A marketers explanation of Internal Rate of Return.

A marketers explanation of Internal Rate of Return.

Mar 19, 2018 | Governance, Management

 

This post should be read by marketers in conjunction with the earlier one that explains Net Present Value.

IRR partners with NPV as another tool in the investment choice toolbox. Both use as their basis, the forecasting of cashflow to make choices between investment options. While there are potentially a whole menu of influences over making decisions about investment options, cash as we know is the lifeblood of any business, and the measure least open to ‘management manipulation’, so should be in the mix.

The Internal Rate of Return, is the discount rate that would result in the net present value of a project to be zero.  In effect, you are  ‘solving’ for the discount rate that is used in the Net present Value calculation.

The discount rate best used in the Net Present Value calculations can be uncertain, we live in volatile times, and IRR is a means of calculating the rate given a set of investment parameters.

Businesses should set out to understand the rate at which the project breaks even,  so the IRR is the interest rate at which the NPV of all cash flows from an investment equals zero. Your investment break even.

IRR enables a ranking of projects by their rates of return to be done, rather than just relying on the NPV of the cash required. However, relying on IRR in isolation has a downside: it does not measure the absolute size of the investment.  A small investment might deliver a very attractive IRR, but be not as strategically attractive as a larger one that positions the business for growth. These are judgements  made outside the straight financial calculations, which are just tools to compare.

As with any mathematical modelling tool, an IRR calculation it also suffers from the ‘garbage in garbage out’ syndrome. Therefore the the most important part of the investigation is to understand and critically analyse the assumptions made, rather than just relying on the numbers Excel spits out to make the decision for you.

 

How to apply logic to the development of KPI’s

How to apply logic to the development of KPI’s

Mar 12, 2018 | Governance, Leadership, Management

‘If it matters, measure it’

There are many variations in that old saying, but it holds true. How therefore do we end up with hundreds of measures that seem not to matter?

Fear.

Fear of missing a measure that does matter, so we create metrics for every-bloody-thing to ensure that we do not miss one.

That is crap management.

Let’s think about measuring stuff that does matter, and then measuring it at the point where the decisions and actions that influence the outcome are made. This is tying cause and effect together at the point where they intersect, not looking at a range of data and wondering what happened to cause that!

How do we define what matters?

To me it is simple, if it moves the performance indicator, it matters. Clearly, the converse is also true.

Ask yourself, does the number of Facebook likes you have impact your profitability? If it does not, and I would contend it never does, so why use it as a KPI? It is simply a readily available metric that has no relevance to performance. It is what those ‘likers’ do with your information that counts, much harder to define and measure, but if you understand that, and the cause/effect chains, it just might move the performance needle and become a KPI worth measuring.

In short, behaviour determines the outcomes, so set out to measure the behaviours you need to deliver the performance you are looking for, not the other way around.

How do we measure what matters?

A measure without a target is not of much value, as we cannot see if any movement is relevant to performance. A measure should articulate the performance against which we need to move the performance needle in a strategically significant manner. This setting of targets is challenging if we do it properly. Applying a 3% increase in last year’s performance is not doing it properly, it is just extrapolating, accepting that history will repeat itself.

To measure properly, we need to consider the factors at work that will influence performance, seeking the causes, and measuring them, not just glancing at the metrics and having no idea of whether or not any movement is significant. Holy cow Batman, we just got another 5,000 likes on the Facebook page. Wow! But so what?

A further caution. ‘Sandbagging’ so called KPI’s is common in situations where there is little strategic linkage, and analysis of flow on impact. Two examples. Sales people when incentivised only by a target will be tempted to keep the targets as low as possible in order to achieve their bonuses.  Who has not seen that? Purchasing people incentivised only by purchase price will not care too much about the performance of the cheaper version they opt for, which in the factory, may corrupt the efficiency numbers, and have a far greater financial impact than the saving of a few bob on the initial purchase price.

Do not focus on averages.

Too many times I see piles of measures, taken at a high level, so that they reflect the average of a whole lot of other factors. If I have one foot in an ice bucket, and the other in the fire, on average the temperature of my feet is about right.

Nonsense.

Measure the outliers, the things that are unseen in averages in order to better manage them. For a KPI to be meaningful, it has to influence the outcome. Removing one foot from the fire will influence the average, but if I have not realised that the effect is caused by the removal of the foot in fire, I will at some point put my foot back in the fire.

I do not remember much from the statistics I did 45 years ago at university, but one of the ideas I do remember is that of standard deviation.  I recall little of the mathematical gobbledy Gook and probably do not need to any longer, as the formula is in Excel, just fill in the boxes, but I do remember what it means. (Forgive the pun).

In the normal distribution curve we are all familiar with, 68% of outcomes are within one standard deviation of the mean. These can reasonably be classified as an ‘expected’ result, given that forecasting is not an exact science, it is just a best informed guess, and the level of ‘informed’ varies hugely, depending on who has their mouth open at any one time.  95% of outcomes fall in the range of 2 standard deviations, and 99.7% fall in the range of three standard deviations. This is commonly called the ‘Rule of 68’

A focus on the unexpected, the outliers, will give you far greater leverage on the outcomes than a focus on the averages, or expected. It might lead to taking one foot out of the fire, and understanding that this is what has caused the increase in the comfort level.

 

 

 

 

 

Defining the outliers, like most things in life, can be made easier by imagery. A core piece of process improvement is defining the levels of variability, and then seeking to understand the causes of that variability. A visual way of communicating this is a performance graph that includes what you define as the limits of the variability you would consider to be ‘normal’. Commonly this is called a ‘statistical control chart’, and includes the upper and lower limits of what can be expected. Anything outside these limits needs to be investigated.

Anything inside the control limits is by definition, ‘normal’ and therefore not necessary to spend a lot of time considering. What however is worth great consideration is determining what the control limits are, where the normal becomes abnormal, which is where action must be taken. Over time, in an improvement process, the control limits will be progressively tightened as the outliers are progressively understood, so they become part of the normal, or eliminated.

 Cascade the KPI responsibility

Having any more than 6 or 7 KPI’s to manage creates a situation where we skate over the top, not able to devote the time and energy to improving the things that matter, that move the performance needle. The things that really matter will be different at each level, and in each part of the enterprise.  Therefore, constructing KPI’s relevant to each role should be a core part of the process of managing the resources of the enterprise, and especially in encouraging the behaviour we want  that will collectively, move the performance needle. Within each functional area, there will be a cascade of KPI’s that together add up to the 6 or 7 KPI’s to which the functional manager is held accountable. This is not to forget that the processes we are measuring are very often cross functional, and ignoring those cause and effect chains leads to sub optimal performance as in the purchasing/operations example noted earlier. This can be addressed by ensuring that the purchasing manager has a KPI that involves operational efficiency in the measurement.

Use the narrative in reporting.

A dashboard of a few easily understood performance indicators is terrific, it tells you what has happened, but lacks two vital pieces of information: Why it is happening in this way, and what should be done about it.

Narrative is the best way to communicate these vital factors, the core of great management, indeed, leadership. Knowing clearly what is happening is step 1, steps 2 and 3 are what make the difference between the companies that struggle to survive and those that prosper and grow. Illustrating these narratives with graphical KPI movements over time is a powerful way to illustrate the impact of performance at any level.

 

Credit Wikipedia: Rule of 68-95-99.7.

Header credit: Hugh McLeod Gaping void

 

11 practises to build a performance culture.

11 practises to build a performance culture.

Mar 1, 2018 | Governance, Leadership

Managing personnel KPI’s, performance reviews by another name, are one of the most intimidating and easy to put off tasks most managers have.

Having recently written about behaviours delivering KPI’s rather than the other way around, it may be useful to do a quick audit of your own practises, and that of your employers.

If you want to shape behaviour, you need to communicate, and more importantly, display the behaviours before they will be taken up by others in the organisation.

This is a crucially important aspect of every person in a position to manage the output of others.

In  no particular order, following are some of the things I  have observed over the years that impact positively in behaviour, and clearly the converse is also true, their absence is telling.

Start from the beginning.

The first thing a new employee should understand is the behaviour that is required, and the connections these have to the KPI’s. Start as you want to continue, as someone who is willing and able to assist the new employee to learn, and contribute to the organisation. So often I see new employees disheartened by the reality of a new job not matching the rosy descriptions given during interviews. This is a bad mistake.

Feedback is a two way street.

Recognise that giving feedback is delicate, and is also a two way street. Positively managing the performance of other people requires a relationship, and no relationship can exist without some give and take. Every employee has expectations of their boss, so you should also ensure they have the opportunity in the conversations about performance to give you feedback. When this happens as a matter of course, as a part of natural conversation, it is a really healthy sign.

Responsibility and credit.

Taking responsibility for the failures around you, but giving credit where credit is due, publicly, is one of the most powerful motivators I have seen. It builds respect, and importantly also builds a well of goodwill amongst those around you, as well as from those reporting to you.

Feedback should be cultural.

Make performance feedback part of the culture. It should not be a once or twice a year conversation,  but an ongoing part of the discourse. This is not an easy part of being a manager, it means you need to be thinking of others all the time, rather than concentrating on yourself.  Have a look through the terrific Netflix culture doc, it is a very useful guide from a business that has managed exponential growth while disrupting established marketers, and building what appears to be a great place to work. Clearly, they know something about performance management and culture that the rest of us can learn from.

Remove emotion.

Keep emotion at bay, by concentrating on facts, and demonstrable cause and effect. This is a challenging task, but emotion is the killer of constructive and mutually beneficial conversations.

Be specific about expectations, exhortations to do better are of no value unless you are able to tell  them exactly how to do better, and the metrics by which that performance will be measured.

Context.

Help people to see their work, and place in the organisation from a broader perspective than just their own little part of it. Understanding the context of a role, and the impact the performance of it has on others is a very powerful motivator.

Educate for the next job

Recognise explicitly that most people move on at some point, and that you take it as a personal challenge to ensure that when someone does move on, it is to a better, more senior job, and that you have contributed to the success that gets them there. Helping them build a career path is a part of your job as a leader and manager, and they will be grateful. When you give something of value to someone else, reciprocity kicks in, and in some way, at some time, most will repay the ‘debt’, often with interest.

See the context of peoples working lives.

Understand the patterns and drivers of the lives of those for whom you are responsible. While keeping a distance is easy, and natural, unless you understand what is going on in someone’s life outside the time they  spend as an employee, you will not  be able to understand them as well as you might, and will therefore fall short of being the perfect boss. This can be a very fine and variable line. Some may not welcome what they see as intrusion, but to one what may be intrusion, to another is genuine interest in them as a an individual.

Address the molehills immediately.

Adverse behaviour does happen, and unless called out immediately, will quickly become  accepted as ‘normal’. When you see something great, immediate recognition will drive a repeat performance, and the opposite is also true, and corrosive. Once poor behaviour becomes the norm, it is very hard to change. Nip it in the bud!

Write it down.

There are regulatory requirements, as well as good governance that relies on things being written down and recorded. Some would  say without a written record, it did not happen. Agreeing a written record with the other party goes a long way towards cementing the  changes you need.

No threat no sweat.

‘Performance review’. Just the words elicit a sweat, an impending doom, that affects the conversation. Remove the implied threat, and the conversation can be mutually constructive. Of course, there are the odd occasions where threat is an intention, but it needs to be the exception, rather than the rule.

In these fractured post Weinstein days, ‘gender politics’ may also play a role, particularly if you are a middle aged, heterosexual white guy with the power. Enough said.

Remove with humanity.

Finally, when someone has to go, do it explicitly, but with humanity. Firing someone, particularly someone with whom you have worked closely, for whom you have had responsibility, and who you might like personally, is the hardest management job there is. Do not shirk it, and do  not leave any room for ambiguity. It is not about blame, it is about both parties moving on in their own best interests. You also need to consider those that remain in employment. They will see the termination,  and the manner of it, and come to their own conclusions about how it was handled, why it was necessary, and how it may impact them. Survivor syndrome is remarkably strong and often overlooked.

What have I missed from your experience?

 

Base KPI’s on behaviour, not outcomes, for best results

Base KPI’s on behaviour, not outcomes, for best results

Feb 21, 2018 | Governance, Leadership

It is budget season, so amongst the detritus of everyday management, we have to make time for creating the budgets for the next 12 months, in Australia usually starting July 1. Hopefully, budget preparation is a normal part of the management ‘flow’ of your enterprise, where it follows naturally after a regular strategic review and preparation of operational plans. The budgets then become a financial expression of the operating plans, but sadly, it is most often not the case.

Irrespective of the procedures that dictate preparation, part of the budget process is the setting, or in most cases, the resetting of Key Performance Indicators, KPI’s.

In almost every case I see, KPI’s are all about outcomes, achievements that more often than not are recorded in the financial reports, which are an alarmingly one dimensional reflection of performance in today’s world.

Would  it not be better to set KPI’s based on the behaviours we want, which are after all the underpinning of outcomes. It is unlikely the outcomes will be favourable unless the behaviours that occur are constructive.

There are many challenges in  setting KPI’s  in this way:

It is hard to do, therefore we take the easier route

To be effective, behaviours, and specifically the behaviours we want, need to be made sustainable, part of the everyday routines,  not something that happens when the boss is watching.

Behaviors are a product of  the environment in which we exist, so the task of management is not just to mold behaviors, but too mold the context in which you want them to evolve. Commonly this gets called alignment, but almost always it implies financial alignment, rather than the broader definition that includes revenue generation activities, operations, process optimisation, and capability development I think appropriate

Behaviours are integrated into the processes of any enterprise, together they make up what is commonly called ‘Culture’. Again, these do not evolve without senior management taking control, and being seen to do so, thus enabling the processes to evolve in a direction consistent with the objectives of the enterprise.

Are the behaviours in your enterprise all contributing to the objectives, or are they disconnected, the KPI’s just a set of optimistic benchmarks dreamed up in the boardroom designed more to intimidate than motivate?

 

 

A marketers explanation of Internal Rate of Return.

A marketers explanation of Net Present Value (NPV)

Feb 12, 2018 | Governance, Management

‘What the Hell is NPV?‘ the marketer cried

Accountants seem to love to baffle with jargon, but that is not, usually, what they set out to do.

Rather , they use terms as a shorthand to describe what to them makes absolute sense, but to the rest of us, mere marketing mortals, seems like gobbledygook.

One of the ones that commonly causes headaches is ‘Net Present Value’  or NPV.

Guaranteed to put most marketers to sleep.

However, you should not sleep, way better to understand the idea in simple  terms so you have an understanding of the conversation, and can contribute in a meaningful way.

NPV  is simply one of the common methods of calculating the relative value of a number of investment choices. It recognises that money you have today is worth more than money you may have tomorrow because it can be invested,   used now, while the ‘future money’ is subject to inflation and risk.

Often the term ‘time value of money’ will be used.

It is one of a suite of calculations that can be used when sorting out which projects to pursue from a range of possibilities. It provides an objective measure that enables you to make better choices, that management challenge in a world of subjectivity, conjecture and bullshit.

Marketers should understand the principal, if not necessarily the formula, which is readily available in just about every spreadsheet application since  Visicalc. Remember that? I do, it became a marketers best friend, years before excel emerged.

The formula is relatively simple, it just looks a bit complex.

The discount rate is the rate of inflation used, plus the amount you choose to add to allow for risk.

Most businesses use a consistent discount rate that reflects their return on investment hurdle rates. For example, if the current inflation rate is 1%, and the business requires an 8% ROI, the discount rate will be 9%

The great benefit of NPV to marketers is that it uses the cash flows derived from a proposal to sort out the priority, not just the quantum of the initial investment, so  it reflects the forecast cash success over time.

For example, you want to invest $3 million in gear to launch a new product, that is forecast to deliver a net profit of $1.3 million/year for 3 years, with a discount rate of 9%.

There are a number of sequential steps to take.

  • Calculate the present value of each years net profit by dividing the net profit by (1+discount rate). In year 1, that is 1,300,000/(1+.09) or 1,192,661. The ‘1’ in the formula being the current inflation rate
  • Repeat the exercise for each subsequent year, in year 2, it would be 1,192661/(1+.09) or 1,094,184.
  • In year 3 1094,184/(1+.09) 1,033,838
  • Add the present values calculated, 1,192,661 + 1,094,184 + 1,003,838 = 3,290,683 to give you the total forecast present value of your money in three years, then subtract the initial investment to give you the net present value of the investment.  $3290683 – 3,000,000 = $290,683.

The larger the positive number the better, a negative number would indicate that the project will drain cash from the business, a positive one adding cash.

To make the choice between investment options, repeat the exercise for  each, and pick the one with the highest positive value.

Clearly, the calculation is based on a series of assumptions and forecasts, so there is a lot of room for error, but when used in a consistent manner it is a good tool to assist making difficult choices, and offers the flexibility to do some informed scenario and ‘what if’ planning.

 

 

 

 

The easy way of course is just to go to excel, and look for NPV in the formulas tab, which will give you the numbers, but not the understanding of what they mean.

Photo Credit: Bentley Smith via Flikr

How does the Amazon innovation formula keep replicating?

How does the Amazon innovation formula keep replicating?

Feb 7, 2018 | Change, Governance, Innovation, Strategy

Amazon is an astonishing company for a whole lot of reasons, but there is one that is not front and centre in most conversations I have seen and in which I have been involved. This is the means by which Amazon just keeps on innovating, genuine, disruptive innovations, time after time, at astonishingly small intervals.

Note: This link is to an expanded version of this infographic from Visualcapitalist.com

 

Amazon must have the internal processes that enable it to punch out new businesses, and business models that way a factory stamping machine pumps out widgets.

The biggest impediment to efficiency on a widget machine is the changeover times between widget sizes and internal specifications.

Quick changeover is a hallmark capability sought by manufacturing companies employing Lean thinking, and is a challenging proposition, even in a small, tightly run factory. So how does Amazon achieve it at scale in businesses as complex as it routinely disrupts.

Amazon started by flogging books, or as CEO Jeff Bezos  (apparently) liked to say in the early days, ‘we do not sell books, we make books easy to buy’

The hallmark of a successful lean implementation in a factory is that there are processes that take a prospective order through the whole ‘sales funnel’ to production, delivery, and ongoing relationship building. Lean practitioners call it the ‘Value Stream,’ the set of activities required to deliver value to the customer. These are all done the same way, every time.

The paradox is that this process stability is the foundation of innovation, you need a stable base in order to trial ideas at speed, then scale the ones that work. This is an idea sometimes hard to communicate but as fundamental as it gets to successful innovation and continuous improvement.

Amazon appears to have achieved this at scale, in a service business, typically harder than a manufacturing business to get traction.

How?

Amazon is organised just like a whole collection of independent business units, all cross fertilising, and cross pollinating each other, using (I suspect) what Ray Dalio would term ‘Radical Transparency‘.

The secret seems twofold:

  • The internal technology that Amazon uses across all its activities, is modular and scaleable.  It is in effect the machine enabling the manufacturing of Amazon widgets. This enables new businesses to be added the way you would add another coloured widget to the sales inventory of a manufacturing business. I suspect the scalability will be the source of the next round of disruptions coming to the fast moving goods retailers.
  • Each part of the business multiplies the customer impact of the ones next door, a ‘flywheel’ effect. Digital technology enables the network or ‘Flywheel’ effect to build momentum. The more eyeballs you have on one side of the network equation, the greater the value to the other side. This effect builds scale very efficiently once you have reached a tipping point, reflecting Metcalf’s law which states that the value of a network increases with the number of nodes in the network.  Amazon has created their own version of Metcalfe’s law amongst their own offerings, one product or service leading to the one next door.

Bezos has achieved something that I think will be studied for decades, and it is clear he is not stopping any time soon. The only thing that appears likely to slow the momentum is regulatory intervention. Amazon has 44% of  on line retail sales in the US, 35% of global cloud services, a market growing at 40% a year,  where AWS is bigger than the next 5 biggest combined. The list goes on. The point is, Amazon is chewing up competition everywhere, yet pays very little tax, $1.4 billion since 2008, while Wal-Mart has paid $64 billion over the same period, so in effect, Wal-mart is subsidising its greatest threat to eat its lunch. Outcomes and numbers like that will have to prod regulators into some sort of action, before Amazon (and to be fair, Facebook and Google are very similar, even more dominating in their markets)  is in a position of power so dominant that regulators cannot stop them.

Amazon, a product of the 21st century is simply outrunning the capacity of the institutions and public mind set of the 20th century by reshaping our world around us, and with our consent by unthinking compliance. They are being joined in this exercise by Google, Facebook,  Alibaba Tencent, and a few other aspirants like Netfliks, to dominate the way we think, behave and work.

Header photo Jeff Bezos circa 1998

 

Update June 2018.

Amazon bought on line pharmacist ‘Pillpack’  last week for almost a billion dollars, saw its own share price jump double what they paid at the same time industry incumbents collectively lost 10% market valuation. Jeff Bezos has signalled his interest in pharmacy in various ways for years, so this should not come as a surprise, but it seems to have done so, as the threat of Amazon had clearly not been priced into the market valuations of the incumbents.

The Pharmacy guild in Australia, one of the most powerful lobby groups in the country, should be asking themselves if they are next for the chopper.

Update August 2022.Amazon last month paid $A5.6 billion for subscription health service One-Health, which gives them a network of doctors surgeries around the US. If ever there was a huge industry mired in its own importance, removed from the needs of those it is supposed to service, and ripe for disruption, it is the US health care industry. It will be a tough nut to crack, others have tried and failed, but Amazon has the street-cred to make it happen. The ‘flywheel’ at work again.