Talking about strategy » Mckinsey Quarterly

Briefings 4: What causes what and how?

Kim Warren — Tue, 19 Oct 2010 10:00:26 +0000

When is theory powerful?

Whether they like it or not, decision makers use theory all the time, even if it is only their own private beliefs about why things happen and the likely impact of their decisions. Theory does not need to be complex – it is simply an explanation for what causes what, and how – without which there can be little confidence in the likely effect of any strategy we develop or decisions we might take.Theory is powerful when it is general (works in a wide variety of situations) useful (tells us something we can affect) and true. We should be skeptical about supposed “rules” of successful strategy that might seem to make sense, but are not in fact reliable, such as “the first firm to enter a new market will always beat firms who follow later.” This would be a general rule, and useful, but is unfortunately not true.Confirming the soundness of management theory is far from easy. Large scale controlled experiments are generally not possible or desirable and management typically resists becoming a lab rat! Nevertheless, there is a strong case for at least some experimentation—as is commonly done for new product launches – and there is an increasing use of “business intelligence” and analytics to support decision making.Business school research often seeks to confirm theories about what causes what by collecting large quantities of data and looking for statistical correlation between possible causes and effects. Unfortunately, the uncertainty and complexity of real-world causality is often so severe, and difficult to trace, that even a strong correlation offers little more than mild support for any theory. As Professor Clayton Christensen of Harvard Business School has remarked, we can often say little more than the business equivalent of “most flying things have feathers and flap their wings.” Attempts to design flying machines based on that statistically significant observation were not notably successful!We can start to deal with this problem by identifying parts of the explanation for performance where concrete causal connections can be stated confidently. To do this we need to work back through the problem and identify the key resources that affect the system. Whether the outcome of concern is financial or non-financial, or a combination of both, the process is the same. Whatever the focus, the key issue remains identifying how performance is changing through time.

Taking the example of airline Ryanair — profit results from the revenue the company receives from the fares that passengers pay, and from other items, minus its operating costs. These are split into some major categories — staff costs, the costs of operating aircraft, airport operations and routes — plus marketing and other costs. The causal relationships here are clear and unambiguous:

profits = total revenue minus operating costs
total revenue = fare revenue plus ancillary revenue
operating costs = aircraft costs plus route costs plus airport costs plus staff costs plus marketing costs plus other costs

If that causal explanation for profits is accurate for y/e March 2006, and the business has been conducting the same activity in the past, it was also accurate for every previous year. It is therefore possible to join up time charts of those items in the same way, as shown in the figure above. Each chart in this figure portrays the historic values for the item named. Although this diagram may be an unfamiliar view of a company’s income statement, it is just showing in a graphical, causal layout the same data we normally see in spreadsheet form.

What these diagrams mean…

Since the approach relies heavily on diagrams such as the one above (this is Figure 2.3 from the book), it is important to be clear about their features. The box at the lower right of the diagram gives a detailed legend for the time charts in the figure. Every item includes a specific, quantified scale on the vertical axis, and a specific time scale on the horizontal axis. The current value “today” — usually the latest time for which data is known — is highlighted as the green value, just above a vertical dashed line for the time at which it applies. The time path of historical data is shown as the solid green line. When adding forecasts, these are denoted by a dashed green line.

It is also important to be clear about what is meant by the connecting arrows in these charts. Word-and-arrow diagrams are common throughout books on management and strategy and usually imply some kind of causal relationship between the factors that are linked by arrows. Often, such implied relationships encompass a whole chain of causality, with all the ambiguity and complexity discussed above. In SMD, every such link will have the more localized and precise meaning that ‘A’ can be calculated or estimated from the values of ‘B’ and ‘C’ at each point in time.” The figure above follows this rule — it displays the relationships in the company’s income statements in a graphical, time-based form. These relationships hardly merit the term “theory”, being simply the conventions by which we determine a company’s profits, but they are nevertheless rigorous, reliable and well understood.

Remember we welcome your comments at any time.

Until next time…

If you would like to receive the series from the beginning in your email inbox, please register on the strategy dynamics site and subscribe to Briefings in “My Account”A small, but critical change in perspective…

A common response to the principles described in chapter 2 is ‘but that’s obvious!’ – well yes it is, but if you don’t ask the right questions accurately, you are not likely to find the right answer. I pointed out to a consulting firm some time ago that their revenues come from the projects they do, and the fees for those projects, and that their profitability depends on pricing the staff time on each project correctly.

They had previously been exhorting their management to ‘improve staff utilisation’, but they had not appreciated that their people have no decision lever connected directly to this ratio [aside from simply firing people]. So a simple start-point was to put together a model of what a profitable project actually looked like – how many man-days by which types of staff, costing how much, and priced at what level. Their targets for growing revenue and profits therefore came down to how many clients had to be won, delivering how many projects, requiring how many staff.

Obvious, of course – but it was not laid out in existing plans.

Briefings 3: Three key questions for strategy design

Kim Warren — Tue, 05 Oct 2010 10:11:01 +0000

This is the third post in the fortnightly series of Strategy Dynamics Briefings.

There are three distinct, but related questions lying behind the issue of how businesses and other organizations perform through time… What are they?

(If you would like to receive the series from the beginning in your email inbox, please register on www.strategydynamics.com and subscribe to Briefings in “MyAccount”)

In my last post I explained that the time path of future performance is central to the concerns of investors in commercial firms.

The three distinct questions lying behind the issue of how businesses and other organizations perform through time are:

Why has our historical performance followed the time path that it has?
Where will the path of future performance take us if we carry on as we are?
How can we improve that future performance?

The first question may not be relevant in every case — for example a new venture startup has no history. However, in most cases, history is highly relevant to the likely trajectory of future performance. To illustrate the importance of these three questions look at the example of Amazon.com, mentioned last time. This story is dealt with in more detail in the book.

Amazon.com is an outstanding growth story, as the company expanded from online books sales to an increasingly wide range of other high-value/small-size consumer goods. Since its founding in 1994, the company has promised and delivered growth in its business although it took until 2002 to translate increasing sales volume and revenue into profitability.

So how do our three questions apply to Amazon.com?

Why has our historical performance followed the time-path that it has?

Sales have grown strongly as consumer uptake of online purchasing has spread and as Amazon.com has extended its product range and entered new geographic markets. Earnings have bounced back from heavy losses into positive profitability, as early expenditure generated the sales growth and gross profits to more than cover the continuing costs of serving customers’ demand.

However, the company’s development could feasibly have followed a different path, even if it ended up at the same point in 2005. Figure 1.6 in SMD, shown above, compares the company’s actual record with an alternative, fictional history. In this other world, the answers to our first question would be quite different. The company might have grown its revenues still more strongly between 1999 and 2002 than it actually did, due to an even faster penetration of online shopping by consumers or extension of its product range and services. From 2002 to 2005, sales growth could have slowed and reversed, perhaps due to saturation of the potential market, the emergence of strong competitors, or a slowdown in the company’s expansion of its offerings. The alternative income line is more worrying still, and explanations might include reduced margins due to competitive activity, poor cost control, or deliberate increases in spending in an effort to restart growth.

Where will the path of future performance take us if we carry on as we are?

This second question shows the importance of answering the first. The two alternative histories must imply very different prospects for the future, even though the 2005 endpoint is identical. If we extend the time horizon beyond 2005, a plausible future for Amazon.com is that sales continue to grow for much the same reasons they have in the past—more consumer use of online shopping and extended coverage by the company of product and geographic markets. As a result, profits continue to grow.

But the answer to “where might we be heading?” would likely be very different, had the alternative history occurred. Now we are worried that the slowdown in sales could become a serious downturn, especially if the recent history had reflected progress by powerful rivals. If this were to come about, the profit forecast could be very disappointing, with the company slipping into losses as it struggles to contain costs that it has built up to support a growing sales rate.

How can we improve that future performance?

Amazon.com’s actual history to 2005 offers encouraging prospects for sales and profit growth thereafter, so in reaality. answers to this third question focus on pushing growth just a little faster, while not risking damage to the business system that supported its performance to date. Perhaps further product and service development would drive additional growth, and this could plausibly lead to still higher profits.

The answers to this third question would have appeared very different if the company had reached 2005 by the alternative path. Instead of asking how the firm might safely push for even faster growth, it would instead be worrying about how to stop sales revenue slipping backwards, and then how to restart growth. Such a turn-round would likely be costly, so the time path of recovery might well show an even worse profit performance in the next year or two than the “do nothing” projection.

Your business history will probably be quite different from Amazon’s, but the questions will be the same. Through the course of the book and these emails I will show more examples, in different cases that I hope will demonstrate that for you.

Remember we welcome your comments at any time.

Until next time…

Briefing Number 3

I love it when the lightbulbs go on!

When I am teaching it’s great to see the reactions when people identify something that makes a real difference for them. In my executive classes in particular there have been insights related to areas that, from the outside, you would have thought would have been obvious – but the sad reality is that people are so often chasing a target that they often don’t manage to look at the overall picture.

I recall one person who ran a mid-sized security firm – the kind that provides guards for buildings of different kinds. He kept driving his head of sales to win new clients, but business was still not growing. When we looked at his numbers, it turned out that he had about 100 client, and each year added 100 new ones, but lost the same number. [Not many cases are quite so extreme!]

How had he got in this awful situation? Well a few quarters ago, HQ were pressing for more profit, so he had to cut back on the staff who did the actual security work for clients. Service quality fell, so next quarter some of his clients did not renew their contracts. Sales and profits fell, so HQ said ‘More profit please’. [Only not so politely!]

In order to sustain profit growth he set bigger sales targets – which his head of sales managed to hit. Taking on new clients meant more work, and with no more staff, service quality fell again, so next quarter still more clients cancelled their contracts. So sales and profits fell … so HQ shouted again … and so it went on, with ever-growing churn amongst his customers.

Getting out of the mess was tricky. Clearly, chasing still more new business was not working – apart from anything else, he was fast working through all the potential customers in his region! The solution was a significant, but selective cutting of still more clients. Mad eh! .. our business is in a mess, losing customers, so you tell me I should deliberately throw away some of those I’ve got? Yes – but the selection process isolated a significant number who were unprofitable, because they had demanded uneconomic prices or service levels that were too costly. Serving a smaller number of customers, even with the same number of staff actually raised profits and improved service. [We will see more about how this can happen in a later briefing - but that is some way off yet].

… from where he could start building business again, but with a little more care.

Briefings 2: It matters how we get there

Kim Warren — Wed, 22 Sep 2010 09:11:49 +0000

This is the second post in the fortnightly series of Strategy Dynamics Briefings.

Despite a wide range of financial measures being available the interests of investors has led to the choice of one specific measure. What is it?

(If you would like to receive the series from the beginning in your email inbox, please register on www.strategydynamics.com and subscribe to Briefings in “MyAccount”)

As you may know, strategy textbooks are largely devoted to commercial business situations, and as a result, the strategy concerns of public sector, voluntary, and other not-for-profit organizations are somewhat neglected. Additionally, many strategic issues in corporate situations, while they will ultimately affect financial performance, primarily concern nonfinancial issues: poor marketplace reputation, rapid loss of staff, business lost to competitors, and so on. Nevertheless, consideration of financial performance is a good starting place…

Despite a wide range of financial measures being available the interests of investors has led to the choice of one specific measure – “economic profit” – the basis for assessing performance for any particular time period. There are two elements of profit that should be distinguished. First is the “normal” profit that investors would expect to receive for the use of their capital, given the level of risk they are taking on. The second element, “economic profit”, is the surplus that remains after the costs of all inputs (including the cost of capital) have been paid out, so:

Economic profit = operating profit minus taxes minus cost of capital

An exclusive focus on current profit poses a rather obvious problem – we can nearly always boost profits now, by pushing up prices or cutting expenditure. Historical and current profits are therefore only relevant insofar as they provide important clues to what profits will likely be in the coming years. This severely limits the value of any strategy approaches or frameworks based on explanations for profitability in a single period, no matter how persuasive the statistical significance.

The money available to distribute to shareholders in future years will be the cash flow generated by the company’s operations, minus any additional capital input required to make that operating cash flow possible. So another measure that receives attention is “free cash flow.” Current period profits include an allowance for writing off the past expenditure on fixed assets, known as depreciation. This depreciation needs to be added back and replaced by the actual expenditures on fixed and working capital. This results in the following measure of a firm’s free cash flow:

Free cash flow = operating profit + depreciation – taxes – change in fixed and working capital

The value of a firm reflects the expected stream of all future free cash flows, discounted by the firm’s cost of capital to arrive at its “present value” (Figure 1.1), and the firm’s total value is the sum of all those values out into the future. So to evaluate a firm’s strategy we need a way to estimate the future trajectory of cash flows, not just a single period. Additionally, we need a way to estimate the impact on that cash flow trajectory from actions or decisions we may be considering. Such changes may be relatively minor, such as a price reduction intended to accelerate sales growth, or major, such as the acquisition of another substantial business.

In Figure 1.2, Strategy B should clearly be preferred even though it involves lower cash flows in year one. Outcome B could, for example, arise from entering a new market or launching a new product, either of which would incur short-term costs but with the prospect of enabling additional growth thereafter. Management will, of course, face the challenge of convincing investors to share their confidence in option B!

Quite simply:

Strategic management is about building and sustaining

performance into the future.

This is not a novel idea in the strategy field – it goes back to work in the 1950s by Edith Penrose, who pointed out that superior profitability is neither interesting in itself, nor sustainable in any but the most exceptional circumstances. Rather, management should be concerned with growing future economic profit. I am implying here that there is a tendency for valuation to be based on near-term profits but it is not always the case that investors look only to the short term. Consider the case of Amazon.com – in the years up to 2001, the company repeatedly delivered only losses (and heavily negative cash flows). Investors nevertheless ascribed value to the firm because of the prospects that profits would arise in due course. Indeed, those early losses were often greater than investors had previously expected, yet they still valued the company positively since each new level of loss arose from additional spending to develop ever more sources of sales and future cash flows.

I referred above to the need to consider non-financial performance measures as well as financial and I will return to these in future posts. In the meantime your comments are welcome at any time.

Until next time…

Briefing Number 2

“It’s common sense – but not as we know it”.

A comment I sometimes hear when teaching strategy dynamics or on client engagements is that “It is just common sense” or “I knew that already” … but it’s rarely true!

One case concerns a strategy to drive sales growth for a popular pain-relief product in what is a pretty mature market. I can ask a class of 50 people to give the questions they would ask if invited to help solve this problem. I usually get a couple of boards full of data items that people would wish for. But never does anyone want to know ‘How many new people start using the product each month, and how many stop using it.’ The problem simply cannot be solved without that information. [We will see why that question is so important in a later briefing].

To a large extent strategy dynamics is common sense – that’s actually key to its power because it means everyone can understand what is going on. But to quote someone famous ‘If you don’t ask the right question, you’re not likely to find the right answer.’
So now, one of the first things I do is establish what the client thinks is the answer to their challenge. When we re-visit the question at the end of the project, their views about the way forward have invariably changed a lot.

There is a case study on the Strategy Dynamics website that illustrates the process – 26 minutes – headphones or speakers required.

“It’s common sense – but not as we know it”.

A comment I sometimes hear when teaching strategy dynamics or on client engagements is that “It is just common sense” or “I knew that already” … but it’s rarely true!

There is a case study on the Strategy Dynamics website that illustrates the process – 26 minutes – headphones or speakers required.

“It’s common sense – but not as we know it”.

A comment I sometimes hear when teaching strategy dynamics or on client engagements is that “It is just common sense” or “I knew that already” … but it’s rarely true!

There is a case study on the Strategy Dynamics website that illustrates the process – 26 minutes – headphones or speakers required.

“It’s common sense – but not as we know it”.

A comment I sometimes hear when teaching strategy dynamics or on client engagements is that “It is just common sense” or “I knew that already” … but it’s rarely true!

There is a case study on the Strategy Dynamics website that illustrates the process – 26 minutes – headphones or speakers required.

Briefing 1: What’s different about Strategy Dynamics?

Kim Warren — Tue, 07 Sep 2010 19:55:30 +0000

This is the first post in the series of Strategy Dynamics Briefings.

Join me, as I introduce and explain ideas behind Strategy Dynamics in these fortnightly blog posts.

(If you would like to receive this series from the beginning in your email inbox, please register on www.strategydynamics.com and subscribe to Briefings in “MyAccount”)

There are many strategy textbooks in the market but "Strategic Management Dynamics" starts from a slightly different point, which may make it seem a bit unconventional. When all is said and done, the purpose of designing and implementing strategy is to improve performance over time. In corporate settings, shareholders value the likely stream of future cash flows, rather than profitability ratios. Simply put, investors will prefer a company generating 12% returns when cost of capital is 8% over a company generating 15% if the first company is growing substantially and the second is not. No matter how sustainable the second company’s superior profitability may be, whether due to finding an attractive industry situation or establishing a hard-to-imitate advantage, its lack of growth limits its value. [See for example ‘How to choose between growth and ROIC’, by Bin Jiang and Timothy Koller - McKinsey Quarterly, September 2007.]

The need to improve performance over time is not limited to the strategic management of corporate entities. It applies equally to public service and voluntary organisations, although they may focus on achieving some other quantifiable purpose rather than creating financial value. Functional parts of organisations also face the requirement to improve performance over time, such as improving service quality, accelerating product development or reducing staff turnover.

To deal with this concern with performance over time requires a rigorous and quantitative causal explanation for the direction and rate at which performance is changing. This analysis quickly identifies that accumulating resources are the ultimate cause of current performance – customers drive revenue; capacity and staff drive costs, for example. Any desire to estimate how performance will change must therefore depend on how those tangible resources will change.

The complicating issue is that accumulation and depletion of resources do not follow the straightforward form of causality we usually hope to discover. The quantity of each resource at any particular time reflects the organisation’s entire history, its customer base today, for example, being precisely the sum of every customer ever won, minus every customer ever lost. This has serious implications. If performance depends on factors that have been built up and sustained throughout the past, it cannot be explained by the current values of other factors today – price or marketing spend, for example – no matter how persuasive the correlation results.

The accumulating asset-stock, or resource, is the fundamental component without which no explanation of performance can be accurate. Its principal consequence is that each organisation is on a trajectory into the future that has been steered by its previous strategies and decisions. Our quest is to find adjustments to those strategies and decisions that will redirect that trajectory onto a better path. Even when it is possible to achieve step-changes in performance, reliable growth thereafter is still required.

The time-based behaviour of accumulating resources and other asset-stocks lies at the heart of a method called system dynamics. This method also captures the next stage in the causal logic – showing why resources are being won and lost. These flow rates of resources are fundamental to why performance is changing over time. If there are no flows, then resources don’t change, and if resources don’t change then performance remains the same. Rates of change in resources reflect management decisions and certain external factors, such as competitors’ efforts or limited availability of those resources. Crucially, however, as the strategy field has long known, the rate at which resources can be acquired depends strongly on the quantities already in place. This gives rise to interdependence relationships, the capture and quantification of which generates the organisation’s basic operating system – its core ‘strategic architecture’.

In the first part of "Strategic Management Dynamics" I establish the need to look at performance over time – not just this year’s results but the direction performance is going, whether improving or declining. It goes on to look at how resources drive performance, how the bath-tub metaphor underpins resource behaviour and how to build up a ‘strategic architecture’, from which further analysis can be accomplished.

Over the coming weeks I will provide some insights into strategy development using the approach.

We welcome your comments at any time.

Until next time…

Briefing Number 1

Join me, Kim Warren, as I introduce and explain ideas behind Strategy Dynamics.

Another thought … There is an important distinction between principle and technique.

Deeply embedded in strategy dynamics is the bath-tub principle – a universal truth about the way things in our world ‘fill’ and ‘drain’ over time – e.g. water, cash, greenhouse gasses, animal poputations etc.

To apply principles needs insight that only you can bring due to your knowledge of your situation. By applying the stages that I lay out in Strategic Management Dynamics you will be able to build a strategic architecture of your business that will generate insight and improved strategy planning.

Analysts keep getting it wrong

Kim Warren — Thu, 22 Apr 2010 14:46:09 +0000

Equity Analysts: Still Too Bullish in McKQ makes depressing, if unsurprising reading. Analysts continue a decades-long tendency to forecast nearly double the profit growth that actually follows, and go most wrong when they most need to get it right – when boom times falter. CEOs get beaten over the head with these forecasts, and mess up business in their efforts to hit stupid targets, so this is of more than academic interest. It is interesting to note, then, that the Chartered Financial Analyst Institute now boasts nearly 100,000 qualified members world-wide, and that its Charter Program is regarded by the Economist as “the gold standard among investment analysis designations”. Interestingly, nowhere in this three-year program of study is there any requirement for its graduates to understand anything about strategic analysis of a business and its market environment. Nor is there any mention of how strategic management affects financial performance (see http://www.cfainstitute.org/cfaprog/courseofstudy/topic.html). How, then, are they likely to come up with realistic forecasts? The CFA Institute has long known of this hole in their training, but interest in fixing it seems slow.

Usable game theory

Kim Warren — Thu, 31 Dec 2009 11:46:45 +0000

Hagen Lindstaedt just alerted me to what looks a smart way of making game theory usable, with a neat link to scenario-based thinking. Probably quite challenging to do, but looks powerful – thanks Hagen. Looking forward to seeing more on how it works.

Better than HBR?

Kim Warren — Thu, 12 Nov 2009 12:08:52 +0000

Harvard Business Review may be seen as the gold-standard for leading edge management thinking. But I am increasingly impressed by the quality of other journals. McKinsey Quarterly, of course, has long produced solid content based on work with major clients, or else on serious research from their Global Institute, and other big consulting firms do some of the same. Now, seems to me, Sloan Management Review is also putting out important, well-informed articles reflecting rigorous work, and strategy+business from Booz & Co does the same.

Meanwhile, HBR offers more and more articles featuring glib slogans or ‘X ways to do Y’ and other styles of thin journalism. Some are downright dangerous! There are still some great exceptions of course, but I wonder if their crown is slipping.

Anyone got other favourite sources?

Great piece on sustainability and business

Kim Warren — Tue, 14 Jul 2009 14:59:45 +0000

Great video with Adam Werbach, author of Strategy for Sustainability: A Business Manifesto, shares an adaptation from his book and talks with the McKinsey Quarterly about trading in green fashion for more enduring business solutions. Practial and commercial.

Don’t surrender to uncertainty!

Kim Warren — Thu, 11 Jun 2009 11:08:43 +0000

I hope senior management do not get persuaded to divert their attention to studying ‘complexity’ in the hope of understanding recent economic turmoil. “‘Power curves’: What natural and economic disasters have in common” argues that “parallels between financial crises and natural disasters–such as earthquakes or forest fires–suggest that the economy, just like complex natural systems, is inherently unstable and prone to occasional huge failures that are very hard or impossible to foresee. Proponents of this school of thinking are bringing new ideas grounded in complexity theory to economic forecasting, strategic planning, and risk management.” This contributes little to the quest for skilled strategic management.

Whilst random fluctuations add complexity to how exactly events unfold, many of the phenomena discussed in this article feature simple underlying mechanisms that are well understood and do not need abstract or complex math.

The sub-prime lending collapse was inevitable, and its timing increasingly clear as conditions worsened. The 2001/02 dotcom crash was indicated as new-firm startups were gradually overtaken by failures – both of which were observable – with IT/telecom suppliers, consultancies and others relentlessly adding capacity while ignoring this data. The same has happened this time round in many sectors – e.g. ship construction, commercial property, credit-card lending.

Many such events feature thresholds being crossed in the organization’s own market environment – making it a basic discipline of competent strategic management to track these mechanisms, rather than looking for abstract and non-actionable answers in complexity.

Please go to this article and challenge its value for helping senior managers steer organizations’ strategy and performance! – there’s a comment facility. … unless of course you know of a real business that made real decisions with real impact on its sustained performance byusing complexity science that could not have been done easier, quicker cheaper another way?

Continuous strategic management

Kim Warren — Wed, 10 Jun 2009 11:46:52 +0000

Just came across a great piece, but curiously embedded in a McKinsey Quarterly article that seems to be about something else entirely – an update of how to decide what businesses should be in a corporate portfolio. The little gem is on the evolution of strategic management - which describes how strategy has evolved from a basically financial approach, through forecasting and then externally driven strategizing, to its ultimate, described as follows:

“When this investment [in strategic planning] is successful, the result is strategic management: the melding of strategic planning and everyday management into a single, seamless process. In this phase, it is not that planning techniques have become more sophisticated than they were in phase three but that they have become inseparable from the process of management itself. No longer is planning a yearly, or even quarterly, activity. Instead, it is woven into the fabric of operational decision making.” It goes on to point out that virtually no companies have reached this point, except perhaps some in the electronics sector, where very fast changes across multiple products and highly segmented markets make it imperative.

… but surely this should be our aspiration for all organizations? though as I have noted before, we are not likely to get to this point with strategy tools that are simply incapable of ever delivering this result.