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 #485: Unconventionality

THE STORY 
Sometimes when my wife and I are on a road trip together, I’ll have fun by telling her that I want to race her to the destination.  Of course, that’s a silly suggestion, because we’re both in the same car.  As a result, we will both get to the destination at the same time.

I think that the very silliness of the suggestion is hilarious.  My wife thinks the very silliness of the suggestion is quite stupid.  So I laugh and she frowns.  But every once in awhile, I still bring up the suggestion when on a road trip.   

THE ANALOGY

If everyone is in the same car, they will arrive at the destination at the same time.  It kind of takes the fun out of being in the race, because there is no way to get a lead over everyone else.  It makes the whole idea of racing kind of silly.

Yet, I see businesses doing this all the time.  The company will set up all kinds of goals to win and to exceed the performance of everyone else in their industry.  The goals are quite impressive.

But when you ask them how they are going to win and achieve those goals, the game plan is to operate by the traditional rules of their industry.  My response is, “How do you plan on beating everyone else if you are doing the same exact conventional activities as everyone else in the industry.”

To me, that makes as much sense as trying to win a road race by piling all the drivers into the same car.  For if everyone in the industry is playing by the same conventional rules of operation, you are in the same car—the car of conventionality.   You are running the race the same way, with the same tools, same business models, the same processes, the same strategies. 

How can you expect to pull away and win a decisive victory under those circumstances?  I don’t care how impressive your goals are.  You haven’t shown me a way to pull ahead and win.

THE PRINCIPLE

The principle here deals with another one of my 23 laws of strategy, the Law of Unconventionality.  This law states that: “You do not achieve unconventional profitability with conventional business models.”  In other words, you do not meaningfully beat your competition if you are doing the same thing they are.  If you want unconventionally high levels of profits, you have to do unconventional things.  You have to get out of the same car of conventionality that everyone else is in and get a car of your own—a car that runs a better race.

Why Conventionality Won’t Win the Race

The problem with conventional methods is that they provide little room for differentiation.  If everyone is going after essentially the same customer in mostly the same way with basically the same offering, all the competitors will look about the same to the consumer base.  There is no natural reason for a customer to prefer one competitor over the other.

Without any meaningful natural differentiation, the only way to get an edge is by “bribing” customers with lower prices or added freebies.  Of course, the other competitors will follow, causing a downward price and profit spiral.

That is why the profitability of industries tend to drop over time and mature industries have returns which are about the same as the industry cost of capital. 

The Need to Differentiate

If there is an outlier in an industry who is beating these odds and making high levels of profits, I’ll bet you it is because they are not following the conventional rules of the industry.  They are doing something very different—playing by different rules.

Southwest Airlines has superior profits over conventional airlines because it doesn’t play by conventional airline rules.  It runs a point to point system with different rules on seating, ticketing (won’t use other ticketing sites online), baggage, fuel purchasing, employee relations and host of different things.  By playing by different rules, it has a lower cost structure and an offering which is superior to a significant sector of the population.

Geico made a splash in the insurance industry by running against the conventional approach of selling insurance personally through a huge network of insurance agents.  Instead, they put the money into advertising and call centers and cut out the agent fee, putting that money into other benefits.

Ashley Furniture gets higher than average returns for furniture retailers by direct sourcing much of its furniture from low cost countries and bypassing the branded furniture manufacturers which the conventional furniture retailers use.

Amancio Ortega became the third richest person in the world by re-writing the rules of the fashion industry.  Instead of running the business around a handful of fashion seasons each year, he built a system based on continuous replenishment.  This system supports his Zara stores in a new way, called “fast fashion,” which is very profitable, because it is a much more productive use of capital and inventory than the conventional fashion operators.

Apple became one of the highest valued companies by avoiding the conventional approach of specializing in either hardware, software or distribution and build an integrated, closed system.  It also changed the rules by focusing on elegance rather than just functionality.

Differentiation Breaks the Bribery Trap

When you do things differently, you give yourself a natural edge.  Either you create cost savings the competition cannot copy so that you can profitably underprice them, or you create superior preference so that customers are willing to pay more for your offering.  Either way, you get to zoom past the conventional operators in the race to profits.

Apple has had long lines of people waiting to full price for their integrated offerings, because many consumers thought their different approach made it worth the effort to get one. 

Because Zara sells through its offerings so quickly and replaces them with something different, people learn that it is useless to wait for items to go on sale.  You have to buy it at full price right away.  And because of their different cost structure, Zara’s full price is still a good deal relative to conventional operators.

The Limitations of Bechmarking

This is why benchmarking is only of limited value.  It helps you to understand how others do things, but it doesn’t tell you how to do things differently from everyone else.

If you are falling behind in the race, benchmarking can help you find a way to get into the car of conventionality.  At least then you are no worse than average and can ride with the rest of the conventional operators.

Or, if you see someone breaking away from the pack, benchmarking can help you figure out how to get inside their car.  For example, others like H&M and Forever 21 have copied much of Zara’s business model, which is starting to make that the “new conventional” model.

But benchmarking won’t tell you how to become the next Southwest, Geico, Apple or Zara.

Sources of Differentiation

There are lots of ways to become unconventional.  It can be done by going after a different customer base, offering a different bundle of benefits, offering a radically different way to solve an old problem, changing how a solution is delivered, changing how an offering is paid for, and so on.  There is not enough room in this blog for all the creative ways to break the mold.  Look for your creative way and you’ll be pleased with the results.

SUMMARY

If you run your business the same way as everyone else in the industry, you will never break away from the pack.  You will be stuck in a world lacking differentiation—and the added profits which come from differentiation.  Only unconventional approaches lead to unconventional returns.

FINAL THOUGHTS

A popular old circus act was to have dozens and dozens of clowns pile out of a tiny car.  If you stick to doing things the conventional way, you are like one of those clowns stuffed into the car of conventionality.  And those clowns get laughed at.  Do you want to be laughed at?  If not, get a car of your own.

Analogy #203: Collaborate Vs. Communicate

THE STORY
One of the most impressive feats of the second half of the 19th century was the completion of the US transcontinental railroad. This railroad line linked Omaha, Nebraska to Sacramento, California. Construction of the railway began in 1863 (during the US Civil War) and ended in 1869. During these 6 years, approximately 1,777 miles (2,859 km) of track were laid down, much of it across treacherous, snowy mountains. Not only did the workers have to battle the terrain, but they had to battle attacks by Indians.

This was an extremely important development, as it connected the entire United States—from coast to coast—with efficient travel. Prior to this rail line, a cross-country trip could take as long as six months. Now, the coast to coast trip could be completed in just one week.

The task to build the line was divided between two companies. The Central Pacific company was to start in Sacramento and build eastward. The Union Pacific company was to start in Omaha and build westward. Each worked independently and devised its own process for building its railway. The US government paid each company independently based on how many miles of track they laid down (at preset amounts based on the difficulty of the terrain).

Although the companies worked independently, the US government, however, needed to intervene in the decision of where the two tracks would connect. Both companies were trying to direct the connection point closer to where they controlled land (so as to maximize their profits). In doing so, the two firms could not come to an agreement. To settle the differences, the US government determined that the connection point would be Promontory Summit in Utah. On May 10, 1869, the golden spike which connected the railways was driven into the ground at Promontory Summit.

THE ANALOGY
The building of the transcontinental railway was a complex and extremely difficult feat. Many strategic business plans today call for their own version of a complex and extremely difficult feat.

In today’s world, when large complex projects are undertaken, there is usually a lot of talk about “collaboration.” The thinking is that complex projects in a “knowledge-based” economy are more efficient if there is continual collaboration and dialogue amongst those with various pieces of the relevant knowledge.

To foster collaboration, companies tend to add quite a bit of complexity to the business. Intricate matrix organizations are built, with multiple reporting relationships (and lots of dotted lines on the org chart). Expensive data/knowledge warehouses are built, with the capability for real-time sharing and interaction across the entire organization.

The transcontinental railroad didn’t worry much about collaboration. Other than collaborating on the initial design and the ending connection point, there was hardly any “working together” between the Union Pacific and the Central Pacific. To the contrary, rather than collaborating, they were encouraged to compete against each other to see who could lay the most track. Without collaboration, they very quickly completed a very difficult task.

This blog will try to show that modern businesses may be over-emphasizing the need to collaborate. As a result, they are building an unnecessarily complex infrastructure which may be choking efficiency rather than helping. It may be more productive to move to a structure more like that used to build the transcontinental railroad.

THE PRINCIPLE
The principle here is that there is a big difference between collaboration and communication. The dictionary defines collaboration as various parties working together on a project. By contrast, communication is just a sharing of information. Communication tends to move in one direction (from the person with the information to the person without). This is typically not a group of people who need to work together side by side to get the project done. It is just a data dump.

If we consider all communication to be “collaboration,” then we significantly overestimate how much true collaboration is going on. These inflated estimates then cause us to create elaborate collaboration solutions which may not be justified. Worse yet, all of that forced collaboration may create a bureaucratic nightmare that makes it harder for people to independently just go out and get the work done.

We can see this by looking at the typical life cycle for a major project.

Usually, a new strategic initiative starts with data gathering. Great strategies are not created in a vacuum, but within a context—an answer to a real need in the marketplace. One must understand the context in order to create the proper strategic solution. Therefore, data is needed to answer questions like:

1) What are My Capabilities?
2) What are the Key Issues/Concerns of my Customer?
3) What is the Competitive Landscape?

Getting the answers to these questions does not require collaboration. Instead, what is needed is a good data dumping process. In the fall 2008 issue of the MIT Sloan Management Review, there is an article about IBM’s attempt to create innovation through a massive collaborative process. Over 150,000 IBM employees were asked to participate in a multi-day on-line collaboration concerning ideas for innovation. IBM came up with a sophisticated process for such collaboration via computer software on the internet.

What was the result? Although lots of people wrote in and submitted ideas (available for all to see), there was virtually no dialogue which built upon any ideas. There was no real collaboration...no connections between submissions. It was just a data dump. All of those ideas could have just as easily have been mailed in on post cards. The ability to collaborate was not necessary.

Next comes the visioning—the choosing of the right course. My experience is that great visions come from great visionaries—not committees. Collaborating committees tend to compromise and dilute the vision into something bland and average. It doesn’t offend, but then again, it doesn’t inspire or excite the emotions. Radical, groundbreaking visions, typically result in love/hate reactions—something that would typically not escape a collaboration until watered down. In the case of the transcontinental railroad, Abraham Lincoln was the visionary who chose the path and made it happen, not a collaborative team.

Yes, visions need to be communicated and accepted around the organization. But this is more about persuasion than it is about collaboration. It is about disseminating information and inspiring folks. Sure, there is room to accept feedback and modify things a bit, but the overall vision, if properly chosen, should remain in tact.

Now comes the implementation phase. Collaboration is important here, particularly at those points where people’s work intersects with each other. Choosing the point at which the Union Pacific and the Central Pacific were to meet was one such intersection. To me, the key here is to:

1) Identify points of intersection early.
2) Come to a rough agreement of how you will mesh at the point of intersection (collaborate).
3) Go off and do your thing somewhat independently (not collaborate).
4) Check in periodically to see if you are still on a path to mesh, or if new information/knowledge requires readdressing the earlier decision (collaborate).

For example, if you are designing a new car, it is important that the people designing the chassis and the people designing the engine have a general agreement about engine dimensions, so that the engine fits into the spot where it is to be located in the chassis. That is collaboration. However, you do not need the chassis people to collaborate on building the engine. They are not trained in that skill. Nor do you need the engine people designing the chassis. As long as the intersection point (putting the engine in the chassis) is worked out well in advance, you have most of the collaboration you need.

The exception would be if the engine designers discover that they cannot design a proper engine to meet the earlier specs. They you may need to reconvene and collaborate on a new revised conclusion.

Having everyone fully collaborating together as one unit all the time can be counter-productive. Most great advances in business are driven by the forces of competition. If you eliminate internal competition, you can become as inefficient as the old communist regimes. Internal competition between Union Pacific and Central Pacific caused the train track to be built more quickly than if they had worked together. In my time at Best Buy, I saw how internal competition can bring out the best and drive great improvement.

A similar thing happens with best-in-class benchmarking. I have often seen people speak of moving best-in-class processes throughout a firm as “collaboration.” This is not collaboration—this is teaching and learning. And if you force everyone, all the time, to act in the same exact way, you have frozen productivity and innovation. You can never get better, because doing anything different from the current standard is not allowed. To make advances, you need renegades—people who do not collaborate and go off on their own to experiment and find the next improvement.

By the time you add internal competition and renegades into the mix, even the implementation stage is not as much about collaboration as one might at first think.

SUMMARY
Collaboration is not the same as communication. Communication seems to be more critical than collaboration. If we focus on building organizations that are unencumbered with bureaucracy, but communicate well, we are probably better off than if we had focused on building complex collaborative structures.

FINAL THOUGHTS
There’s an old saying that “too many cooks spoil the broth.” In other words, if you bring together a lot of chefs to collaborate on a cooking project, it will fail because the combination of all of their conflicting ideas will create a disaster. Better to find one great chef and let him or her create their masterpiece with a single, working recipe.