Financial Reporting Goes Global
January 23, 2006
As business goes global, pressure is increasing for adoption of a single
set of accounting standards worldwide. In this e-mail interview, Harvard
Business School professor Gregory S. Miller discusses this trend and
India's unique position to be a leader in the international accounting
environment.
Miller and colleague V.G. Narayanan have made this case to the Institute
of Chartered Accountants of India, and wrote "Accounting Standards and
the Globalisation of Indian Businesses," which appeared in the July 2005
issue of The Chartered Accountant.
Cynthia Churchwell: What prompted you to write about globalization,
accounting standards and, in particular, Indian accounting standards?
Gregory Miller: Globalization is the major issue in determining the
future of financial reporting. As financial and product markets become
global, the need for a global set of accounting information to
facilitate global transactions has really become overwhelming. This is
clear in practice, both with the International Accounting Standards
Board attempting to pull together one set of global standards and with
the U.S. Financial Accounting Standards Board agreeing to an attempt to
converge U.S. standards with international standards. I can't say what
accounting standards will look like in ten years, but I can say that
globalization will have been a major force in determining what they are.
Given this situation, many accounting researchers and practitioners are
spending a large amount of their time considering the implications of a
set of global standards.
My work, and that of others in the area, shows that global differences
in accounting have important economic impacts. For example, in my
peer-reviewed research I have examined how global differences in
accounting impact investment around the world (we find non-domestic
investors are more likely to invest in firms with accounting similar to
that used in their home country) and in looking at whether a single set
of standards really will be applied in a consistent global manner
(cross-country accounting information becomes closer, but we still find
systematic differences in some components of the accounting output).
Findings like these indicate that the focus on overcoming accounting
differences is important. Further, while we will be able to make some
headway as we focus on the issue, it also appears that some aspects of
accounting are very "sticky," suggesting there will need to be a strong
set of actions and incentives to get us to truly comparable global
accounting.
The insights from the body of literature I just mentioned are important,
but mostly provide broad guidance on the attributes and importance of
global accounting. As V.G. Narayanan and I were discussing the work on
international accounting issues, it became clear that India was a very
interesting case of many of these forces coming together. For example,
while India's capital markets are still emerging, they have a highly
trained set of chartered accountants (CAs) who practice in India and
around the world. Further, the CAs in India have much more control over
the standards than in many other countries, where standard setting and
practice are more separated. Additionally, there is no real leader in
international accounting in Asia. Thus, India has a unique opportunity
to grab that position. When we combined V.G.'s knowledge of accounting
and institutional features in India with the research in the area, it
really became compelling to us that we should make this case to the CA
institute in India.
Q: What role do accounting standards play in the globalization of Indian
businesses, U.S. businesses, and businesses of other countries?
A: This really comes back to what makes India unique. India is having an
amazing growth spurt that has led to having global leadership in some
industries while moving forward in many other aspects of developing
globally competitive businesses. Much of their growth is driven by a
wealth of smart, hard working, well-educated individuals. In other
words, great human capital. However, they do not have fully formed
financial markets and have not been able to generate large amounts of
financial capital, particularly from international sources. This acts as
a constraint on growth. Thus, by adopting International Accounting
Standards and really becoming a leader in the field, India could lower
their domestic firms' barriers to international markets. When you think
of the human capital of all the talented CAs in India, this really is
another way to use the human capital they have to fuel economy-wide
growth.
Globalization is the major issue in determining the future of financial
reporting.
Compare that to the U.S., which has a strong pool of human capital but
also the world's largest financial capital markets. You can see that the
U.S. has less reason to feel the need to move quickly to IAS. However,
even the U.S. is feeling pressure to have similar standards to be a
fully functioning part of the global economy.
For an in-between example, think of Europe. The EU decided long ago that
creating one financial market across the Union was crucial to allowing
true coordination within the Union. They quickly realized that having
one set of accounting was a necessary component in making the "one
market" concept work. Thus, they have required adoption this year. This
is an example of moving towards globalization to create the scale needed
for business today.
Q: Is there a benefit of International Accountings Standards being
recognized at the national level rather than by voluntary adoption by
individual companies?
A: Definitely. If you adopt the standards nationally then all the
regulators, auditors, analysts, management teams, etc. know that they
have a single set of standards to understand and implement. This allows
all of those entities to focus resources on making that single set of
standards work in the intended manner. Without that strong knowledge
base, even well-intentioned practitioners just may not have the skill
set to properly implement the standards. In the study of international
adoption of standards I mentioned previously, one of the things we find
is that oversight by a regulator who is actively involved with the
standards (in our case the SEC) greatly increases the comparability of
implementation across countries. So you can see that country-level
adoption could be both economically more efficient and make the
accounting much more credible to outsiders who need to rely on it.
In addition to the domestic scale issue, there is also an international
scale advantage. As discussed previously, my research shows that once
outsiders realize that understanding the accounting is much less of a
barrier, they are more likely to invest in a company. By adopting at a
country level, this accounting decision becomes very visible to
outsiders. If only individual companies adopt, they then must also
attract the attention of investors to let them know that the company is
using the familiar form of accounting. Add to that the credibility
issues from above, and you can see the advantage an individual firm gets
from countrywide adoption.
Finally, countrywide adoption allows the nation more ability to
influence the standard-setting process. We have recently seen Europe
push for a stronger position in influencing the IASB based on being the
largest user of the standards. By adopting as a country, it is much
easier to push for a board position or some other method of impacting
standard setting.
Q: Have you spotted any country or regional trends in the implementation
of IAS?
A: Europe is really the leader right now. The EU decision to adopt IAS
(the actual standards are now called International Financial Reporting
Standards, or IFRS) pushed them to the forefront in this area. After
that, individual countries such as Australia and Canada announced they
would be converging with IAS soon. By this point, many countries have
indicated they intend to be on IAS within the foreseeable future, so it
has really picked up steam.
I think most [global managers] would love to have one set of solid
accounting standards, rather than having to deal with "translation"
issues.
There is even some evidence of impact in the U.S., which has
traditionally been very firm on sticking to GAAP-Generally Accepted
Accounting Principles. The IASB is working closely with the FASB to
converge the U.S. and IAS standards. The Securities and Exchange
Commission has even considered letting foreign companies list on U.S.
exchanges using IAS.
Q: What position do you encourage the Institute of Chartered Accountants
of India to take on the adoption of IAS by Indian businesses? Why is
this important?
A: V.G. and I recommend that they announce a desire to fully adopt IAS
countrywide. They could have a tiered actual adoption, so the larger
international companies adopt first and smaller companies get a little
more time to adjust. Since many of the large companies already provide
IAS-based information, the first step could happen quickly.
We believe that only full adoption of IAS will give the benefits we
discuss above. That is, it will make the basis of accounting clear to
international investors and also position India and its CA institute to
be one of the important forces in shaping IAS. There is a narrow window
for the second benefit; if the institute waits too long they will not be
able to influence the direction of IAS. Further, while they currently
have what is probably the largest and strongest set of trained
accountants in Asia, China is rapidly moving to get on board with IAS.
That makes the window even tighter.
Q: Are there any other changes in accounting standards and practices
you've identified that provide further evidence of a globalizing trend?
A: Between the adoption of IAS in Europe and the U.S. consideration of
allowing IAS for listings here, I think it is clear that globalization
has arrived. Discussions with management at top global companies from an
operational perspective also make it clear that they feel they are
really financially global-many are listed on exchanges in multiple
countries and undertake international investor relations
programs-including visits by top management around the globe. I think
most would love to have one set of solid accounting standards, rather
than having to deal with "translation" issues. Absent that single set of
accounting standards, more and more companies are using whatever
accounting choices they have within their current standards to make
their accounting as comparable to their international competitors as
possible. We also have observed an increase in the number of firms
providing reconciliations between their accounting numbers and U.S. or
IAS GAAP. All of this suggests that the market supports the push for a
global set of standards-the issue is what that set of standards should
really look like.
Q: Has anything you observed in the last few years about accounting
standards and the international marketplace surprised you?
A: I have been surprised by the speed with which IAS/IFRS was overhauled
once the EU decided to adopt the standards. I truly did not think the
board would be able to pull it off. They really should be commended for
the speed with which they created a high quality and coherent set of
standards.
I also have been surprised about the push for fair value accounting.
While the FASB also is heading in this direction, the IASB really led
the push. It is a major change in our basis for accounting and I think
business leaders are just catching on to the dramatic impact on
financial statements. I think this is actually likely to lead to a
heated debate internationally and in the U.S.-I am still not sure the
standard setters will win out on this issue. There is a lot more that
could be said in that area, but since it is not a purely international
issue I will leave it at that.
Q: What are the latest research projects you are working on?
A: In addition to my ongoing international work, I am looking into how
firms use investor relations to impact the visibility and understanding
of their firms. For example, I have a new study that looks at whether
investor relations can impact firm visibility for smaller U.S. firms.
There we find that investor relations can lead to increased
institutional investing, analysts following, share turn, and even have
some valuation impact. That work was inspired by some of the
international work that indicated how important visibility is in making
firm communication work. I also am working on a few studies that look at
the role of the media in disseminating and interpreting financial
information. The media has been largely ignored in studies of financial
information intermediaries. Given the importance of the media in
information flows, I believe this is a ripe area for study.
Of course, there are also political issues and disagreements that are
slowing the progress of the IASB. The IASB has had problems getting some
standards through in Europe. They recently had to withdraw guidance on
hedging because some large countries, such as France, said they would
not require it. Further, there has been a strong push back from European
managers who feel the new IFRSs are too "ivory tower." This has forced
members of the IASB to have meetings with these executives to better
understand their concerns.
I think a lot of this is due to growing pains as the IASB truly becomes
an important standard setter in the world. The requirement that firms
use IASB has really pushed the board into the spotlight. Before IAS was
widely mandated, they were able to make rules without that much outcry.
Now they are learning how hard it is to balance the needs of all the
constituency groups. These are the same issues FASB has long faced in
the U.S. (for example, stock option accounting), and I think we will see
that the IASB will find itself dealing with more and more of these
items.
Cynthia D. Churchwell is a business information librarian at Baker
Library, Harvard Business School, with a specialty in the international
economy.
:::::::::::::::
How to Raise Your Firm's Financial IQ
January 16, 2006
We all live and die by the numbers-but do we really understand what they
mean? Here's how managers can help all employees understand cash flows
and liquidity ratios. From the new book Financial Intelligence.
by Karen Berman and Joe Knight with John Case
If your goal is to have a financially intelligent workplace or
department, your first step is to figure out a strategy for getting
there. We don't use the word strategy lightly. You can't just give a
one-time training course or hand out an instruction book and expect
everyone to be enlightened. People need to be engaged in the learning.
The material needs to be repeated, then revisited in different ways.
Financial literacy needs to become part of a company's culture. That
takes time, effort, and even a little monetary investment. But it's very
doable. We'll outline three approaches-not mutually exclusive-that we
have seen work.
Tools and techniques
The following tools and techniques hardly constitute an exhaustive list.
But they are all approaches that you can implement on your own fairly
easily.
Training (over and over)
Start by putting together three short training sessions. We don't mean
anything fancy: even a PowerPoint presentation with some handouts works
fine (though we would caution you that PowerPoint isn't always conducive
to lasting learning!). Each session should last between thirty and sixty
minutes. Focus on one financial concept per session. Joe, for example,
conducts three one-hour courses at Setpoint-on the income statement, on
cash flow and project finance, and on the balance sheet. Depending on
your situation, you might look at gross margin, selling expenses as a
percent of sales, or even inventory turns. The concepts should be
relevant to your team's job, and you should show people how they affect
the numbers.
When the numbers are out there for everyone to see, it's tough for
people to forget or ignore them.
Offer these classes on a regular basis, maybe once a month. Let people
attend two or three times if they want-it often takes that long for
folks to get it. Encourage 100 percent attendance among your direct
reports. Create an environment that tells the participants you believe
they are an important part of the success of the department and that you
want their involvement. Eventually, you can ask other people to teach
the class-that's a good way for them to learn the material, and their
teaching styles might be different enough from yours that they're able
to reach people you can't.
Weekly "numbers" meetings
What are the two or three numbers that measure your unit's performance
week after week and month after month? What are the two or three numbers
that you yourself watch to know whether you are doing a good job as a
manager? Shipments? Sales? Hours billed? Performance to budget? Chances
are, the key numbers that you watch relate in some way to your company's
financial statements and hence ultimately affect financial performance.
So start sharing those numbers with your team in weekly meetings.
Explain where the numbers come from, why they're important, and how
everybody on the team affects them. Track the trend lines over time.
You know what will happen? Pretty soon people will begin talking about
the numbers themselves. They'll start figuring out ways to move the
needle in the right direction. Once that begins to occur, try taking it
to the next level: Forecast where the numbers will be in the coming
month or quarter. You'd be amazed how people begin to take ownership of
a number once they have staked their credibility on a forecast. (We've
seen companies where employees have set up a betting pool on where a
given number will be!)
Reinforcements: scoreboards and other visual aids
It's fashionable these days for corporate executives to have a
"dashboard" on their computers, showing where business's performance
indicators stand at any given moment. We always wonder why operating
units don't have the same thing out in the open for all employees to
see. So we not only recommend discussing the key number or numbers in
meetings, we also suggest posting them on a scoreboard and comparing
past performance with present performance and future forecasts. When the
numbers are out there for everybody to see, it's tough for people to
forget or ignore them. Remember, though, that small graphs can be easily
ignored-and if they can be, they will be. As with your dashboard, make
sure the scoreboard is clear, straightforward, and easy to see.
We also like the visual aids that remind people how the company makes
money. They provide a context for the day-to-day focus on key numbers.
Our own company has developed what we call Money Maps, illustrating
topics such as where profits come from. . . . The map traces the entire
business process at a fictional company, showing how much of each sales
dollar goes to paying the expenses of each department, and then
highlighting how much is leftover profit. We customize them for our
clients, so that everyone can see all the operations in their companies.
But you can even draw maps and diagrams yourself, if you know the
material well enough. A visual is always a powerful tool for reinforcing
learning. When people look at it, it reminds them of how they fit into
the big picture. It's useful as well. One company we know of put up two
copies of the same map. One showed the company's target numbers-what its
best branch would do. On the other, managers wrote their own branch's
actual numbers. People could see for each critical element how close
they were to, or far away from, the best branch's performance.
Teach those basics in a way that ensures that no one is embarrassed
about what they didn't know.
In all of these approaches, you have to remember a few key precepts that
will have to do with the way adults learn. Probably the most important
precept is to involve them in the learning. Adults learn least well if
lectured to; they learn best if they are doing it themselves. So after
you give them the basics, ask them to do the calculations, discuss the
impact, and explain the meaning. We bet you'll hear some amazing things,
like new ideas for how to reduce downtime or improve cash flow. Adults
learn especially fast when they see a reason to. If they understand the
big picture-and if they understand how what they're learning connects to
their job, their impact on the company results, and their own financial
situation (e.g., job security, the chance for raises)-they'll pay close
attention. Just be careful not to make assumptions about what they
already know. (Managers often assume their team members know more than
they really do.) Instead, teach those basics in a way that ensures no
one is embarrassed about what they didn't know. Keep the teaching
tightly focused, kept it fun, and remember, don't try to make them into
accountants!
Of course, if you are really ambitious, this could become an
organizational initiative. You'll need a high-level sponsor (such as
your CEO or CFO, or an operational VP), and you'll probably need some
outside help to develop and deliver the education. But if the culture is
right in your company, the opportunity for improvement is huge. At one
company we worked with, part of the education process included a change
in language (which can be tremendously important in any culture change).
It started at one location, where the regional manager began calling
employees business partners. These new business partners took the change
seriously, mostly because there were other things going on that told
them management truly saw them as partners, and began calling each other
business partners. Before long they had even changed the parking lot
signs, so that the word employee effectively disappeared from the
location. Then other locations began to catch on, and soon the president
of this national company was talking about business partners in the
internal newsletter. The final piece came when a large customer wrote a
thank-you to a vice president, calling the employees of this company
business partners. The new language, in turn, was reflected in greater
commitment, more involvement, and better results.
Excerpted by permission of Harvard Business School Press from Financial
Intelligence: A Manager's Guide to Knowing What the Numbers Really Mean
by Karen Berman and Joe Knight with John Case. Copyright 2006 by
Business Literacy Institute, Inc. All rights reserved.
[
<http://harvardbusinessonline.hbsp.harvard.edu/b01/en/common/item_detail
.jhtml?id=7642> Buy this book ]
Karen Berman and Joe Knight are the owners of the Los Angeles-based
Business Literacy Institute and have trained managers at many leading
organizations.
John Case has written several popular books on management.
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Low Prices = More Customers? Not Always
May 1, 2006
Wal-Mart, Southwest Airlines, and Dell Computer are famous for their low
prices. But before you follow their lead, consider the downside of
cutting prices. An excerpt from the new book Manage for Profit, Not for
Market Share.
by Hermann Simon, Frank F. Bilstein, and Frank Luby
By arguing against price cuts as a form of competitive reaction when you
perceive a competitive threat, we hope to convince you to plan your
responses more carefully and consciously by thinking through the
consequences first. In some situations, your competitor may force you to
make this decision, because it has cut prices itself or entered your
market at a much lower price point.
But in other situations, companies decide to cut prices voluntarily,
with no prompting from competitors and-as we show in this section-hardly
any prompting from customers either. They decide to cut their prices out
of sheer devotion to the idea that lower prices will revive their
customers' wavering devotion and ultimately make the company better off.
To defend the cuts, they cite changes in the competitive landscape, the
convictions of upper management, a willingness to share cost savings and
productivity improvements with customers, and the passage in their
Economics 101 textbook that said lower prices result in higher volumes.
Because price cuts seem to offer the easiest way to lavish special
treatment on customers, companies find the temptation hard to resist.
But resist they should. Proactive price cuts don't make you different,
nor do they make you better off. They make you poorer, unless you have
the evidence, the data, and the math to prove otherwise.
You run a company, not a charity.
This holds true regardless of how you cut prices. You can cut them
through outright price reductions, by offering coupons or cash-back
incentives, and by heaping services upon your customers in order to
clinch a deal or cling to an existing customer relationship. The people
making these decisions defend them with platitudes like "The customer is
always right" or "We always go the extra mile." Or they rattle off
magazine covers that sing the praises of Wal-Mart, Southwest Airlines,
and Dell Computer. The argument seems straightforward: If you read that
Sam Walton and Michael Dell became billionaires by selling products at
bargain-basement prices, why can't you do the same thing in your
business?
The reason you can neither quickly nor easily replicate the success of
Wal-Mart, Southwest Airlines, and Dell Computer is that they have
achieved a cost advantage so large that no company could easily rival
them. They also baked this advantage into their business model from Day
One. There can only be one cost leader in the industry. To have
Southwest's or Wal-Mart's ability to offer low prices, you would need a
significant and sustainable cost advantage. We doubt that you have that
advantage now, nor will you achieve it in the short term, if ever. If
you operate in a mature industry in which competitors offer similar
products based on similar technology and inputs, it may even be
impossible for any company to achieve more than a slight cost advantage.
And even if you had that ability, why would you use it? Cutting prices
almost always amounts to a huge transfer of wealth from corporate
stakeholders to customers. You run a company, not a charity. But you
show your charitable side when your decision to cut prices reflects
entrenched political or philosophical motives, not objective ones. The
following case shows how some straightforward math could have prevented
a company from making a highly publicized price cut that backfired.
Case study
Issue: Whether to cut prices
Company: Universal Music Group
Product: Compact discs
Source: Analysis of publicly available information
Universal Music Group (UMG), which controlled roughly one-third of the
North American market for recorded music, announced in September 2003
that it had cut the suggested retail prices and wholesale prices of
compact discs by 25 to 30 percent.
<http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 12 It cited consumer
research that showed a strong preference at a price point well below its
current price levels. It had also concluded that the threat of online
piracy not only had persisted, but had fundamentally changed the way
certain customers segments buy music.
None of its competitors responded with similar price cuts (a very
prescient reaction!), so UMG was free to observe just how strongly a
price cut will drive consumer demand. UMG cut the wholesale prices for
most of its artists' compact discs to $9.09 from $12.02 to bring people
back into the music stores. The goal of this initiative, called
JumpStart by the company, seems to have been to provide customers with a
clear incentive to return to the traditional way of buying music.
One commentary said that UMG's decision "seems less a savvy attempt to
fight back and more a last--ditch effort to avoid losing any further
ground." <http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 13 Following
the price cut, UMG would have needed to ship 33 percent more CD units
just to maintain the same amount of revenue. Achieving the same amount
of profit presented an even greater challenge. Depending on what
assumptions you make about variable costs, UMG would have needed to sell
between 45 and 55 percent more CDs to break even. Where was all the
customer demand before the price cuts? Can a lower price point really
make that many artists that hot? You might argue that UMG would have
seen lower profits anyway, if it had done nothing. But even when you
take the "do nothing" scenario with a volume decline into account, UMG
would have been much better off without the price cuts.
UMG also fell victim to the law of unexpected consequences. In our
experience, managers often neglect to ask the question of whether their
price changes will contaminate their future dealings with distributors
and customers. Nor do they ask how someone could use their price cut as
a weapon against them. The New York Times reported that the cut in
suggested retail prices, combined with a less steep cut in wholesale
prices, could cause retailers to shift shelf space away from CDs to
other products. <http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 14 At
the time of the price cuts, Wal--Mart had already planned to reduce the
space it devoted to music by 15 percent because of slow sales and low
profits, the story said. UMG also shifted its marketing dollars away
from in--store promotions and toward advertising directly to consumers.
This move could accelerate the demise of smaller and specialty chains.
These developments are rather ironic when you consider that Doug Morris,
Universal Music's CEO and chairman, said upon announcing the price cuts
that "we are making a bold move to bring people back to music stores."
<http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 15
Finally, exactly whom was Morris trying to lure back into the music
stores? You might think it is the old Napster--Kazaa crowd, which came
of age by downloading music for free and could be defined as the fifteen
to twenty--four age group.
But according to the Recording Industry Association of America (RIAA),
that demographic group accounted for only 25 percent of all music
purchases, down from 32 percent in the early 1990s. The age group
thirty--five and older accounts for nearly half of all purchases (45.2
percent), up from roughly a third (33.7 percent) a decade earlier.
<http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 16
If nearly half of all music buyers in the United States haven't seen a
high school classroom in almost twenty years, these are probably not
people who have abandoned retail stores. Instead, these are the same
people who pay hundreds of dollars for Bruce Springsteen or Rolling
Stones tickets. . . . They have a proven willingness to pay for music.
A few months after the price cuts, UMG executives "conceded that the
price--cut program has not yet been successful."
<http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 17 Instead of boosting
unit sales and bringing customers back into music stores, the price cut
appeared to have no effect at all. Universal's market share in both new
releases and overall had actually fallen slightly.
After waiting almost a year for its original plan to work, UMG
"partially retreated from many of the price cuts."
<http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 18 The company
originally expected JumpStart to boost volume by 21 percent. It achieved
that only for "carryover" CDs, or those on the market for more than
eight weeks but less than two years. That segment grew by 27 percent in
volume. New releases, though, grew by only 5.8 percent, and sales of
older CDs by just 3 percent. UMG officials said that the plan did not
work because retailers did not cooperate as expected by passing on the
price cuts.
What other alternatives did UMG's Morris have? He had several viable
ones. He could have raised prices indirectly. Sony Music, one of
Universal's main rivals, has kept CD prices steady, but has reduced the
number of tracks on some discs. On a per--song basis, this amounts to a
price increase. Howard Stringer, at that time the chairman and CEO of
Sony Corporation of America, said that consumers actually prefer fewer
tracks on each CD, and added that putting fewer tracks on a CD could
speed up the next release by the artist.
<http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 19 Although this
reflects a price increase-customers get less for their money and spend
more often-it does not hurt them as long as the artist remains popular.
This move reflects a return to the way record companies released albums
decades ago. In the 1960s, rock--and--roll bands released smaller albums
more frequently than they do today.
UMG could have raised prices directly. Had Morris mimicked AOL's
approach and raised prices directly, we would argue strongly that he not
only would have generated continued strong revenues from older music
buyers, but also would have made his business more attractive to
retailers.
The burden of proof must rest with the advocates of the price cut or
loyalty incentive.
Finally, UMG could have used a preference--based segmentation instead of
taking a shotgun approach with the price reduction. As the results
suggested, price cuts did make sense to some degree for carryover CDs. A
strategy of "Price cuts for everybody!" does permanent damage to your
price integrity as well as your profitability. Porsche's CEO Wendelin
Wiedeking defined price integrity and summarized its importance in
Automotive News. "Once you have sold a car with high rebates to a
customer, he comes back and wants the same deal again. You'll never be
able to make this customer happy, because he will say your pricing is
wrong." <http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 20 But sometimes
even Porsche carefully uses incentives to reduce inventories. The trick
is this: Most people don't know about them. For several months, Porsche
offered $2,000 to $3,500 cash rebates on 911 and Boxster models. But it
offered these incentives only to current Porsche owners and never
advertised them. <http://hbswk.hbs.edu/item_popup.jhtml?id=5314> 21
When momentum in favor of a price cut or loyalty incentive grows within
your company, take a "guilty until proven innocent" approach. The burden
of proof must rest with the advocates of the price cut or loyalty
incentive. Their proof must have hard profit numbers to support it, not
just political weight or philosophical conviction.
Summary
You should not overindulge your customer. Instead, make sure that you
extract fair value for what you deliver. Aggressive and acquiescent
actions hinder your own efforts to pursue higher profits. [C]ustomer
giveaways, value attacks, and aggressive price cuts represent a huge
transfer of wealth from you to your customers.
Value attacks occur when you provide customers with increasingly better
quality, but fail to charge for it adequately. Loyalty programs make
sense only when competitors cannot easily duplicate them, which means
they cannot provide the same benefits to the same degree. Even then, you
need to do the math to make sure the investment in loyalty programs
earns a sufficient return.
Price cuts make sense only when they earn you higher profits. Most
don't. When the Toronto Blue Jays lowered some prices [. . .], they had
hard analyses to show that the lower prices in certain sections would
earn them more money. It is unlikely that Universal Music Group had
similar analyses in the case in this chapter.
Take a "guilty until proven innocent" approach when someone suggests
that you offer a customer giveaway, make a value attack, or cut prices.
The risks to your profit are too great.
Keeping your team on the path to higher profits requires more than
rhetoric. It demands the alignment of goals across the organization,
with incentives to cement that alignment.
Excerpted by permission of Harvard Business School Press from Manage for
Profit, Not for Market Share: A Guide to Greater Profits in Highly
Contested Markets. Copyright 2006 Frank F. Bilstein, Frank Luby, and
Hermann Simon. All rights reserved.
[
<http://harvardbusinessonline.hbsp.harvard.edu/b02/en/common/item_detail
.jhtml?id=5267> Buy this book ]
Hermann Simon is founder and chairman of Simon-Kucher & Partners
Strategy and Marketing Consultants (SKP) in Germany. Frank F. Bilstein
and Frank Luby are partners in SKP's Boston office.
:::::::::::::::
"Revenues are Good, Costs are Bad" and Other Business Myths
May 1, 2006
Jonathan Byrnes (HBS DBA '80) writes The Bottom Line, a monthly column
that details innovative methods for increasing profit from an existing
business without costly new initiatives.
by Jonathan Byrnes
Precise thinking and business discipline are essential for business
success. Yet, for too many managers in too many companies, "self-evident
truths," that really are vague generalities, get in the way. I call
these "business myths." I'll draw on material from previous columns I've
written here to expose ten of the worst offenders.
1. Revenues are good, costs are bad
This is the biggest myth of all. The truth is that some revenues are
very profitable, and some are very unprofitable. If you look carefully
at the net profitability of virtually any company, using a technique I
call profit mapping, only 20-30 percent of the company by any measure
(customers, products, orders) is profitable, while 30-40 percent is
unprofitable, and the remainder is marginal.
By focusing on average, or aggregate, profitability, you lose this
essential fact, along with the opportunity to radically increase
profitability at very little cost using sharply targeted measures.
Because most sales compensation systems are based simply on revenues,
most companies are doomed to carry significant embedded unprofitability.
What about costs? If all revenues are viewed as equally desirable, it
follows that all costs are uniformly bad. Thus, most cost reduction
programs are broad and across the board. In fact, the very profitable
portion of your business can support the extra expenditures needed to
lock in and grow that portion of your business. But this is usually
precluded because the unprofitable business absorbs unwarranted
resources. The danger is that competitors can identify and pick off your
best business by focusing their resources very selectively.
2. We should give our customers what they want
This myth goes to the heart of how you define your business. You should
give your customers what they need, which often is different from what
they want. What your customers want is usually defined by their current
way of doing business; what they need usually moves them forward and
enables them to change and improve their business.
Your ability to move a customer to a new and better way of doing
business will make you an essential strategic partner, and not just a
substitutable vendor. This is how you leapfrog your competitors and lock
in lasting advantage. You can discover real customer needs, and new ways
to create value, by spending time with the customer and employing
powerful tools like channel mapping.
Often, a customer will not immediately see its real needs, and both
lower-level purchasing people and your own sales reps can resist change.
There are, however, effective measures that you can employ to sell and
manage the change within the customer.
3. Sales reps should sell, operations should fulfill orders
In transactional account relationships, where you are responding to
one-off customer needs, this distinction holds true. But in relationship
selling, operations has a critical role, both in the initial sale and on
an ongoing basis. Important companies in industry after industry are
reducing their supplier bases by 40-60 percent. The suppliers that
remain see huge market share increases, while others see big losses. The
key factor that allows a supplier to remain is the ability to increase
the customer's profitability on the supplier's products by employing
vendor-managed inventory, co-design, and other intercompany operating
innovations. Here, the operations team is critical to successful account
retention and revenue growth.
4. All customers should get the same great service
In most companies, if you try to give all customers the same great
service, you wind up in a syndrome in which service declines and costs
spin out of control. When this happens, management has trouble
rebalancing the supply chain: The objectives swing back and forth
between cost and service like a pendulum. One quarter, management
focuses on reducing inventories because costs are too high; the next
quarter, they push for increased inventories because "the customers are
screaming."
You should give your customers what they need, which often is different
from what they want.
The answer is service differentiation, a process in which you set
different order cycle times for different customers and products.
Typically, customers are divided into core and non-core categories,
according to sales volume, profitability, and loyalty. Products are
similarly divided into core and non-core categories according to sales
volume, profitability, criticality, and substitutability.
When you break your customers into these four groups, it turns out that
each group can best be served with a different supply chain, each with
finely tuned service and cost characteristics. The key is to make
different but appropriate order cycle promises to different customers
for different products, but always to keep the promises you make.
5. Supply chain integration is a great goal
I recall seeing a presentation depicting the stages of supply chain
evolution. The stages progressed from primitive arm's-length
relationships to sophisticated, fully integrated channels. The clear
implication was that the latter was the ideal to which all supply chains
should aspire. This is ridiculous.
The proper degree of supply chain integration should reflect a variety
of factors, including channel economics, customer willingness and
ability to innovate, loyalty, and customer-supplier strategic alignment.
For example, if you created a simple 2x2 matrix with customer importance
on one axis, and customer willingness and ability to innovate on the
other, you would find that the correct degree of supply chain
integration depends on the quadrant the customer is in. Because
companies have finite resources, and supply chain integration is a very
intense relationship, it is necessary to be very selective and tailor
the degree of supply chain integration to the account relationship.
6. If everyone does his or her job well, the company will prosper
In a stable situation, in which customer needs are known and unchanging,
and markets are relatively homogeneous, a company can set policies for
each functional area that managers can carry out for a period of time
without much change. This was the situation that most companies faced in
the Age of Mass Markets, decades ago.
But the world has changed enormously for most companies. Today,
companies face increasingly heterogeneous markets, and they form very
different relationships with different customers. In this situation,
which I call the Age of Precision Markets, what one manager does has a
huge impact on other managers, and managers need to have overlapping
responsibility.
For example, if a supply chain manager works hard to bring inventory
costs down by 10-20 percent on a product, and the product is
unprofitable, should the supply manager feel successful? The answer is
that his or her "job" has to extend beyond traditional cost control to
encompass asset productivity, which encompasses both costs and revenues.
Both the supply chain manager and the sales and marketing managers
should feel joint responsibility for the profitability of each piece of
the company. Unless they act together, the interactions between their
functions will almost inevitably lead to high levels of embedded
unprofitability.
You have to define the "job" properly in each situation in order to have
any chance that someone might do it well, and this definition is a
rapidly moving target. The best execution will fail if the managers are
not executing what needs to be done.
7. If you are promoted, you should keep doing what brought you success
This is the natural inclination of many managers. However, this is
exactly the wrong thing to do when you are promoted. In many companies,
managers at all levels manage "a level too low." They focus on
micromanaging their subordinates, who often have their old jobs. Rather
than teaching the subordinates and focusing on helping the subordinates
improve their work processes, they force the subordinates to spend an
inordinate amount of time preparing for a "grilling" on their operating
performance.
This causes two problems. First, the subordinates lose the opportunity
to learn and grow. Second, the manager fails to accomplish the key
components of his or her new job.
Leading companies are great because, no matter how good they are, they
are desperate to get better.
Simply put, first-line managers should operate the company. Directors
should coach the managers and spend an equal amount of time working with
their counterpart directors in other functional areas to ensure that
each piece of the business is productive and profitable. Vice presidents
should coach the directors and spend the majority of their time defining
and developing the company as it will need to be in three to five years.
When everyone focuses only on the day-to-day, the opportunity cost from
embedded unprofitability and failure to position the company for the
future is enormous.
8. Business cases can drive significant change
The business case process is a key component of the resource allocation
process in most companies. If a manager wants to create a new
initiative, he or she assembles a request for resources, which includes
projected benefits and projected costs. If the likely return is high
enough, the initiative will be funded.
Business cases work well in well-understood situations where both costs
and benefits can be predicted. The problem is that many of the most
important strategic initiatives move a company into uncharted territory.
These investments require a very different decision process, one that
involves funding market experimentation without a clearly defined stream
of returns.
I recall working with a number of leading companies in the early days of
PCs, cell phones, and the Internet. All of these now-huge markets were
relatively small and undefined at the time. Investments to probe these
markets and learn how to accelerate their development had great
difficulty passing muster in the rigorous, traditional business case
processes. Instead, in many cases, new competitors captured enormous
market share from incumbents.
9. Big changes can't be done without crisis
Large-scale change in advance of crisis is one of the most challenging
problems a top manager can face. Resetting the fundamental way a company
does business requires a completely different management process. An
effective process for managing large-scale change can be derived from
successful companies' experiences and from observing change management
in fields as diverse as the development of scientific theory.
Successful change management before crisis has four cornerstones. First,
the top manager must present clear evidence that without change, crisis
will occur. Second, he or she must develop a clear picture of what
success looks like, because a company will only move toward a concrete,
detailed, believable new way of doing business that solves the old
problems and creates new advantage. Here, strategic market investments
like limited-scale showcases to discover and demonstrate new ways of
doing business can be extremely effective. Third, the top manager must
be relentless and unwavering in advocating the need for change and the
effectiveness of the new way of doing business. Fourth, as in the
process of climbing a large mountain, the organization needs a set of
base camps in the change process. These make change digestible, allow
managers to acclimate to new ways of doing things, and enable different
parts of the organization to catch up with each other.
Even in this context, large-scale change is not at all linear. The
organization probably will resist change for a time, then suddenly it
will lurch forward as a critical mass of managers change their attitudes
and influence each other, then it will remain stationary for a time,
then lurch forward again. This is why well-thought-out base camps are so
important for managing large-scale change. Contrast this process with
the business case process discussed earlier.
10. Don't change a good thing
"If it ain't broke, don't fix it" is management at its worst. Leading
companies are great because, no matter how good they are, they are
desperate to get better. Lagging companies are most often complacent and
self-satisfied, and that's why they stay behind. When great managers
have a lead, they step on the gas.
Successful management is reinforcing. Leading companies are not just
looking for change, but also their managers get acclimated to constant
change and become expert at managing progressive change. This
environment attracts creative, disciplined managers, and together it
creates a virtuous cycle. The more they change, the more they can
change, and the more they do change.
Can a lagging company become a leader? Certainly, but this requires
considerable leadership from the top management team, and a
well-defined, disciplined program for large-scale change in advance of
crisis. Note that this is not continuous improvement, but rather
disruptive, discontinuous change.
Beyond mythology
Every company has enormous potential waiting to be unleashed: a
potential for enhanced profitability, for accelerated growth, for
renewing change. The key to achieving this potential is precise thinking
and business discipline on the part of every manager, particularly those
at the top.
The ten business myths I discussed in this column are not really wrong,
they are imprecise enough to be misleading. And this is what creates so
much unrealized potential in company after company.
By moving beyond business mythology, you can develop a systematic
program of relentless business improvement and renewing change.
See you next month . . . here and at my Web site!
Copyright 2006 Jonathan L. S. Byrnes.
Jonathan Byrnes is a senior lecturer at MIT and President of Jonathan
Byrnes & Co., a focused consulting company. He earned a doctorate from
Harvard Business School in 1980 and can be reached at
<mailto:jlbyrn***@m*****.edu> jlbyrn***@m*****.edu. Please see his Web site
<http://mit.edu/jlbyrnes> http://mit.edu/jlbyrnes and join a discussion
forum on his articles and other topics of interest.
::::::::::::..
What Companies Lose from Forced Disclosure
May 1, 2006
Increased corporate financial reporting may benefit many parties, but
not necessarily the companies themselves. New research from Harvard
Business School professor Romana Autrey and coauthors looks at the
relationship between executive performance and public disclosure.
by Ann Cullen
Increased financial disclosure standards on such issues as executive
compensation should provide more useful information for investors,
policy makers, and regulators. But do the companies themselves benefit?
What researchers are now discovering is that increasing levels of
mandatory disclosure have unforeseen consequences on executive
performance and may work against the interests of employers.
Romana Autrey
Romana Autrey, an assistant professor at Harvard Business School,
recently completed two working papers on this subject in collaboration
with colleagues from the University of Texas at Austin. Her other
research examines the design of performance measurement systems and
incentive contracts for rewarding teams and channel partners.
In short, this research explores the idea that career concerns,
influenced by disclosure requirements, may direct the actions of
executives, sometimes against the interests of the employer. Why?
Financial disclosures are read by labor markets, that is, potential
future employers. An executive who has an interest in career advancement
may take actions that look good in mandated disclosure but might well be
against the overall interests of the company he or she works for.
Career concerns occur whenever employees take into account the impact of
their current actions on their future career.
The results of the research suggest that financial disclosures have
implications for the debate over whether firms should make executive
compensation more transparent. The work also provides insights into how
firms can create employment contracts that are in step with company
goals.
This e-mail interview is based on two working papers by Autrey and
colleagues Shane Dikolli and D. Paul Newman: "Career Concerns and
Mandated Disclosure," a HBS Working Paper from March 2006; and
"Aggregation, Precision, and Contracting with a Long-Horizon Agent in a
Multi-Task Setting," a HBS Working Paper from April 2006.
Ann Cullen: How did you get interested in this topic?
Romana Autrey: Career concerns affect every industry, even academia and
government. I find this topic so fascinating in part because it is so
accessible-everybody understands the concept of doing a good job so you
can build a good reputation-and yet so many of the consequences of
career concerns remain unexplored.
Q: Why is evaluating career concerns so important to companies?
A: Career concerns occur whenever employees take into account the impact
of their current actions on their future career. In essence, whenever
the internal and/or external labor market observes a performance measure
that helps revise its beliefs about an employee's ability, the employee
works harder to make that performance measure look more favorable.
Surprisingly, this extra work can be dysfunctional from a firm's
perspective, especially when labor markets are most competitive. In a
hot labor market, a firm will lose employees to its competitors unless
it meets the market wage, and the market wage is higher due to the extra
career-related effort. The end result is that the firm may pay for more
effort than it wanted to consume.
Q: Why is non-contractible information about executives important?
A: Non-contractible information distorts actions relative to the actions
a firm might prefer. And, there is far more information that is not
contracted upon than is contracted upon.
This goes against the oft-held belief that "more information is better"
For example, consider the extensive details in footnotes to financial
statements; this information is rarely included in compensation
contracts. The distortion occurs because, in the presence of career
concerns, employees are motivated to work harder to make all observable
information more favorable, whether it is contractible or not (and
whether it is valued by the firm or not).
Firms anticipate this extra effort and reduce current explicit
incentives to offset the career incentives to yield the actions it
actually wants. When information is not contractible, typically for cost
reasons, a firm's ability to offset the distortions caused by career
concerns is limited.
Q: What unique insight does the model you propose in these papers offer
in terms of evaluating performance?
A: Our model demonstrates that, in the presence of career concerns, more
measures are not always in a company's best interest. This goes against
the oft-held belief that "more information is better."
For example, when a firm contracts only on an aggregate measure such as
net income, it can undo career concerns if that measure is the only
publicly observable information. Now consider the subsequent release of
additional details-for example, segment reporting-to the labor market.
In this situation, the firm faces a cost-benefit tradeoff: On the one
hand, more measures provide more dials to turn to get the manager to
take actions consistent with the firm's best interests. On the other
hand, more public information imposes more risk on the manager (more
chances for things beyond the manager's control to go wrong), and that
risk will be exacerbated if the manager has little or no control over
the information that the labor market sees (i.e., is mandated beyond the
manager's control).
Q: Given the current debate about financial transparency, do you see
accountants becoming obligated to include such measures in the standard
financial statements they issue for firms in the future?
A: The current debate focuses on the desirability of making additional
information observable to shareholders. Of course, this information will
also be observable by the labor market. Our model shows that mandated
public disclosure of performance measures, particularly measures that
are relatively informative about management's ability but that are
difficult for management to influence, may have unintended and
undesirable consequences.
Our results suggest further consideration of these unintended
consequences is warranted. Indeed, this is a sensitive and important
issue in practice, as evidenced by corporate pushback to recent
proposals for additional mandatory disclosures. For example, the SEC has
proposed mandatory disclosure of certain compensation information;
however, several media companies (including Viacom, News Corp., and
Disney) argue that this compensation information should be treated as a
trade secret.
Q: How can regulated public disclosure of performance measures generate
inefficiencies in firms' employment contracts?
A: An inefficiency can occur when the incentive effects of the
additional disclosure are outweighed by additional career risk from the
disclosure. Disclosures inform the labor market about ability, but
management may be able to do relatively little to change the outcome of
those disclosures. For example, a disclosure about stock option
compensation may be correlated with information about an executive's
ability, but in some cases the executive may be able to do very little
to change the measured value of stock option expense.
Q: A unique feature of your model is its focus on short-term objectives
of a company as opposed to the long-term objectives of the employee
doing the work. You indicate that most models haven't accounted for
this. Why is that?
A: The typical horizon-mismatch model studies a manager whose tendency
is to take relatively myopic actions (for example, using resources to
pump the stock price now at the expense of lost future value) because
the manager has a shorter-term payoff than the firm. In our model, the
horizon mismatch occurs because managers take actions based on
longer-term consequences than the firm cares about. That is, the firm's
preferred actions are myopic relative to the manager's career.
For example, a troubled firm may hire a turnaround specialist as CEO,
with the intention of using the specialist for a limited time only. The
specialist, on the other hand, takes actions that benefit not only the
firm but also inform future employers of his or her abilities as a
turnaround specialist.
Q: How can this research help boards of directors do a better job?
A: The key lesson to boards is that, for compensation and incentive
purposes, when management has high career concerns, sometimes less
information is better. And, recent evidence suggests that high career
concerns in management is quite common: A 2005 survey by Graham, Harvey,
and Rajgopal of more than 400 CFOs indicates that career concerns is a
primary motivator for management-even more so than short-term
compensation motivation-for hitting earnings benchmarks.
Ann Cullen is a business information librarian at Baker Library, Harvard
Business School, with a specialty in finance.
:::::::::::::
Who Will Cast a Longer Shadow on the 21st Century: Friedman or
Galbraith?
May 1, 2006
Each month, professor Jim Heskett offers his thoughts on specific events
and activities in the world of business and their impact on the way
managers manage. "What Do YOU Think?"
<javascript:openWin('/topics/heskett/feedback.htm',530,540);> invites
readers to respond, and selections from these responses are made
available online.
by Jim Heskett
With the death of John Kenneth Galbraith on April 29, it is perhaps
appropriate to reflect about the influence of two economists, Galbraith
and Milton Friedman, described by Time magazine in 1975 as the modern
world's most important economists along with Alfred Keynes and Adam
Smith. There were remarkable similarities between them. Both strongly
influenced government policy. Both wrote prolifically, and for a broader
audience than just theoretical economists. Both, of course, lived to see
the age of ninety and then some. And despite their sharply contrasting
views of political economics (Friedman regarded Galbraith as a
socialist), the Friedman's occasionally vacationed with the Galbraith's
at the latter's Vermont farm, according to biographer Richard Parker.
Galbraith, in his book The Affluent Society, argued for the importance
of fiscal policy in influencing the allocation of resources between rich
and poor. This was to be done through the maintenance of a progressive
tax system to insure that the wealthy provided their proportionate share
of funding to enable government to channel funds to such endeavors as
the environment, support for the poor, and the development of the arts.
The objective was to create a society that would provide a better
standard of living for all.
Friedman, on the other hand, in a book Free to Choose, advocated a
minimalist role for government, relying instead on lower tax rates to
provide the wherewithal for Americans to decide for themselves how they
wished to live and spend their increased take-home pay. In another work
coauthored with Anna Jacobson Schwartz, The Monetary History of the
United States, he had earlier argued, however, for a significant
government role in managing monetary policy to guard against the booms
and busts that characterized the early part of the twentieth century.
According to this thesis, by regulating the supply of money, governments
could have an immediate and important impact on such things as interest
rates, inflation, and general economic prosperity.
Galbraith advocated the state's involvement in insuring the defense of
the country, education for all, a just society, support for the arts and
environment, and most important, a minimum standard of living. Friedman,
on the other hand, while advocating a strong government role in
maintaining a strong defense and the enforcement of antitrust laws,
placed his primary bets on the individual. According to a friend, Ben
Stein, "Professor Friedman and his wife stood up for the glory of the
rights and choices of the individual. From the individual, not from the
state, came creativity, progress, freedom, prosperity. From the state
came oppression and stagnation." One illustration of this philosophy was
contained in an article written for the Harvard Business Review in which
Friedman opposed corporate philanthropy, arguing that corporations
should let individual investors choose how to spend or give away their
money.
One can argue that both of these economists had an important influence
on the political economics of the twentieth century. But what of this
century? Which set of views will most shape the policies of governments
and our way of life? Or have both served their purpose, only to be
forgotten? If so, will we have to relearn them at a later time? What do
you think?
Readers:
If you'd like to respond, please write in before the deadline of
Tuesday, May 23 at 9 a.m. EST.
To learn more:
Richard Parker, John Kenneth Galbraith: His Life, His Politics, His
Economics (New York: Farrar, Straus, and Giroux, 2005)
John Kenneth Galbraith, The Affluent Society (Boston: Houghton-Mifflin,
1958)
Milton and Rose Friedman, Free to Choose (New York: Harcourt, Brace,
Jovanovich, 1980)
Milton Friedman and Anna Jacobson Schwartz, The Monetary History of the
United States, 1867-1960 (Princeton: Princeton University Press, 1971)
Ben Stein, "On
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