Strategic Planning Analogy #525: Budget Madness

THE STORY
Well, here we are in the middle of March Madness, when Americans go nuts over college basketball. Millions of people choose who they think is going to win all the games. Warren Buffet is giving out a billion dollars to anyone who chooses the correct outcome for every game in the NCAA basketball tournament.

The Wall Street Journal has come up with their own version of how to pick the teams. They put together a site where the names of the colleges are eliminated. All you have to look at are statistics. Over the years, they have found that people are more accurate at choosing winners if they are not biased by seeing the team name before making their choice.

They call it the “blind” bracket. I guess sometimes we see better when we are blind.

THE ANALOGY
We all have built-in biases. These biases affect our objectivity. Eliminate the bias and we make better choices. This is true in picking the winning college basketball team. I believe it would also be true in business budgets.

Most companies have horribly uncreative budget processes. They consist of little more than just taking last year’s numbers and tweaking them a little (sales go up a little and costs go down a little). And even with that, the budget targets are often missed.

I think the problem has to do with too much familiarity with the company divisions. This creates biases anchored around the status quo (what we know). I believe we would get better budgets if we could do it more blindly (like the Wall Street Journal Blind Brackets).

Why do I say this? Look at how most companies do M&A work. The M&A folks tend to know less about who they acquiring than what their company knows about their own divisions. Yet the M&A people tend to do a much better job of thinking through their forward forecasts than the budget folk.

The M&A crew tends to look as much as 10 years out and do sophisticated discounted cash flow (DCF) analyses. They try multiple scenarios, with different levels of investment and synergies. They look at ways to change the business model in order to justify the acquisition premium.

All this for an outside company they are somewhat blind to. Yet, for our own divisions, which we should know far more intimately, we take a far less sophisticated approach—just look out a year or so and do a small tweak on what was done last year. Something here just doesn’t seem right.

THE PRINCIPLE
The principle here is that budgeting processes won’t dramatically improve unless we find ways to reduce the bias towards the status quo. There is no reason to believe that the status quo optimizes the current portfolio. We don’t expect the status quo for acquisitions. Why should we expect any less for our divisions?

Short Time Frame

The problem with a one year budget time frame is that one year is usually too short to complete a radical transformation of a division. In a radical transformation, the first year typically has added investments and a disruption of sales. As a result, if you are only looking one year out, the budget for a radical transformation scenario looks awful.

What executive wants to accept a budget where sales go down and costs go up? They know that the status quo looks a lot better than that, so they opt for a minor tweak of incremental improvement rather than the first stage of a radical transformation into a far better future.

That’s why companies like Kodak couldn’t make the radical transformation to digital imaging. The bias towards the status quo looks so much better only one year out. Unfortunately, as you string together a series of these “one year out” budgets, you never get around to making the transformation. It keeps getting tabled for an unknown future date until it is too late.

I’ll bet that if Kodak had not already been in the photography business, and had their M&A team examine the business (more blindly), they would have come back with an aggressive transformation to digital imaging as a condition to purchase.  

Go Blind

Is there anything we can do to reduce the bias and budget our divisions more blindly? Sure, perhaps we could make the budgeting team act more like an M&A team that looks at outside businesses more objectively on a longer DCF basis. Or maybe you could disguise a few of your divisions (without the division name) and give it to the M&A team to look at as an acquisition and see what they come up with.

I know that many investment bankers (and activist investors) look at companies from the outside (somewhat blindly) and make proposals about how a company can do something radically different with their assets. I’m not saying they are always right, but at least it can stimulate some non-status quo thinking.

Right now, a lot of these suggestions come unsolicited. What if you proactively sought out more of these less-biased points of view from trusted outsiders?

Even something as simple as benchmarking and best practice analyses could provide a new perspective on what to do differently. These potential budget-line inputs are not biased by what YOU do, but by what best-in-class do. And it could be something radically different.

The Importance of Pursuit

Over the years, I have continually stressed the threefold strategy requirements of:

1.     Positioning (A place where you can win)

2.     Pursuit (Having the Competencies and Capabilities needed to win)

3.     Productivity (A business model that can earns an optimal profit off the winning position)

In the typical one-year budget cycle, it is usually assumed that the positioning stays about the same and the focus turns towards getting more productivity out of the status quo model. The issues of pursuit are rarely discussed.

But pursuit is a critical component to success. If you want to grow, you need to build the capacity to effectively handle that growth. This includes the size of your sales force, the limits on your current supply chain, the capacity of your IT systems, and so on. If you don’t plan in radical changes to capacity, then you won’t effectively be able to capture that growth.

You also need to build in radical improvements to competencies. The world is changing. Today’s status quo is tomorrow’s obsolescence. Are you staying on top of what you need to know to win in the future? How’s your R&D spending? How about educational programs? Are you pro-actively bringing in new talent with the new knowledge you will need?

We can often miss these pursuit issues in a typical budgeting process because of that bias towards the status quo. It makes us falsely believe that we already have the capacity required and competencies needed. After all, we are only tweaking the status quo for the next year.

As a result, the needed step-wise leaps in capacity and competencies never get into the budget. Eventually, that chokes the division’s ability to do what is needed. Then, even the status quo no longer works any more.

I dare say that if we were looking at are divisions more blindly, as we would an acquisition, we would do a better job of factoring these types of investments into our analysis.

SUMMARY
Biases tend to cloud our judgment and make us less objective. This is particularly true when it comes to annual budgets. The bias towards the status quo keeps us from seeing a more radical—and much brighter—future. By changing up the typical budgeting process and adding blinder, more objective eyes, we can find these radical transformations and incorporate into the budgets the radical “pursuit” changes needed to make them a reality.

FINAL THOUGHTS
Most vision statements talk in some way about being leaders or best-in-class. Achieving exceptional results like that don’t come from perpetuating the mediocre status quo past. So why accept a budgeting process which encourages perpetuating the mediocre status quo past?

Strategic Planning Analogy #523: Why Let Facts Get in the Way?

THE STORY
A retailer once asked me to look at the data to see how much sales increased after his stores were remodeled. After examining the data, I concluded that for most of the remodeled stores, sales did not change at all as a result of the remodel.

The response by the CEO of the retailer? “I don’t believe the data.” He went on to spend a bunch of money on further remodels.

Another retailer asked me to study their idea to add a new product category to their stores. I wrote a memo—with lots of facts and numbers—showing that adding this product line would be an incredibly stupid idea.

The response of the retailer. “We had no intention of ever not adding this category. We already signed the deal and are going to do it anyway. We just wanted some paperwork in the files to help justify the deal we already intended to do. If your paperwork won’t support the project, then we’ll just do it without support documents on file.”

I’m reminded of the Mark Twain quote, “Never let facts get in the way of a good story.” Or in this case, it should read “Never let facts get in the way of a pre-conceived notion.”

THE ANALOGY
Business leaders have to make a lot of decisions. Most claim they want their decisions to be based on facts. The problem occurs when those “facts” contradict the pre-conceived notions of the business leader.

Do you ignore the facts and go with your gut (as they did in my stories)? Or do you ignore your gut and go with the facts?

As we will see in this blog, there is no automatic answer that works in all cases, but there is a process to figure out what to do in every case.

THE PRINCIPLE
The principle here is that there is a difference between facts and insight. A fact is an isolated nugget of truth. Insight is having sufficient understanding of the situation in order to make the proper decision.

Not all facts lead to insight. For example, I might have a fact that my grass is tall. From that fact, I might conclude that it is time to cut the grass. But true insight would have also known that at that very moment my grass was wet, the ground was soft & mushy, and that it was a pitch-black night outside. Under those conditions, it was not a good time to cut the grass.

Was my fact on grass length incorrect? No, but that fact did not give enough insight to make the right decision.

My gut intuition can also be insufficient for insight, particularly if my experience is not very relevant for the current decision.

So how do I gain insight when facts and intuition disagree? Here are three suggestions.

1) Question the Fact-Giver

There’s a Samuel Butler quote which says “Figures never lie, but liars often figure.” In other words, a person with a personal agenda can selectively use facts to promote their agenda rather than true insight. They present a false insight, distorted by what they choose to disclose and what they choose not to disclose.

It has been said that you can prove just about anything with the Bible if you are willing to take the words out of context. And that’s what these “liars” (people with an agenda) do. They start with their preconceived agenda and let that bias dictate how they present the facts. Their goal is to sell their position rather than provide true insight into what is going on.

You see this all the time in politics, where each extreme position uses facts to “prove” their agenda is true. How can the use of so-called “true facts” come to such different conclusions? It’s all in the packaging.

Several decades ago, U.S. News and World Report Magazine looked at some of the political hot-buttons of that time, like abortion and gun control. They showed that, depending upon how a survey question is worded, you can get a majority of the people to agree with either extreme.

Therefore, when the facts contradict your gut, one can start by questioning the motives of the one presenting the facts. Do they have a hidden agenda? Is their objective unbiased insight or something else?

Ask yourself these questions:

1. Are ALL the facts clearly moving in only one direction? (Rarely is the world that neat and tidy—there are probably relevant facts not being shown)
2. What does this individual gain or lose personally depending on how the decision goes?

Actions you can take:

1. Ask for all the data collected (not just what is in the Powerpoint deck).
2. Have an independent third party (with no agenda) look at the data.
3. Spend less time discussing the conclusions in the deck and more time discussing the assumptions behind those conclusions.

2. Question the Fact Receiver

The feelings of your gut are based on a lifetime of experience. This experience has exposed you to a lot more facts than just what is in front of you with today’s Powerpoint deck. This experience can help expand your insight and provide a better context for making decisions than just dealing with facts presented at the moment. The gut may indeed be more insightful than the facts.

But, then again, your gut may be way off base. You may have your own hidden biases, which impact your gut (even if you are not aware of them). Perhaps your experiences are irrelevant to the question at hand. Perhaps you’ve spent so much time living detached from the real world and surrounded by “yes-men” that you are out-of-touch with how your customer really lives (I spoke more about that here).

Often times, situations when facts and intuition are add odds with each other occur when a company is going through a crisis. Things are going badly. The old approaches aren’t working any more. Is this really a good time to rely on past-based intuition when the successes and tricks of the past don’t appear to be working?

Therefore, before going with your gut, ask yourself these questions?

1. Is my past experience really relevant for today’s decision?
2. Have things changed enough that the rules of the past no longer apply?
3. Do I have a hidden bias? Does my personal situation change depending upon how I decide?
4. Is my gut based on true insight or desperation and panic?

Actions you can take:

1. Have some confidants outside the industry that you can bounce ideas off of.
2. Spend more time out in the field talking to customers and seeing how the world works out on the front lines where your business interacts with the marketplace.

3. Look for the Story Behind the Facts

An individual fact is like an individual word. It can only tell you so much by itself. However, if you can string a bunch of words together into a story, then you really have something—insight.

All of that intuition you have has been strung together into a wondrous story of how the world works. The problem occurs when the new facts don’t fit into your story of how things work.

The problem may be that the facts have been distorted (as mentioned earlier). In that case, it may make sense to stick with the story in your gut.

However, times may have changed and your story may no longer fit how the world of today (or tomorrow) works. It may be time for a new story of how the world works.

So, when looking at facts which don’t conform with your story, ask yourself these questions:

1. Is there sufficient proof that times have changed enough to make old assumptions irrelevant?
2. Do the new facts string together to make a coherent and believable alternate story more in tune with the times? (or is there no story found within the facts).

Actions you can take:

1. Try to build an alternative story that holds the new facts together and compare that story to your old story.
2. Spend more time discussing what has changed in the environment and WHY.

I knew a company who held a story that the disgruntled customers who complain a lot are at high risk to leave because they are the ones most frustrated. They ran their business based on that story. However, facts showed that it was more often the quiet customers who left. This puzzled them until further analysis came up with a new story. They discovered that the noisy customers really wanted the relationship to work and were actively making noise in order to make the relationship better. The quiet ones had given up on the company and were ready to move on to the competition. Since the new story better fit the facts, they adopted the new story and ran their business accordingly.

SUMMARY
Many times, decision makers are faced with facts that disagree with their gut. Rather than always going with the gut or always going with the facts, do some further investigation. Check to see if the fact-presenter has a biased agenda. Check to see if your intuition is relevant to the situation at hand. Check to see if the facts tell a better story than the story you already cling to. Based on this further analysis you can determine when to go with the guts and when to go with the facts.

FINAL THOUGHTS
In the case of the store remodel research mentioned earlier, the CEO had a story in his head that if you make a store better, customers will like you more and reward you with more sales. In most cases this is true. And that is why he stuck with his gut and ignored the facts. But times had changed and this store concept was becoming irrelevant. This created the need for a new story: When you make an irrelevant store nicer, you don’t make it relevant. You just have a prettier irrelevant store. This new story fit the facts. Today, this retailer no longer exists because of its irrelevance.

Strategic Planning Analogy #476: Passion for What

THE STORY
Back in the late 1990s, I went to a seminar at the annual Consumer Electronics Show in Las Vegas.  There was a panel of experts talking about the future of connected consumer homes.

Most of the “panel of experts” were the geekiest of geeks, the nerdiest of nerds.  They each seemed to live in homes with about a half dozen satellite dishes on them and about four different sets of connectivity wires running through their houses.  They had all sorts of bizarre homemade networking devices trying to connect all their computers.  And they were predicting that eventually all consumers would have homes as geeky as theirs.

The audience was almost as geeky as the panel and were nodding their heads in approval.  That is, until the last panel member began to speak.

The last member was not geeky or nerdy.  He was a consumer marketer.  He had done consumer research and found that the average person would not put up with all of that geeky stuff.  The audience started to boo him walked out in disapproval.

Well, here we are, about 15 years later.  None of the geeky predictions came to pass and the marketer was right. 

 

THE ANALOGY
The members of the so-called “panel of experts” were extremists in their enthusiasm for consumer electronics and technology.  It was their passion.   They knew all the jargon.  They were willing to devote all their spare time to learning the obscure technology behind it.  They could build their own computers and program them to do specialized tasks.

In other words, they were not normal.

These people mistakenly believed that eventually everyone else would have the same level of passion as they did for all this geeky stuff.  In other words, they felt that eventually, their odd behavior would become normal.  It did not.

As it turns out, the panel member who best understood the future of the connected home had no passion for the subject.  His expertise was in listening to the customer, who was saying something entirely different.

I’ve been around a lot of companies who are looking for passionate employees.  I’ve seen a lot of job advertisements looking to hire people with passion for the products the company was selling.  The rationale is that employees who are passionate about the product are better employees.

But is that really true?

That panel of experts was so passionate for their business that the members were blind to the fact that they were outliers in society.  They were so abnormal that they couldn’t understand normal people.  And normal people are the customers.  As a result, they completely missed the mark on helping businesses in the industry prepare for the future.

Instead, it was the one panel member who was not biased by personal passion (the marketer), who could accurately hear the customer and give sound advice.

This excessive passion can be particularly messy for strategic planners.  If they are too passionate for the business they are in, they can become biased extremists who are blind to the realities of normal people.  As a result, their strategic recommendations can be way off the mark and hurt the companies they work for. 

 

THE PRINCIPLE
The principle here is that it is often better to hire people who have passion for their individual job skill than passion for the business where they apply that skill.  In other words, if you are in the green energy business, it is better to hire an accountant who is passionate about accounting than one who is passionate about green energy. 

There are many reasons why I believe this:

1. Improper Bias

In the story, we saw that the people with excessive passion had a biased and distorted view of the world.  Their extremism blinded them to what normal people are like.  They rejected consumer research (the facts), because it did not line up with their distorted, passionate viewpoint.  As a result, they became useless in helping companies address the needs of normal people.

I’ve seen this occur in multiple companies, where passionate extremist employees would promote all sorts of crazy ideas and bad strategies based on the notion that they found it appealing to their own passions.  Their rational was, “I would like that, so everyone else should like it, too.”

Unfortunately, the ultra-passionate segment of most businesses is quite small.  There are not enough of them to support these ideas.  Just because abnormally passionate people like something does not mean that normal people would also like it. 

And when you fill a company with passionate extremists, they start thinking that they are closer to normal than they really are, because all of their co-workers share the same biased extreme.  This leads to bad forecasts, bad strategies, and bad results.

Think about the battery-powered automotive industry.  Many of the companies were filled with employees who loved the idea of electric cars and thought everyone else should love them too.  So they came up with business models that were far too optimistic and now many of these businesses are going bankrupt.

2. The Charitable Cause Phenomenon

Although there are some great charitable organizations out there, I’d have to say that some of the worst-run businesses I’ve ever seen are charitable organizations.  Why?  Usually it is because the people running the business have more passion for the cause than for their individual job. 

They want to be a part of the cause, so they will do whatever job they can get to become a part of it.  That often means doing jobs for which they are not the most qualified.  Yes, passion can make up for some skill inadequacies, but often not enough to make many of them truly productive.  Just because their heart is in the right place doesn’t mean they are best qualified to get their job done.

Organizations need a lot of different skill-sets, from as mundane as janitorial or data entry to as sophisticated as a strategist, CEO, CIO, or COO, etc.  If people do not have lots of skills or passion for their individual task, then that task will not get done well.  If enough tasks don’t get done well, then the entire organization starts to fall apart.

That is why I like people’s primary passion to be around their assigned task, rather than the business.  That way, the people are happily excelling on that which they are assigned to do, because that is their love and passion.

3.  The Stockholm Syndrome

The Stockholm Syndrome is based on studies which show that people captured by terrorists will, over time, tend to become more sympathetic to the views of their captors. If normal people can start feeling more like the radical extremists who captured and tortured them, then I think normal people can start feeling good about the businesses which capture the bulk of their waking hours.

In other words, if you take a great accountant and put him or her into a green energy company, most over time will become more sympathetic to the green energy cause.  It is a natural consequence.

However, I don’t think the opposite is necessarily true.  If I take someone who loves green energy and is only moderately interested in accounting and put them into a green energy company, I don’t think they become a lot more passionate about being an accountant. 

Therefore, hire people who are passionate about their task, and you can train them to care about the business.  This will work out better than hiring people who love the business and then try to get them to love their individual job.

That’s why you commonly hear people in service businesses say that they look for people who love giving service (their job) and then train them in their business.  This works a lot better than finding people intimately in love with the business but have no desire to serve.

 

SUMMARY
Great strategies rely on great insight and great execution.  Great insight and execution often are at odds with people who are excessively passionate about the business they are in.  First, their excessive passion biases them so they cannot see the realities of the normal world.  Therefore, their insights are inaccurately biased and subject to failure.  Second, people who are doing jobs based on their passion for the business rather than a passion for their job are not the best at doing their job, so execution suffers.  A better approach is to fill your business with people who are passionate for the skills of their individual task.  They will execute well on more accurate assessments of reality.

 

FINAL THOUGHTS
I have been a strategist at many companies where I did not have an excessive passion for the products being sold.  And I was proud of that.  I would tell people that this kept me from becoming too biased based on personal distortions.   I was forced to listen to the customer.  Second, my passion was for doing strategy, so they would get great strategies (and isn’t that what they hired me for in the first place?).

Strategic Planning Analogy #451: Too Much Cotton in the Bottle

THE STORY
The other day I bought a bottle of ibuprofen. I bought it to help with the occasional headache I get with my spring allergies.

When I opened the bottle, I couldn’t get the pills out. There was so much cotton stuffed in the bottle that I couldn’t get to the pills. It was quite a struggle to get that cotton out of the jar.

I understand why the cotton is put in the bottle. It is to protect the pills from bouncing around in the bottle and getting damaged during shipping.

But here is my question: What is the benefit of having perfectly undamaged pills if I am unable to get to them and use them for my headache? If they are locked up in a bottle behind too much cotton, they cannot help my headache. They are worthless to me.  I’d rather have easier access to a slightly damaged pill.

THE ANALOGY
That ibuprofen is only useful to me if I can get those pills into my bloodstream. Having them in a bottle does nothing for the pain.

A similar situation can occur in the business world. Businesses have all sorts of resources. They can be financial, technological, intellectual or a wide range of other resources. These resources are like those ibuprofen pills. If properly used, they can be productive and solve problems.

However, if the company tries too hard to protect those resources, it can be like over-stuffing the medicine bottle with cotton. The protection makes it nearly impossible to get access to those resources. And if you cannot use the resources, it is irrelevant that you kept them in top condition. They become worthless to you in your battle to increase your prosperity in the marketplace. THE

PRINCIPLE
The principle here has to do with risk. The problem is that if a company gets overly protective of its resources in order to eliminate downside risk, they will not only prevent undesirable activity—they will prevent all activity. Like over-stuffing the medicine bottle with cotton to prevent any damage, over-stuffing your business with policies to prevent any risk leads renders your resources worthless.

The only way to be 100% certain that activities with downside risks are eliminated is to eliminate all activity. And that leads to another 100% certainty—100% certainty that the company will cease to exist due to a lack of investment. And so, ironically, the policies intended to minimize downside risk actually increase the likelihood of the greatest downside risk—the risk of destroying the entire business through resource starvation.

As the old saying goes, you have to take some risks in order to receive any rewards. So, the goal should not be to stuff the medicine bottle with as much cotton as possible. The goal should be to find the best way to use the pills in the bottle. Or, to use business terms, the goal is not to avoid risk by preventing investments, but to find the most prudent ways to invest.

Now I understand the need to prevent wasteful and reckless use of resources. For example, if I had been reckless and swallowed all of those ibuprofen pills at once, I would have killed myself. But, if used properly, ibuprofen can do wonderful things. And similarly, wise use of company resources can do great things.

So the rest of this blog will look at ways to prevent over-stuffing the bottle with cotton and promote more prudent investing.

Problem #1: Personal Biases
Scientists and researchers tell us that most managers have built-in biases when it comes to making decisions. They say that the typical manager over-emphasizes the potential downside risk and under-emphasizes the upside potential. As a result, managers become too protective and miss out on making perfectly sensible investments.

I have a theory about why that occurs. I believe the problem is that the upside and downside risks for the company are not always in sync with the upside and downside risks for the individual making the decision.

For example, let’s assume that a manager has a tough decision to make. If you just look at the math from a probability analysis, you would see that although the downside risk is large, the upside risk is a little bit larger and a little bit more likely. Therefore, the “experts” would say that the manager should make the investment.

However, that is just considering the risk to the business. Now consider the risk to the manager making the decision. The manager may think that if the upside potential occurs, he/she may only get a minor recognition. After all, it is their job to make good decisions, so if the decision turns out well, they were just doing their job properly.

On the other hand, if the downside were to occur, the manager may rightly assume that he/she would lose their job. Just look at what is happening at J.P. Morgan. Some trading deals went bad and the downside scenario came to pass. And as a result, a number of people at J.P Morgan are losing their job.

So, from the manager’s perspective, there is very little personal upside potential from recommending the deal and if the downside potential occurs, he/she could lose their job. Therefore, it is no wonder that executives appear irrational (from the company’s perspective) in saying no to “reasonable” risk. After all, from a personal perspective, saying no seems highly rational.

Consequently, if you want management decisions to be in the best interests of the company, you need to make the personal risk profile more similar to the company risk profile. Otherwise, you can end up with managers overstuffing the medicine bottle, which hurts the company but protects their career.

Problem #2: Departmental Biases
Large business decisions often impact large sections of a business. Problems can occur if the risk profile varies between the sectors of a business impacted by a decision.

For example, one part of a business might bear the biggest brunt of the investment while another department may reap most of the benefits. In such a circumstance, the department needing to make the investment may resist the move, because the math may not make sense when just looking at that particular department in isolation.

To prevent this “irrational” cotton stuffing, one needs to get all of the affected parties to share in the entire company-wide risk profile. That way, decisions will be made for the good of the company rather than the good of the individual department.

Problem #3: Excessive Busyness
Just because a resource is kept busy does not mean it is being invested properly. There is an opportunity cost risk in missing out on potentially huge gains because resources are focused on surer, but much smaller gains.

Take, for example, your human resources. Since the start of the great recession, there has been a push to keep those human resources as busy as possible. Individuals are often doing a workload previously done by two or three people before the recession. At first, this may be admired as a wonderful productivity gain.

However, if someone is too busy with the mundane, they will not have the luxury of time to ponder larger issues which produce major breakthroughs. As we’ve seen in prior blogs (here and here), some down time is needed if you want the brain to discover that next huge breakthrough.

As a result, excessive busyness can act like that cotton, and prevent you from being able to use those resources for greater benefit. Therefore, one may need to program in some more “slack” time in order to get the most out of the resource.

Problem #4: All or Nothing
Often times, an investment can look scary because it is positioned to appear so massive. It is proposed as an all or nothing deal. You are told you are either in or you are out. And if you are in, you have to make the big bet all at once. And that can scare people away.

Well, this is often a false premise. Most big deals can be broken down into smaller deals. You may be able to test it in a small fashion before rolling it out. You may be able to borrow or rent resources before committing to purchase. You may be able to do a joint venture with a firm rather than have to acquire it.

Tactics such as risk-sharing, stage-gating or real options theory can help keep the risks manageable by placing them into smaller chunks. If a small chunk goes bad, you can stop before investing in the next stage.

Problem #5: A Portfolio of One
One of the best ways to overcome downside risk is to avoid putting all of one’s eggs in a single investment basket. That is just another scare tactic akin to the all or nothing approach mentioned above. Instead, invest in multiple investments. With a portfolio of investments in your pipeline, then the odds increase that the entire mix of investments will be positive (even if some of the individual investments are negative).

Therefore, to encourage better levels of investing, two actions should occur. First one needs to diversify the risk by building a portfolio of investments (at least in their initial stages). Second, one needs to move away from treating risk in isolation but look at the risk in terms of the whole portfolio. Accept some individual failures as a necessary part of the overall quest to create a positive portfolio.

Problem #6: Fear of Obsolescence
Often times, there can be a fear of investing in something new out of fear that it will hurt the core business. For example, Kodak did not aggressively invest in digital imaging for fear of hurting the core analog film business.

But here is what one needs to realize. If it is a good investment, somebody else will make it. Consequently, the core business is at risk whether you make the move or not. So in most cases you’d be better off making the move, since at least then you would be a part of that which destroys your core. Otherwise, you core is destroyed by someone else and you are left with nothing.

SUMMARY
There are many factors which can act to hold people back from making the investments which they should. We were only able to scratch the surface here. However, in the areas we looked at, it was seen that these factors can be minimized/reduced by becoming proactive in addressing them. By getting in front of these issues, we can establish approaches which keep people from stuffing the investment bottle with too much cotton.

FINAL THOUGHTS
By first investing in policies and approaches which help us to better handle risk, we will end up making more good investments in the business.

Strategic Planning Analogy #412: It’s Rational To Me

THE STORY
There’s an old story about a champion swimmer who lost one of his little pinky fingers in an accident. After the accident, the swimmer said that he was unable to swim anymore and refused to get back into the water.

His fans thought he was acting crazy. Okay, maybe his swimming might be a tiny bit slower without that finger. But to claim that he couldn’t swim any more at all? This didn’t make any sense to them.

Finally, one of the fans asked the swimmer why he couldn’t swim any more. The swimmer responded, “I use my pinky finger to get the pool water out of my ear after I swim. Without the pinky finger, I can’t get the water out, so I can’t swim anymore.”

THE ANALOGY
To an outsider, a lot of actions look irrational. The fans in the story thought that the swimmer was acting irrational. They didn’t understand how losing a finger prevented the act of swimming.

The problem was that the fans didn’t see the big picture. They were only looking at what happens in the pool. In the pool, the finger loss was not such a big deal.

The swimmer, however, saw the bigger picture. He knew that after he was out of the pool, that finger was essential to maintaining ear health. Without that finger, his ear would get infected and he would not be able to swim in the future.

So, even though the fans thought his refusal to swim was irrational (because they only looked in the pool), the swimmer felt he was being very rational, because he saw the larger implications.

It seems that a similar problem frequently occurs in business. Executives are constantly making decisions. Many times outsiders will look at these decisions and question the rationality of the decision. They will think the executive was crazy or misguided.

Literature in recent years has referred to this supposed irrationality as “decision bias.” The argument for decision bias goes something like this:

1) The decision maker has biases;
2) The biases in the mind of the decision maker triumph over logic;
3) Therefore, the decision maker makes an illogical decision.

However, I’m not so sure this is always the case. Executives don’t make it to the top because of a propensity for illogic. I think there is often something else going on. The ones claiming this so-called illogic are like the swimmer fans. Their view of the decision is too narrow (just looking in the pool). The executive may be looking at a larger scope (outside the pool) and see a reason why his decision is very logical (at least from their larger perspective). So before making a quick judgment about someone’s rationality (or supposed lack thereof), try to understand the perspective of the one making the decision.

THE PRINCIPLE
The principle here is that if you want someone to make the right strategic decision, then you have frame the decision within the context of the framework used by the decision maker. In other words, don’t blame bad decisions on irrational biases. Blame bad decisions on having created a system where the decision maker’s logic is contrary to the success of the strategy.

This is an important distinction. For if you believe the problem lies with illogical beings, you will try to fix the problem by trying to change the way people think. However, if you believe that the person is very rational, but has been put into a system where his/her personal logic is contrary to business goals, then you will try to change the system.

The Pool Example
Think of the business executives as being like that swimmer and the business environment as being like that swimming pool. As an investor in that business, you focus on what is happening in that pool and how well the swimmer is performing in that pool. You don’t care about what happens outside the pool.

The swimmer (the executive), however, has a life outside the work environment (the stuff outside the pool). In the story, this caused him/her to stop swimming.

The investor thinks this is illogical, since they see nothing in the pool to cause concerns. The investor sees the solution as trying to change the way the swimmer thinks about swimming (try to replace the so-called swimming illogic with logic). Since all the investor looks at is the pool, they try to find the solution within the pool (the way the person performs relative to the business). For example, they might focus on telling the swimmer that, logically, the hand stroke in the water still works with a missing finger (and to think otherwise is crazy).

However, had the investor assumed that the swimmer had a logical reason for his/her actions, the investor would have looked outside the pool at the swimmer’s concern for getting water out of the ear. They would have then come up with a replacement for the pinky to get the water out of the ear. With such a replacement, the swimmer would gladly get back into the pool and do what the investor wants. In other words, the best way to fix what was happening in the pool was to take care of a systemic issue outside of the pool. No amount of lecturing on the best way to swim would have fixed that issue.

The Real Example
I was reminded of this concept in a recent article from September 2011 in the McKinsey Quarterly. The article was entitled “A Bias Against Investment?”. The article was based on a recent survey of executives. According to the survey, executives claimed that their companies were not investing enough in their businesses. And the folks at McKinsey felt that underinvesting at this time was illogical.

McKinsey blamed the illogic on “well-known biases.” As “proof” of these biases, they pointed to some hypothetical questions in the survey. One hypothetical scenario was about a doing a deal with the potential of a small loss or huge reward. Many of the executives refused to do the deal. McKinsey claimed that this was mathematically illogical, in what they referred to as the “loss aversion bias”. McKinsey thought this illogical bias was even more tragic when applied to smaller investments (which were also looked at in the survey and had similar results). To quote the article, “Even if it made sense to be so loss averse for larger deals, it still wouldn’t make sense to be as averse to loss for smaller ones.”

But I think there may be a lot more going on here. There may be some sense here after all. I think those executives may be very logical. They are just using logic from outside the pool. These executives are not only worried about the health of the business, but the health of their career (like the swimmer who cared about the health of his ear).

The executive may have logical reasons to believe that being seen as responsible for losses, even small ones, could put their career at serious risk. They may get fired, not get a bonus, or never see a promotion because of that loss. However, if the upside occurs, the amount of the profits on a small deal may not be large enough to cause any personal benefits to the executive. They were already expected to do well, so doing well does not trigger extra bonuses or promotions.

Given that logic, the executive doesn’t just see what’s in the “pool”—big profit gains versus the risk of a small loss. Instead they see it as gaining nothing personally versus potentially losing their job. No wonder executives have a tendency to be averse to these types of options. From outside the pool, rejection of the deal looks very logical.

The Implications
Depending on which of us is correct (me or McKinsey) there is a major difference as to how to solve the problem. McKinsey’s approach would lead to the conclusion that companies should focus on getting people to change the way they think—to root out those nasty biases—or at least downplay them during decision making.

My approach would be to understand what is happening outside the decision at hand (outside the pool) which is causing a logical person to “rightly” (for them) make the “wrong” choice for the business (inside the pool). Once that is determined, then change the system so that the two are compatible. For example, in the scenario above, the company may need to change compensation and rewards/punishment policies which cause people to act contrary to what is in the best interests of the company. The companies need to get personal risks to be consistent with business risks.

Although luck may be a contributing factor, I believe most people make it to the top of a business because they logically made the right choices regarding what it takes to get to (and stay at) the top. The real problem is that the logical choice for getting to or staying at the top is not always consistent with the most logical choice for the business. If you want to fix some of the bad decisions, look at how to get the logic behind personal and business decisions to be more similar.

SUMMARY
Don’t automatically assume that bad decisions are caused by illogical executives. Instead, start by assuming that the executive is being perfectly logical from their perspective. Then try to figure out why the current system is causing personal logic to be out of sync with business logic and fix the system. Otherwise, your “logical” strategy may not get implemented, because it conflicts with the personal logic of the people implementing it.

FINAL THOUGHTS
A personal benefit from looking for a solution by changing the system is that it keeps you from having to go to senior executives and tell them to their face that they are illogical.

Strategic Planning Analogy #327: Number Bias

THE STORY
On May 6, 2010, the Dow Jones Industrial Average dropped by nearly 1000 points in a matter of minutes. Companies like Procter & Gamble and 3M lost more than 30% of their value in through computer trades in just 15 minutes. Accenture went from computer trading at around $40 per share all the way down to a penny. There was nothing going on in the world that would create the sudden need for a market drop that extreme at precisely that moment.

A number of hypotheses have been suggested for why this sudden drop occurred. They include everything from a typing error by an analyst to cascading “Stop Loss” orders that were computer generated. The fact that a large portion of that drop came back before the day was over would seem to indicate to me that the original drop was not fully justified in any rational sense. This is further validated by the fact that the stock exchange cancelled many of those trades during that vulnerable time period. Apparently, they didn’t think those trades made sense, either.

Although we may never know exactly what triggered the mess, one thing we do know is this: The mess was compounded by computers blindly doing something which they were programmed to do, regardless of whether or not it was logical or sensible at that moment. Human logic was bypassed as the computers coldly and uncaringly executed orders that were triggered by programming algorithms put in place a long time ago. And because computers can do these calculations so quickly, they can distort markets well before human logic and common sense can intervene.

It seems to me that the more we rely on so-called “rational” computers to do stock trading, the more “irrational” the market swings become.

THE ANALOGY
There has been quite a bit written recently on the decision-making biases of humans. It has cropped up on the web in places like the McKinsey & Co. site, the Booz & Co. site, the Harvard Business Review Blog site and numerous other places.

Many of these biases have been well researched and have become a part of “common knowledge.” As a result of these biases, many “experts” are advising leaders to set aside their gut instincts and instead just load up on numbers…and then let the numbers make the decision.

The assumption in many of these materials is that if we get rid of human biases and just rely on the numbers, we will get better decisions. Unfortunately, when I look at things like the stock market crash of May 6th, I get a little nervous in abandoning human intuition and relying 100% on numbers and computers. So-called “blind” decisions made by computers on that day don’t appear to have been logical or sensible. Why should I abandon my gut intuition to cold mechanics that can bring down the stock market? Couldn’t it do the same to my business?

The crux of the problem, as I see it, is the false assumption that just because you eliminate human biases, you have eliminated all biases. My contention is that numbers can be just as biased as humans. If you fail to take into account the inherent biases in numbers, you will be driven astray as much as you would be by human biases. In fact, I believe that the biases inherent to numbers are even more dangerous that human biases, because numbers cannot step back and ponder about their implications as humans can.

THE PRINCIPLE
The principle here is that numbers should not be accepted at face value any more than gut intuition. Both have biases that need to be brought out into the open. Until you deal with these biases, you will not be able to see reality. And until you see reality, you cannot make the best decisions.

Since there has already been a lot written on human biases, I will shift the attention of the remainder of this blog to some biases inherent to numbers.

1. Bias of Backwards
Most numbers relate to the past. They tell you about history...what has already happened. Therefore, the numbers are biased by that historical context.

The problem is that your decision-making is about the future. There is no guarantee that the context of the past will continue into the future. Therefore, numbers of the past may not accurately provide guidance for the future. As Warren Buffett put it, “If past history was all there was to the game, the richest people would be librarians.”

For example, consumer data collected prior to the tragedy of 9-11 (or the great recession we just had) may be worthless in projecting behavior after those events. As another example, consumer media behavior data gathered prior to the invention of the next form of media (radio, TV, vcr, internet, ipad, etc.) will not automatically give 100% accuracy to how behavior will change when the new medium appears. Looking at Baby Boomer behavior in their 30s may not give accurate insight into how Millenials will act in their 30s. Or for that matter, looking at how Millenials act in their 20s may not give accurate insight into how Millenials will act in their 30s, either. The contexts are different, so the results may also be different. It takes human intervention to make sense of the changes in context.

2. Bias of Availability
When gathering numbers, one is limited by the numbers available to gather. When looking at the pile of numbers you have gathered, the larger piles are not necessarily more important or more meaningful. There are just more of them available to gather. Just because a number is available does not make it relevant.

The problem is that a lot of strategic decision-making is about finding new, untaken white spaces in the environment—sometimes referred to as Blue Oceans. These new opportunities typically come about by reorganizing things in a new way—looking at things as they have not been looked at before. Almost by definition, if you are gathering numbers that are already available, they are biased by the conventional way of categorizing and organizing numbers.

For example, governments tend to categorize economic data based on the conventional, historical ways in which industries were classified. All the numbers neatly fit into the black spaces (which is why they are black). There aren’t any available numbers in the white spaces, because that’s not how governments deal with numbers. If you are planning to reinvent the marketplace and create new industries (or significantly redefine the borders of old industries), the available numbers will be distorted and not give a good picture of that redefined world. They may even keep you from finding that Blue Ocean, because all the numbers are allocated to black spaces, making it appear that the potential is empty outside those black spaces.

3. Bias of Source
Numbers come from someplace. People compiled those numbers, and the biases of those who created the numbers often distort these numbers. Just look at how different political parties can look at the same world and find numbers to support their radically different positions. So even if you do not inject your bias into the equation, the numbers you have may be full of biases from the people at the source of those numbers.

This bias from the source doesn’t have to even be intentional. For example, if you are trying to gather numbers about the future, there are not many options. Either you gather opinions from “experts,” opinions from consumer research, or results from computer models. Experts can have all kinds of biases that creep into their opinions, intentional or not. Scientists even have a name for this, called “Expert Bias.” Computer models are based on underlying assumptions placed there by people. There can be lots of biases in those assumptions.

Finally, consumers are notorious for their generosity in giving opinions about how they might act in the future, but even they do not really know how they will behave in a new environment. Their guesses often are quite different from what they eventually do. It’s not that they intentionally lie…they are just bad guessers.

4. Bias of Bigness
Numbers are often gathered at the macro level, yet consumers behave at the micro level. Macro level numbers have a bias towards bigness which distorts our conclusions about micro level behavior.

Take, for example, economic stimulus plans. A government might say it is pouring millions, or maybe even billions of dollars into the marketplace. Once could look at all that money at the macro level and conclude that surely customers would be stimulated to spend more on big-ticket items with that much money flowing towards them. However, if you look at the numbers at the micro level, you may see that the stimulus package results in an extra five dollars per household per paycheck. How many people are going to radically change their big-ticket purchases based on a five dollar increase in their paycheck? Heck, they might not even notice the five dollar bump.

In an earlier blog, we talked about how macro numbers tend to portray average behavior, whereas if you get down to the micro level, you can see all the extreme behaviors which are averaged out of the big number. By looking at big roll-up numbers, you may not see all the great niche potential hidden in those averages.

5. Bias of Unusual Event
Numbers gathered for a period of time are biased by the quirky little events occurring at that time. Outcomes would be different depending on the presence or absence of those events. For example, the green movement was on a particular trajectory. Then, Wal-Mart decided that it was going to take green issues very seriously. That one change in circumstances radically changed the trajectory of the green movement, because of the power and influence of Wal-Mart.

Consider that the entire evolution of the consumer technology industry has been influenced by the fact that Steve Jobs is in the business. Had he not been a part of Apple, the entire industry probably would have evolved differently. Have you factored into your numbers the possibility of a “Steve Jobs” person emerging who can change the course of history or the possibility that a powerful force like a Wal-Mart may change its direction? Or what if you decide to inject yourself into your industry the way Steve Jobs did or change directions like Wal-Mart did? You will not see this in the numbers, since those numbers did not include such a circumstance

When computer models are built to predict the future, the assumption is that all of the relevant events are included within the model. As the stock market crash of May 6th showed us, new events may turn up which were not accounted for in the model, causing the models to fail.

SUMMARY
We have been told not to rely on our gut instincts at face value, because they are biased. Similarly, I believe that we should not just rely on numbers at face value, because they are also biased. Instead, we need to rely on both our gut instincts and numbers, keeping in mind the biases inherent to both.

FINAL THOUGHTS
To borrow another quote from Warren Buffett, “Never invest in a business you cannot understand.” Just because you have a pile of numbers doesn’t mean you understand what is going on now (and what could go on in the future). You need to comprehend what is behind the numbers. This takes insight, something which transcends mere data and must incorporate human intuition and imagination.

Strategic Planning Analogy #276: Bias to Stop

THE STORY
Ford invented the minivan, but refused to build them. Why? First, Ford was #1 in the sales of station wagons at that time. Ford feared that the minivan would cannibalize the sales on all those station wagons. Second, the truck division thought it might cannibalize some truck sales, as well.

Ford saw little benefit in spending all the money needed to gear up production for a new vehicle (the minivan) if all it was going to is steal business from their other profitable lines. Therefore, they did not introduce the minivan. It seemed like a wise financial move at the time. Why needlessly spend all that extra capital to get sales you already had?

Of course, when Lee Iacocca left Ford and went to Chrysler, he found himself at a company that was weak in the station wagon and truck businesses. There wasn’t much at Chrysler to be cannibalized by the minivan. Therefore, Chrysler introduced the minivan. It was a huge success, mostly at Ford’s expense.

Ford was correct about one thing. The minivan did make the station wagon obsolete. Ford lost nearly all of its station wagon sales. Too bad Ford did not factor in a competitive introduction of the minivan into their business model. In the end, Ford did not save the expense of introducing a minivan (as they had hoped). They had to do it anyway, as a response to Chrysler. However, because they let Chrysler get a head start, Chrysler got most of the benefit of the minivan.

THE ANALOGY
As this story illustrates, one can create logical arguments to kill a new project, as Ford did with the minivan. One can even back up that argument with solid financials. However, that does not always mean that the new project should be killed.

Logical arguments and financial models can be flawed. A natural bias to kill new initiatives can exist in an organization. This bias can cloud one’s judgment, leading to a flawed analysis.

Due to a bias towards past success, Ford failed to take into account the inevitability that station wagons would eventually become passé. By not proactively planning for their replacement, they allowed Chrysler to replace them.

Businesses need to be aware of the potential for this bias, so that they do not fall into the trap which hurt Ford.

THE PRINCIPLE
In the last blog, we looked at how a bias to “go” on new ventures can hurt a company. In this blog, we will look at how a bias to “no go” on new ventures can also hurt a company. We will look at the causes of the “no go” bias, how it can distort our analysis, and questions to ask ourselves in order to keep the bias from causing us to make the wrong decision.

1. Bias Source #1: Avoiding the Hammer
The old saying is that the hammer hits the tallest nail. If you stand out too much, you are vulnerable to attack. New ventures have high visibility and stand out. If they fail, you run the risk of being attacked. Their failure becomes your failure. By contrast, it is easier to hide in the bureaucracy of the established businesses.

2. Bias Source #2: Avoiding Accountability
If you say “go” and the new business fails, there is hell to pay, because a highly visible loss is right there on the books for all to see. However, if you say “no go” and the business would have been great, there is less of a backlash, because it is all subjective. Hence, if you want to avoid accountability for your decision, it is easier if you say “no go.”

3. Bias Source #3: New Game Threatens My Game
You’ve been working yourself up the corporate ladder playing by the old rules associated with the old way of doing things. The new ways could make your “game” obsolete. To protect your personal future, you need to protect the ways of the past.

4. Bias Source #4: Short-Term Pressure
There tends to be more pressure on hitting the targets for the current month or current quarter than for long-term profits. Since new initiatives usually have a near-term drain on profits, there is a tendency to put them off, so they won’t hurt near-term earnings.

5. Bias Source #5: Not on My Watch
The remaining tenure for most CEOs is relatively short—shorter than the time for a new initiate to have a positive impact. The leaders may be retired or have moved on by the time the new initiative pans out. As one CEO put it, “Why should I invest in something that hurts earnings on my watch, but provides benefits for my successor that he will take credit for?”

6. Bias Source #5: Fear of Cannibalization
As we saw in the story, new projects often cannibalize older businesses. The thought is that by avoiding the new businesses, we can protect the old ones while at the same time avoiding all that new investment.

These factors can cause a bias to say “no go” to projects which should move forward. They can even distort the financial analysis, to make “no go” look better than it should.

1. Distortion #1: Old Cash Flow Will Go On Forever
New initiatives are often compared to the status quo. If you assume the status quo will always be strong and healthy, then it is hard to justify change. However, it is a fact of life that all strategic initiatives eventually fail. Customer desires change and innovations from others change demand. Product lifecycles eventually reach maturity and decline. The “next big thing” eventually becomes “that obsolete thing.” 8-Track players were once the rage in music. Now they are junk.

The cash flow on the old business will not go on forever. If you don’t replace it, another company will. Either way, there is inevitable decline. Make sure you put it in the model.

2. Distortion #2: Things Won’t Change if I Don’t Change
Ford thought that if they didn’t build the minivan, the minivan would not be built. This, as we saw, was not the case. Innovation is going on all over the place in your industry. If you can see the potential in the new venture, so can others. Just because you like the status quo and don’t want change (because right now you are the leader) does not mean that everyone likes the status quo (especially the non-leaders). Change is inevitable. Either you can take advantage of it (by action) or be hurt by it (through inaction). Therefore, your modeling should assume changing conditions caused by others.

3. Distortion #3: Old Beasts don’t Need to be Fed
To keep older businesses vital, one needs to reinvest in them. For example, I know of a retailer who built a lot of stores in the 1970s and 1980s and then hardly ever reinvested in those locations. Eventually the stores looked rather shabby. In addition, over the next 30 years, those neighborhoods changed and became less desirable locations for stores. People wanted to shop the newer, nicer stores of the competition which were closer to their new homes, rather than drive into the dangerous inner-city locations where these old shabby stores were. By not reinvesting in the old business and refusing to relocate those stores to better locations, the company eventually went bankrupt. In the near term, those relocations looked more expensive than staying in the older locations. Over time, however, the lack of reinvestment killed the old business. Does your business model include reinvestments in the status quo? The old beasts still need to be fed, or they will die.

So how can we avoid this bias and resulting distortions? If helps if we ask ourselves the following questions before making a decision.

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

2. If near-term pressures were eliminated, what would you do? (near-term is biased towards status quo) Keep in mind that astute investors value your firm based on future cash flow potential, not history. If you can convince them that these are good long term investments, they will support you. It helps if incentive programs de-emphasize near-term and also reward good long-term decisions.

3. What if another company says “go” to your “no go” decision? Can you survive the impact to your core businesses? (This provides a more realistic way to evaluate cannibalization)

4. In your model, are you adequately feeding the old beast to keep it relevant or are you choking it? Either the modeling needs to include lots of cash to invigorate the old, or the future prospects for the status quo need to be significantly reduced. Make sure the residual value on the status quo does not overstate its potential.

SUMMARY
Since all current initiatives will eventually fail, there is a need to continually reinvent a firm with new initiatives. Otherwise, your company will fail when all the current initiatives fail. Unfortunately, it is often difficult to justify the cost of reinvention while the old initiatives are still cranking out healthy cash flows. This creates a bias to kill off new initiatives. The more we are aware of this bias, the more we can avoid its disastrous consequences.

FINAL THOUGHTS
Just as the station wagon did not live forever, it appears that the minivan is now in decline. Crossover vehicles are starting to take its place. And guess what? Ford has aggressively gone after the crossover business, because they do not have many minivan sales to cannibalize. By contrast, Chrysler has been slow to get into the crossover business, in large part due to not wanting to cannibalize the most profitable piece of their portfolio (the minivan). Times may change, but the mistaken logic appears to live on.

Strategic Planning Analogy #275: Bias to Go

THE STORY
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.

THE ANALOGY
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
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)

SUMMARY
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.

FINAL THOUGHTS
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.

Strategic Planning Analogy #262: Blind Loyalty

THE STORY
I was listening to an interview with P&G’s outgoing CEO A.G. Lafley shortly after P&G acquired Gillette. Lafley was talking about how he uses all the P&G products at his home. He was excited about adding the Gillette products to the mix because they, too, were already products he used at his home.

Then he paused and remembered that he was currently using Edge shaving cream rather than Gillette shaving cream. Lafley then said, “Well, I guess I’ll be switching from Edge to Gillette shaving cream.”

Goody, goody…Gillette shaving cream has one more customer (Mr. Lafley), because he bought the company. I hope he has additional ideas for increasing share, since that plan (buying the products because you bought the company) is pretty limited.

THE ANALOGY
Lafley felt an obligation to always buy P&G products, for no other reason than the fact that he was CEO of the company. It became a knee-jerk reaction: if P&G owns it, then I have to buy it.

I guess that, as a leader, Lafley felt a need to show confidence in his products. He may have feared what would happen if word got out that Lafley used a competitor’s detergent. Would it damage employee morale? Would customers switch away from P&G products?

I don’t think that would have much of an impact in those areas. I remember when Brittney Spears was doing commercials for Pepsi and word got out that when she was on tour during that time, she had it in her contract that her dressing room would only have coke products. It didn’t seem to cause much of a stir. So I wouldn’t be too worried about that.

What I would worry about is how Lafley’s behavior may distort his business judgment. If you are blindly choosing P&G products based solely on whether your company owns them, then you are acting quite differently from the marketplace. Yes, perhaps a few P&G employees may switch to using Gillette products as a result of the acquisition, but for the rest of the world, the acquisition is a non-issue for brand choice.

The rest of the world needs a more compelling reason to choose your brand. Lafley’s behavior is out-of-touch with the market, which is far less loyal to the brand. This could distort his view of the P&G brand strength.

A similar situation can occur for strategists. If you become too strong of a company person, your perception of the company becomes ever more distorted relative to the rest of the world. You may give too much credit to your own brands and too little credit to the competition. This can cloud your strategic perspective. Your company bias can distort your judgment and cause you to make strategic errors.

THE PRINCIPLE
The principle here is that Blind Loyalty can blind you from the truth. How can you tell if you are superior to the competition if you never experience the competition? Sure, you can read market reports, but there is a lot to be said for personal experience.

I believe that blind loyalty can distort your perspective of the marketplace. Since strategies are designed to optimize performance within the marketplace, distorted visions of the marketplace can create useless, distorted strategies.

Think about people you have known who have gotten divorced. If you only talk to the wife, you will get a distorted view as to what went wrong with the marriage and probably put too much blame on the husband. Similarly, if you only talked to the husband, you would get a different distorted picture and probably put too much blame on the wife. Depending on which one you are most loyal to, you will have a different perspective on the divorce. If you want the truth about the divorce, you need exposure to both sides and a bit of objectivity.

Similarly, if you only surround yourself with your own products and with your own loyal employees, you will get a distorted picture of your brand. You need exposure to the other side.

I would have been more impressed if Lafley had said in his interview, “I’m a loyal user of Edge and I’m sure there’s a good reason for that. I need to find a way for Gillette to give me an even better reason to use them than Edge.”

Experience the Competition
I knew someone who had been an engineering executive at Ford. Ford put him in a program where he was given a series of competitor’s cars to drive. Every few months, he’d be given a different competitor’s car to drive as his personal car. For each of these experiences, he was to write up his impressions of the car.

This helped him to understand how the Ford engineering stacked up against the competition. He could learn from some of the superior things the competitors did. He could learn where Ford was weak. If he had only driven Ford cars during his employment, they would have missed out on these insights.

No matter where I have worked over the years, I have always told my wife to ignore that knowledge and shop as she normally would. I told her to make her purchase decisions based on what she thought was best, rather than who was paying my paycheck. Although I wasn’t always happy when she chose the competition, I was able to learn from her why she acted that way.

This helped to anchor me closer to the real world. I wasn’t distorted as much by blind loyalty. My perspective was not as overly biased in favor my employer to the point where I could no longer see all the warts on my company that the consumer could see. It made me a better strategist.

Watch Out For Brand Extensions
One place where this distortion causes many problems is in strategies surrounding brand extension. Your blind loyalty (and the blind loyalty of the rest of the decision-makers in your company) can cause you to overestimate the power of that brand. As a result, you overextend the brand into places where it doesn’t belong.

There’s a reason why most brand extension strategies turn out to be disappointments. It is because the rest of the world is not as enamored with your brand as you are, so you over-reach.

Watch Out for New Business Models & Fear of Cannibalization
You can also become so used to doing things the “company way” that you become blind to different business models. Kodak was blind to digital photography because of their infatuation with the “Kodak way” using analog film-based photography. The rest of the world didn’t care that much about Kodak magic moments. They just wanted the best way to get and share pictures. And as it turns out, the digital model was (for most) the superior business model. Blind loyalty blinded management to the need to quickly adopt a digital strategy.

A variation on this problem is cannibalization. You may become so loyal to legacy products that you do not want any type of strategy which will hurt those legacy products. At Kodak, it would have been difficult to get aggressive at trying to own the digital space without hurting the core legacy film business. The new business would have cannibalized the old.

Well guess what. Other companies got aggressive with digital and now Kodak is fighting for survival. Either you cannibalize your business or someone else will do it to you. If you do it yourself, at least you are left with a new, successful replacement business. If someone else does it, you are left with nothing.

The Solution
So what is the solution to avoiding some of these problems? First, you need a corporate culture that shuns blind loyalty and encourages more interaction with the competition. It needs to be okay to question the status quo and say an occasional nice thing about the opposition. The prized image should be that of an objective person, not an overly-loyal company puppet.

Second, spend more time listening to voices outside of your headquarters. Recent technological advances in Web 2.0 make this even easier than before. The more you get involved with your customers, the better your strategic perspective, provided you listen to more than just your most loyal customers. Listen to both the good and the bad comments.

Third, be skeptical. If we, by nature, have too much of a positive bias towards our own company, then we need to counteract that by being overly harsh in our strategic analyses. When estimating the likelihood success of your strategy, shy away from the optimistic scenarios. Be more realistic.

SUMMARY
Most leaders in a company have a natural tendency to develop a distorted positive bias towards that company. This blind loyalty can cause us to make poor strategic decisions. One needs to proactively take steps to counter this tendency, in order to help retain more objectivity.

FINAL THOUGHTS
There was an old saying that loyal IBM employees were so loyal that if you cut them, they would bleed in “IBM Blue.” I’d rather your blood was red, because then I would know you were alive and well (and useful).