Sunday, October 26, 2008

Analogy #217: Hot Potato

There’s a children’s game we played when I was young called “Hot Potato.” Although there are lots of versions of the game, it goes something like this:

First children stand, facing each other, in a circle. They have a small ball, which is called the potato. The ball is tossed around as if it is a hot potato—as soon as you catch it you quickly toss it to someone else in the circle so that it won’t (theoretically) “burn” your hand.

All the while you are tossing the ball around, someone else is keeping track of the time. When the allotted time is over, the timer yells “STOP!” Whoever has the hot potato in their hand when the time stops loses and has to leave the circle.

A lot of business strategies rely on the tactic of buying or selling companies/divisions. In these transactions, assets change hands from one owner to another. It’s sort of like the game of hot potato. Property ownership gets tossed around from firm to firm, just like that ball gets tossed around with the children.

One time when asset tossing is particularly frequent is when the growth phase of an industry is long over and an industry is well into maturity or is starting to decline. The lack of growth creates a period of consolidation. At this point, a firm typically decides to either “get out” or “double-down.”

The ones who want to get out toss their assets away, as if it is a hot potato. The ones who want to double-down collect all of potatoes that the others are tossing out.

Just as in the game of hot potato, eventually the time for consolidation stops. In the game, whoever is holding the “potato” when the time ends loses the round. My observation is that more often than not, the company holding all the assets when the consolidation phase ends also tends to be a loser.

In this blog, we will see why.

The principle here is that during consolidation, the company that is doing the consolidating more often than not creates less value than the one who is exiting the business. In fact, the consolidator often ends up destroying value.

Although not directly applicable, you could see some of this principle at work in the dotcom bubble. There were a lot of young college dropouts who started up all kinds of businesses. Eventually, big companies wanted to get in on the action, so they started buying up a bunch of these dotcom startups, with the hope of creating something great out the accumulation of many dotcom assets.

After the consolidation phase ended, businesses realized those assets were purchased at bubble-sized prices. After the bubble burst, the consolidators found they were holding onto fairly worthless assets, while the ones who sold out were sitting on piles of wealth beyond belief. The ones holding the hot potato when the bubble burst lost.

Now you may argue that this was not a true consolidation phase and that bubbles are not the norm. That may be true, but the principle still holds true. It just may take a little longer to see the results.

The rationale for doubling down during the consolidation phase tends to go as follows:

1) There are economies of scale on the cost side in becoming large.
The logic is that if I buy up the assets from others and combine them with mine, I can create a ton of synergies and eliminate a boatload of duplications and waste. For example, in the recent talks to combine Chrysler and GM, there are estimates that the economies of scale could possibly cut out $10 billion in costs.

2) There are top-line sales benefits if the number of competitors are reduced.
There’s a reason why governments tend to discourage monopolies or near monopolies. They believe that if too much power is placed in the hands of too few companies, prices will go up, hurting the consumer, and putting excessive profits in the hands of the remaining firms. Although a company would not admit this is true (in order to get the deal approved by the government), there is a belief that being a large player with fewer competitors is helpful in the fight for sales and profits in a no-growth industry.

Unfortunately, reality tends to makes these two points less powerful than they at first appear. Instead, what occurs is the following:

1) The consolidator overpays for the companies it purchases.
In today’s sophisticated environment, it is highly unlikely that one can acquire a business at a lowball price (the current situation with the valuation of banks and other financial institutions notwithstanding). Everyone knows all the tricks in how to valuate companies (or can hire someone who does). Therefore, one typically has to pay a fairly high price to consolidate the market. In other words, in the purchase price, the consolidator has to pay the other company a portion of the expected synergies in order to get a deal done. So the seller gets part of the benefits of the synergies without taking any of the risk.

2) The economies of scale are less than expected.
Although people may argue about the cause, the raw fact is that business plans tend to overstate the economies of scale—both in the amount and in how soon they will occur. As a result, most of the remaining synergies are too small to cover the premium price paid. And you probably gave that amount away to the seller when you overpaid.

3) Not all of the Sales Stick
There is a reason why some customers preferred doing business with your competitor rather than with you. For some reason, a certain percentage of the market preferred not to do business with you and chose the competitor in order to avoid doing business with you. When you buy that competitor, you are buying a customer list which includes people who have been avoiding you. They may continue to want to avoid you and defect to another firm once you make the acquisition. Therefore, there are usually top-line dis-synergies in an acquisition, causing your combined sales to be less than the sum of what each firm did separately.

4) The integration of the assets is harder than one thinks.
Pride, differing cultures, different IT systems, key employee defections, and other such factors often make integration of companies slower and more costly than anticipated. All those expected synergies come up short. You save less than you think.

5) The market shrinks faster than one thinks
The reason why industries stop growing is not because people stop spending. Typically, what happens is that another industry provides a superior solution and the growth moves to the superior solution. People didn’t stop buying photographic film because they stopped taking pictures. In reality, people are taking more pictures now than ever before. They just found digital photography to be a superior solution.

The problem in declining industries is that the consolidators tend to underestimate the growth of the new industry that is providing the superior solution, in part because they do not understand the new solution. In addition, they may not see how interconnected their old solution is to the new solution and not realize how the growth of the new is at the expense of the old. Kodak terribly underestimated the digital world, because it was not their world. They could not imagine cell phones replacing cameras.

Macy’s spent a fortune to consolidate the department store industry in the US. Unfortunately, many people have found superior solutions to the department store, such as the lower priced Kohl’s chain or in high-end specialty formats, like Williams Sonoma. In addition, apparel, the core of the department store, is not as hot a category as it used to be. The greater growth has been in areas like consumer electronics, which diverts money away from apparel into stores like Best Buy.

As I’ve mentioned many times before, study after study has shown that most acquisitions end up destroying value for the acquirer. A successful consolidation strategy usually depends upon making a series of acquisitions. Just getting one right is difficult. The likelihood that all will work is slim. That’s why the seller usually does better than the buyer.

So what is the solution?

1. Consider selling out early, while you can still get top dollar for your business. For more on this, see my blog “We Can All Act Like Sports Franchise Owners.”

2. If you still want to be the consolidator, make doing good acquisitions your core competency. Cisco succeeded in consolidation because they took the time to become world class at acquisitions. That became a big part of their value-added vision.

3. Discover early what superior solution is taking the growth out of your industry and shift to that superior solution. In other words, continue to be a growth company even through your industry is may not be by moving to where the growth is. Fuji saw that photographic growth was moving to digital and they rushed into the digital void early to stake out a position and sustain growth. Dayton Hudson saw that discount stores were growing at the expense of department stores, so they sold out of many of their department store divisions early and put the money into the faster growing Target chain.

Becoming a consolidator can be an alluring strategy. You get to become the big fish in the shrinking pond. It strokes the ego to buy out those hated competitors and become the last big survivor. By contrast, selling out to the consolidator can look like defeat. However, the reality is that selling out is often the strategy which creates the greatest value, while the consolidator destroys value.

Remember the moral of the hot potato—if you hold on to it too long, you will burn your hand.

Thursday, October 23, 2008

Analogy #216: Stop the Labeling!

When I was a young boy, my parents would occasionally send me off for a week of summer camp.

In order to keep track of things, the camps would ask parents to label everything with their child’s name. Clothes were to have labels sewn onto them. Property was to have sticky labels. That way the camp could make sure that all the boys went home with the same stuff they brought.

Of course, all of the boys would ridicule the other boys when they saw one of those labels. They would call them a “mama’s boy.” Having those labels with your name on it became a badge of shame.

Therefore, one of the first things the boys would do when they got to camp would be to rip off all those labels with their names on them. All that careful work by the parents to label things was for naught.

There’s a certain comfort level in labeling things. The camps and the parents felt assured that such labeling would make it easier to track all of those possessions. Unfortunately, the children did not like the stigma of being labeled.

Businesses also tend to like labeling people…and each person seems to only be allowed one label. For example, some people are labeled good customers and others bad customers, and the label sticks regardless of the situation. And if you are labeled a customer, then you cannot be labeled a vendor, and vice versa.

What if businesses acted more like those boys at summer camp and ripped off those labels?

The principle here is that once something gets labeled, the label tends to dictate how the item is treated. For example, if you label someone as “aggressive,” you will approach them differently than if they had been labeled “passive.” The less labeling one does, the more flexible and adaptable one can be towards that object.

Businesses interact with a lot of different people/companies. Those people/companies tend to get labeled and put into a category: customer, supplier, partner, competitor, employee, and so on. Once placed in a category, the tendency is to limit interactions to just what is implied by that label. However, new strategic opportunities open up if we rip out those labels we have mentally sewn onto them.

For a recent example of this, we can look at an article in the October 2008 Harvard Business Review. The article, entitled “The Contribution Revolution: Letting Volunteers Build Your Business,” was written by Scott Cook, founder-chairman of Intuit.

The basic idea of the article is that if a company provides the right kinds of Web 2.0-type tools, all sorts of people will voluntarily make contributions that will have a significant profitability impact on your business. Cook then lists all sorts of examples.

At his own company, Intuit, they do not have a Spanish language manual, but Spanish speaking volunteers have offered all sorts of Spanish language mini-manuals and podcasts. Unilever has the “In the Motherhood” user forum and Proctor & Gamble has the BeingGirl online community for teens. Cook likes the way both provide all sorts of relevant user-generated content.

Some companies use “free volunteers” to help design and critique products. Others ask their customers to help create their advertising. Key bloggers can be used as “free advertising” as well.

My point is that if you label someone as a customer, then you will think of them in terms of how to get them to buy from you—after all, that’s what customers are supposed to do. However, if you rip off the label, you can see how they are connected to your brand in many ways and can help in many ways—often for free.

The same thing goes for suppliers. If you think of them only in terms of that label, then the tendency is to just try to use “hardball” negotiations to get the lowest price for what they supply. But if you think of them as a strategic partner in your supply chain, you may see that you can help each other create a more efficient supply chain, which could be far more profitable than what you can get only through hardball price negotiations. Toyota’s relationships with its suppliers is an example of this.

In the grocery industry, it is not uncommon for supermarket companies to outsource a lot of their shelf space management to a variety of their vendors/suppliers. The logic is that the supplier is a specialist expert who understands that particular product class better than anyone else. In other words, the supplier becomes a “free” merchandising consultant to the supermarket.

Even those labeled as “competition” may be seen as free helpers if you rip off that label. For example, maybe you can work together to lobby the government on various causes of mutual interest. Or maybe you can jointly support an effort to create a more favorable image for your industry which could expand the total industry demand.

Employees could be seen as free “brand advocates” or free “guinea pigs” for various experiments. Really loyal and engaged employees may want to freely volunteer ideas to help the company in areas that have no direct bearing to their job label.

Although these ideas work well in the digital web 2.0 world, it can go well beyond that. Face to face meetings, joint committees, call centers, and the ol’ suggestion box can be a part of the mix as well.

To get all of this free help requires several things. First, as mentioned, get out of the mode of narrowly labeling people and companies. Look as everyone as a potential partner, willing to help you for free (or at least at below market prices).

Second, create lots of ways to make it easy for people to help you. That requires both creating lots of ways for them to communicate with you as well as people on your end to willingly and graciously receive the free help.

Third, don’t be bashful. Ask a lot of questions to a lot of people. You’re more likely to get the help you want if you let them know what you’re looking for.

Finally, get out of the habit of describing some customers as always “good” or always “bad.” Even people labeled as “bad” customers can be “good” customers if you look at them differently. Perhaps they can become good customers if you design a new business model. For example, much work has been done recently to find economic ways to sell to low income third world areas, people who had traditionally been seen as too poor to be a good customer.

Or perhaps a so-called “bad” customer is merely a “future-good” customer. It may just be too early in their life-stage for them to hit their prime opportunity years. However, if you appeal a bit to them today, they may be more loyal to you once they hit their prime opportunity years. Get a young girl hooked on your luxury handbag today, and you may create a strong brand supporter for your entire luxury portfolio once they get older and wealthier.

Labeling can have the unintended negative consequence of narrowing our expectations of people. We only expect of them what is implied by the label. For example, a customer is only expected to consume, a supplier is only expected to supply. However, if we take the labels off, we can see broader potential. Everyone can become a potential strategic partner, offering all sorts of assistance. And best of all, it is often nearly free.

One time when I was at camp, they did a spot inspection of the cabins and happened to luck into coming at a rare moment when my cabin was clean. This was the exception rather than the rule. But needless to say, that rare inspection paid off and I was given a badge for “cleanliness.” Later, I was running through the woods with the badge, tripped and took a terrible tumble into the dirt. The cleanliness badge got all mangled and blackened with dirt smudges.

When camp was over, I proudly gave my dirty, mangled “cleanliness” badge to my parents. They weren’t fooled by the cleanliness label. They knew better. You should know better than to be fooled by labels, too.

Monday, October 20, 2008

Analogy #215: Slacker Terrorists

Here’s a story you’ll probably never hear—a story about slacker suicide bombers. Imagine if you will, suicide bombers who are indifferent to their task—not caring if they show up or not.

They come late to the meetings to learn how to make the suicide bombs, because they’re not really into the task at hand. Even though their bosses have set a date for when they are to perform their suicide mission, they say they’ll get around to it later. They only half-heartedly care about the greater mission of the terrorist group to which they belong. If it weren’t for the paycheck, they wouldn’t show up.

No, I don’t think there are very many slacker suicide bombers out there.

There may not be many slackers in the ranks of suicide bombers, but there sure are a lot of them in the ranks of business. According to the Gallup organization, it is estimated that unengaged employees cost the US economy about $300 billion a year. They claim that about 17% of the workforce is “actively” disengaged. Each of these employees cost their employer about $13,000 a year in lost productivity.

To some extent, the quality of one’s strategy is irrelevant if the bulk of your employees are indifferent to it. Therefore, a strategy needs to be more than just needs to inspire.

This blog will look at terrorist organizations to see what we can learn about creating inspired and engaged employees.

The principle here is that effective organizations mentally and emotionally engage their employees. As I’ve said earlier, dedicated patriots are more effective than mercenaries, who only fight for the money (see blogs “Soulless Capitalism” and “Sweat is Swell”).

Terrorists seem to do a very good job of creating this attitude. Not only are they willing to work hard for the cause, but die for the cause. These terrorist are willing to sacrifice a great deal for the cause. How much sacrifice do your employees want to give to the cause?

Here are a few things we can learn from terrorist organizations to create that engagement:

1) Create a Great Cause
People are not willing to die for a small cause, but they will do remarkable things for a great cause. Employees will be far more engaged if they feel like they are a part of a great and mighty movement, bigger than themselves. Mission statements can be an important tool to communicate that great cause.

You may be thinking to yourself, “Sure, it’s easy for a terrorist organization to extol a great cause. They’re fighting for freedom, eliminating oppression, furthering their religion. But all my company does is sell widgets. Where’s the great cause in that?”

Well, if you can’t find the great cause, don’t expect the employees to find it. There is a great cause out there for almost every company. Part of your job is to find it and then make it the common great cause for the organization. If you don’t supply a great cause, employees may conclude that their only mission is to make the boss wealthy at their expense. Now that has slacker written all over it.

Google could have said that their job is to make advertising more effective (ho-hum, yawn). Instead, their mission is to “organize the world's information and make it universally accessible and useful.” Now that’s something to get excited about…to be the first to conquer knowledge and give it to the world in a way that betters everyone.

ADM could have said they sell food-based chemicals. Instead, their great cause is to “unlock the potential of nature to improve the quality of life.” How’s that for inspiration?

Even someone like Avery Dennison, maker of stickers and labels, was able to find a greater cause in all that: to enable and transform the way consumers and businesses gather, manage, distribute and communicate information.

A bland statement like “optimizing shareholder value for our shareholders” is about as inspiring as cold oatmeal. The younger portion of the workforce is especially interested in working at inspirational companies. If you want to tap into this talent pool make sure you wrap your company’s work around a great cause.

2) Keep the Organization Small
It’s hard to feel like a nameless, faceless cog in a giant impersonal machine when the organization is so small that you know everyone by name (and they all know you). Small groups create more of a family-type atmosphere. And people will go to great ends to protect their “family.”

Terrorist cell groups are often very effective because they are intentionally kept small. Once they get to a certain size, they are split up in order to stay small. It’s hard to slack off when you know that everyone in the small group is depending on you. There is no place to hide.

Many successful companies do a good job of capturing this idea of keeping groups small. Some experts say that effective organizations stay under 200 people. Once you start approaching that size, split up the organization. Create a network of small companies, rather than one giant behemoth.

3) Spread the Glory
Terrorists are in the business of creating heroes. Everyone who works hard for the cause is a hero. They write songs about the great heroes of the cause. If you die for the cause, you bring honor to your family and perhaps are rewarded yourself with 50 virgins in the afterlife. Stories of great heroism become integral to the culture.

There’s no law that a company can have only a limited number of heroes. Making heroes is not like handing out slices of a pizza, where you can run out of slices if you pass them out too quickly. You can have an unlimited number of heroes. Don’t be stingy with the praise of heroics.

And don’t just give the praise to folks at the top. Spread the glory out into the front line troops. It doesn’t cost a lot and it creates tremendous engagement.

4) Demonize the Enemy
Terror groups are great at depicting their opposition as evil incarnate. “Death to Satan” can be a great motivator. The desire to beat the competition becomes more emotional and convicting when the competition is painted as an evil foe. Just as a great cause makes you want to work hard for your company, painting the competition as the enemy of that great cause makes you want to work even harder to stop them.

In the early days, when the founder of Best Buy was trying to build his company, he saw the much larger Circuit City as his enemy. In conversation, he always referred to it as “the Evil Empire.” And over time, Best Buy overcame that “evil empire.”

I know of many other firms companies that have also used the demonizing of their opposition to engage the troops.

5) Live the Cause
Decades after the revolution, Fidel Castro still wore army fatigues. Castro understood that if he stopped living the cause and started looking like he was living the life of decadence, the followers of the cause would stop following. Followers expect their leaders to live a life consistent with the cause. Hypocrisy will lead to a counter revolution.

Appearance is very important. Companies like Patagonia and W.L Gore have impassioned employees in part because they see that passion so integral to the lives of their leaders. It is real and genuine. It’s not just a slogan. Live the cause in a way that your people can see it in who you are.

You just don’t hear about slacker suicide bombers, because only impassioned and engaged followers will desire the life of the suicide bomber. Terrorists have done a good job of building passion into their followers, and you can do the same. Follow their tactics of creating a great cause, keeping the organization small, spreading the glory, demonizing the enemy, and living the cause. Integrate this into your strategy and you will become a much greater organization.

People talk about the problems of finding and recruiting great talent. Terrorists seem to do a pretty good job of recruiting. In fact, once they get all the factors we talked about running smoothly, the recruiting almost takes care of itself. People flock to those types of organizations.

Thursday, October 16, 2008

Analogy #214: Maid or Maiden

Once upon a time, a young man saw a bottle wash up on the shore. The young man opened the bottle and out popped a Genie.

The Genie said, “Thank you for letting me get out of that bottle. Out of gratitude, I will grant you a wish. Behold, I place two women before you…one a maid and the other a maiden. You must choose only one of them and she will be yours.”

The young man thought, “Boy, it would be great to have a maid to take care of all the things I do not want to deal with. The maid would do all the work while I have all the fun. But it’s not much fun being alone.

“On the other hand, it would be a lot more fun having a great time together with the young maiden. However, without the maid, I would be so busy with chores that I wouldn’t have much spare time to enjoy being with the maiden. I’d really like both.”

Feeling perplexed, the young man asked the Genie, “Wouldn’t be possible have a woman who is both a maid and a maiden?”

“Oh, no,” the Genie replied. “If you made the maiden work hard at maid chores, she would lose her beauty and charm. If you had the maid try to act the maiden, she would be in a world beyond her upbringing and not know how to act. No, you must pick one or the other.”

So the young man made his choice. Immediately afterward he scoured the beach looking for another genie in the bottle, so that he could request the other option and have both a maid and a maiden.

Successful strategies require choosing a position in the marketplace. Although there often are many positioning options to choose from, they tend to fall into one of two basic types. Either the position is like a maid or it is like a maiden.

A “maid” position is a one where you offer the solution of eliminating or reducing the effort in some task a person does not want to do. The idea is that if you hand over your problems to the maid, they will take care of the mess for you, so that you can spend more time on the things you enjoy.

A “maiden” position tends to be the opposite approach. Here one is offering an even better experience in something which you desire to do. The idea is that your enjoyable times will be even more enjoyable when accompanied by the maiden.

If you can own the position of the superior maid or maiden in your industry, then you have a great shot at success. People will choose you.

However, as we saw in the story, it is difficult to try to become known as both the maid and the maiden. For example, it would be difficult to believe that someone is the most qualified maid if they act like a maiden. You would believe that Maiden-like people wouldn’t want to get their hands dirty enough to clean properly. Their dignity would supposedly not let them act like a common laborer.

Similarly, a maiden loses some of her allure if she’s also known to be a maid. If she is such a good maiden, then why does she have to stoop to do common labor? It’s never a good idea to date the household help.

The principle here is focus and consistency. Focus on either being the maid or the maiden and then consistently act in a way which reinforces that focus.

For example, let us look at the world of computing. The Microsoft PC success has traditionally been based on being the best maid. It is designed to efficiently do all of that boring stuff at work for you, like spreadsheets and charts. You don’t need to know much about computing. The machine does most of the work for you, and it could work in just about any business environment. Not very glamorous or sexy, but it gets all that boring stuff done for you. The perfect maid.

By contrast, Apple is positioned as that sexy and glamorous maiden. It is known for helping you be more creative and have more fun with the things you like to spend time on, like listening to music or making movies. The machines look sexier, and the interface is more glamorous and alluring. The perfect maiden.

The problem came when the Microsoft Maid wanted to become more of a maiden. Out came Vista. Vista was a disaster on many levels. First, it didn’t seem to work as well as Windows XP. In other words, it was a less efficient maid—slower and more cumbersome. Second, although it was a bit more glamorous, Vista was an inferior maiden to Apple. You can put a fancy dress on the maid, but it is still the maid. By losing its focus and being inconsistent, Microsoft has suffered.

By contrast, Apple has been consistent in its focus by taking key technology elements to become the best maiden in music and mobile devices. Even the Apple retail stores are more maiden in their approach. The consistency has reinforced the Apple brand, giving each new brand extension a built-in maiden allure.

Speaking of retail, let’s turn our attention to Best Buy. Best Buy is essentially a maiden. It is positioned to help people use technology to make their lives more enjoyable. It’s all about maximizing pleasure. One of their old slogans was “Turn on the Fun.” There was logic to adding the Magnolia higher end Home Theater departments to Best Buy. After all, Magnolia was just a higher class maiden, helping create a more glamorous home enjoyment entertainment solution.

But then there is the major appliance section at Best Buy. You know, those stoves, refrigerators and washing machines off to the side of the Best Buy store in the area that doesn’t have any customer traffic. People tend to be more in more of a “maid” mindset when looking for major appliances. As a result, when Home Depot and Lowes started selling major appliances, they quickly overtook Best Buy in market share (and then some).

Home Depot and Lowes are positioned more like “maids.” They are efficient places to help you get all those nasty projects done. As a result, it was a more consistent fit to put maid-like appliances in these maid stores than in the Best Buy maiden stores. Of course, now that the manufacturers are trying to make the appliances sexer, perhaps Best Buy has a chance to fight back (although I’m not sure what the demand is for sexy washing machines).

Many articles have been written about the problems of being positioned in the messy middle. It is better to be seen more on the extreme—an extreme solver of problems (the maid) or an extreme provider of pleasure (the maiden).

In the competitive world of today, one needs to stand for something in order to survive. One way to look at positioning options is with respect to how you help a consumer improve their lives. Are you helping them by being the best at eliminating the drudgery (like a maid) or are you helping them by being the best at improving the pleasure (like a maiden)? Either option can succeed. However, once the choice is made, be consistent to that position and build upon it. And avoid trying to merge the two. There is a dis-synergy to adding the maid and maiden together.

Since most industries can support both a maid and a maiden approach, one has the opportunity to avoid direct competition by choosing the one not chosen by the competition. Direct competition usually leads to price wars and lower profitability for both of you. But if one of you chooses to be the maid and the other the maiden, then you can more successfully co-exist.

Sunday, October 12, 2008

Analogy #213: Wait for the Votes

In election years, the media seem to take great pleasure in declaring winners before all the votes are counted. Heck, they like to declare winners before the voting has started. What if other businesses did the same thing?

What if race tracks declared winners before the race was over? The race track would pay off betters based on their estimates of how the race would end up based on only half of the race being finished. Is that fair?

Or how about if Olympic gold medals were handed out based on estimated outcomes when only part of the competition was completed? Taken to an extreme, they could even pass out the medals before the competition even begins, based on projected performances.

In Tennis, the athletes are seeded in order based on estimated abilities. Why not skip the tennis matches and just give out the awards based on the seeding?

As another example, we could tip the service staff at a restaurant before the meal, based on the reputation of the staff or how they were rated by a restaurant critic.

Well, I think we know why we don’t do these things. First of all, people do not always live up to your expectations. The favored horse doesn’t always win; the best athlete can have a bad day. You can end up rewarding the wrong person if you reward too quickly. Second, if you reward people before they perform, they may not be as motivated to excel at finishing the performance well. Why give excellent service if you get the tip in advance?

No thank you. I’ll think I’ll wait until the results are in before I declare winners, pay off bets, hand out awards, or give out tips.

It seems a little ridiculous to give out rewards too early in the game, perhaps even unjust or criminal. Yet we seem to do that in the business world all the time.

For example, there has been study after study throughout the decades concerning the success rates for acquisitions. Depending on the study methodology, somewhere between 60 to 90% of these deals fail. In other words, most of the deals will destroy value.

In spite of all the potential for failure, we pay investment bankers huge funds at the moment the deal is consummated—as a “reward” for helping us get the deal done. Since most deals fail, why are we rewarding these investment firms so well for very likely helping us destroy value?

Don’t you think we’d get better service from investment bankers (and have a higher success rate) if we withheld payment until it was known whether or not they were winners in helping us do a successful deal? Why do you think all those investment houses got into trouble in the current financial meltdown? I think a lot of it had to do with a system that provided them with huge financial rewards before all the votes were in on the quality of their performance. Why only do good work if the bad work is equally rewarded? It was about quantity, not quality.

The same goes for the home mortgage crisis. We rewarded the people writing the loans at the moment the papers were signed. This was too early in the race…it was not known yet which loans would be winners. Why try to win a race if you are rewarded every time you simply enter the race? As a result, we ended up with a lot of loser loans.

In the legal profession, there are many lawyers who only get paid if they are successful in working on your behalf. In other words, rewards aren’t handed out until we know who the winner is. Wouldn’t it be a novel idea to try something like that with the reward system in your company?

The principle here is about linking rewards to success. Now you may be saying to yourself, “Of course I link rewards to success. Bonuses are only paid out if we successfully achieve the numbers.”

The problem is that the bonus cycle tends to be shorter than the strategy cycle. Getting a strategy successfully in place and then adhering to it/strengthening it can take years. Bonuses are paid out much sooner, before one knows whether:

a) The Strategy is Successful;
b) Whether the Strategy Has Been Successfully Implemented.

This is like paying off on bets before the horse race is over.

Here are some tips to help ensure that the rewards are going to the true winners.

1) Set Goals Around Success Rather Than Task Completion
The mortgage lenders were rewarded for signing up loans. The investment bankers were rewarded for doing a deal. In other words, they were rewarded for completing tasks. It didn’t matter how well the task was done. Rewards came whether the ultimate result of the task was successful or not. Bad mortgages and bad deals were rewarded the same as good ones, because they required the same task.

Just because a task is completed does not mean one is any closer to the goal. For example, I can think up all kinds of ways to temporarily boost sales which could end up obliterating the strategy—or worse yet, destroy the company. Does Enron come to mind?

Getting sales today which destroy your image, disappoint customers, involve illegal or immoral acts, move the company towards selling the wrong thing, or cause you to sell at a great financial loss are not successful sales. Similarly, not all near-term profits are a sign of long-term success. A profit “at any cost” is too high a cost. If I sell off the resources needed to create future profits today, how do I create profits tomorrow?

If all you do is reward people for completing tasks, the tasks will indeed get done. However, you may not like the long-term results caused by how the tasks get done. By contrast, if you reward success (both strategic and financial), people will find the proper tasks to reach the success. In other words, if you reward the right outcome, the process will take care of itself, but if you reward the process, you can get a horrible outcome.

Therefore, once a strategy is created, determine the key drivers of strategic success. Put a measurement to key drivers, and reward on that measure.

2) Link to the Big Picture
I believe that any reward system needs to not only reward people for the things they have complete control over, but also for achieving broader success for the entire organization. Success usually requires cooperation between business silos. If you only reward silo optimization, then the cross-functional necessities will get missed.

The big strategic picture should be important to everyone. People should be able to see how their function helps in achieving the big strategic picture. And part of the rewards need to be dependent on getting the entire company closer to that strategic goal.

You’d be amazed at how much indirect control/influence an area has in helping the get the cross-functional big-picture goals achieved, IF you put it into the reward system. Remember, it really doesn’t do you a whole lot of good to have one area humming along at full speed if the rest of the company is dragging you into failure. We’re all in this together.

3) Put Patience Into Your Payout
The problem with many reward systems is that it is easy to “game” them. In other words, people find ways to trick the system so that they can get rewards without really doing the things that lead to success.

One of the common ways to game a system is to take advantage of the difference between the timing of the bonus cycle and the strategy cycle. For example, if a strategic initiative takes two years and the reward is paid annually, one could game the system to push all of the “problems” into the second year, so that one could get a big reward in the first year. Granted, this would probably not get one a big reward in the second year, but if you averaged out the weak performance over the two years, it might have been less than the big bonus gained in the first year through gaming the system.

One way to get around this is to put some of the annual reward into a “bank” and only pay it out once it is determined that the strategic initiative was ultimately a success. If the long-term results are a failure, the money in the bank is forfeited back to the company. It may take a year or two to find out whether you really earned that reward.

Sure, this can be a tricky process to implement. But think of all those bad deals and bad mortgages which would not have happened if patience had been put into the system so that those people only got rewarded for the good ones.

Don’t pay it all out when the deal is done or the year is over. Hold some back until it is known if the effort leads to success.

4) Watch Out for Unintended Consequences
There is usually more than one way to hit a reward target. People will tend to pick the easy way over the successful way. For example, one company wanted to encourage the strategic intent of increasing innovation. To do so, they set reward targets based on the percent of sales coming from new products. That sounded pretty good, until they found out that some areas were achieving the goal by prematurely killing off profitable old businesses. It got to the reward, but did not live true to the strategic intent of accelerating innovation. Instead, it accelerated closing down good businesses.

Therefore, when setting the targets, try to think through the potential unintended consequences in advance. That way, you can minimize their unwelcome intrusion later on. For more on unintended consequences, see the blog on the "Chisholm Trail."

Just as you wouldn’t want to reward a race horse before the race is over, you shouldn’t want to reward people in your business for actions until you know whether or not the actions lead to strategic success. One needs to set up a reward system that ensures that only the ultimate winning activities get rewarded. To do so requires: a) setting goals around successes rather than mere task completion, b) linking rewards to the strategic big picture, c) delaying some rewards until success is truly known, and d) avoiding goals with bad unintended consequences.

I knew someone who was handed a division to turnaround. There was money put into the budget to spend on repositioning the division. The person did not spend the money to turnaround the division. As a result, he got a huge bonus that year for exceeding budgeted profits, largely from not spending the repositioning money. The following year, the division was sold to an investor at a huge loss because it had not been successfully repositioned. Was that huge bonus really earned for achieving strategic success?

Thursday, October 9, 2008

Analogy #212: Incremental Dead-Ends

In case you were wondering why it has been so long since I wrote my blog, two weeks ago I was on vacation. This past week I had a medical problem with my eye.

The eye doctor diagnosed it as “Recurrent Corneal Erosion.” What happened was that the outer layer of my eye became sort of detatched from the rest of the eye. It is sort of like what happens when a popped boil creates loose outer skin on your body.

Every time my eyelid rubbed against the eye, it was irritating the loose eye layer. It was sort of like the pain of pulling a bandage off a scab. The eye doctor said that she was taught in school that this is the most painful condition one can have with an eye. I don’t know if it is the most painful, but I can vouch that it was indeed very painful.

To counter the pain and help it heal, the standard recommendation was an anti-biotic inside petroleum jelly. The jelly supposedly helps lubricate the scraping of the eye by the eyelid, while the anti-biotic fights infection.

The jelly came in a little tube, like tiny toothpaste. However, when you squeezed on the tube, the jelly all rolled up into a ball, making it almost impossible to apply to the eye. I was not very good at applying it, so it was not helping. Next, I had my wife help me apply it. That was better, but still problematic. The next day I went to the eye doctor and had her put it in. I figured that since she was a pro, she could do it better. It was only slightly better. I even asked the pharmacist if she knew any tricks to applying the jelly.

Even with the jelly in my eye, it only temporarily helped ease the pain. And it made it hard to see, because I was looking through a film of jelly. So even at its best, it wasn’t very good.

Finally, my eye doctor referred me to a specialist. It only took him a couple of minutes to solve the problem. He took something like a blank contact lens and put it in my eye. The contact lens immediately and permanently protected the cornea from the eyelid. The pain was finally gone. And I didn’t have to mess with the jelly any more. I wish we would have done that a lot sooner.

In the business world we need strategies to solve problems and grow the business. Often times, the place where we start is with the conventional thinking of the recent past. In other words, we try to create a better future by making incremental improvements to the current way of doing things.

This was what I was trying to do with my eye problem. I was trying to find incrementally better ways to apply the jelly. The thinking was that the jelly was good and the standard cure, so if I can just apply it better, I’ll have a better cure.

The solution, however, required throwing away the jelly and trying something entirely different. Instead of looking to prescription ointments, we went in an entirely different direction and tried an artificial lens-like device.

Frequently, we need to do the same thing with our strategy. Rather than trying to improve the current business model, we need to throw it away and come at the problem from an entirely different direction that has almost nothing in common with the old approach.

The principle here is the concept of discontinuous improvement. Great leaps in innovation and growth rarely come from a series of small incremental improvements. Instead, the great leaps come from completely abandoning the old business models and technologies and processes and doing something entirely different.

You cannot make incremental improvements to the radio and eventually end up with an iPod. The technology is entirely different. The way the money is made in the business model is entirely different. The players in the business model are entirely different.

Similarly, you cannot make incremental changes to the stove and eventually come up with a microwave oven. The technology is totally different. The cooking is done in such a radically different way that entirely new ways of packaging and preparing food developed.

If you want to go back even further, you cannot evolve carbon paper into photocopiers. You cannot evolve slide rules into calculators. New approaches created entirely new industries, which made the old ways obsolete.

One of my favorite recent examples is Procter & Gamble. For years, they had looked for solutions for better cleaning through better chemistry. This had about run its course. Then someone got the idea of looking for cleaning solutions through better physics. Suddenly, there were several new cleaning products for Mr. Clean, such as the Magic Eraser. Swiffer was based in part on the science of static electricity. These successful new products were relying on business principles as different from traditional chemistry as my petroleum jelly anti-biotic was from contact lenses.

Speaking of contact lenses, Bausch & Lomb for years had relied on lens technology to help improve eyesight. Eventually, they had the epiphany that you can improve eyesight with treatments that have nothing to do with creating lenses. For example, Bausch and Lomb is a leader in building machines to do laser surgery. Bausch and Lomb is also a leader in producing vitamin supplements which have been found to improve particular types of eye problems.

You cannot incrementally get from lenses to laser surgery and vitamins. These are radically new approaches with an entirely different business model. It requires taking an entirely different look at your entire approach to profitability.

The pharmaceutical industry has been hitting a slump because the traditional approach has pretty much been exhausted. New blockbuster drugs are not coming out like they used to. Perhaps the problem is that we shouldn’t be looking for blockbuster drugs anymore. The age of the pill as the solution may be coming to an end.

Perhaps the next phase will be electronic signals…or nano machines…or sound waves…or implants…or whatever. These new cures may not provide any business for the local pharmacy. A whole new industry may replace it.

Some key things to remember.

1) If the current players in an industry do not embrace and lead in these new directions, eventually an outsider will try going in the new direction. As long as the old ways will eventually be cast aside and marginalized (or made obsolete), one may as well seek out the replacements.

2) Don’t be afraid of experimenting with radically different business models. I don’t think the folks at Apple are upset with the new model they created with iPod. Of course, one may need to try many small experiments before finding the next big thing.

3) Don’t look at your changes in isolation. They may not only upset the current way you do things, but also the way others in the supply chain need to operate. In fact, it may require you to reinvent yourself into taking some of the roles.

4) Rather than focus on the process, focus on the solution. When Bausch and Lomb switched their thinking from the process (making lenses) to the solution (better eyesight) entirely new growth paths came into being. Consumers buy your solutions, not your process. If a new process gives customers a better solution, they will abandon you in a heartbeat.

Big new successes and major leaps in growth typically come through radical changes to the business model. Incremental improvements to conventional wisdom won’t get you there. They eventually lead to dead-ends. Instead of thinking of how to do the current thing better, think of how to create a superior solution by doing something different.

I’ve still got a ways to go before my recurrent corneal erosion is healed, but I am so grateful that someone thought out of the box and came up with a radically better solution. Otherwise, I would be lying in bed in pain rather than writing this blog.