Tuesday, September 15, 2009

Strategic Planning Analogy #275: Bias to Go

I worked with a company that desired to have a new corporate headquarters building. The company at the time was spread over several buildings around the city, making things inconvenient. Not only would a new headquarters get rid of that problem, but many thought it would be fun and a boost to the ego to work in a flashy new building.

The problem was that the new headquarters was difficult to justify based on financials. New headquarters can be very expensive, and the benefits to the rest of the business are difficult to quantify.

To make the financials more appealing, two assumptions for the model were changed. First, the resale value of the old headquarters was increased in the model. In other words, if we moved to a new building, it was assumed we would get more when we sold the old building (to help pay for the new building).

Second, it was assumed that the company’s unusually rapid growth rate would continue for awhile. This meant that the current infrastructure was even less adequate moving forward (we’d have to add more office space anyway). It also made the cost of the new headquarters more efficient, since a bigger headquarters costs less per square foot to build.

These changes gave the new headquarters scenario just enough of an edge so that it looked slightly better to build an impressive new corporate headquarters building than work with the current hodge-podge of buildings. So the decision was made to “go” with the flashy new headquarters.

Well it takes a year or two to get one of these headquarters built. Between the time of giving the go-ahead to build the new headquarters and the time it opened, two particular things occurred. First, the bottom dropped out of the real estate market, meaning that the old headquarters sold for a lot less than what was put in the model. Second, internal growth had stopped and the company had actually shrunk the headquarters staff. So the new headquarters opened up as about half empty. At this point, it would be difficult to justify that new building. But it was really cool and people still liked the prestige of being there.

At the end of the day, that huge new headquarters was not built because it was the wisest financial move. It was built because people wanted a cool new building to work in. That bias of desire overtook common sense. The financial model had been unjustly modified to make it look like a wise move, but in the end, reality told a different story.

In the business world, there are all sorts of similar types of business decisions. They are some variation of this question: Do we stick with the old and familiar or go with the new and different? This applies not only to headquarters, but to potential new product offerings, brand extensions, acquisitions, diversifications, and the like. The sexiness of the new initiative lures people in like the songs of the Sirens.

People seem to forget that most new initiatives fail. They think that this one is the exception to the rule. So they push forward on the new initiative and create one more disaster, confirming one again that most new initiatives fail.

The principle here is that when it comes to “go” vs. “no go” decisions on new initiatives, there are many internal biases towards “go.” If we don’t understand the impact of these biases, we can become blinded into making less than ideal decisions. Therefore, this blog will look at three things: Sources of a bias to “go,” distortions to the decision-making process which come from the biases, and the questions we need to ask ourselves to unmask the bias to “Go.”

In the next blog, we will do the same thing for the biases to “No Go.”

1. Bias Source #1: Fun Factor
Let’s face it. It’s fun to work on the “new” project. It sure beats working on the old routine stuff. You get to go to lots of committee meetings (and eat lots of yummy donuts). If you keep saying “yes” the fun continues. If you say “no” the fun ends.

2. Bias Source #2: Freedom
The old routine stuff has all sorts of tight budgets and short performance deadlines. There is a clear line of authority and accountability. It’s a hassle and you get yelled at a lot if budgets are missed. By contrast, the new stuff is usually more open-ended. There is a lot more freedom and less accountability as it is being set up.

3. Bias Source #3: Career Enrichment
The new stuff is highly visible. If you can make the new project a success, you can quickly become a hero in the organization. That can lead to all sorts of bigger titles, promotions, perks and money. Your rise in the organization tends to be faster if you work on the new stuff (and succeed), so you are biased to work on these projects and promote them so that you have a chance to succeed with them.

4. Bias Source #4: Linkage of Person and Project Image
Of course, this also works in the other direction. If the highly visible new project fails, your “failure” is very visible. The more a person sees their personal success as linked to the project success, the more likely they will push the project forward. After all, saying “no” to the project is viewed as being like saying “no” to the people working on it. This creates a strong bias to avoid shutting a project down, no matter how bad it looks.

5. Bias Source #5: The Panacea Phenomenon, or the Optimism of Ignorance
We all tend to know the shortcomings of our current businesses. However, when we venture into new territory, there are more unknowns. Given all of the other biases, we tend to take a more optimistic slant to those unknowns. After all, we have expectations to grow corporate sales and profitability. We know we cannot hit those aggressive goals with our current ventures. Therefore, the gap has to be filled by new ventures. If we say “yes” to the new ventures, we have a shot at filling the goal (our panacea for our problems). If we reject the new ventures, we run out of options for filling the gap.

So, given all of these biases, there is a tendency to create financial models which are biased towards moving the new ventures forward, even when they should be halted (whether we are aware of it or not). Some of the ways the models get distorted are as follows:

1. Distortion #1: Forget about Life Cycle Impacts
New ventures are often very profitable in the beginning. This is because it tends to be in an uncontested space with little competition. However, once we show that profits exist in the space, others will jump in. Competition will erupt and profits will go down. In addition, all that new business is probably coming to us at the expense of someone else’s old business. As soon as they see their business being attacked, they will fight back and get some of that business back. This is all part of the natural rhythm of the product life cycle. Eventually the industry matures and profitability drops to something near the cost of capital. If you only project the good, early times into your model, you will distort the model to be too optimistic. This is particularly true if there is a large residual value at the end of your model’s time frame.

2. Distortion #2: Forget about Transition Costs
The models for the new business often look at the venture once it is up and operating smoothly. That’s nice, but there is usually a costly transition to get there. For example, I’ve seen lots of people model out the benefits of an acquisition and only look at how the acquired company will perform once acquired. They leave out all sorts of very expensive costs associated with doing the acquisition, like investment banker fees, legal fees, PR fees, severance costs on the people let go, and so on. When you factor in all of these transition fees, a supposedly “good” deal can become a money loser. There are also substantial transition costs in new ventures. It takes a lot of time and money to get them up and running, which may not get into your model.

These two distortions can make your models biased more towards the new venture than they should be. They reinforce the bias to “go” which was already there, increasing the likelihood that you will vote to “go” when “no go” is the better response.

To help avoid the consequences of making poor decisions due to the bias to “go”, ask yourself these questions:

1. If it were your money, would you still do it? (We tend to have less of a bias to “go” when it is our own money at stake)

2. If you were assured of a promotion regardless of the success or failure of the project would you still want to go forward? (This unlinks your fate from the fate of the project, so that you can look at it more objectively)

3. Can the new venture overcome the competitive reactions and the copycats that will naturally occur as part of the life cycle? (Put it into the model and see)

4. Can the new venture absorb all of the transition costs and still work? (Put them in the model and see)

Since most new initiatives fail, there is reason to be skeptical when new initiatives are proposed. Double check to see if the new initiative is truly worthy of a “go” vote. Don’t just assume the analysis is telling the whole story, since the bias to “go” can distort the analysis (even if you are unaware of it at the time). And check out your own biases to be sure you are choosing based on reality not some irrational emotion.

According to the book Parkinson’s Law, “During a period of exciting discovery or progress, there is no time to plan the perfect headquarters. The time for that comes later, what all the important work has been done. Perfection, as we know is finality; and finality is death.” So when people are pushing for a luxurious new headquarters, it may be time to get out of there, before it is too late.

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