input into the process. Aligning your resources, either direct report or corporate finance, is key to creating a sound business team, and good business performance.