Staff Balance Blog

Forensic Analysis – Irish Times Innovation Article

Robert Kaplan - StaffBalance InnovationThis article is featured in the Irish Times Innovation Magazine (Sept. 2010 Edition). View the full article here

WARREN BUFFETT has a nice line when it comes to describing the post-boom business landscape. “A rising tide lifts all the boats,” says the Sage of Omaha, “and when the tide goes out we see who’s been swimming naked”. It’s a joke that has a relevance far beyond Ireland, but seems to capture the post-Celtic Tiger era. After years of high economic growth, we have reached the stick or twist moment, time for the chief executive and his C-level team to earn their considerable salaries. Some will show a detailed and nuanced appreciation of where the value lies within their businesses. Others will not, and will be exposed, like those in Buffett’s joke, leaving the world to see that perhaps it wasn’t strategic smarts that helped them reap the rewards of the last decade, but something not far from dumb luck.

“The real question is,” says Professor Robert Kaplan, talking ahead of his appearance at the StaffBalance conference in Dublin on October 19th, “can business leaders think strategically – and do they know which customers are profitable and which aren’t? Do they really know the microeconomics of their businesses?”

Kaplan’s career as an author and academic is based on answering such questions of crucial detail; as the tide goes out in Buffet’s seaside analogy, Kaplan is the bloke on the beach with binoculars, staring at your privates.

His forensic approach to cost analysis and business strategy – his full title is Baker Foundation Professor at the Harvard Business School – was the basis of The Balanced Scorecard: Translating Strategy into Action , the book he co-wrote with David P Norton.

His work in this area led to his election to the Accounting Hall of Fame, and he has received several similar awards including a Lifetime Contribution Award from the American Accounting Association (AAA), the Outstanding Accounting Educator Award in 1988 from the AAA, the 1994 CIMA Award from the Chartered Institute of Management Accountants (UK) for “outstanding contributions to the accountancy profession”, and the 2001 Distinguished Service Award from the Institute of Management Accountants (IMA) for contributions to the practice and academic community.

“In good times, businesses are encouraged by positive cashflows to feel exuberant and expansionary,” he says. “They go into new markets and new customer segments and the growth carries them along. But when the growth stops, as happened two years ago, you realise that a bunch of the new relationships you formed, and perhaps some of the new product service lines you developed, just disappear.

“Companies know they have to cut, but often they don’t know where to cut,” says Kaplan. “If you analyse the traditional income and cost statement, and see the categories of cost – selling expenses, marketing expenses, administrative expenses and so on – [you see] they make arbitrary cuts across the different categories without realising those expenses are caused by producing products and services delivering value to their customers.” This is the heart of the Balanced Scorecard approach: do you really know where the value in your business lies?

Whichever strategy is adopted, he says, “you’d better know where the true costs of servicing your customers are”. The low-cost low-price model – the race to the bottom – is “probably not a strategy that can be sustained” says Kaplan, whether in a service economy or the manufacturing sector, “because there are always lower cost ways of producing those products and services outside the country. The death spiral starts when you start cutting and then you have to cut some more.

“You really have to understand what your competitive advantage is. Is it products and services that are sustainable, that customers are not just buying on price but consider best value? To do this effectively you have to have an intimate understanding of your cost base, because it’s really the specific demands of the customer that determine the cost being incurred.”

The point, says Kaplan, is to understand the economics of that on a customer-by-customer basis. And with the right strategy and information management systems, you can do that.

The Celtic Tiger threw a mantle over much of this, with many businesses prospering, despite their management team, rather than because of it.

“Detailed analysis of costs is something they should have done, but when times are good you don’t think ‘gee, let’s impose a new cost measurement system’. The strategy doesn’t go much beyond ‘we’ll sell a few more and we can live with the high costs’.

“But the problem is finding where to get the value at the best unit cost. Sometimes what it costs to create the value for the customer is higher than the value you are getting back. Differentiation strategy, where you’re trying to provide more value to customers, is only profitable if the value of the differentiation to the customer exceeds what it costs you to create it.

“Measuring customer satisfaction and loyalty on the scorecard is only part of the picture, because of course customers are saying, ‘yes, we want more of this’, and they value the personalised services and customisation you’re giving them. But unless you realise what it’s costing to provide that service, you could be following a faulty strategy.

“The amount of added value the customer feels is expressed by the premium you’re getting from your price. The incremental margins from the customer have to cover the incremental cost of those services. For example, if you’re offering customisation, you’ve got specialised technical teams, the cost of which must be put against the product.”

If they don’t have the ability to customise the service or product, Irish businesses have to compete by being the cheapest, the lowest cost producer. “You’d better understand what your costs are there, too, because you have to drive all costs down and take out any that are unnecessary for the delivery of the product or service.”

Received wisdom suggests the future of the Irish economy should rest on businesses focused on the added value strategy. But, Kaplan says, there will be companies seeking to exploit the EU’s competition environment,

“It is possible in a high-cost area such as the European community that some Irish companies could compete on a low-cost basis. But you run the risk of someone in Bangalore, China or Vietnam offering a similar service with lower cost over time as the world becomes more globalised.”

Either way, investing sufficiently to understand the microeconomics of the business is a good bet, he says, and the payback period is “very short”.

However, time is a major limiting factor in company decision making, with the need for instant results paramount, particularly where shareholders are concerned.

Many companies work to the timings of the stock market and its pressure for quarterly results. “Since they use only financial measures to report their performance to analysts and shareholders, they don’t have a credible way of communicating their progress in enhancing customer relationships, improvement in critical processes and aligning their employees’ motivations and competencies to strategic objectives. Thus, management meetings can become obsessed with meeting Wall Street’s short-term financial targets.”

There is another factor at work here, one that mitigates against longer term planning.

“Those companies that have not yet implemented a management system based on their strategy rely mainly on the budget system for setting the agenda for periodic management meetings. By its very nature, the budget is short-term oriented and management spends the bulk of its time trying to understand reported cost over-runs and revenue shortfalls, and developing action plans for coping with the problems.

“It is important for management to meet to address short-term operational problems. But it is also important for senior managers to meet to discuss their progress in strategy implementation. These are very different meetings, with different agendas and, usually, with different participants attending. Having a management system anchored firmly in strategy will enable a new type of management meeting to occur, at which managers can debate and devise solutions to emerging problems in strategy execution.”