How to assess the impact of our business decisions?

The idea of “impact” itself is wide in scope, so can be interpreted in many ways. For example, a manufacturing manager can relate this idea with the cost of production, a supply chain manager with the level of inventories, a sales manager with the volume of sales, the treasure manager with the debt cost, and a human resources manager with the working environment. All those are both right and wrong in some sense. Correct in recognition that the affectation of those variables describes some sort of impact. Wrong by the fact that those affectations usually do not happen in a ceteris paribus situation. What does this mean? It means that a reduction of inventories can affect the availability of products which increases the level of stockouts and, in consequence, reduces the volume of sales. It means that increasing the volume of sales by accepting a rush order can generate the need for overtimes and additional changeovers, which increases the cost of production.

A way for narrowing the idea of “impact” is the identification of a signal that considers all the relevant variables for a business. Plenty of people within the company can argue against the general validity of process efficiencies for measuring in a precise way the impact on a business, for instance, but almost no one would try such an argument when it comes to money generation. In this line, an indicator that accurate measures this signal is the Return on Investment (ROI). ROI measures the proportion of earnings in respect of the investment. For example, it is not the same earning $10 by investing $100 than earning $10 by investing $1,000. Clearly, the first situation is more profitable than the second, which is easy assessed by comparing both ROI, 10% and 1% respectively. The idea of earning represents the difference between what we obtain, income, and what it cost us, cost. It is important to differentiate the concepts of cost and investment. For example, the production of a product costs us, among other things, the raw material it uses, the energy the machine consumes for its production, and the manpower required for its operation and manipulation. In the same fashion, the production of a product demands the investment on, among other things as well, machines, a level of raw materials inventories, and working capital for sustaining the payment terms of customers.

At this point, we have three concepts for assessing the “impact” of our decision in a business -income, cost, and investment- but still is not enough. One curious member of our organization can suggest: “What if we use this new experimental raw material? It costs half, but the results are not fully guaranteed.” Yes, the new raw material reduces the cost for sure, but introduce a new variable, uncertainty, which can be understood as a probability of success. This new likelihood brings also a chance for failing, which implies new different conditions -income, cost, and investment- for measuring our ROI. Now we have at least two ROI, one for the success and the other for the failure. From this point, due to the introduction of uncertainty, the idea of “impact” grows to the idea of “expected impact”, which corresponds to the superposition of the success and failure states or all the scenarios one seems relevant to evaluate.

I think it is getting clear where I am going. I have defined two of the three components considered in the calculation of risk in the risk management theory. The one variable that is missing is the detectability, that is also relevant for our purpose. In the same example of the new experimental raw material, we know it reduces the cost and increases the uncertainty for success, but we have not thought about how do we detect whether the raw material has failed or not. It could be that the process of failure is not easily identifiable, so the defect gets introduced in the market. This would cause in our model the introduction of a new probability, the probability of detection, and a new ROI, the ROI in case the failure is not detected.

My intention with this framework is to create a reflection in the decision-maker but I can understand If someone wants to convert its insights into numbers. If this last is the case, the formula for the “expected impact” is:

Return on Investment (ROI):

= (Income-Cost)/Investment

Expected impact:

= P_s × ROI_s + (1 - P_s ) × P_d × ROI_f + (1 - P_s ) × (1 - P_d ) × ROI_nd 

P_s = Probability of success

ROI_s = Return on Investment in success state

P_d = Probability of detection

ROI_f = Return on Investment in failure state and timely detection

ROI_nd = Return on Investment in failure state and delayed detection

Even at this stage, I consider the model is incomplete. Let us imagine that another clever member of our organization argues: “What if we delay the payments of our suppliers? This can reduce the level of investment and does not affect both income and cost, and the suppliers will not tell, so no negative repercussion will occur.” I know that the answer is obvious and most of you are thinking: “That is extremely immoral” Well, sometimes the answer is not that obvious, so I propose a sanity check against the business strategy. By strategy I mean: vision, mission, shared values, and strategic pillars -or similar-.

As I mentioned, my primary intention is to trigger reflection and, for that purpose, I consider that the best way is to present this model in the form of a survey, which is described next:

• Does my decision entail conflict with the business’ vision, mission, shared values or strategic pillars?

If yes, discard the initiative unless the benefits can justify a shift in the strategy

If no, proceed with the next questions

1. What are the impacts on income, cost, and investment in case the initiative success?
2. What is your best estimation for success? Is this probability enhanced by the initiative?
3. What are the impacts on income, cost, and investment in case the initiative fails and get timely detected?
4. In case the initiative fails, what is your best estimation for the probability of detecting the failure? Is this probability enhanced by the initiative?
5. What are the impacts on income, cost, and investment in case the initiative fails and get not timely detected?

After assessing questions from one to five, proceed with the next decision guideline:

• If the initiative seems beneficial and the levels of cost, investment, failure, and undetectability seem negligible, proceed with the implementation
• If the initiative seems somehow beneficial and the levels of cost, investment, failure, and undetectability seem concerning, do not implement and map the initiative for future reconsiderations
• If the initiative seems beneficial and the levels of cost, investment, failure, and undetectability seem concerning, prepare a detailed business case
• If the initiative seems harmful, do not implement and map the initiative

Finally, I recognize some limitations of this proposal. First, this framework does not consider the time value of money. Second, I did not consider the variable of sustainability since I am supposing it can be recognized when the probability of failure is assessed and that strategies normally include it in their formulation. Third, it demands a holistic knowledge of business for the evaluator. In simple, someone capable of understanding at least core business activities and the way those interact with each other. This kind of professional is very rare, so, to overcome this constraint, I recommend the assemble of multifunctional teams for the application of this framework.