Founder and Principal

 

 

May 2014 Vol. 3 No. 5

 

 

 

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Goodrich & Associates
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I've written here before about the importance of using the right time frame when making decisions. ("What you need to know about your cost of capital;" "What's The Opportunity Cost of Your Next Decision?")

In addition to using the correct cost of capital and understanding opportunity cost, the means of analysis will often vary depending upon the term - short vs. long - of the decision in question.

For example, while many short term decisions on pricing and customers will appropriately focus on marginal contribution, long term decisions need to consider full costs (including the cost of capital). In this way, and over the longer term, the business will earn an adequate profit given the capital employed.

In the short term, projects that boost margins fall to the bottom line. Over the longer term, however, competitive pressures eventually squeeze those margins. The speed with which this occurs can be key to getting the time frame right.

Applying an incorrect time frame can also lead to paralysis by analysis. When routine short term decisions, for example, are caught up in excessive long term analysis, actions may be delayed and opportunities missed.

It is important, as well, to make sure short term decisions don't undermine long term strategy, something that may occur when the time frame of a decision is really longer than one may think.

Back in 1989, for example, famed investor, Warren Buffett, bought a large ownership stake in The Gillette Company; he saw a company with great brands that was woefully underperforming. Later, he encouraged Gillette's Board to bring in Jim Kilts as CEO. Kilts transformed the company, eventually leading to a sale to Proctor & Gamble for a huge premium price.

Key to Kilts' turnaround was his realization that Gillette had been setting unrealistic short term goals to please Wall Street. As a result, every year, Gillette fell short of plan, cutting advertising and new product development in an effort to make up the difference - a move that undermined long term financial performance.

Clearly, as the examples above indicate, choosing the proper time frame can have a great impact on the quality of decisions made. And so with that in mind, I offer seven suggestions for doing this effectively:

1. Begin with the pros and cons. A simple list of the pros and cons of a particular decision will often shine a light on the trade-offs involved in taking a short or long term point of view.

2. Determine the nature of the decision. Many decisions are easily classified as either tactical (short term) or strategic (long term) in nature. Here as well, there is no right or wrong - the key is in understanding which type of decision you are looking at and in taking clear and conscious action that takes into account the associated time frame.

3. Make an objective, honest assessment. In the case of Gillette, Kilts understood the importance of a frank assessment of the current business situation and the need to communicate that clearly. As a result, long term decisions were not undermined by (unrealistic) short term plans and targets.

4. Beware of things that shorten the time frame from the natural economics. For example, when reviewing investment decisions for plant and equipment that are located in a leased facility, the time frame is truncated by the end of the lease term and any economic lease extensions. Ignoring this constraint can lead to poor decisions. Similar circumstances may occur with regard to sales and supply contracts.
   
   If a company is at or near insolvency or bankruptcy, the time frame shortens as well. In these circumstances, when liquidity crises are at the live or die stage, all decisions are short term.
   
   In one crisis in which I was involved, Human Resources was adamant that severance clauses in employment agreements be honored. HR believed that by not doing so it would lead to high employee turnover and recruiting difficulties. They were right in their assessment of the impact, but missed the point that by honoring these, the company would likely be gone before their fears were realized.
   
   A different, but similar situation occurs when a company's equity is not in the money - and the company's value only covers the creditors' stake in the company. Here, if loan covenant or other triggers could force a restructuring where equity loses out, then any long term investment will benefit the creditors and not the current owners of the company. In this case, better to restructure first. (See my newsletter on enterprise value to learn more about this.)

5. Protect long term investments from short term decisions. Decisions which negatively impact brand, trust and customer loyalty are often justified in the short term, thanks to their immediate positive impact on profits. Profits, for example, can be boosted by cutting customer service, using cheaper raw materials, or otherwise cheapening the customer experience.
   
   This is not to say that these types of changes are not appropriate. What matters is that they are the result of deliberate, strategic shifts which in turn reflect changes in market and industry conditions.
   
   Understand that these really are long terms decisions - because they impact strategy as well. Customer good will, typically built up over years, can quickly be eroded with this approach. And while hard to detect in the short term, over time they are noticeable.
   
   Consider Kraft Foods, which for many years had a "Kraft" brand barbeque sauce. As so called "premium sauces" became the rage (led by Kansas City Masterpiece), Kraft bought a premium brand called Bull's Eye. Six months after the acquisition closed, R&D noticed that Bull's Eye's formula was nearly identical to the Kraft brand barbeque sauce - from 20 years ago.
   
   The way to avoid this is by having a clear statement about a product's positioning and brand. In this case, an alternative to repetitively taking cost and quality out of the barbeque sauce in the name of remaining competitive would have been to create an alternative, "value" brand.

6. Consider the opportunity cost. If the cost is short term in nature, it is a short term decision and vice versa. As referenced in an earlier newsletter, for example, when Kraft considered that particular acquisition, this was a short term tactic intended to achieve a well-defined strategy. But the cost of tying up the organization to fix the target company would have been long term.

7. Have a clear, well understood, vision, strategy and plan for the company. One of the best guides in making smart decisions is a clear sense of where the company is headed. When vision, strategy and plan all align - and when everyone in the organization understands how they fit together -the long term impact of short term decisions don't have to be continually rehashed.

Understanding whether decisions are short term or long term in nature is critical in conducting proper analysis prior to a decision and in making the right decision.

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Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent financial problems. Our Founder and Principal, Charlie Goodrich, holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia, and has over 30 years experience in this area.

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