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EASCA President's blog - February 2017

Hear from EASCA’s President, Tom Lewis, on why he thinks you manage what you measure.

"The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business."
- Warren Buffett, 2011

Parties contracting to collaborate, rather than merely transact, work best together when their objectives are aligned – that is where, when one party gains, so does the other.

This is the principle of win-win; the creation of circumstances in which the game is not played for a zero-sum but where the creation of additional value is facilitated by a greater mutual focus on growing the pie, than on how it is carved up.

In a world dominated by short-term hard metrics, the broader manifold effects of value creation are harder to measure and quantify. This does not make them less important – quite the opposite, in fact.

Creating value

According to the 1% windfall approach, the various levers available to increase profitability show differing return levels, with the highest coming from pricing improvements and cost savings showing a lower return.

Financial cost reductions may be easier to measure, the return they give is lower; cost reductions are a form of value capturing, but value can only be captured once it has been created and delivered.

The challenge then is firstly to create value, and only once it has been created can it be delivered and captured; the purchase of value-creating activities, such as professional services and consultancy, on a “time spent” basis is unsatisfactory for both sides. Clients want access to talent and motivation, not merely a guarantee of billable hours which fails to distinguish between busy fools and eureka moments. Service providers find they become what they sell – a commodity supplier of people’s time.

We might call this result the triumph of efficiency over effectiveness - a focus on short-term financial metrics to the exclusion of longer-term value measures.

In the words of Peter Drucker, “There is nothing quite so useless, as doing with great efficiency, something that should not be done at all.”

Effectiveness and efficiency

An organisation needs to start with Effectiveness (creating and delivering value) and only afterwards consider Efficiency (capturing value). Commercial Effectiveness - covering reduced risk of price sensitivity, competitor entry or base erosion of sales, better economies of scale, product launches or brand extensions - is much harder to measure than operational efficiency, yet far more important.

Traditional Efficiency measures, often based on data, are also entirely historic; they tell you at best where you are right now, not where you are going or what to do next.

Behavioural Economist Rory Sutherland puts it this way:

"Doctors are uncomfortable with the placebo effect not because they believe it doesn’t work but because they don’t know how – it does not sit with any available model they have of how medicine works. In the same way, the finance function in business is uncomfortable with marketing not so much because they think it is ineffective but because it is not congruent with their reductionist, neo-classical economic view of the world."

Talking to a finance director about brand iconography is like going to the head surgeon at St Mary’s Hospital and suggesting that he ‘trust to the healing power of the crystal’.

As Freakonomics author Stephen Levitt notes, people respond to incentives; that does not make them bad people, it just makes them human.

To mis-quote a common saying, as accountants, we need to remember that not everything that counts is in the financial statements and not everything in the financial statements counts. Or, put another way, you manage what you measure.