Saturday, February 9, 2008

Strategic Planning Analogy #153: Gaps & Plugs Part 1

Although Wal-Mart is on the leading edge of technology today, this was not always the case. Back in the early 1960s, when Wal-Mart was first starting out, its systems were very crude.

The accounting system consisted of a bunch of pigeon holes on the wall of the office—one pigeonhole per store. The paperwork for each store would then be stuffed into its appropriate pigeonhole. Once a month, the paper would be taken out of the holes and Sam Walton and Wanda Wiseman would close the books.

Not wanting to waste a lot of time doing paperwork, Sam Walton came up with a way to really speed up closing the books. He called it the ESP method. This is how Sam Walton explained the method in his autobiography:

“It’s a pretty basic method: if you can’t make your books balance, you take however much they’re off by and enter it under the heading ESP, which stands for Error Some Place.”

Sam Walton used a simple plug to make his books balance. The plug was needed because Sam did not know how else to bridge the gap in his books.

A similar situation often occurs in strategic planning. First, one comes up with ambitious goals for the company. Then the core business is examined to see if it can achieve the ambitious goal. Many times, the core business appears to fall short of the goal. This creates a “planning gap.”

The question then is how to plug this strategy gap. One approach is to just make-up a line in the plans and stick the gap there, sort of like what Sam Walton did with his accounting books. Perhaps instead of calling it ESP, we could call it USP—Unknown Source of Profits.

Unfortunately, just as Sam had no idea what caused his accounting error, this method will give you no idea for how to fill your strategy gap. Your strategic goal in this case has no real connection to your planning activities. Therefore, it should be no surprise that when plugging your goal in this manner, you usually fall short of hitting the goal. The unknown source of profits becomes an unfound source of profits.

In general, there are two places to look when trying to fill this gap—current operations and new ventures. The main principle here is that “putting all of your eggs into one basket,” be it current operations or a new venture, is typically sub-optimal. Instead, a more balanced approach between the two is normally more successful.

In this blog, we will examine some of the pitfalls associated with the extremes—either looking to get it all from current operations or all from new ventures. In the next blog, we will look at how a more balanced approach can often be better.

1) Too much Dependence on the Core can Start a Death Spiral
Ambitious goals are not bad, per se. In the book Built to Last, the authors say that successful companies tend to have “Big Hairy Audacious Goals,” called BHAGs.

If a goal is big, hairy and audacious, then it must by definition expect more than what one would naturally receive from current operations run similar to how they are run today. Therefore, by definition, BHAGs create a planning gap with current operations.

One way to fill the planning gap is to place nearly all of the expectations for filling the gap on current operations, even though by definition BHAGs stretch beyond the capacity of current operations. In other words, once the current patterns of expectations are trended out, they are adjusted to become exceedingly aggressive—far more than just stretch goals. For example:

a) Sales growth goals could be raised significantly above historical trends;
b) Cost cutting goals could place expense expectations well below anything ever done before;
c) Performance is expected to improve even though capital spending is curtailed.

Under this scenario, the implications to the company tend to follow one or more of these patterns:

a) Internal Decline: Employees figure out that the goals are unrealistic/unattainable and that they will now have a miserable time being yelled at and no longer get any bonuses. The good people will start to leave the company and the rest will be demoralized. The balance of employees’ time could move from trying to make improvements to trying to “cover one’s ass” and deflect the blame to someone else. Instead of performance getting better, performance will get worse.

b) External Decline: In order to hit the extraordinary near-term goals, the long-term viability will be threatened. For example, to hit unrealistic sales goals, promises may be made that cannot be fulfilled. To hit unrealistic expense goals, customer service could suffer. Lack of proper investment could eventually make your internal processes obsolete. For a short period of time, these tactics could work, but in the long run, they will ruin your future potential. Customers will eventually realize you do not live up to your promises, have lousy service and are obsolete. They will take their business elsewhere.

These two types of decline can put a company into a “Death Spiral.” It works as follows: over time, demoralized employees and defecting customers hurt performance. As a result, the planning gap between ambitious goals and shrinking results gets even larger. With a bigger gap, the pressure increases on the core business, causing even more internal and external decline. Every year it gets worse until the whole thing blows up.

2) Too much Dependence on New Ventures can Start a Money Pit
Although putting all the burden for filling the gap on the current business can lead to a death spiral, it is also potentially dangerous to put all of the burden on new ventures. One of the big problems with new ventures is that they tend to be at least partly outside our range of expertise. Without that expertise, we do not know what a realistic expectation should be for new ventures. Not knowing all the potential pitfalls, there is a tendency to set these goals unrealistically too high.

This can lead to one or more of the following issues:

a) Distorting One’s Risk Profile:
There are two ways this can increase the riskiness of your firm. First, if one wants big rewards quickly, there is a tendency to gravitate towards riskier investments (risk=rewards). Second, to find big results quickly, one tends to focus on fewer, larger ventures rather than a lot of smaller ones. By focusing on fewer, larger new ventures, the likelihood of failure increases, since most new ventures fail and you don’t have a large pipeline of options.

Technically speaking, if your risk profile goes up, then your key stakeholders should demand an even higher return on investment, since they want to be compensated for taking the added risk. This places even more pressure on looking for even bigger near-term returns. Even if you do not increase your return hurdle rate due to extra riskiness, it should be done. Otherwise you may approve projects at the lower rate which would not pass the test at the more accurate higher rate.

b) Hesitancy to Pull Back if News is Bad:
With all the pressure to find a success with a few big new ventures, there is pressure to be overly optimistic in expectations on these ventures. Revenues tend to be estimated on the high range and costs tend to be estimated on the low range. When reality starts setting in—and prospects do not look as bright—there is pressure to keep plodding along anyway. Too much has already been invested, people are expecting a success, there is little else in the pipeline to replace it, and your career may be damaged if you admit failure. As a result, bad ventures tend to live on longer than they should.

c) Throwing Money at the Problem:
When prospects start looking bad and you still want to succeed, a common response is to throw more money at the problem. Since this is a new venture, you may not have a lot of internal expertise to rely on…all you have is money. The hope is that if you throw more good money after bad, something good will turn out. It rarely does, so then you try an additional round of throwing money at the problem.

d) Current Business Envy:
With all of the attention and glamour given to the new venture, those working on the current business could feel left out and jealous. All the good people may shift over to the glamour side of the business, which hurts current business performance. Or, to keep them working on the current business, you may need to throw some additional money in their direction.

As a result of these four possible results, a focus on trying to get too big of a return too quickly on too few new projects can create a money pit—a place where you keep throwing money, but see little in return.

Setting ambitious goals is often a good early step in planning. However, if you have no idea of how to achieve those goals, you will most likely not achieve them. In general, there are two sources for filling the gap between current trends and an ambitious goal—current operations and new ventures.

As we saw in this blog, too much reliance on only one of these sources will tend to lead to problems, so the goal is still not met. In the next blog, we will see that a more balanced approach tends to be more successful.

Studies have shown that smaller, consistent increases in performance improve stock prices more than large promises which are never realized. Too much blind ambition can be a hindrance.

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