The Problem with Accounting

What’s the difference between profits and profitability? In most companies, a net income deficiency of 30% or more. Let me explain.

Accounting information is at the core of virtually all of our business processes. It is axiomatic that accounting has two roles: providing financial information and providing management control information. The problem is that it is very good at the first role, and surprisingly poor at the second.

Financial accounting is critical to every business. The objective is to present an accurate picture of a company’s overall performance – its profits. It grew up in the time of quill pens and arm garters, and its role is to tell shareholders how much their company earned. This discipline is well perfected and highly regulated. Just ask the Audit Committee of any public company.

The management control role is another story altogether. Even with an accurate financial accounting picture of overall profits, nearly every company is 30-40% unprofitable by any measure, and 20–30% provides all the reported profits and subsidizes the losses. In years of writing about this, no one has disagreed. How can this be?

This situation is a legacy of the prior Age of Mass Markets, when companies sought the economies of scale of mass production, coupled with mass distribution using arm’s length customer relationships. In this context, more revenues really did mean more profits. Virtually all of our management information and processes were developed in this earlier era.

We now live in what I call “The Age of Precision Markets,” in which companies form a variety of relationships with their customers – some very profitable, many not. Traditional accounting information is much too aggregated and broad for profitability management today. This is the underlying reason why almost every company has so much embedded unprofitability and why so many managers fail to identify and build their sustainably profitable core of business.

Instead, a transaction-based approach to developing management control information gives you the granularity you need to understand your profit picture, and to develop sharply targeted initiatives. I call this profit mapping.

Start by extracting a three- to four-month sample that includes every transaction (order line). The next step is to create what is essentially an “income statement” for each transaction, subtracting distribution, sales, and other operating costs from gross margin. You can do this at “70% accuracy” using available information and rules of thumb. Avoid lengthy debates about cost allocations, and sharpen your pencil later in the few places where better accuracy will matter.

Once you have this information, input it into a database program. In a few weeks, you can figure out precisely which products and customers are profitable, and what concrete steps you can take to improve things. Even in profitable customers, there are many unprofitable products, and vice versa. My forthcoming book gives several concrete examples of this.

This is very different from traditional “top-down” profit analysis, which focuses on the aggregate profitability of broad groups of products and customers – a process that derives directly from traditional financial accounting approaches.

The problem with accounting is that most managers simply assume that they can use the same process to develop accurate financial information and useful management control information. This is a big mistake.

Instead, if you develop an appropriate transaction-based analysis for management control, you can identify your profitability landscape and create the sharply targeted initiatives that will quickly increase your company’s profitability – and profits – both this year and for years to come.

The Missing Element in Large-scale Change

Large-scale change. Most managers view it as the ultimate management challenge.

I remember when I wrote my Harvard Business School Working Knowledge column, “The Challenges of Paradigmatic Change.” The column went out on the Web on a Monday morning, and by noon I received a flood of emails from my readers describing their experiences and asking questions.

Managing large-scale change certainly is a big challenge, and it requires a different set of building-block actions than improving the day-to-day business. Most of the change management literature focuses on this.

But, the most important thing I’ve learned from years of involvement in change management is that more often than not, the need for large-scale change is avoidable. And many large-scale change projects really are evidence of a prior failure to keep the organization on track in a changing world.

Certainly, from time to time a big abrupt change takes place in an industry – a change in technology, a new regulation, a major new competitor – and these require a strong, thoughtful response.

I remember talking to the head of a major telecom company, now one of the world’s most successful, during the early days of deregulation. Aggressive new competitors were taking market share in the most lucrative markets, and the company’s culture was rooted in the days of cost-plus regulation. I remember the questions clearly: How can I get our managers to understand that they need to manage differently? What do I do? Send them a memo?

I wrote “The Challenges of Paradigmatic Change” as a guide to managers facing this type of situation.

Most companies, however, have a very different situation. The world around them is changing, often at an accelerating rate, and yet they tend to do things in more or less the same way. They may get better and better at it, but nevertheless, it is more or less the same approach. Over time, they become more and more disconnected from their customers and markets, until eventually someone rings the fire bell for a big, disruptive change.

What can a manager do? The answer is obvious: Develop ongoing processes that keep the company on track all along.

But how can a manager do this? The answer to this question is not obvious at all.

In my experience, many managers make two big mistakes in change management:

  • They fail to realize that managing change is not necessarily more difficult than day-to-day management, but it is very different;
  • They fail to see that there are three very different types of change and that each requires a completely different change-management process – and they almost always prioritize them incorrectly.

Most managers focus on the first problem – how managing change is different from making day-to-day tactical improvements.

But the second is the real source of lasting management effectiveness and great financial performance.

There are three very different types of change: (a) constant weeding – tuning up the way you do things in fundamental ways; (b) new strategic initiatives – trying out new things and scaling them up if they work; and (c) large-scale change – fundamentally changing the way everyone does things.

Which is the most important? Judging from the literature and my own observations, most managers probably would rank large-scale change as most important, new strategic initiatives second, and constant weeding as the last priority – if it’s a priority at all.

For most companies, this ranking is backwards.

Constant weeding. In most companies, the failure to institute an effective process for constant weeding is the biggest cause of suboptimal performance.

For example, in my research and consulting in over a dozen industries, I’ve found that even in the best-known leading companies, 30–40% of the business is unprofitable by any measure, and 20–30% provides all the reported profits and subsidizes the losses. Moreover, a lot of the marginal business can be turned around in a surprisingly easy way, and can become sustainably profitable.

In years of writing about this, no one has disagreed. Successful profit generation and profitability management requires four elements: (1) the right information – rarely available from accounting systems; (2) the right priorities – a strong focus on securing your best business and turning around high-potential underpenetrated accounts; (3) the right processes – almost always involving ongoing coordination of Sales, Marketing, and Operations; and (4) the right compensation – not assuming that all revenue dollars are equally profitable.

Yet how many companies have really focused on perfecting these four elements – successfully making profitability management (not budgeting and operating reviews) a core business process?

New strategic initiatives. This is the second change management priority. A vibrant, successful company should always be trying showcase projects – low risk experiments that enable it to try new things and “learn by doing.” Unfortunately, the business case process (capital budgeting) discourages this – because, by definition, a showcase project has uncertain returns. This is a huge mistake.

The companion issue in managing new strategic initiatives is developing an effective process to scale up those that are successful.

I recently spent time with the management team of a very successful international service company. The company had a number of great showcase projects. But, after discussion, the managers realized that they lacked a strong, explicit process to scale them up, transforming the company’s core business to incorporate these new ways of doing business. Without this, they remained isolated pockets of interesting innovation.

Large-scale change. This is the prime focus of most managers and writers. Yet in the absence of truly extraordinary circumstances, painful transformations should be only rarely be needed. If a company has an effective process for constant weeding, it will stay highly profitable even in the presence of rapidly changing markets. And if it has an effective process for developing and scaling new strategic initiatives, it will carve out a lucrative competitive positioning as the market leader and as strategic partner to the most important customers.

If a company succeeds in these two critical change management areas, it will have accomplished the essential goal of large-scale change: repositioning the company for the future. But, without the need for abrupt, painful large-scale change.

When a company is in trouble, it is easy to get everyone’s focus and attention. But the real missing piece in the jigsaw puzzle of change is an understanding of how important and feasible it is to avoid the need for abrupt large-scale change in the first place.

Doing the right things all the time through constant weeding and new strategic initiatives – this is the real missing element in large-scale change.

How Did Microsoft Become Microsoft?

First, a little quiz.

Which company invented these cornerstones of the personal computer revolution:

  • First personal computer
  • First high-speed computer network
  • First laser printer
  • First graphical user interface (mouse, pull-down menus, etc.)?

(The answer is three paragraphs down.)

A few days ago, I taught a new case, Apple Inc. in 2010, in a graduate student orientation session at MIT. In preparation, I reread one of the most interesting and informative books on strategy that I know.

The book is Accidental Empires: How the Boys of Silicon Valley Make Their Millions, Battle Foreign Competition, and Still Can’t Get a Date, by Robert X. Cringely. Cringely was a columnist for InfoWorld, a PC trade magazine, and his book chronicles the early days of PCs and software. Written in 1993, it is still a wonderful read.

By the way, the answer to the quiz is Xerox. These were all invented at Xerox’s PARC (Palo Alto Research Center). The company failed to commercialize them because they didn’t seem to fit its strategy closely enough. Think about it.

Some of the most informative stories in the book concern the early history of Microsoft. The company’s story starts in 1975, when Bill Gates was a sophomore at Harvard. Cringely writes,

Like the Buddha, Gates’s enlightenment came in a flash. Walking across Harvard Yard while Paul Allen waved in his face the January 1975 issue of Popular Electronics announcing the Altair 8800 microcomputer from MITS, they both saw instantly that there would really be a personal computer industry, and that the industry would need programming languages. Although there were no microcomputer software companies yet, 19-year-old Bill’s first concern was that they were already too late. “We realized that the revolution might happen without us,” Gates said. “After we saw the article, there was no question of where our life would focus.”

In a recent Harvard Commencement address, Bill Gates told of how he went to his dorm room and called the responsible executive at Altair, offering to provide software for the new PC,

One of my biggest memories of Harvard came in January 1975, when I made a call from Currier House to a company in Albuquerque that had begun making the world’s first personal computers. I offered to sell them software.

I worried that they would realize I was just a student in a dorm and hang up on me. Instead they said: “We’re not quite ready, come see us in a month,” which was a good thing, because we hadn’t written the software yet.

When Gates received the nod, he dropped out of Harvard, Allen left his programming job, and they moved to New Mexico to finish the software. That was how Microsoft began.

Cringely notes, “Gates and Allen started Microsoft with the stated mission of putting ‘a computer on every desk and in every home, running Microsoft software.’” Before long, Microsoft was the dominant provider of software to the early PC business.

Unlike the other PC and software pioneers, however, Bill Gates was first and foremost a businessman. He saw clearly the need to get an inside track on the revolutionary growth by using his products to create a dominant strategy.

The second major cornerstone of Microsoft’s early success came about five years later. IBM had developed its PC, and Gates had agreed to provide BASIC for the new computer. He also offered to provide an operating system.

At that time, Microsoft was the dominant provider of software, but Digital Research’s CP/M was the dominant operating system. IBM sent a team of managers to Digital Research and Microsoft to find out more about the companies.

First they went to Digital Research. Cringely writes, “When the IBMers arrived… to talk with Gary Kildall at Digital Research, he wasn’t there. Despite his appointment with IBM, Gary had gone flying in his small plane. Not a good first impression.”

Needless to say, when the IBM team arrived at Microsoft, they were greeted by Bill Gates. Gates proposed providing an operating system, and IBM was interested. The only problem was that Gates didn’t have an appropriate system.

When he heard that IBM was interested, Gates contacted Seattle Computer Products, a small local company that had an early operating system called QDOS (“quick and dirty operating system” – later to become a more respectable-sounding MS-DOS). Microsoft bought the system for $50,000 even though it didn’t work well. They rewrote it, and entered into their historic agreement with IBM in which DOS would be provided on every IBM PC, while Microsoft was free to sell DOS to every other PC maker as well.

And that’s how Microsoft become Microsoft. The rest is history. Bill Gates was 25 years old at the time.

This story is remarkable. What’s even more amazing is that at every point, someone else had a better product. But Microsoft always had a much better strategy. Remember Xerox’s PARC?

There’s an old rule of thumb in checkers that if you’re not sure what to do, move toward the middle. Bill Gates relentlessly moved toward the middle, and won by constantly positioning Microsoft at the center of the entire PC industry.

The moral of the story: a great strategy always beats a great product.

Or, as my father used to say about sailboat racing, a good sailor in a bad boat will always beat a bad sailor in a good boat.

Profit from Managing Returns. Yes, Returns.

What do a typical hospital and a typical retailer have in common? They both have a problem managing returns. Let me explain.

About a year ago, I spent a day with the President’s Cabinet of a major medical center. This is one of the most prominent institutions in the country, with a very talented and dedicated management team. During the day, we reviewed and discussed a number of important topics, ranging from prospective healthcare legislation to growth plans.

One comment in particular caught my attention. A senior physician noted that the hospital didn’t systematically monitor readmissions – patients who are discharged and soon return to the hospital for additional care.

I thought about a friend who had started a company to oversee the care of patients who had a particularly difficult chronic illness. He had done studies of patient care, and he found that a surprisingly large portion of hospital readmissions occurred because of simple logistical errors. For example, when many patients were discharged, the oxygen or other medical supplies were not delivered to their homes in time. This resulted in very costly readmissions.

A few years ago, I did a number of studies of product returns in retail and distribution companies. I found that virtually all companies viewed returns as a logistical hassle to be managed primarily to minimize the handling cost and residual product value.

My studies showed something very interesting, however. When I compared retailers in the same industry, their rate of product returns varied significantly. Not only that, but even within the same retailer different associates had very different returns rates – even for the same product.

The conclusion: the returns rate was really a measure of the quality of the sales process. The retailers and associates who had low returns rates were very good at diagnosing a customer’s real needs, and had a good understanding of what supplemental instructions a customer typically needed. The others did not.

The traditional way of managing returns turned out to be to not manage them at all – just to handle them efficiently. The right way to manage returns is very different: to view them as a quality feedback loop that enables a manager to pinpoint the places where the sales process breaks down, and to formulate sharply targeted measures to improve the process.

In a sense, the hospital readmissions rate is very much like the retail returns rate. Some patients legitimately need additional care, but many simply come back because they experience avoidable errors – most of which are not the hospital’s fault. And in most institutions, this critical measure is not systematically analyzed.

Both the hospital and the retailer had the potential to monitor their “returns” not just for handling efficiency, but more importantly to improve the quality and drive down the cost of their core organizational processes.

The big profit leverage that comes from managing returns – not just handling them efficiently – is that the returns rate offers a very important window into how well the institution or business provides service to its customers.

In both business and not-for-profit management, there are a number of “hidden” quality measures like the returns rate. The insightful manager will seek out these measures, and use them to maximize the overall performance and profitability of his or her organization.

Managing in a Deflationary Economy–A View From Malaysia

Today’s economic news features descriptions of our stalled economy, punctuated by concerns that we may slip into deflation. Most U.S. managers have not had direct experience with managing in a deflationary economy. This economic environment creates extraordinary challenges and requires a completely different way of managing.

In my last post, I related the experiences of Tenglum Low, a top Malaysian executive (and former executive student), in managing mergers and reorganizations in Malaysia. Tenglum also has successfully guided his company through a series of severe deflationary episodes that accompanied the Southeast Asian economic crises that took place over the decade of the 1990s.

In 1999, Tenglum wrote a letter to me about managing in an economic crisis that I read to my class every year. I reproduce the letter below (with some minor editing). Tenglum wrote:

It has been a long time since we last met and corresponded. The Asian crisis has been going on for almost two years. The initial stage was a lot of arguments between IMF medicine (i.e., International Monetary Fund mandated belt-tightening) and Keynesian theory.

Under the IMF package, we see the recovery of Korea. Until the restructuring of our bankruptcy law, we have yet to see a major shakeout. Indonesia is still going through chaos, because the tightening affects the poor more. One school of thought is that unless there is military power, peace would be a long way off because of the breakdown in law and order. Malaysia is already near the bottom, and has not shown signs of further decline. Meanwhile, the banking sector is undergoing major restructuring, and major M&A is just beginning. However, we think foreign direct investment will still be slow until investors see stability in long term government policy.

Meanwhile, we are beginning to feel a breakdown in the international trade system due to more protectionism everywhere – like don’t export your problem away.

As for me, this is the second recession I have gone through in Malaysia during the past ten years. The last one was milder because it did not hit all Asia. This round is much tougher because it is a combination of financial and economic crises. Further, I was made responsible for what used to be a US$200 million company, which has plummeted to US$80 million.

Probably, I have learned my lesson well. There are many things we needed to do which can now be summarized into newly conventional wisdom (which seemed to be lacking at the beginning of the crisis, or perhaps we could not swallow our pride and face reality or overcome denial).

  1. The first step is to clear all inventories, because selling prices will drop very fast, and demand will shrink even faster. Two months stock will turn into nine months stock.
  1. Next, go on just-in-time to reduce financial risk, and focus on making only the manufacturing margin (variable cost), otherwise you will be too rigid to sell at all.
  1. When you are in a difficult time, still allocate time and money for new products.
  1. Strengthen your strategic alliances with your best customers, and be prepared to drop your fringe customers because you cannot count on everyone to be able to make it.
  1. Further, it helps to see clearly beyond the current distortions to determine whether you can be an ultimate world player with sound competitive advantages.
  1. The weak foreign exchange rate will help you to export, but the bigger question is whether you can create productivity improvements over the next few years that will enable you to sustain business growth when economic order returns.

Tenglum’s letter closes with these six points of essential management advice. It is clear that a deflationary economic crisis removes all the safety nets and margin for error that prosperity provides.

The essential question for managers is to what extent these six principles should guide our actions today.