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August 3, 2005

Business Cases: a pound of prevention

My colleague Sid Kemp, President of Quality Technology & Instruction, Inc., zeroes in on a "point of sale" aspect regarding ROI when he comments on my previous post ("ROI: the Echinacea of Change").

I described a problem wherein false expectations are placed on the meaning of ROI, leading to its misuse. The question Sid asks us to consider: how do you make ROI most effective when it most matters?

Here's Sid's comment, en toto. He promises a very healthy elaboration of this in later efforts that span articles, workshops and other items.

"This article [Ryder's] assumes that return on investment does not measure value. Granted, forecasting value is very difficult. But I believe it is possible to forecast value, and then use an ROI calculation as ROI = (forecasted value)/(forecasted cost), adjusted for the time value of money.

Sid Kemp,QTI, Inc. (Copyright 2005 QTI) "

This is clearly a good overview of organizing a use of ROI.

BUT... I can't resist running the pitch in slow-motion for a bit, to see the seams and spin of the ball. The two things that I think are worth special consideration are as follows:

1. How do you put a financial measure on "value"? Here, I'm using the customary Archestra definition of "value" as being "the distinction that makes the difference". Value is a state, and in most business instances it signifies "a desired state having given importance". This makes it clear that value can be represented by many modes of description, only some of which are numeric. When we attribute a dollar impact to value, we have to provide the reason for which -- and the logic by which -- that dollar amount was associated with the achieved state. In that logic, assumptions will have to be tested. This means that executive evaluations have to test the assumptions and determine their plausibility. (To consider the effects of not testing them, take a week off and Google the phrase "voodoo economics"...)

2. What is "soft value" ?? Here are two good ways to show it, the first of which is the head-knocking cartoon by S. Harris about assumptions, called "Then, A Miracle Occurs..." A lot of venture capitalists in the Dot-Bomb era saw, in effect, elaborate powerpoint versions of this cartoon titled (ahem) "Business Model" -- but to be fair, it hasn't gotten any easier to describe the miracle than it was in 1982 when M. M. Parker wrote his "Enterprise Information Analysis" paper in the IBM Systems Journal and presented a taxonomy for intangible benefits --turning the lights on with his observation:

"As a system grows and supports multiple functional areas... it can no longer be readily expensed to products or product lines because of its sphere of influence over the ... total management structure of the enterprise."

It's not the value that is soft! It's the measuring system. Today, most of what is in Parker's taxonomy is considered to be "key performance indicators" or "objectives".

NOW... Where this matters the most is against the idea of what it means to "create optimal value." The easy way to handle it is to rely on executives taking the responsibility to say up front what is most important -- because for the record that is what the company's management will consider to be most valuable. But that is not a forecast. And when executives (as managers) do that, are they referring to (a.) the formula (model) for success, or to (b.) the after-the-fact dollar-impact of the outcomes? The answer is, it can be both, therefore it is not necessarily the latter. (That said, I'll keep an eye out for how Sid Kemp forecasts value.)

Meanwhile, to understand how "valuable" soft or intangible stuff is, just name it explicitly, then plan on leaving it out, and then watch the credibility of the proposal's forecasts disintegrate. It starts to look like the soft stuff is actually at the hard core...

Forbes Magazine and Ernst&Young drilled down on this issue in the year 2000 with their Value Creation Index , making explicit the point that the high-performance companies have certain attributes that are the critical success factors of their performance and thus their corporate value. Companies without the attributes simply did not lead their markets nor their industries. Further, different markets and industries required different attributes.

And this is the point of their Value Creation Index: performance is something that can be modeled, and executing to the model is something that can be measured. The model makes certain kinds of execution important, but that is operational-level value. In the end, the importance of the impact of the execution is context-sensitive, and there is another level of value determined in that context. An objective, market or industry are each examples of context.

Value is firstly the importance of the impact. Assigning dollars (i.e., "worth") to that impact is a follow-up step that may or may not be done. To easily recognize this difference, consider that a non-profit organization takes grants (investments), executes, but then does not measure its value in dollars; rather, its value is in the outcomes that its constituents find beneficial. Donors understand this, and they are not looking for dollar "payback" to themselves as a "return" on their "investment".

So what about forecasting value? Forecasting execution and forecasting context are both essential to forecasting the likelihood of achieving desired value from targeted performance levels. A given performance level is more likely to generate certain levels of value, and less likely to generate others.

What must be understood is the requirements for reaching the performance levels necessary to the value targets.

Then, investment in meeting those requirements should occur.

Payback on those investments might be arranged to occur regardless of the performance level reached. But payback on the investment is not the same as the worth of the performance's value. Investors must understand the difference and make arrangements accordingly.

Posted by Malcolm Ryder at August 3, 2005 11:54 AM

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