If families were funded like public companies…

Imagine, if you will, that your family has just decided to run their finances like a public company, including the following controls:

• the financial plan for the family is now agreed annually, in advance of the financial year covered by the plan
• the plan has capital expenditure (capex) and operational expenditure (opex) budgets
• budgets are sacrosanct and shall not be changed throughout the year (expect when income does not meet forecast – see next control)
• operational expenditure is planned quarterly, and is adjusted down in the next quarter if income does not meet forecast
• capex and opex shall never be confused or traded off

So let’s just play that out:

The Jones family starts the year with the following (admittedly very simplified) plan:

• Cash at hand (capital): $50,000
• Forecast income: $100,000
• Forecast operational expense: $80,000
• Savings (retained income before capital expenditure): $20,000
• Planned capital expenditure: $20,000

According to this plan, the family will end the year pretty much where is started financially (although with an additional asset(s) valued at $20,000 – note that we are also ignoring asset appreciation/depreciation, for the sake of simplicity).

And so the year starts.

Income in the first quarter is $25,000 and expenses are $20,000, so everything is wonderful. Given things are going so well, the Jones spend $15,000 of their capex budget and install a new kitchen.

But then, in the second quarter, Ken Jones loses his job. Income falls to $15,000 for the quarter, and operational expense is commensurately cut to $10,000.  New jobs are not easy to come by and the family is really starting to suffer.

By the third quarter, things are getting desperate.  The drop is operational expense means the family is now eating instant noodles very night and lights go out at 8pm to save on electricity.

Out of the blue, a great job opportunity comes up for Ken.  The only catch: it’s in the next town, and he needs his own transport to get there.  The capital budget only has $5,000 left, so buying a reliable car is a real stretch – but finally Ken finds one and the deal is done.  He starts his new job, and the expense budget goes back to normal.

Well, for two weeks, that is – then Ken’s car is stolen.

Unfortunately, given the operational expense budget in the third quarter could only afford the minimum third-party insurance, the theft is not covered and the capital is gone.

Unable to get to work, Ken loses his job (for the second time!) and the family must now live out the final quarter of the year on the reduced operational budget. More instant noodles and early nights…

The family is not totally despondent, however, as the new financial year is just around the corner!  They all know that that means a new capital budget (which will allow them to buy a new car!).  Ken’s most recent employer already said he could come back anytime he had the means to be there reliably, so all they need to do now is wait for the first day of the new financial year.  Thank goodness for annual financial plans!

It may seem that this story is a bit trite and condescending, but it actually mimics the financial ‘discipline’ that is used for budgets and funding in many public companies.

Specifically:

• capital budgets are fixed and shall not be exceeded (even if, as in Ken’s case, there is a significant economic cost to the family that could be easily avoided by releasing additional capital to buy a new car)
• retained income (earnings) are sacrosanct – we’d rather the family (employees) starve than admit to the neighbours (market) that we can’t manage our money
• the financial year is also sacrosanct – should a great opportunity to make even more income appear, if the budgeted capital is spent, the family must wait until next year to invest

The message from this tale: you wouldn’t do it if it were your own money.

The problem is not that there should be no financial controls in public companies (even individuals and families run a budget of some kind or another), but rather that controls should be managed within the context of the objective of the public company: to make an adequate (or better) return on investment for shareholders.

If the opportunity to make more money exists now, surely waiting until the capital budget is ‘refreshed’ is not only sub-optimal – it could also mean the opportunity is lost.

Similarly, the cost of idle resources (Ken in the case above) is also an operational cost (either opportunity or cash).  While ludicrous in the case above, this is exactly what happens in public companies when capital projects are stopped (due to funding cutbacks) and the employees working on them are put on ‘other duties’ until the new capital year.

The next article in this series will discuss why public companies operate like this, and the changes they can adopt to focus more on value creation and less on ‘keeping to budget’.

The Fable of the (Un)Productive Executive

Jeremy considered himself the epitome of efficiency.

His annual budgets were always submitted early, his work and that of his team was always planned well in advance and there was rarely a moment of downtime in his business unit.  Indeed, to the untrained eye, Jeremy’s operation was a great example of how a well-oiled machine should operate.

Except for one minor problem: Jeremy’s business unit was consistently an underperformer.

It wasn’t that his unit ever lost money – they always did ‘OK’.  And by industry comparisons, the unit also did ‘well enough’ against peers, but not once did Jeremy’s business unit excel and hit the Top Ten in its industry, nor was it ever one of the top-performing business units in his own company.

And yet in Jeremy’s mind, he was doing an excellent job:

• he always hit his targets (almost always within a few percent) and his budgeting was impeccable;
• his team always gave him good feedback in his performance review (although never glowing – but that was just what one should expect from subordinates, right?)
• the industry he worked in was very competitive – anyone who kept making some money year-after-year must be doing the right thing.

Jeremy felt very confident in his abilities and his overall performance.  Until, that is, he was suddenly fired from his job on grounds of poor performance.

Jeremy was stunned!  How could this happen?  I’ve been doing a great job – there must be some mistake!

After a few days of wondering what could possibly have gone wrong, Jeremy thought back to the conversation he had with his manager the day he was let go.  He had been in such a state of shock that day – even though he had been listening, he didn’t really hear what his boss had said to him.

He then remembered there were three main ‘contributing factors’, his boss had said, that had led to the decision to let him go:

“You continually focus on sticking to the plan, rather than doing what’s right”

Jeremy thought about this for a while and at first felt quite confused.

“Isn’t sticking to a plan just what a good manager should do?  Predictability in results, right?”

Generally speaking, this was true, but unfortunately for Jeremy, his results were predictably and consistently below average.  It was Jeremy’s fear of taking the road less travelled, of taking some risk in an effort to get a better result, that left his business unit as the perennial underachiever.

In Jeremy’s world, the planning was everything.  And while Jeremy’s budgets and plans were certainly detailed and extremely well-thought out, that’s where Jeremy thought the ‘hard’ work ended.  After that, it was simply a matter of keeping things on track, right?

Unfortunately, the reality was just the opposite.  The industry Jeremy worked in was highly competitive.  And even though it was a commodity industry, demand and prices often fluctuated wildly throughout the year.

So when demand was low and prices were down, Jeremy’s unit just kept pumping out more and more inventory, until the warehouses were full.

And when demand was high and prices went through the roof, Jeremy’s unit worked to their standard 40 hour week, leaving the competitors to soak up all the ‘cream’ that appeared maybe once or twice a year at most.

So in the end, even though Jeremy’s team produced about the same amount of product as his competitors per person, the cost of inventory when business was slow, and the lost profits when business was booming, meant Jeremy’s unit was always destined to be a laggard.

“You put too much dependence on the numbers”

Jeremy was indeed a spreadsheet czar.  He could pivot-table and scenario-plan with the best of them.  And his Monte Carlo simulations were in some ways a work of art.

But this was where the root of the problem really laid.

What Jeremy failed to realize was that while numbers never lie, they are always only as good as the assumptions and data upon which the underlying analyses are based.

And Jeremy made a huge mistake in never questioning his assumptions, and hardly ever changing his scenarios.  After all, they had worked in the past and had produced ‘predictable results’ year-after-year.  It would be madness to mess with such reliable performance, wouldn’t it?

But, unfortunately, the predictable results were just that – predictably inadequate.

Now, you might ask why Jeremy was never challenged about these deficiencies by those he worked with.  Surely others must have challenged his assumptions and some of his decisions?

The answer was in the third contributing factor:

“You seem unable to take on the advice and counsel of those around you”

Jeremy had three bosses during his four years managing the business unit.

All three of them had shared more-or-less the same feedback about sub-optimal performance and lost opportunity.

Early on, his subordinates had also been almost relentless in their remonstrations about how they could do better.

And while Jeremy didn’t ignore any of them, he always had reasons why they shouldn’t deviate from the course he had set:

• “The market could fall sharply tomorrow – where would we be then?”
• “We’ll always have supplies ready for our customers – that’s important, you know!”
• “I’ve been doing this for all my life – I know this better than any of you, trust me…”

And so on…

But in reality, Jeremy was simply too scared to take a chance, to see if they could indeed do better.

Luckily for Jeremy, his first two bosses had been fairly sanguine about the situation – after all, the business unit was doing ‘OK’ and they has more important issues to deal with.

But Jeremy’s luck ran out with his third boss.

Knowing that the business unit could do far better, this boss set objectives for Jeremy that he knew the business could achieve, but Jeremy never changed course to meet them.  Months of coaching and guidance came to nothing, as Jeremy was steadfast in his convictions that the business was being run as best as it could – after all, his spreadsheets confirmed this in black-and-white!

But as it turned out, Jeremy was wrong in his convictions.

His replacement, Mia, doubled the profits of the unit in her first year in the job, and won an industry award the year after.

Jeremy was blind-sighted by a number of factors, including an overconfidence in spreadsheets and planning, and an unwillingness to learn from team members, peers, mentors, and the market.

So, what did Mia do differently?

She recognised that businesses, and the environment in which they operate, are always changing.  Making a plan one year, and sticking to it feverishly the next, is, at best, an exercise in futility and, at worst, a recipe for disaster.

Mia used three key principles to guide her in her decision-making each day:

• While planning is important, the planning process is more important than the plan.  Once the plan is done, don’t think of it as a blueprint, but rather a rough sketch of the route that will be embarked upon; as more information becomes available, keep refining the plan and make course-corrections along the way.  The environment is always changing.
• The certainty provided by numbers is as dangerous as it is seductive.  Budgets, spreadsheets, even ‘official’ financial statements, are only ever as good as their underlying data and assumptions.  Always question numerical analyses and never confuse accuracy (i.e. what the numbers say) with actuality (i.e. what really is happening).
• Consistently seek out new information and ideas from the market, your competitors and your colleagues. While business leaders and professionals have, by definition, highly-developed skills and real depth of experience, there is always more to learn.  The adaptive organisation depends on the adaptive executive.