Strategic Planning Analogy #324: Protect the Core

THE STORY
I used to work for a company where the legal department seemed to get the best perks. They had the larger offices, the better equipment, the larger staffs, and the higher wages. I did some investigation to find out why the legal department was getting preferential treatment.

As it turns out, when budgeting time came about, the legal department would justify their existence using large hypothetical numbers. They would say something like this: “Just one smart move by the legal department can prevent a future legal liability of hundreds of millions of dollars. Considering all the potential legal liability avoidances, they add up to a huge number. By comparison, spending a little more on offices, equipment and salaries in the legal department looks like a real bargain.”

Since that approach seemed to work for them, I decided to try a similar approach for the strategic planning department. I said that good strategic planning puts companies on a path to long-term success and keeps them off a path to failure. Given the alternative of good strategic planning or failure, how much would you be willing to spend on Strategic Planning in order to avoid failure?

I may have over-reached on that appeal, since the top executives would not accept the idea that they could possibly fail if the strategic planning department disappeared. Therefore, in future years, I toned down the message and said that Strategic Planning could find new paths to growth that were worth hundreds of millions of dollars and avoid hundreds of millions of dollars of losses from poor investments. That approach worked better.

THE ANALOGY
In retailing, there is an old saying that “There are no cash registers in the corporate office.” In other words, all the money is made when a customer buys something at the store. Therefore, focus investments on getting the store right, because otherwise there will not be any income to pay for that corporate office.

Yes, it is true that getting things right at the point where sales are made is very important. Without sales, there are no profits. Sales, however, are not the only factor determining profits. As my friends in the legal department pointed out every year, bad legal decisions can cause all of your profits to disappear through legal liability payments. In other words, profits are also impacted greatly by actions at the home office—far away from the cash registers.

If the legal department could portray themselves as a savior of profits, and I could portray the strategic planning department as a savior of profits, I’ll bet a lot of other corporate office departments could do the same. Are we missing a lot of potential profitability if we focus too exclusively on just where the cash register is?

THE PRINCIPLE
The principle here is that strategy needs to be concerned not only with cash flow creation, but cash flow protection. Without proper concern for protection, the cash flow machine can stop working.

There have been lots of stories in the news recently of threats to cash flow machines:

1) The oil leak in the Gulf of Mexico is putting a big dent in the BP cash flow machine.

2) Several recent mining disasters (like the Massy Energy mine in the US, the Raspadskaya mine in Russia, or the Guomin mine in China) have crippled the cash-making ability of these mines.

3) Quality issues at Toyota have had a negative impact on image and cash flow.

4) A little typing error on a stock trade caused computerized trading on Wall Street last week to destroy stock values, wiping out huge amounts of profits in a short amount of time.

In many of these cases, the disaster occurred due to too much emphasis on cash flow creation and not enough emphasis on cash flow protection.

At Toyota, the cash flow strategy—based on a superior quality product—was taken too much for granted. Emphasis was placed on increasing the cash flow from that strategy through more rapid expansion and more strident cost control. However, those measures to increase the cash flow worked to destroy the cash flow machine. They took the focus off quality and put extras stress on the ability to continue quality. As a result, quality suffered. The core strategy was damaged.

Productive mines and oil wells can be great cash flow machines. However, there is the risk of assuming the cash flow machine will continue all on its own. Hence, one can be tempted to cut back on mine-related costs in order to increase that cash flow. If you do not protect that mine or well with the proper safety, maintenance or employee training, disaster can erupt, shutting down the cash flow machine and causing huge sums of additional costs to fix the problem.

The point here is that all company actions impact the core strategy. Some of those actions may create near-term boosts to cash flow, but destroy the long term functionality of the core cash flow machine. Don’t assume that the cash flow machine will continue on its own. Put into your strategy and tactics proactive means to protect that cash flow.

Sure, I hear people strategize about some of the key threats found in Porter’s Five Forces, like competitive threats or new product threats. But what about some other threats to the cash flow machine, like:

1) Putting the wrong people in charge of key functions (I have seen this mistake literally destroy entire businesses).
2) Ignoring safety, maintenance, and training issues
3) Growing faster than you can manage the growth
4) Legal Liabilities
5) Risk Management
6) Swings in foreign currency translations
7) Tax issues (earlier, we spent an entire blog on just this one issue)
8) Computer programming errors.
9) Breeches of privacy or data theft

Cost cutting in areas such as these may look like a way to increase cash flow. But if the cost cutting damages the core cash flow machine, you are worse off. If cash flow protection investments are made, you can actually increase long-term cash flow while spending more money, because the investments increase the effectiveness of the core cash flow strategy.

So what can we learn from this?

1) Understand what is the core of your strategy
In most cases, strategic success is based on excelling at the key differentiating point of your strategic position. Mess that up and the whole strategy starts to crumble. Therefore, it is essential for everyone in the organization to know where that key focus is, so that it can be protected.

If the key focal point is quality, everyone needs to know that—not just the folks on the assembly line. There are lots of areas in a business where decisions can be made which affect quality, from finance to human resources to expansion planning and so on. If you want to protect quality, you need to protect it from all of the decisions throughout the business that can potentially impact quality.

The best way to do that is by holding everyone accountable for their impact on the core focus of the strategy. And of course, this means that companies must first know what that key focus really is (from the perspective of the customers). Then they must communicate it as a priority for all decision making, regardless of where you are in the organization.

2) When developing a new strategic initiative, design protection into the setup
The best way to protect a cash flow is to incorporate the protection in up front at the beginning. Once the oil rig in the Gulf of Mexico erupts, it is too late to start the protection process.

This applies to numerous areas. For example, how you initially set up a business or an acquisition can have huge impact on your level of legal liability or tax liability. The type of people and process you use to integrate a new initiative may have more of an impact on cash flow than the actual initiative.

Considering all the risk issues up-front allows you to incorporate more protection into the process, before all the contracts are written up and all the deals concluded. Think beyond the point where business in transacted (the “cash registers”) to all the places that could indirectly impact success.

3) Don’t assume that a cash flow machine will work forever if unprotected.
Left unattended, cash flow machines will break down. They can be made less efficient through hundreds of little decisions around the company which each have a small impact of compromising one’s ability to excel at the point of strategic focus. They can be rendered obsolete by competitive advances. Lack of investment in maintenance or R&D can slow it down.

If this is the key to your success, don’t take it for granted. Protect it like the crown jewels, because that is exactly what it is. Protect it from inside threats as well as outside threats. Invest in your point of differentiation so that it is always a step ahead of the competition. Keep awareness of what is the core of your success at the top of mind, so that it will be given its proper attention. Whenever big decisions are being made, always ask yourself “How will this decision impact the core of our cash flow machine?” Be vigilant.

SUMMARY
Great strategies need to be more than just great ideas. They need to become the core of how your business operates. This can only happen if you put in place strategies and tactics to protect this core from losing its strategic focus.

FINAL THOUGHTS
One little drop of water is pretty harmless. But get enough of them and the dam won’t be able to hold back the water and it will burst, destroying everything below the dam. Similarly, get enough little, seemingly harmless, decisions that weaken a strategic position and before you know it, the strategy bursts.

Don’t Forget the Taxman

THE STORY
On the front page of one of last week’s editions of the Wall Street Journal (October 23, 2007), there was a story about the tax strategy of Wal-Mart. According to the article, back in May of 2001 Wal-Mart Stores, Inc. sent out a call to the big accounting firms to find creative ways to cut their state tax bills.

Ernst & Young LLP aggressively went after the business. They put together a 37-page proposal outlining 27 potential tax strategies. Ernst & Young characterized the proposal as “a very aggressive strategy with considerable risk.” Indeed, many of these proposals skated along the edge of the law, and many states have since closed some of these loopholes.

But in the end, records show that Wal-Mart’s effective tax rate at the state level tends to be about half the average state corporate tax rate. So they are winning the war against the tax-man.

Wal-Mart is not the only aggressive tax avoider. According to the Wall Street Journal article, “Publicly traded companies reduced their federal income taxes by about $12 billion in 2004 through potentially abusive tax transactions, according to Internal Revenue data. Some experts say companies save far more than that each year through elaborate tax-cutting maneuvers.”

THE ANALOGY
Taxes take a big bite out of a company’s income. For most businesses, taxes are one of the largest single expenditures. Therefore, it is not surprising that firms like Wal-Mart spent time getting aggressive about finding ways to reduce their taxation.

Yet, although many companies work diligently at getting the tax burden reduced on ongoing businesses, it seems that far fewer incorporate taxation into their long-range strategic planning. My experience has been that tax specialists are rarely invited to the long range planning discussions. Taxation is often an afterthought in the process, if thought of at all.

If it is so important to the business of today, shouldn’t it get some attention when looking into the businesses of tomorrow?

THE PRINCIPLE
Although it pains me to admit it, the principle here is that sometimes the way a business is structured as it is related to taxation can have a greater impact on the success of the strategy that the choice in how the business is run. Even when this is not the case, taxation strategies can have a major impact on the degree of success which a strategy has. Therefore, it might not be a bad idea to give a little time to the subject of taxes when developing a strategy.

I have seen companies who finalize their comprehensive strategy and then go to the tax expert and say, “Here is the strategy. Find the way to pay the least amount of taxes on this strategy.” Tax experts have told me that there is only so much magic they can do when brought in at the tail end. If they were brought into the discussion earlier, they claim they could be more effective in reducing the tax burden.

Many times a strategy leads a company to do things differently than in the past. It may suggest getting out of some businesses, acquiring some new skills, developing a new source of revenues, inventing a business model which doesn’t currently exist, and so on. As it turns out, there are many ways to accomplish these tasks. You can have acquisitions, joint ventures, venture funding, internal start-ups, as well as many other structures.

Each structure has differing levels of implications for taxation. If taxation considerations are brought earlier into the discussion, then perhaps the strategy would choose a different (and potentially far superior) path for getting the task accomplished.

I am not suggesting here that taxation become the main driver of the strategy or that the core of the company strategy revolve around questionable abusive tax schemes. What I am recommending is that perhaps tax issues should be brought into the discussion at an earlier stage.

Sometimes, an earlier approach to thinking about taxation can change your whole approach to how you look at your business. Many years ago, I was reading an article about a strategic financial consultant who specialized in helping small independent grocers. What he would tell his clients was that they were too focused on trying to improve profitability. He told them that this was a mistake. Instead, their goal should be to find ever higher levels of break-even.

His point was that for a small independent entrepreneur, his or her lifestyle should be more important than their earnings. Earnings get taxed. Lifestyles may not get taxed if structured properly. The less you pay in taxes, the more money there is to support a nice lifestyle.

Therefore, the more care an entrepreneur makes in structuring the combination of their business and their lifestyle, the more they can make their lifestyle tax deductible to their business. By shifting more of one’s lifestyle expenses to the business, you get several advantages. First, the business becomes less profitable, so you pay less on business taxes. Second, this could result in the entrepreneur having a lower personal income, so fewer personal taxes are paid. Third, by paying fewer taxes, there is more money available to enrich the lifestyle.
So in the end, the entrepreneur is having a better lifestyle, even though on paper it looks less profitable. Hence, the expert’s admonition to chase “ever higher levels of breakeven” rather than profits.

This may not be the best advice for your situation. However, the point is that the way you look at your business can change how you act. And if you look at your business more often through the eyes of a tax expert, you may act in ways that provide superior long-term benefits.

SUMMARY
Tax issues are often not a part of the strategy-framing discussion. Given the fact that taxes are one of the single largest expenditures of a business, it may make sense to bring in tax experts at earlier points in the strategic discussion.

FINAL THOUGHTS
I used to spend a lot of time with a tax expert at one of the places where I worked. His annual bonus was based on each year bringing to the company two new approaches to the business structure which would meaningfully reduce taxes. One year, he told me that he had three great ideas. He refused to tell the company about the third idea. He only told them about the first two (which qualified him to get a full bonus). Then he figured he’d save the third idea for the following year, which would put him halfway towards his bonus before the year even began.

I guess if you are looking for a tax expert to use his magic to take advantage of the tax rules, you’ll find someone who is also an expert at taking advantage of the bonus rules.