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December 20, 2011

First Thought
Profit: The Red Herring

Recently, interest has risen in how obsessive focus on expectation of profits and financials destroys value–it reminds me of a recurring argument I’ve been holding separately with three close friends who all work in finance.

The argument goes something like this: I suggest that those who make their living obsessing over money–like those in financial services–sap value from society rather than create it. I argue that the number of people focused in finance top to bottom has been far too many and that all this time we spend trying to figure out what something will be worth in a year or more time is fruitless given how poorly humans are at these types of projections.

As I said in Naked Innovation, NPV is a “dirty secret” because there’s just too much evidence to prove it and other predictive economic models don’t map to reality. It is better to spend our resources on creating value for people than estimating or trading it. Their collective response: without understanding financial “worth” and trade enabling liquidity, markets can’t function, companies ultimately can’t grow and innovation can’t happen. We’ve been going back and forth on this for a decade.

The more recent public conversation around how financial metrics focus slights customers or organizational value plays out at three different levels.

Level 1 - Initiative
Offering development projects are amazing because they have a life of their own. They are seeds of opportunity which can grow into something unexpectedly amazing, beautiful and powerful, but which can just as easily wither and die. Jony Ive, SVP of Design for Apple, describes early stages of a project like this:

“While ideas ultimately can be so powerful, they begin as fragile, barely formed thoughts so easily missed, so easily compromised, so easily just squished.”

While Steve Jobs was great at nurturing fragile ideas, those in finance excel1 in crushing them. I once consulted with a company helping them re-envision the future of their “multichannel experience” in a big multiyear program with high aspirations, a big budget, but also many stakeholders. In discussing a key idea in the overall initiative which could have had a net result in adding more employee to stores, a program team member from finance instantly shot it down because the company was focused on “reducing workers in stores, not adding them”.

Without proper senior support or stubborn team members, this type of interaction with finance at an initiative level kills many great ideas and opportunities for innovation. While we obviously don’t want to add tremendous additional cost without adding any revenue, it is easy to justify adding staff if we see it positively affecting the business. There are many models where increasing the quality of the interaction between employees and customers–which may ultimately require more employees–increases all of the company metrics that really matter: revenue, profit and customer satisfaction.

Level 2 - Organization
An organization or company is a machine in society built for creating value. With luck, you’ve had an opportunity to worked for an organization that really had a clear purpose and did something that matters. But regardless of where you’ve worked, there were well intentioned, well regarded individuals in your company absolutely destroying value in the name of maximizing profit.

This second level where obsessive focus on financial metrics results in us losing is the organization. At the Gartner Symposium, the great Clayton Christensen explained how solely profit-based decisions guts an organization’s ability to compete. Steve Denning provides a nice overview of Clay’s talk in a Forbes article titled How Pursuit of Profits Kills Innovation and the U.S. Economy.

Key to Christensen’s thinking is that the MBA hegemony which dominates senior leadership’s thinking in modern day business has sapped the organizations’ strategic focus. Decision-making through mostly arbitrary financial measures like Internal Rate of Return (IRR) and Rate of Return on Net Assets (RONA) is pushing organizations again and again to focus on the short rather than the long term. This short-termism erodes an organization's core competencies and investment in future revenues.

Christensen gives several good examples but his tale of Dell is illustrative. Dell used a Taiwan-based outsourced manufacturer, ASUSTeK, to produce its PCs at the height of Dell’s success. Over time, ASUSTeK took on more and more of Dell’s activities–moves which immediately contributed to Dell’s bottom line–until they were even designing the computers themselves. The result: ASUSTeK over time were producing cheaper, better computers to retailers at lower cost than Dell, who had eroded their core competency to deliver their primary product. Needless to say, we don’t want our organizations to succumb to a similar fate.

Level 3 - Society
The third and most disturbing level obsession with profit and finance effects us is in society. Today in the United States, and in much of the “free” Western world, the system has been increasingly planned to benefit its wealthiest citizens resulting in a historically significant gap in income equality. Over the past several decades, a combination of trickle-down economics, outsized corporate bonuses, a pay for play legislation and the deregulation of the banking industries has aligned the stars to extract value out of society rather than create it. We've created a shadow system, the current stock market, which only barely mirrors the realities of the real market.

A couple of weeks ago Helen Walters published a series of tweets and then blog post about a talk Roger Martin, Dean of Rotman School of Management, gave about his thoughts on why society’s, company’s and their executives’ goals are misaligned: Roger Martin on Fixing the Game.

A few key quotes representing his argument:

“The problem society faces,” says Roger Martin, “is that the best way to become rich is to trade value, not create value... We take it on faith that heavy compensation creates organizational performance. There’s no proof for this... The only useful reason for being on a board is to protect democratic capitalism... Focus on serving customers, not on maximizing shareholder value or on making money.”

Roger expounds on the topic in his book, Fixing the Game. Let’s just say Roger is no bleeding heart liberal or trust fund kid found in an Occupy camp. He was a Director and lead of the highly regarded management consultancy the Monitor Group and is dean of an internationally recognized business school in Toronto, Rotman School of Management. He is absolutely pro-business. It’s hard to ignore someone like Roger as he sounds an alarm that we’re over-indexing financial expectations based decision-making a bit too much.

*Update January 2, 2012* I had not realized Steve Denning wrote a nice overview of Roger's book as well. It's worth a read: The Dumbest Idea In The World: Maximizing Shareholder Value.

Where does this leave us? I’m absolutely not suggesting we push aside all methods of financial modeling but we do have to push back on single perspective, Excel sheet driven, decision-making on new ideas and innovation. We must push for balanced solutions which do not result in a zero-sum game with companies and customers, societies and citizens. Top to bottom, initiative and organization to society, we’ve got to move to a place where we are optimizing outcomes and not maximizing them. This is a critical difference.

I’ll end with these two definitions. To optimize means to make as effective, perfect, or useful as possible. To maximize means to increase to the greatest possible amount or degree. The former goal suggests constraint and compromise while driving effectiveness through the notion of it being “useful as possible.” The latter, the over arching goal of modern day corporate life, focuses on an “increase to the greatest possible” regardless of consequence. Let’s all drive hard to optimize our organization’s relationships in an ecosystem. Let’s create “win win” situations by focusing passionately on customers and their problems first, rather than maximizing profit. If we build great organizations and products, the profit will come.

1 Pun intended.

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