Ensure fewer surprises and better results.
Time to Act
October 2016 Vol. 5 No. 10
Charlie Goodrich

Negotiating and managing performance expectations represents an ongoing, fundamental relationship between those who oversee performance and those who are tasked with delivering it. This includes both the relationship between management and their investors and between businesses and their lenders.

Having a clear understanding of what goes into these numbers - the subject of this month's newsletter - will help ensure fewer surprises and better results for all involved.

I appreciate your comments. Simply reply to this email to send them to me.

Charlie Goodrich
Founder and Principal
Goodrich & Associates
In this issue...
Five Recommendations for Managing Performance Expectations Well

Many years ago, when I first started working for Kraft Foods, I was responsible for the financial planning for what Kraft called "viscous products" (think Mayonnaise and Miracle Whip). It was Kraft's biggest profit contributor at the time, and had return on investment (ROI) numbers well in excess of 100%.

My instincts told me we were headed for a period of industry softness, so I started to dial back expectations internally. I did that by gradually increasing the forecast cost of goods sold, relative to the price of the benchmark ingredient, soy bean oil.

In late November, when my division was short of plan and the marketing manager of the viscous business was on vacation, the Vice President of marketing called me and said he needed another $2MM in profit from the business that year. I agreed to increase forecast gross margin by $21MM if he would increase advertising on the brand by $19MM. It worked, and the brands delivered even more well into the next year, because the advertising also worked.

Three months later I was promoted to a position in corporate strategy and development. I soon realized why I was there: To set the financial goals for the operating groups for the coming annual plan. I was told I was "the best sandbagger in the company." But now, instead of inserting the sand into my own budget, I was told to go find it in everyone else's. And find it I did...

Kraft owned Duracell at the time. Duracell was on track to deliver $112MM after a prior year disaster of only $67MM. The Duracell team was running a victory lap - until I set next year's target at $200MM and laid out how, while by no means a layup, it should be readily achieved. To say the Duracell President was upset is a substantial understatement. So Kraft decided to sell Duracell. Long story short, Wall Street expected a sale price of $900MM and Duracell was sold to KKR for $1.4 billion. How did KKR justify such a price? They thought they could make $200MM a year in profit, day one.

These stories emphasize the impact that setting performance expectations - particularly financial ones - can have. And, how regardless of which side of the performance expectation negotiation you are on - whether as the one setting targets or the one approving them - you'll need to keep in mind a few critical things:
  1. Understand how business metrics translate to financial performance better than the other party. This basic idea is often ignored, particularly by those tasked with delivering the performance.

    Often I am sent into companies by creditors and investors because the company hasn't met its financial commitment. Over and over, these companies say they will meet a certain financial goal but fail to deliver. Most of the time, it's because the company in question had no rational, empirically-based financial basis on which to make the commitment in the first place. They don't understand how their business works financially, which means that even if they do everything they say they are going to do operationally, the financial goals remain unmet.

    In the viscous products group at Kraft, because I understood how costs behaved and impacted gross margins, I had the flexibility to negotiate different financial performance for the brands, something that in the end was better for the company too. In the Duracell case, I dug deep into the financials, allowing me to have a better understanding of the big picture than Duracell management. Both examples underscore the importance of not setting or agreeing to financial goals in the dark.
  1. Understand the purpose and ramifications of performance setting. For example, when setting expectations with investors and creditors, don't use stretch goals; here, the consequences of failure can be devastating. Conversely, stretch goals often make perfect sense for internal purposes.

    The first time I did an annual plan for the S.S. Pierce Company, for example, I gave all four operations stretch goals that, if met, would allow us to max out the bonus plan. I tempered corporate expectations of our performance by layering in extra expense in the back half of the year in allocated costs. That meant there would be tremendous pressure in the first half of the year to stay on plan and if we continued that performance in the second half of the year, we would maximize bonus. And we did.

    The recent Wells Fargo cross-selling fiasco, on the other hand, is a great example of not understanding the internal ramifications of stretch goals. The bank incentivized its front line employees and managers to hit certain cross-selling targets without monitoring for dysfunctional activity. The resulting unethical behavior destroyed any trusting relationship Wells Fargo had with its retail customers. As damaging, by firing both those who got into trouble by pushing the cross selling and those who complained about it (over 5,000 people, according to the bank), the internal culture was rotted as well.
  1. Don't offer a floodlight when a candle will do. In the viscous products example, I did not shed light on the detailed inner workings of soy bean oil product costs and gross margins to the higher ups. And they never asked for it. Similarly, when I prepared Board presentations in my corporate life, they were always simple and rudimentary. Today, when lenders ask for a cash flow forecast, I send them a simple printout or PDF. I never send the model.

    (Note, however, that if you agree to goals while keeping the other party too much in the dark, you might not like how they react to surprises, even if those surprises were foreseeable to you.)

    Conversely, when agreeing to financial performance commitments from others, make sure you have enough information to validate the commitment and to understand the risks involved.
  1. Lay out upsides and downsides to any financial commitment made. This way, most variances won't be surprises - they will be fluctuations within expectations. This does more than just help in understanding the risks involved. It also helps isolate future performance variances between uncontrollable factors and management execution.
  1. Set multiple, offsetting goals that balance each other. The Wells Fargo CEO might still have a job if, in addition to cross-selling goals, he had set customer satisfaction goals that were measured by third party surveys. By setting goals that conflict with each other to some extent, a balance is more likely.
Negotiating and managing performance expectations represents an ongoing, fundamental relationship between those who oversee performance and those who are tasked with delivering it. Having a clear understanding of what goes into these numbers, regardless of which side of the equation on which you may be sitting, will help ensure fewer surprises and better results for all involved.

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Heard on the Street

About the only thing the two presidential candidates seem to agree on is raising tariffs to protect American jobs. One of the few things all economists agree on, is that raising tariffs is a sure way to lower our standard of living.

Paul Kasriel, the former chief economist for Northern Trust, explains why. In particular, he shows how tire tariffs saved no more than 1,200 jobs at a cost of $900,000 per job saved. And, 3,732 retail workers lost their jobs too.

Read why here.

About Us

Goodrich & Associates is a management consulting firm. We specialize in helping our business clients solve urgent liquidity 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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