Why businesses fail

This week I’ve been thinking about why businesses underperform.?

I’ve come across a number of underperforming businesses over the last decade, and I think that there are some misconceptions about underperforming businesses, so this week I wanted to talk about some of those misconceptions.? I have had a go at cataloguing my view of the causes of underperformance in the businesses that I’ve worked on over the past decade.? This is my view of the root cause - other people might have different opinions about what caused it for these businesses.? As the great philosopher Homer rightly pointed out “Oh people can come up with statistics to prove anything Kent, forfty percent of all people know that!".? So take these metrics as what they are – an indicative opinion.? This is my view, others may have their view, that’s fine.?

When I say “the cause for underperformance”, this is distinct from (and should be confused with) the improvement that is put in place to resolve it.? In my experience, a mistake at the outset, like an inaccurate estimate in a fixed price contract, will set a business off into a downward spiral.? In order to get the business out of that spiral, the work that is required to improve it may involve employing anything and everything in our power to improve performance, which might have nothing to do with the cause.? E.g. If an estimate is bad, we might need to improve operational performance by x% and reduce overhead by x% - it wasn’t operations or the support teams that caused it, but in order to rectify it, we need to execute all initiatives to improve it.?

For each underperforming business that I have spent time understanding the root cause for, I tagged it with a cause.? A single business might have multiple causes.?

The graph on the left shows the number of times a common cause came up across all of the businesses – so initial forecast / budget accuracy came up as a factor in 9 different underperforming businesses.

The graph on the right shows the number of causes each business had – so for the business with 9, it meant that there were 9 different things that caused that business to underperform.?

I’ve obfuscated the names for obvious reasons (so please don’t try and guess which ones which), and when I say businesses, I take this to be profit centres – whole distinct units which are able to derive profit in their own right as opposed to separate legal entities.? ??

There are some causes in my graph that might not make sense. ?My definition for some of the more nuanced ones are set out at the end, so skip ahead if you want more info on what each one means to me.?

So, what does it tell us…?

Misconception number 1a – We are good at estimating

The most frequent cause across all underperforming businesses that I have worked with is a bad initial estimate.? This is also usually coupled with a commercial model which includes a fixed price contract and an unbalanced client relationship that is tense, litigious, and doesn’t allow for changes – hence the 1a / 1b as I describe below.?

When I say “Commercial Model”, I mean how the business is paid for the work it performs.? It could be paid a fixed price ($100,000 to build this asset), or unit rate ($5 per widget), cost plus (e.g. like a mechanic, supplier is reimbursed for any costs incurred and charges only for their delivery component) or performance driven contracts (profit element is linked to hitting KPIs).

I think that bad forecasting is something we as Australian’s culturally struggle with.? Our “she’ll be right” pragmatic attitude causes us to back ourselves to improve, which results in hockey stick optimistic forecasts which improve over time, and it’s the under-delivery on improvement that gets us.? In striving for a high result, we overexert ourselves, over-complicate and end up underperforming.? I’m an Aussie and I will admit that I am especially bad at it.? We are willing to put in effort to try harder, and we like that about ourselves so we see a 10% increase in performance year on year as a challenge we should absolutely take on, and eagerness and optimism to take on greater tasks are admirable qualities.? As managers, we see it as our job to review and estimate and get it as low as possible, to sharpen our pencil and make sure that we win that job.?

However, I think we need to be more tolerant towards a mindset that says “we will make a 7% return each year, with 100% confidence” rather than “I sorta reckon I can drive it up to about 10 ish %”.? We shouldn’t challenge the existence of contingency and should instead review estimates with a mind to having the team convince us that the estimate is enough and has enough contingency.? ?Financial markets value predictability more than we do as management, and we should put more stock in the integrity of delivering on a promise, rather than respect at taking on an ambitious feat.

I have an enduring memory (which is folded and yellowed and frayed at the edges but still in tact) of a meeting I had with a particular maintenance planner in Spain many years ago.? This gentleman, about 2 years into a ~20-year contract, had planned optimised scheduled maintenance cycles for a complex asset for the next 18 years.? He did it in a sophisticated but simple way completely in Excel.? He basically finished his job 2 years into the contract and he laughed and shrugged his shoulders and in broken English said “Now I just have to wait around and wait for things to go wrong”.? They weren’t trying to run the pants off the asset, they ran it to achieve the desired performance in a consistent, reliable way, to achieve a financial outcome akin to a term deposit rather than a volatile penny stock.? We would second guess that behaviour and say maybe there are ways to make it better and set higher targets, but maybe having 5 assets doing what they say on the box with low management is better than having 3 assets striving to reach the stars with intense management.? ??

I’ve also seen this estimation accuracy impact acquisitions, and in orders of magnitude much higher than that in new business contract tenders.? Conservatism during the frantic process that is M&A is equally, if not more important than it is in the tendering process.?

Misconception number 1b – There is safety for a customer in fixed price contracts

When it comes to fixed price contracts, a bad initial estimate and a contract and client relationship that does not allow for any room for change will almost certainly lead to doom.? Commercial models which involve locked down fixed price contracts are a procurement team’s dream, as they lead to a well understood cost as a customer.? However, where the work required is subject to variability that is beyond the control of a supplier, it can push them to the point of economic loss.? That can lead to poor quality, slow delivery, increased tension, unpredictable delivery, more management time etc – not always a good outcome as a customer.

When structuring the commercial model of a new contract, I would always recommend a commercial model that best reflects the controllable elements of both parties.? Parties should be incentivised to work together to reduce the overall cost of delivery, and where a supplier is working well, they deserve profit.?

Paying a supplier profit is not a bad thing.?

If you’re entering into a fixed price contract, I cannot stress enough - make sure you have the time and information to understand all of the factors involved, have a high level of confidence in every assumption, and make sure that all the way through from estimate to delivery, those assumptions are understood and clear.? ?

Misconception number 2 – If we fix this one thing, we can fix the underperformance

It is rare to see an underperforming business in which I can truthfully say “if that one thing hadn’t happened, this business would be operating perfectly”.? It is usually a complex confluence of causes intermingled in such a way that its impossible to determine which one happened first, and hard to determine which one to work on because of their interconnectedness.?

If it were a single problem, it probably would have been fixed before I got there.?

The exception to this trend is fixed price contracts.? As I explained above, a bad initial estimate in a fixed price contract is dangerous thing, and screwing up that one estimate can bring down billion-dollar companies.?

The majority of the underperforming businesses that I’ve witnessed had 4 or more distinct problems.? I’ve often heard also “there is so much wrong with this place, this must be the worst place you’ve ever seen”.? If you’re in an underperforming business where there are many perceived problems:

-????????? Don’t stress, because it’s not uncommon, but

-????????? Pick 3 problems, and start working through them, and when you finish those 3, pick another 3.?

Misconception number 3 – The business isn’t hitting its goals because Managers aren’t pushing their people hard enough

In my experience, operations teams not performing the way that they should is rarely the cause of a business to underperform, but there is often “chest beating” and emotional shouting about needing to drive people harder to get the job done. ??

People very, very rarely turn up to work to deliberately do a bad job.? If they do, they are usually outliers that are able to be swiftly managed out of the business, because their lack of motivation drives others around them to be disgruntled, and when they are removed, the team as a whole operate more efficiently.

Leadership and management rhythm are much more important factors than operations teams not working hard enough.? If the business has a revolving door of managers, it is not healthy.? If the business has a list of 17 strategic imperative projects for this financial year to execute on top of their day jobs, it’s not healthy.? If management structures change from state-based managers to product-based managers, to a matrix structure and then back to state-based, it’s not healthy.? If KPIs and performance metrics are not clearly communicated to all parts of the organisation, it’s not healthy.? ???

Leaders need to align, incentivise, motivate and problem solve for their teams in times of underperformance, not whip them like livestock.?

Misconception number 4 – If we had a better system, this wouldn’t be happening

In my experience:

-????????? Management will blame operations for not working hard enough,

-????????? Operations will blame management for setting unrealistic goals, and

-????????? Everyone will blame IT for the system being crap.

The system is not usually the cause.? Humans built pyramids without SAP.? I am always highly suspicious when I hear that the system can’t do what we need it to do.? It is sometimes the case, but not always.? Usually it is a process issue around training / capability / how we use the system.?

The times when I have seen a system become the cause of underperformance is when not enough time and energy was exhausted in making sure that a new system was set up and configured correctly.? In all 3 cases, more time was needed to fully embed a system properly, and the underperformance stemmed from rushing in an interim solution that made the situation worse.? A lack of easy-to-follow simple role-based instructions is also high on the list of causes for systems copping the blame.? ? ??

Let me know if this resonates, or what common causes you’ve seen impact performance and what you took away from it.?

Glossary of obscure causes

Inappropriate commercial model – The commercial model (as discussed above) was not the right one, given the controllability of factors from both parties.? In a simplistic example, imagine a supplier might have the contractual requirement to pay for maintenance parts in a machine, but the number of times maintenance is required is influenced by the asset owner and how long they run the machine for.? The asset owner’s action (or inaction) might adversely affect the amount of material the supplier needs to purchase.? A fixed price commercial model is inappropriate, and a fee per maintenance task might be more appropriate.?

Explosive parts in a portfolio – There is usually safety in numbers and underperformance in a couple of elements in a portfolio will be offset by others.? But in some business models, the downside risk is a much higher magnitude than (and just as probable as) the upside opportunity.? When this is the case, when a couple of the elements don’t work out, they erode the good work of the rest of the portfolio, and mean that you cannot rely on the safety of the portfolio effect.? Good detective controls to monitor performance and quickly remediate are important in this situation, but in reality, the beta of these businesses will be skewed, as you cannot rely on the portfolio for protection, and a couple of bad eggs might persistently ruin your financial year, unless you change the business model to protect against this.? If you do an honest tornado diagram of the risks inherent in a sample of the items in a portfolio, you will see the downside risk skew, which should lead you to discount the portfolio effect and assume that at some point, some of these things might go wrong, an go wrong badly.?

Business model / product quality – The product/service that the business provided ultimately didn’t resonate with customers as much as it needed.

Due diligence – When acquiring a new business, research to determine all the factors relevant to performance was not done effectively.?

Economic moat – or lack thereof.? The business performance was particularly susceptible to downturns in the economic environment – i.e. the business operated in a boom/bust cyclical environment, and didn’t have protections in place to ensure that returns were protected in bust cycles.? E.g. in Australia, production of chicken meat is not as exposed to economic downturn as say luxury cars, so a chicken meat producer would have a wide economic moat, whereas a luxury car dealership might have a narrower economic moat.

Resource management – Processes and procedures around the management of contracted resources were not effective e.g. KPIs were not communicated, feedback was not delivered/actioned.? ???

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