Six business traps every business owner should watch out for!

1. The Sunk cost fallacy

Many businesses keep throwing good money after a prior investment decision turns bad, resulting in what is termed in economic literature as the sunk cost fallacy. A sunk cost is a cost that has already been incurred and cannot be recovered. Consider the example of a company which recently spent 2 Cr in implementation of an ERP module for its sales team. However, the sales team did not find the module as user friendly and this reduced the productivity of the sales team even after conducting frequent training programs. The Sales Head wants to discontinue the use of the new system. Should he consider the 2 Cr spent on the system to decide whether to continue using the system? If your answer is yes, you have fallen into the sunk cost fallacy. It is for the same reason people decide to continue going to watch a movie even after reading its universal bad reviews since they have already paid the ticket price. The sunk cost fallacy prevents people from realizing what the best choice is making them place greater importance on the loss of money, which anyways is unrecoverable.

2. The fa?ade of the Narrative

A well-known saying in academia is that everything which is doable must be represented in cashflows. Think about the last time when your business development team requested for the approval of a not-so-novel discount scheme to enter into a new geography or to gain market share. Or the operations team demanding for a sophisticated technology to improve productivity. Ask them to quantify these benefits in terms of tangible financial benefits, whether revenue enhancements or cost reductions for a foreseeable time. After all, everything must be reflected in terms of future cash flows and discounted in present value terms. An intuition-based approach works well if its augmented with data and projections, and if all these fantastically articulated opportunities cannot be presented in terms of cashflows, they remain at best, wonderful narratives. As W.E Deming said, “In God we trust, everyone else must bring data.”

3. The unbreakable (supply) chain

Most companies do not realize how much of their business is actually dependent on their suppliers. A typical car manufacturer is dependent on its suppliers for 70% of its total business value. Similarly, a real estate developer depends on its suppliers for as high as 60% of the business value added. Startling figures, right? Ask yourself the question, how much of your business value is added by your suppliers. Now think about how much time and effort your company puts in planning and building these supply chains. Most companies acknowledge that suppliers are critical for their businesses, but their management teams do not focus on setting the objectives right when it comes to supplier relationship and network management. When procurement and supply chain teams are incentivized on cost savings and value-added measures instead of a myopic obsession with price-reduction, and when switching costs (cost of finding new suppliers and supplier onboarding), firefighting issues and project delays are accounted in total system cost, companies often discover that alternative strategies such as Quality-cum-Cost Based Selection (QCBS), Quality-Based Selection (QBS) or Life Cycle Costing (LCC) are far more valuable than the conventional L1 system which most management teams are obsessed with.

If a substantial share of your business value is added by your suppliers or partner ecosystem, it is critical to formulate an integrated supply chain system where cooperation will drive sustained performance. An integrated supply chain is not only a process but rather a mindset which is based on pillars of trust, coordination, partnership, and integration. As the Japanese companies have shown the world, unbreakable supply chains are enforced by following an arm’s around strategy rather than keeping your suppliers at arm’s length. 

4. The WACC fallacy

If your company operates in multiple businesses, it is important to not fall into the trap of weighted average cost of capital (or WACC). Averages, after-all do not tell the whole story. Consider a scenario where a company operates two divisions with different risks. From Corporate finance 101, we know that a project’s cash-flows should be discounted at a rate that reflects the project’s risk characteristics. Discounting cash flows at the firm’s weighted average cost of capital (WACC) is therefore inappropriate if the business units differs in terms of their riskiness from the rest of the firm’s assets.  The use of a single firm-wide WACC would lead to overestimation of the net present value (NPV) of a business opportunity whenever the opportunity is riskier than the typical business of the company. The WACC fallacy relates to managerial bounded rationality and research shows that this bias is stronger especially when the measured cost of taking the wrong discount rate is low which is true especially for smaller business divisions.

5. The related business fallacy

This one is the most obvious trap for companies which found themselves in stagnating markets with increasing competition and decide to diversify seeing synergy in related products. For example, an industrial safety equipment company after facing sluggish demand in its current market decided to foray into consumer safety products citing similar production base and brand image. While it may appear synergic on the surface, the problem here is the classification itself. Instead of looking at businesses, companies must look at their unique capabilities- a set of competencies, resources, assets which they have built over time, also termed as strategic assets in the strategy literature. These resources could be as generic as intellectual capital or human capital or as specific as a technological patent or a proprietary industrial process. It is important to identify the strategic assets as company owned resources which in combination with the businesses the company decides to operate in, provides the company a distinct competitive advantage in its industry. In the previous example, the company’s strength in its industrial market is its direct salesforce, strong customer relationships, and carefully built long-term expertise to bring to market novel technologies in the field of health, safety and environment. A combination of these unique capabilities provide the company with a distinct competitive advantage in the current market where it is operating and perhaps winning. The question therefore the company needs to ask before foraying into a new business area is whether it will be utilizing any of the existing capabilities to add value to the new business, or whether the existing capabilities can be further enhanced by learning or acquiring a new set of capabilities in the targeted business, or will there be an element of synergy (the sum being greater than the parts) between the two businesses. Asking such questions will reveal the challenges ahead. The company may realize the pain of building a distribution network for selling consumer safety products and the volume required to achieve economies of scale does not justify the investment required.

6. Culture- The ultimate killer

When Peter Drucker said "Culture eats Strategy for breakfast", he probably implied that the most difficult part of any strategy is its implementation. Most businesses fail to implement their strategies due to poor formal and informal control systems. While formal control demands a robust performance management system, informal controls are governed by a firm's culture which is defined as a set of shared values, goals, attitudes and practices that characterize firm's members and define firm's core. Mostly, culture at any upstart firm is shaped by the founder's vision and values. It is important for the founder and the top management team to repeatedly stress on the firm's vision as the firm begins to scale. This ensures the original culture is preserved and not diluted. Most firms face this issue as scale brings growth but also complexity, and complexity soon starts hindering growth as the formal and informal control systems fail to support growth. The role of a strong and sustained culture cannot be discounted. Besides guiding employees in conflicting situations as a true north star, culture also influences the formal control systems. After all, a formal performance management system is essentially a four-way process inter-linking organizational structure, people, culture, and process controls, and ensures alignment of leadership as well as employees.

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