Tuesday, June 29, 2004

A Perilous Lack of Vision

Warren Buffett has made passing reference to the unenviable position mutual-fund managers find themselves in. They are constrained by the need to show short-term (often quarterly) results, which often means that they must prematurely exit from investments that, for various reasons, have taken a turn for the worse. Conversely, they must often invest in what are clearly short-term upswings in order to make up the numbers. This results in a kind of flocking behaviour ("follow the leader"), which leads to the observed erratic, manic-depressive behaviour in the stock market that has little basis in economic reality.

This type of flocking is not limited to investors, of course. Fundamentally, it represents a kind of risk-aversion that is endemic in modern capitalist systems. This is the type of thinking that goes, "I may not achieve the best results in the long term, but at least I'll never suffer a major setback in the short term. Or at any rate, I'll be no worse off than my competitors". There is nothing wrong in principle with an avoidance of risk: I myself am one of the most risk-averse people I know. However, it becomes a problem when it begins to strangle growth and the achievement of one's potential.

The Operational Efficiency Chimera

The operational efficiency of a business can be measured by dividing its overhead costs by its gross profit. The ratio can be improved either by increasing gross profitability, or by reducing overhead costs (usually by means of retrenchments -- although executives can occasionally be convinced to give up the corporate jet, too). Since increasing profitability is usually extremely difficult, it's always tempting to focus exclusively on eliminating overhead. In moderation, this is a good exercise; but cut too deeply into the fat, and you start to hit the muscle and the bone. An amusing if not entirely valid extension to this analogy is that the fat often underlies the muscle.

It is logical then that good managers should also be asking themselves: what can I do to increase gross profitability? The answer to this varies from industry to industry. In the 'commodity' industries (steel, agriculture, general manufacturing), the answer is unfortunately "not much". Improved processes are about the only thing that will do the trick. The conclusion we should draw is that these industries should invest heavily in R&D, which can be viewed as a mini-industry in itself. R&D is more like a service industry.

Services are Different

In service industries, we run into an accounting convention that I believe is detrimental to efficient management. The problem is that service industries rely almost entirely on human capital to produce the goods. However, the cost of salaries is still recorded as an overhead cost. This makes accounting sense, but it can lead to bad decisions when managers try to treat services the same way they treat manufacturing. Basically, overhead is seen as "bad", and since services typically operate at low or even zero gross marginal cost, there doesn't seem to be much improvement to be made at that end of the system. Thus managers are compelled to cut overhead, even though this 'overhead' should properly be treated as a direct cost of production!

This brings me to the crux of my argument. The manufacturing model of accounting is inappropriate for service-type industries. The salary costs of those actually performing the work are in fact a direct cost of sales. However, the problem lies not in the accounting but in the way the figures are used to make decisions: humans providing services are assets, not expenses, and they should be treated as such.

The Human Asset

The remarkable thing about these human assets is that they do not depreciate. In fact, handled correctly, your people actually increase in value. Yet we do not see nearly enough investment in human assets -- certainly not below executive level. The trend I have noticed is that positions are hired rather than people. The candidate should be able to do X, Y and Z, and that is the end of that. This is a huge mistake. A person hired to do a job that involves thinking is an investment. You do not want such a person simply to perform mandated functions: you want them to contribute to the value of your business.

This argument is eminently reasonable, and I have never heard anyone disagree with it. Yet there is a reason why this theoretical ideal is not reflected in practice. You guessed it: risk-aversion. The problem with competent people is that you come to rely upon them. This is a risk (one might reason). What if the person leaves? What if I have to compensate him in an extraordinary fashion for his extraordinary service? Far better, surely, to rely only upon fungible minimum-standard employees, and not put my business at risk?

This line of thinking is, if you'll forgive me, rubbish. It's completely wrong-headed. Yes, competent employees are a risk. But that's what business is all about! You take a risk by investing, and you reap the rewards. If you don't invest, you'll never see a return. Imagine what we would say if a steel mill owner decided only to purchase the cheapest furnaces, on the grounds that the premier models are expensive to run and expensive to rebuild if they crack. False economy? You bet.

In Conclusion...

So what am I saying? In service industries (and, importantly, service divisions of companies in other industries), people form the bulk of the assets that are missing from the balance sheet. The money that is paid to them should be viewed as a cost of production rather than overhead cost. As in any other business, the job of the managers of a service company is to select and maintain the appropriate assets for the work in question. That means finding skilled people, and nurturing them. The more competent the better! It is absolutely a false economy to try to minimize the necessary skill levels. Trying to create fungible employees is actually counter-productive. When you attempt to treat skilled employees as interchangeable units, you are harming your business.

There is vast untapped productivity in the human asset. Ability should be allowed to flourish rather than supressed into conformity. Managing a services company is extremely difficult, because it's a lot harder to measure the performance of people than it is to make similar measurements of machines. It takes a different kind of manager, certainly, and a different kind of approach.

Unfortunately, it's taking a long time for us to become aware of the fact that providing services is not like producing steel. The attempts to fit services into the old manufacturing patterns represent a perilous lack of vision. Too much attention is paid to things that are irrelevant (fixed assets), and too little is paid to things that most certainly are relevant (human capital). This is an instance of experience letting us down: we're trying to apply a pattern that we're familiar with to a new subject, and it doesn't fit. That is why service industries, and software in particular, are so inefficient and risky. We're squeezing them in the wrong places.

What if we were to start listing our employees on the balance sheet as assets? What if their salaries were written up as costs of sales?

If you're in services, do as Apple says, and "think different".


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