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‘Only variety can absorb variety’. Failure to provide ‘requisite variety’ will result in instability (boom and bust) and ultimately system failure.”
– Ross Ashby’s Law of Requisite Variety

A couple of days ago, I launched a blog introducing The Cost Efficiency Paradox, stating that organizations focusing on cost reduction (Operational Excellence) are generally less cost efficient than those organizations focusing on creating business value (Customer intimacy). It is a game changing statement that has received attention worldwide. But what is the mechanics behind this statement? What does this statement have to do with leadership, governance and culture?

Until recently I worked in a planning and control function responsible for performance reporting. I could notice that 95% of our time was spend on control by setting target and reporting financial and performance figures in Excel templates (to emphasize command and control of the organization), and a remaining 5% of defining strategy and performance management methods (how to deliver business value from a holistic perspective). What the units should do (to contribute to business growth) and how they should cooperate was not as important as having performance metrics in place to force a centralized objective to be achieved. Managers were drowning is enormous bureaucracy and administration (20-30% of time) in a “command and control” machinery. There was obviously some success but very limited to its potential – and created a culture of distrust and demotivated people. This is not a special case but a normal behavior for a majority of IT organizations worldwide. I would estimate 50-60% of IT organizations are stuck in a “command and control” management style with very little business value created.

But budgeting (“command and control” of organization) has been the approach in many organizations with some success. So why is it wrong? Well, budgeting has fundamental problems that effect cost efficiency, customer/business value and return of equity (RoE). Some of the key problems are (recent articles):

• Budgeting prevents rapid response to change
• Budgeting is too bureaucratic and expensive
• Budgeting is separated from strategy and prevents innovation and value creation
• Budgeting demotivates people
• Budgeting is out of date in a couple of months

So what to do?

I am current probing into the new management philosophy of Beyond Budgeting. Beyond Budgeting is a practicing that means beyond “command-and-control” toward a management model that is more empowered and adaptive. Meg Wheatley, a pioneer in beyond budgeting methodology, describes two different approaches to management – with different abilities to create sustainable competitive advantage, cost efficiency and customer value.

1. The obedient machine (similar to Operational Excellence): The key assumption of the “obedient machine” approach is that everything and every part (often separated without holistic overview) of the organization can be controlled and managed with the right governance structure (like machinery in a production line).

The governance structure is based on central planning and a “command and control” culture through management dashboards. Measurements replace management, and the traffic lights and happy faces indicate success or failure in management computer game (dashboards).

The challenge of the “obedient machine” approach is that is brings limited business/customer value and cost efficiency. The key dilemma is that it is very tough and costly to align the strategy, measurements and management style to the changes in the environment. The way to handle change (disruptive trends) is re-structuring or re-organization which are unlikely to succeed and does not bring long-term business effects.

Employees are small cogs in this giant organizational wheel of fortune. The result is that leaders consistently fail to connect with their people and thus miss the opportunity of harnessing a potentially huge store of ‘free’ knowledge and creativity.” – Beyond Budgeting Roundtable

2. Adaptive system (similar to Customer Intimacy): The key assumptions of adaptive system are the focus on the whole system rather than parts, teams are capable to self-governing, and the change is a natural part of our environment. The system is built on trust, change, value creation, and limiting bureaucracy.

The adaptive system can be traced back to Darwinist ideas and the “survival of the fittest”. In a changing environment, is the organization best suitable for adaptation that will survive based on a dynamic governance (agile) – not the one with bureaucracy and “control and command”.

It is clear that many businesses today are undergoing a digital revolution where advances in IT and technology are re-writing the rules of the business game. Destroyed barrier of entry, changed completion, definition of customer value and commoditization are effects of digitalization trends. Advances in IT and technology are the biggest threat to business competitiveness and business models in the near future according CEO in a Gartner survey. The IT (and business landscape) is dominated by an “unpredictability” resulting in that management only can see 6-12 months into the future.

Looking at IT organizations, it is clear that many organizations are stuck in “obedient machine” (Operational Excellent) approach and handle the demand for further cost reduction and business value (driven by requirements and disruptive trends) by further “command and control”, re-organization, and digging further in to the hole of Operational Excellence – with little effects. The key assumption that an organization can be successful through further “control and command” is still correct. Or is it?

The truth is that there is a relationship (Ross Ashby’s Law of Requisite Variety) between the complexities of the environment, the flexibility a control system and the specificity of the goal imposed on the system. Meaning, the more complex the environment the IT organization works in, the more flexible the control system (agile) has to be to achieve its goals. Attempts to manage complex environment “Varity” with rigid “command and control” control systems has resulted in either a “boom or burst” and ultimate system failure scenario or by artificially injecting flexibility into the system by other means (cheating).

There are a few examples of companies that have adapted a “Beyond Budgeting” (Agile Performance Management) management style. One such company is Handelsbanken in Sweden who have a decentralized management approach based on self-governing and fast planning processes to continuously increase performance and customer value. In fact, Handelsbanken is one of the most cost efficient banks in the world, has the highest customer ratings, and fewest customer complaints – and have been profitable for the last 30 years. In the recent financial crises (2008), Handelsbanken showed increased profits while other banks suffered heavy losses and needed government support to survive. Agile Performance Management is their, and other successful companies, receipt for moving from good to great.

My recommendation:
• Measure how much time and resources is spent on “control and command” activities and how much is spent on business value generating activities (adaptive system). Try to even out the two activities.

The Cost Efficiency Paradox is a game changing insight that states that companies focusing on cost reduction through “command and control” are less cost efficient than those focusing on creating business value. My view is that in our attempt to be more cost efficient and profitable, we prioritize economical models (by controllers) that only focused on performance measurements and budgeting to create a sense of financial control and that don’t take business value, disruptive technology trends, innovation, agility and other practices needed to actually maximize business value into consideration. I am not saying that financial control should be neglected but a new approach is needed to optimize business value in a rapidly changing environment.

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