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.

Strategic Planning Analogy #266: Consequences of Fame

THE STORY
Once there was a young boy who lived in poverty. All he had was the ability to run very fast. He was discovered by some sports promoters, who made him into a popular and successful athlete.

As a result of this popularity and new-found fortune, the boy was able to alter his lifestyle. Instead of running everywhere, his was driven around. He spent his evenings partying and eating lavish meals.

Eventually, he became so fat and out of shape that he could no longer run quickly. Once he lost his athletic ability, he lost his fame and fortune. He was back to where he started—living in poverty.

THE ANALOGY
I’m sure you’ve heard many variations of this story over the years. Often times, athletes, actors or musicians get caught up in the lifestyle of the rich and famous. This wild living of sex and drugs and partying destroys their ability to continue with their gift. As a result, they lose their ability to continue the fame and fortune.

The story is sad, but sadder yet, it is rather common. There’s something about fame and fortune that can often lead to self destruction.

This same concept can also happen to national economies or to individual businesses. Initial success can trigger changes which work to destroy the foundation of that success. We need to understand these factors so that we can accurately assess the future of national economies, as well as minimize the tendency towards self destruction in our businesses.

THE PRINCIPLE
The principle here is that economic success tends to naturally create aftereffects which act to weaken the cause of the original success. Unless we understand these aftereffects and work to counter them, our strategic assessments will be wrong and we will end up with a failed strategy.

The Principle at the National Level
Take, for example, national economies. Nations typically start on the road to economic success by taking advantage of their low labor costs. This is like the athlete in our story who took advantage of his ability to run fast. It is a competitive edge which provides a platform for gaining success.

Once a nation can prove that it is good at providing lowest cost production, money will flood the country to build low-cost factories. All of these factories, filled with low cost labor, begin the nation down the path to economic success.

Unfortunately, all of this success has aftereffects which work against success. First, the laborers eventually get tired of working under unsafe conditions for little pay. They demand better conditions and a bigger piece of the profits.

Second, the economic success is usually not spread evenly throughout the country. Poor, rural people begin to flood the cities where the initial success began. This creates all sorts of problems, such as inadequate housing and water, congested streets, massive pollution and social unrest. The country must now divert some of its attention from building an export economy to fixing internal infrastructure and strife. This requires increases in taxes, creating even more pressure by the workers to get wage increases.

All of these aftereffects create a situation where the country is no longer the lowest in cost of production. Like the boy in the story, the country becomes fat and is no longer competitive. As a result, all the fame and fortune starts moving to the next nation with a claim to lowest cost of production.

You can see all of this starting to happen in China. There has been tremendous pressure to build safer products in safer factories by employees who get paid a decent wage. Labor unrest builds until it explodes in places like Urumqi this past week. Already, there are some Chinese manufacturing companies that are shifting their production to Vietnam because their own country has gotten too expensive. Exports are way down. Internal strife is on the rise.

Yes, China is still a large and growing economy. But I remember when prognosticators were predicting huge, rapid growth in China seemingly forever until they dominated the entire world. I chuckled to myself, because I knew that eventually the forces behind the initial economic success would lead to natural factors (we are now seeing) which would slow down that economic juggernaut. If you bought into the distortions from these initial prognosticators, you may have made some poor economic decisions.

The Principle at the Business Level
This same situation can happen to individual businesses as well. If your success is based on having created an entirely new business opportunity, natural forces will lead to competitors flooding into the new business as well. Competitive pressure will drive down those initially high profit margins. You may not even survive the consolidation of the industry if the ones who follow you have a superior infrastructure (for more on this, see the blog “Gimme Shelter”).

If, on the other hand, your initial success comes from taking large market share away from someone else, then natural forces will cause the person who is losing share to wake up and retaliate. This retaliation will cause some of the share to go back to the original party and will probably make the entire business less profitable due to lowering of prices (for more on this, see the blog “Bombs Start Wars”).

And then, of course, there are the natural internal factors which tend to follow success. Workers will demand better wages. Leaders will want more lavish compensation. Internal bureaucracy will become bloated, costly and slow. Just look at the US automobile industry to see how initial success can start natural forces inside which tend to destroy the initial success.

The Prescription
So what should strategists do? Two things:

1) Temper Your Optimism
When making predictions about economic situations (be it internal or external), don’t become overly optimistic about early successes. Realize that there are forces in play that will work against those successes. Factor those forces into your long-term projections. Assume aggressive competitive reactions and rising costs of production, for example.

Your modeling should almost never treat “best case scenario” as “most likely scenario.” In fact, if you see a big retaliation coming, the wisest strategy may be to sell out early at top dollar, before the retaliation comes.

2) Put in Measures to Counteract the Natural Aftereffects
Although there is a natural tendency for success to breed high wages and a bloated bureaucracy, it doesn’t mean that you cannot fight the trend. If you know about the forces in advance, you can instill in your strategy measures to resist these forces. By being proactive, you can slow down or eliminate many of these threats.

Proactive, aggressive measures to fight bureaucratic bloat can help keep your core strategic success successful for a longer period of time.

SUMMARY
Initial success does not guarantee long-term success. There are natural forces which accompany success and work to destroy the principles behind that initial success. As a result, your strategies should temper their optimism around early successes and put into place measures to fight the negative natural forces.

FINAL THOUGHTS
Since competitive advantages like low labor or getting to the market first tend to be temporary, good strategies should look for advantages which are more difficult to lose, such as patents, unique skills, or synergies that are difficult to copy.