Friday, February 1, 2013

Strategic Planning Analogy #487: Tying-Out Fantasies

Years ago, I worked for a CFO who liked to tell this story. He said that in a lifetime of being in finance he had seen hundreds, if not thousands of financial pro formas. He said that almost without exception, every one of those pro formas projected a financial outcome high enough to exceed whatever financial hurdle was necessary to get a project approved.

Yet, once the best of those projects were approved and put into action, a significant proportion of those projects would be dismal failures. And one could assume that if a high percentage of the better projects failed, an even higher percentage of the ones not approved would have also failed.

So how is it that so many projects with favorable financial pro formas at the beginning turned out to be dismal failures in the end? It was enough to get this CFO to lose confidence in the value of most pro formas. Yet, as CFO, a large percentage of his job was in dealing with pro formas. It got him very discouraged.

Strategic planning deals with the future.  Even though the future is not known, we try to make projections about how we think the future could occur under various scenarios. Then we choose the strategic plan which appears to have the best future outcome.

These strategic plans tend to be like a more sophisticated version of a financial pro forma, which also tries to quantify the future.  In the story, we saw that there was not a strong correlation between a great pro forma projection and a great future outcome. Similarly, strategic outcomes rarely look like our initial projections. Hardly anyone would willingly promote a strategic path that they knew would fail, yet many strategies do, in fact, fail. Even when the planning process is thorough and dives deep into the details, the targeted numbers in the plan are often woefully missed.

It’s enough to get one very discouraged.

The principle here has to do with the concept of “accuracy.” In both the world of finance and the world of strategy, we would like to have accurate projections. Yet, as we have seen, even a strong desire for accuracy does not guarantee that financial pro formas and strategic plans will do a very good job of capturing reality.

Part of the problem is that a person can take two approaches to accuracy.  We’ll call them “Internal Linkage” accuracy and “External Linkage” accuracy.  One of these approaches is far better at eliminating unpleasant surprise outcomes than the other.  And far too often, companies focus on the wrong one.

Internal Linkage Accuracy
Internal linkage accuracy is concerned with making sure the mechanics of the modeling mesh together properly. Areas where the eye to accuracy is focused on in this approach include:

1.      Making sure the balance sheet, income statement and cash flow statement all tie out precisely (without rounding).
2.      Making sure all the sub-accounts are filled and add up to the total.
3.      Making sure the precise cost of capital is used.
4.      Making sure all the boxes are filled in on the forms and scorecards.
5.      Making sure there are measurable KPI’s (Key Performance Indicators) for every initiative.
6.      Making sure you have all the proper sign-offs by the required people.
7.      Making sure all of the data is accurately represented, and fully tied to the stated strategic goals and annual budgets.

The idea here is to make sure everything in the process ties together. The assumption is that if there is a high degree of accuracy in getting all the parts of the process to agree, then you have a good, solid plan. The comfort comes from having lots of numbers carried out to several decimal points.

External Linkage Accuracy
External Linkage Accuracy, on the other hand, is concerned with making sure the internal strategy meshes together with the anticipated external marketplace where the strategy will be executed. Areas where the eye to accuracy is focused in this approach include:

1.      Making sure the strategy is superior to all the external alternatives in solving a problem important to your consumer segment. These can be similar or dis-similar alternatives.
2.      Making sure competitive reaction is factored into the analysis.
3.      Making sure evolving technologies and social issues are taken into account.
4.      Making sure the company and its employees are willing and capable of delivering on the promises inherent in the strategy.
5.      Making sure to factor in changes over time in external factors such as raw material pricing, final product pricing, consumer adoption rates, etc.

The idea here is that the more accurately your strategy accounts for the external dynamics, the more likely the strategy will succeed in that environment. The comfort comes not so much from numbers, but from relative superiority and strategic fit.

Why a Focus on External Linkage is Better
If you want your strategy to succeed in the future, the focus on external linkage is more important than the focus on internal linkage. After all, making sure your financial statements tie out is worthless if all the financial statements are based on horribly inaccurate assumptions about the external environment. Getting bad numbers to tie out doesn’t instantly convert them into good numbers. They’re still bad numbers.

Think about Iridium. This was a company formed back in the early days of cell phones. Their strategy was to ignore the conventional land-based broadcast tower approach to cell phone transmissions. Instead, they would transmit all signals via a network of satellites in space. This strategy was extremely capital intensive.  Putting up a network of satellites costs a fortune. Therefore, I would assume that all of their internal calculations had to tie together pretty well in order to get the strategy approved.  And I’m also confident that those internally accurate calculations showed a positive return on investment. Otherwise, they would not have proceeded with the project.

Unfortunately, Iridium proved to be one of the largest value-destroying strategies of the late 20th century. It was a dismal failure. The reason Iridium failed was because the external links were terrible. Iridium’s success was based on the following assumptions:

  1. Cell phone adoption rates would stay relatively low (a niche product). This would make it impractical to fully build out a land-based transmission system. There would be too many holes in the land-based network to make it practical.
  1. Land-based cell phone service charges would remain at or near current high levels. As a result, it would be possible to spend a fortune on satellites and still sell the service at lower rates than the land-based companies. 
  1. Phones would remain large, so that the larger mechanics needed to transmit to satellites would fit in them.
These assumptions turned out to be totally inaccurate.  Prices dropped dramatically and adoption rates soared. Land-based networks filled nearly all of the holes.  Smaller phone sizes could not accommodate the needs for satellite transmissions. As a result, Iridium could not effectively compete, because its cost structure made it impossible for them to match the new pricing environment. That left Iridium viable with only a small sector of the industry—spies, the military, and ships at sea—not enough to generate a profit.

Has Iridium spent less time on internal accuracy and more time on external accuracy, they probably would not have made the mistake of moving forward.

A professor once told me about a research project which compared pro forma performance to actual performance. The results looked something like the nearby chart. The study found that most pro formas projected results which tightly clustered near the hurdle point for success.  However, most projects ended up at the extremes—either very good or very bad. Very few were near the hurdle point.

As a result, internal precision seems out of touch with reality. If most projects tend towards the extremes, then fine-tuning internal models near the hurdle rate is not the best use of one’s time.  Instead, one needs to spend more time on the softer issues to determine if the external fit is high or low.

So Why Do Companies Focus Internally?
If external accuracy is so much more important, why do so many companies focus internally?  Here are a few suggestions:

  1. A lot of strategic planning takes place in finance departments, where there is more comfort in the CPA mindset of putting a priority on making sure all the numbers tie.
  2. Internal issues are more controllable, so there is more comfort focusing there.
  3. People are personally motivated to make big bonuses, so they focus on the goals and the budgets, because they help determine bonuses.
  4. It is easier (and less controversial) to find a mistake in math than a mistake in assumptions.
  5. The people managing the process are evaluated based on their ability to manage the process, so they focus on getting the process right rather than getting the assumptions right.
We need to overcome some of these biases towards an internal focus and create more incentives around a focus on external accuracy.

When seeking accuracy, one can take two approaches. One can focus on making sure there are good internal linkages within the numerical process.  Or one can focus on making sure there is a strong fit between the strategy and the evolving external environment.  The latter approach is more likely to lead to success.

This is not to say that sloppy internal processes should be tolerated.  Instead, one can perhaps step away from the costly and time consuming effort to drill down too deep internally and use some of that effort to fine tune the assumptions related to the external.

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