When a business is small, the owner can physically see what is going on, can personally review the work of each staff member and will be involved in virtually all external transactions.
They can almost physically feel what is going on. The noises around them tell them about what is going on. They can hear phones ringing, machines working, doors opening and closing and keyboards clicking.
If the level of activity changes, they can look around, ask questions and take action immediately. However, this sense of what is happening soon disappears with size. Physical activity now takes place in a different part of the building, in another building or another location. Management is often isolated on another floor or another location. That sense of knowing must, from then on, rely on communications – an often inexact and untimely process.
As the business grows, physical activities must be translated into information – data with meaning. As the business becomes more complex and longer term decisions are made, the ability to convey what is going on becomes more and more difficult. There are problems of measurement, of aggregation and interpretation. Many things which can be seen or heard don’t have any simple way of conveying meaningful information using verbal, printed or graphical representation. Gradually the business moves to periodic reports based mostly on financial information. However, the interpretation of financial information is problematic since much of it is based on assumptions and conventions.
Accounting has struggled for centuries to convey complex physical states and activities into meaningful numbers. But imagine how difficult it is to convey
performance information when you have numerous choices of revenue recognition rules, depreciation methods, capitalisation rules, periodic expense recovery rules and so on. Then there are the decisions to make on what R&D costs to expense, which provision to make for warranty claims, what percentage of outstanding debts to write off and how much to set aside for inventory write downs. At best, decision makers can compare one period to another to see what changes have taken place – but do they really know what is going on?
Budgeting systems should be in place to define levels of activity throughout the business. However, few budgeting systems cope well with lumpy business activities. Most often they are prepared using linear projections and by assigning revenues and expenses equally across the 12 months. This fails to take into account the seasonality of the business, differences in working days in each month and the lumpiness of expenses. Instead of setting out what can reasonably be expected to happen in each month, executives spend a lot of time rejecting results for obvious business reasons.
Another common mistake of budgets is to assume that the original budget is still valid in the light of changing circumstances. Instead of updating the budget to predict where the business is likely to be by year end, the variances accumulate with greater and greater deviations from the budget, leaving the variance analysis as a meaningless exercise. Unless year-end projections are revised continually, the business continues to make decisions on out of date assumptions.
High growth businesses often operate in turbulent environments. It is the rapidly changing external environment that is often the reason for their existence and success, thus systems which cannot cope with rapid change are actually inhibiting the ability of management to take advantage of the very environment within which they exist.
Of course, no business stands still while numbers are being prepared and reported. Most firms report monthly performance several weeks after the end of the month and annual financial reports often take several months to prepare.
In the meantime, changes are happening throughout the market and inside the business. While stable businesses may be able to cope and manage under these circumstance, high growth businesses have learned that timing is everything and that the information they need is more than financial data and that they need it as soon as possible.
A business which is in touch with its underlying activities, monitors physical as well as financial activity. It maps physical transactions throughout the enterprise and then designs systems to monitor them. It sets performance levels for each activity and warning bands to alert action. Individual staff are given responsibility for monitoring performance and policies are defined as to what action should be taken in the event of an unusual activity change.
Some monitoring devices are set up to provide early warning signals, or ‘lead indicators’ of a change in the external environment. These are used to predict levels of business activity which would normally follow from the lead activity.
Thus a downturn in sales leads would predict a downturn in sales, a need to reduce manufacturing and component purchasing and ultimately, would predict a downturn in profit. Lead indicators can be external to the firm, such as interest rate changes, housing starts, consumer confidence and so on. They often exist at the interface of the firm to its customers, suppliers and partners. Each lead indicator is linked to activity levels within the firm. Thus a change in an external lead indicator will predict a future change in an internal activity of the firm. By monitoring lead indicators the firm can take action to correct a possible disruptive situation through additional marketing, sales effort, trimming costs and so on.
Successful high growth firms don’t wait until the end of the month to find out how they have done, they monitor activities continuously so they can take action as soon as possible when activity levels change.
Successful firms also assign responsibility for achieving activity levels at a very low level in the organisation. This way the firm does not wait until the reporting system eventually reports a problem to senior management. Events which deviate from the expected are reported as soon as possible at a detailed level to the person who is most able to influence the change. Incentives for performance are also put in place for both prediction accuracy as well as performance.
Few plans ever result in events happening the way they were predicted. Thus business plans needs to be tested across multiple scenarios to ensure that a reasonable financial return can be achieved even in the most unlikely circumstances. Every plan is based on a set of environmental and internal performance assumptions. Robust financial forecasts should declare and test the validity of the basic assumptions. By changing basic assumptions to different possible situations, the model can be tested for robustness. Those assumptions which have the greatest sensitivity can then be addressed with counter measures or additional activities to minimise their impact.
Entrepreneurial businesses do not grow in a linear manner. They monitor external situations and identify business opportunities they can take advantage of. Thus you see many high growth businesses branch out into related activities which complements their mainstream activity. The business, however, needs to have processes for capturing these ideas, evaluating and then resourcing them.
Since entrepreneurial opportunities are not risk free, the business also needs to have a culture which allows new opportunities to be investigated and developed in stages. Successful progress would encourage more investment while setbacks and failures need to be written off and lessons learned. High growth businesses have systematic processes for evaluating opportunities which uncover underlying assumptions, test out financial feasibility and the impact of likely outcomes on the main business. Only if the opportunity is reasonably profitable and possible failure can be absorbed, will such ventures proceed.
Successful businesses also use industry and best practice benchmarking to test their performance levels. Since high growth demands the highest productivity possible, testing internal performance levels against other firms can uncover situations where additional effort in training, or new systems and processes should be implemented. A business which is open to learning from others can tap into a greater pool of knowledge than can be accumulated internally. Most leading firms actively support benchmarking studies in order to learn how to do things better but also to encourage their own staff to be open about introducing better processes into the business.
Tom McKaskill is a successful global serial entrepreneur, educator and author who is a world acknowledged authority on exit strategies and the former Richard Pratt Professor of Entrepreneurship, Australian Graduate School of Entrepreneurship, Swinburne University of Technology, Melbourne, Australia. A series of free eBooks for entrepreneurs and angel and VC investors can be found at his site here.
Smart Company is a sister publication to The Mandarin, catering to Australia’s entrepreneurs, small and medium business owners and business managers.
