Strategic Planning Analogy #487: Tying-Out Fantasies

THE STORY

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

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

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

THE ANALOGY

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

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

It’s enough to get one very discouraged.

THE PRINCIPLE

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

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

Internal Linkage Accuracy

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

1.      Making sure the balance sheet, income statement and cash flow statement all tie out precisely (without rounding).

2.      Making sure all the sub-accounts are filled and add up to the total.

3.      Making sure the precise cost of capital is used.

4.      Making sure all the boxes are filled in on the forms and scorecards.

5.      Making sure there are measurable KPI’s (Key Performance Indicators) for every initiative.

6.      Making sure you have all the proper sign-offs by the required people.

7.      Making sure all of the data is accurately represented, and fully tied to the stated strategic goals and annual budgets.

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

External Linkage Accuracy

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

1.      Making sure the strategy is superior to all the external alternatives in solving a problem important to your consumer segment. These can be similar or dis-similar alternatives.

2.      Making sure competitive reaction is factored into the analysis.

3.      Making sure evolving technologies and social issues are taken into account.

4.      Making sure the company and its employees are willing and capable of delivering on the promises inherent in the strategy.

5.      Making sure to factor in changes over time in external factors such as raw material pricing, final product pricing, consumer adoption rates, etc.

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

Why a Focus on External Linkage is Better

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

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

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

1. Cell phone adoption rates would stay relatively low (a niche product). This would make it impractical to fully build out a land-based transmission system. There would be too many holes in the land-based network to make it practical.

2. Land-based cell phone service charges would remain at or near current high levels. As a result, it would be possible to spend a fortune on satellites and still sell the service at lower rates than the land-based companies. 

3. Phones would remain large, so that the larger mechanics needed to transmit to satellites would fit in them.

These assumptions turned out to be totally inaccurate.  Prices dropped dramatically and adoption rates soared. Land-based networks filled nearly all of the holes.  Smaller phone sizes could not accommodate the needs for satellite transmissions. As a result, Iridium could not effectively compete, because its cost structure made it impossible for them to match the new pricing environment. That left Iridium viable with only a small sector of the industry—spies, the military, and ships at sea—not enough to generate a profit.

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

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

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

So Why Do Companies Focus Internally?

If external accuracy is so much more important, why do so many companies focus internally?  Here are a few suggestions:

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

We need to overcome some of these biases towards an internal focus and create more incentives around a focus on external accuracy.

SUMMARY

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

FINAL THOUGHTS

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

Too Many Clocks

The Story
My first job out of college was as Assistant to the President of a furniture retailer. This retailer sold a fair amount of grandfather clocks—enough so that there was a separate selling room in the store just for displaying a large number of these clocks.

On one of my first weeks on the job, I noticed that the grandfather clocks were all set at different, and seemingly random, times. I thought I would do everyone a favor and set all of the grandfather clocks to the same time that was on my watch. There were many clocks, so this took a bit of time.

After I finished, the president of the company saw what I had done and told me to go back and reset all of the clocks to different random times. I was a little upset because of all the time it took to set the clocks to the time on my watch, so the president explained why he wanted them switched back. This is basically what he said…

Grandfather clocks are relatively expensive timepieces. As a result, customers want to make sure the clocks keep accurate time. Since the potential customer is not going to stare at the clock all day long to check how well the clock keeps time, the typical customer uses a short-cut. The short-cut is to compare the time on the clock to a reference point to see if the both have the same exact time.

For example, the customer may compare the time on the grandfather clock to the time on his or her watch. The likelihood that I set that clock to exactly the same time as that customer’s watch is highly unlikely. Since the watch and the clock are not exactly identical in time, one must conclude that at least one of them—if not both—are inaccurate. If the clock is not accurate in displaying the correct time, then there is a feeling that the clock may not be accurate in keeping time.

Another reference point would be to compare all of the grandfather clocks in the room to each other. The likelihood that I was able to set all of the clocks to exactly the same time is also highly unlikely. Since all of the clocks would be slightly different from each other in the time they are displaying, the customer could not have confidence that any of the clocks are accurate. The customer would wonder how all these clocks could be accurate if they are all showing slightly different times. In fact, the more clocks in the room, the more likely they would convince the customer that they were inaccurate.

By contrast, if all of the clocks are set at different and random times that are nowhere near the current time, then there is no reference point. The customer then has no reason to assume that the clocks are inaccurate, because there is no known variance. If fact, given the high price the clocks were being sold for, the customer might assume that the clock is built well enough to keep accurate time.

The irony is that the further away the clocks are from the current time, the more accurate they will appear to the customer. I quickly caught on to what the president was saying and immediately changed the clocks back to random and different times.

The Analogy
Strategic planning and clocks both have something in common. Both are used to better understand the time. Clocks are used to help us understand the current time. Strategic planning is used to help us better understand time in the future. Rather than looking at a clock to tell the time, strategic planners look at research. Strategic planning is all about trying to build a more successful future. Research helps planners understand what kind of future they are trying to build that success in. The better one understands the future environment, the more likely one can design the proper plan for that future.

There is an odd relationship between clocks and the perception of their accuracy. If you have only one clock, when you want to know the time, you just look at it and assume it is accurate, without even thinking about it. However, if you want to know what time it is and you have two clocks to check, your feeling of confidence in their accuracy goes down because they will not be exactly the same. Since you do not know which of the two clocks is accurate, a bit of doubt fills your mind. You are less confident that you know the real time, since you now have more options to choose from—the first clock, the second clock or something in-between. If you add a third clock the confidence goes down even more, because there is even more variability in the times being displayed.

The irony is that the more clocks you check, the more uncertainty you have regarding your confidence in knowing what the exact time is. If you have an entire room of clocks, like the store in the story above, there is a feeling that you will never know the exact time. There are too many different options to choose from. By looking at all of the clocks in the room you may feel reasonably confident that the time is, say, approximately two o’clock in the afternoon. However, you will never know when it is exactly two o’clock.

Adding more clocks will not help the situation. Two rooms of clocks will not give you any more of a sense of the accurate time than one room of clocks. You will know no more than you did before—that the approximate time is around two o’clock.

A similar situation occurs when gathering research for strategic planning. After a certain point, the amount of research you have gathered may start pointing to a rough approximation of where the future may evolve. However, it will never give you an exact knowledge of what the future will look like. There is too much variability in the research—they never say exactly the same thing about the future.

Further research in that area will not increase your accuracy. You will know no more than you did before—the same approximation of what the future may look like. Two rooms full of research will not get you any closer to accuracy than one room of research.

The Principle
There is a phenomenon that often occurs in strategic planning referred to as the “paralysis of analysis.” The phenomenon occurs with people who are afraid to take action until they have a certainty of information. Since there is never certainty about the future, these people procrastinate about taking any action. Instead of implementing a plan, they decide to find additional research. The reasoning is that, if one gets additional information, one can make a make a better decision later. Therefore, the person waits for more research.

However, as we saw above, after a certain point, additional research does not increase the accuracy of your prediction. The additional research just keeps roughly circulating around the same approximate direction. If your plan is to continue searching for research until you reach certainty, you will be researching forever, because certainty will never be found. Hence the term “paralysis of analysis.” The person is paralyzed and unable to take any action towards building a better future because he or she is lost in an endless cycle of gathering and analyzing research. While this person is paralyzed, a competitor may not be, which gives the competitor the opportunity to win a better position in the future than the paralyzed one.

Planning is not an exact science. There is always a little bit of uncertainty. Action will need to be taken with less than perfect information.

Going back to the clock story, most people are able to function and take appropriate action in the current moment even if they know that the clocks in their life are not 100% accurate. As long as one knows that it is approximately two o’clock, then that is good enough to take action. This same attitude needs to be applied to thinking about the future. One needs to be able to take appropriate actions towards the future even if one knows that the research possessed about the future is not 100% accurate.

There are three reasons why any additional research beyond a base level will never achieve greater clarity about knowing the future:

1. Consumers are Unreliable in Predicting What they will do in the Future
2. The Future is Not Destiny
3. By the Time Something is Completely Knowable, it is Too Late to Make a Meaningful Strategic Impact.

These are all discussed below.

1. Consumers are Unreliable in Predicting What they will do in the Future. History has shown that consumers are terrible at predicting what they will do in the future, especially as it relates to activities surrounding situations they have not yet encountered. As a result, research that asks your consumers about what they will do in the future has significant limitations. Sony is proud to point out that no consumer has ever asked for any of the myriad of successful inventions they have introduced. If Sony had waited for research to tell them what to invent, none of those items would have been invented. Rather than doing rooms full of specific consumer research, one needs to rely more on generalized research about the basic needs and desires of your consumers and then make inferences about how your plan would play to those basic needs and desires. Consumer research about the future will never give you the specific answer about what to do. At best, it will tell you what general areas or qualities to focus on.

2. The Future is not Destiny. Because I have spent decades studying the retail industry, I am often asked my opinion regarding future trends in retailing. When asked about a particular retail trend, I often respond by saying, “I will not answer your question until you answer a question for me. How aggressively do you think Wal-Mart will be in adopting this trend or in trying to block this trend?” The point I am trying to make is that the future is not written in stone. The future is not an unalterable destiny to be discovered. Instead, the future is changeable. Wal-Mart is so big and powerful, that the decisions it makes can significantly alter the way a retail trend evolves. If Wal-Mart decides to go after a particular business with a particular format, then the trends surrounding that format will be larger and occur faster than what would have occurred if Wal-Mart had not participated.

The same principle applies to you. Since the actions of you and others can alter how the future unfolds, no amount of research alone will ever be able to accurately predict the future. Rather than spending all of your time analyzing two rooms of research, it is better to have spent some of that time considering how you can use your influence to alter the future. Rather than only looking for ways to discover the future, look for ways to create the future.

If the future were 100% certain, then there would be no way to alter it. If one could not alter the future, then one could not alter his or her level of success in that future. If that is the case, then there is no point in planning. It is precisely because the future is not destiny that makes planning so important. Your strategic plans can alter the course of the future. The better your plans, the better your future.

3. By the Time Something is Completely Knowable, it is Too Late to Make a Meaningful Strategic Impact. Often times, the most successful plans are ones in which your company is the first to make a meaningful impact in a new space. If you wait until the space is completely defined and understood before entering, it is often too late. Starbucks rapidly expanded into the new space it created well before it was completely understood. There were no books describing in detail the types of coffee shops that Starbucks invented. In fact, the conventional wisdom based on the research of the time was that consumers wanted their coffee to be inexpensive and convenient. Starbucks was expensive and time consuming.

If you are waiting for all of the research to be written down in complete detail in a book before taking any action, you will be too late. The only way to get research in that much detail is to wait until the market is already fully developed. By the time it is fully developed, your ability to enter and win in that space is severely limited. It is better to get into a new space early and learn via experimentation rather than wait for all of the facts before taking any action.

With all of that said, this is not an excuse to avoid doing any research. Research is still an important part of any strategic planning process. However, the goal should not be to gather rooms full of data in search of exact information. The goal is to gather enough information to get a general impression of how the future may evolve and then start crafting your actions.

Summary
Strategic planning deals with the future. Just as clocks help us understand the current time, research helps planners understand future time. Gathering rooms full of clocks will not give you certainty of the current time. Neither will rooms full of research give you certainty of the future. There are diminishing returns to time spent getting and analyzing research. Just as you can have too many clocks, you can have too much analysis. Gather enough to get a feeling for the general trends and then supplement the research with activities and experiments. Otherwise, you may fall into the trap of “paralysis of analysis.”

Final Thoughts
General George S. Patton is famous for saying that “A good plan violently executed now is better than a perfect plan executed next week.” The goal of strategic planning is not to create a perfect plan. The goal is to create a better future. This requires more than just planning. It requires doing. Good research and good planning can help you reduce the risk of doing the wrong thing. But if you never get around to doing anything because of the search for the perfect plan, the plans do you no good.