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Balanced Business – Irish Director Article

Leading business strategist Robert Kaplan is the inventor of the ‘balanced scorecard’, and adviser to President Barack Obama. Ann O’Dea caught up with him on a recent trip to Dublin.

Harvard professor Robert S Kaplan is probably best known as the creator of both activity-based costing and the balanced scorecard – the renowned tool for linking a company’s actions to its strategic goals, first presented in his bestselling book The Balanced Business Scorecard in 1996. His model aims to help business leaders clarify their corporate vision and align people, business units and resources with a unified strategy.

He was in Dublin in October addressing senior executives at an event organised by StaffBalance, and we caught up with him afterwards to discuss some of his thoughts on how Irish leaders can get their companies through these tough times.

He began by telling me that in growth times, people become very exuberant – recruiting customers, launching products and spending widely – something that of course happened during the boom of recent years.

“In an expansionary environment, what Keynes called the ‘animal spirit’ of businesspeople gets aroused and they go hunting into new territories and you see an expansion of product lines, new customer segments, new geographical markets,” says Kaplan. “With enough growth all these things seem to be working well.

“Then when growth stops, companies really have to examine their operations, and get back to their core and find out with their product lines, with their customers where they literally have some type of advantage that enables them to retain the customers they want and also to make money from them.

“It is this second part that is difficult to identify. It’s easy to measure customer retention and customer loyalty and satisfaction – the challenge is whether all those customers are making money for the company. Often times the company, in order to attract and retain customers, has offered lots of services or features, and made the offering more customised, more individualised to customers’ needs. The question is are they getting paid for all the features and the services that they’re offering the customer?”

Not that Kaplan is saying companies should not offer such elements. “I would actually encourage companies to follow differentiated strategies, and to get out of just offering commodity-type products and services,” he says. “However, it is important that the value you create from this exceeds what it costs you to create and deliver that differentiation.”

The problem, he points out, is that you cannot know this unless you have an accurate costing system that’s able to trace the cost right down to individual orders, individual products and customers.

“This becomes particularly noticeable during a downturn when the revenues and the market start to decline, but the companies don’t adapt to see whether in fact the features and services they’re offering are still being covered by the margins and the revenues that they currently are experiencing.”

Taking stock

It is easy for companies to see why this is important in a downturn, but Kaplan stresses that companies need to be making these measurements on an ongoing basis, as part of their business processes.  “I mean technically we should be doing this continually; you shouldn’t just be doing this in bad times,” he says.

“Given the technologies that now exist, the combination of first hardware, where you can actually track products and orders as they go through your system very well; then software which is able to capture the data that comes from these transactions, whether production or customer delivery; and the third part is the analytic thinking – which is the model that I’ve contributed on activity-based costing, where you aggregate all the very detailed transaction data into measuring a cost and linking it to prices and revenue, and therefore profitability.

“This should really be part of a company’s ongoing management systems, that two to four times a year they should be calculating the profit and loss on every product and every customer. I’m not saying you drop products or fire customers based on losing money in a three-month period, but you want to be able to highlight where in fact you are losing money, because often you fall into these situations, and they’re correctable. Once you see the drivers of the loss, there’s a set of actions that the managers can take that will enable you to transform unprofitable products and customers into profitable ones.”

Quick results

The results come very quickly, says Kaplan. “It’s about changes like improved processes in order to create the differentiation, sometimes it’s about getting an appropriate level of customisation in a product or service, or it could be about price changes,” he says.

“And it’s not only price increases. Often you discover, some of your high-volume, somewhat standard products are the most profitable, and you may actually be able to cut your prices and win some additional market share, in a very price-sensitive portion of the market, and so make money that way.

“It’s about having that kind of detailed information available to the managers, but they have to have the discipline to collect the data, to report it themselves and meet periodically.”

Case in point

He points to a company he has worked with, and whose experience he has captured. “They run on a six-month cycle for their products and their customers. So, in Q1 they review the P&L [profit and loss] of all their products and then take some actions based on that. In Q2 they look at the data from the point of view of customers, and then take some actions based on the unprofitable customers, and try to get closer to the profitable ones. Then in the third quarter they come back and review the products because now they’ve had six months’ additional work since they made the decision at the end of the first quarter. Finally, at the end of the fourth quarter they look back at the customer.

“So they’re looking at six months’ worth of data on products and customers and just alternating the quarters, which gives them six months to see the impact of the actions that they’ve taken – first at the product level and then the next quarter at the customer level.

“It’s just a very disciplined process that’s built into their management system. It’s a fundamental way of looking at the products you’re producing and the customers that you’re serving.”

The key, says Kaplan, is the continuous nature of the process, and with today’s technologies there’s little excuse not to do this.

“Take that company I’ve just described. They couldn’t have done this 20 or 25 years ago because they didn’t have the information available or accessible.

After 20 years of companies investing in their ERP [enterprise resource planning] systems of various kinds, they have captured transaction-level data.

“A lot of companies have not gotten much of a return on their investment in the ERP system. So having this  P&L calculation, it’s what’s going to give you the value of return from the data capture that you’ve invested in over the last 10 to 20 years.”

Cost-cutting no solution

The companies that are not doing this often have little option but to cut costs when growth stops, but cutting costs is often not the solution, explains Kaplan.

“If you’re not doing that measurement, then the only information you have is your operating profit and loss data, so you are looking at what is really a horizontal view, how much we’re spending on costs, on selling expenses, on marketing expenses, distribution expenses and product development expenses. So you can go through the line items of your income statement and you start slashing at that level.

“I think that’s really a mistake because some of that spending is supporting profitable products and profitable customers – if you’re slashing across the board like that, you do get rid of some excess fat or waste and inefficiency, but you’re also likely to start slashing into muscle and bone and compromising important products and not serving important and profitable customers.

Rather than taking that ‘horizontal’ look, Kaplan advocates a different approach. “Take a vertical look. For every customer, look at the net price you’re getting from them. Many companies don’t know the net price for transactions because there are so many promotions and allowances and discounts that get taken and that are authorised by different parts of the organisation. That can be sales incentives, some of it is the marketing or advertising allowance, sometimes it’s the financial department giving a discount for prompt payment.

“So you have this myriad of discounts, promotions and allowances which we know in an aggregate financial statement will say: ‘This is how much we’re dropping from total revenue through all these special deals’, but you don’t know it by transaction or by customer.”

Look instead at all the discounts and allowances customer by customer, urges Kaplan. “Then you look down at the cost associated with each customer, how much selling expense, how much distribution expense, how much packaging expense. That’s a vertical look.

“If you have 5,000 customers you’ll have 5,000 P&Ls, each one of which looks like a full income statement. But that’s actionable because you’ll find that 1,000 of those P&Ls are good, profitable, 3,000 or so are breaking even, and then you’ll have 500 customers where you’re losing a lot of money and you’ll be able to see where it is – too much discounting, too much special packaging, too much customised delivery? But now it’s actionable, to reduce these through some negotiations with the customer.”

Again he refers back to his case study. “In that company, the costing study was led by the vice-president of sales who knew that they had difficult unprofitable customers and he said: ‘I’m prepared to have difficult discussions with those customers but first I have to be sure what the facts are. I have to know how much discounting we’re doing with the customer, how much the cost is of special handling and delivery. Our current costing system doesn’t give me that’.

“So, he insisted that they get to an accurate cost system and then he would use that in his discussions with the customers,” continues Kaplan.

“I was just at a conference where the chief financial officer of the company gave a report – this was a year and a half after I finished the case – and he said the company had picked up 10 percentage points of operating margins in the last year just through these discussions they have about their products and our features and the customer relationships. That’s huge.”

Negotiate with the customer

Kaplan is not suggesting you fire the unprofitable customers. “Firing the customer is the last thing you want to do. You may have to if everything else fails because you can’t continue to lose money, but you find that once you see the data, there’s a set of actions you can take.”

Going back to the case study, he says one customer was the second largest loss customer at that company. “I know it was at least 10pc of sales on a very high revenue base, and in six months it became their fifth most profitable customer. It was not just one thing but a series of changes in the relationship, including pricing, being careful about the discounting policies, etc.”

“You can take a very large loss customer in this case, and a customer much larger than the company, and make it into a profitable one. Because in general the customer doesn’t want to be fired. But it’s not their responsibility to make sure that you’re profitable! That’s your responsibility.”

Leadership is the key

Leadership is essential here, says Kaplan. “Everybody in the company has a job and they’re doing the job they’re told to do within the framework they’re operating, but it’s up to the leader to look outside, to look at the competitive environment, the competitors and where are they going, and who are the customers that can be reached. The leader, with the support of the executive team, has to devise that strategy that enables you to compete.”

Irish companies need to do this in an ever more competitive landscape where competing on cost is no longer a differentiator, advises Kaplan. “If leadership is just staying with the existing product line and the existing customer base, if it isn’t doing the things I was describing, like fine tuning the product line, or fine tuning how you work with customers, if they don’t have a really coherent strategy for competitive sustainable advantage, over time whatever advantage they have will be eroded.

“So we do look for leadership to position the company favourably in a competitive environment, and to choose a strategy that looks like it gives some advantage in the marketplace, then communicate that to all the people, and implement it extremely well. And one of the tools for implementing this very well is the feedback you get from the activity-based costing and profit model of products and customers.”

Irish businesses need to be looking at differentiation and innovation in their products and services, concludes Kaplan.

“Otherwise, over time you’ll be competing in a commodity space. And you can do that – I mean Ryanair does it, Walmart does it – but then you have to be ruthless about your cost position because only the lowest cost will survive with that type of strategy.”

This article first appeared in the Winter 2010 issue of Irish Director magazine.