There has been a trend in the last few years for finance professors to reach out beyond their traditional territory and explain business processes from the realistic view of ‘non-rational man’, as opposed to the idealised rational men of perfect market theories.
Kevin Kaiser is a finance professor by background though now has the title of Professor of Management Practice at INSEAD, his co-author, S. David Young, is professor of Accounting & Control there. Kaiser and Young have been developing their ‘Blue Line Management’ theory for over five years. Blue Line Management is an approach to management that focuses on long-term value creation rather than short-term target acquisition. Kaiser believes that many, probably most, companies destroy value by focusing on short-term indicators rather than their real business purpose. He has discombobulated many an experienced executive in his executive programs by asking them variations of the question: “How many of you have taken actions that you knew would destroy value, even if they allowed you to hit an assigned target?”. In companies where value has clearly been destroyed, this is a damned if you do, damned if you don’t situation. The respondents have to be either guilty of the action, or guilty of not realising the consequences of their actions.
Ultimately, according to Kaiser, value equates to happiness. “No matter what products or services we strive to create, our overall purpose is the same: delivering happiness….”. The attraction of this book however is that it takes that true, yet fabulously nebulous, definition and re-writes it in measurable business terms: value = the future free cash flow discounted at the opportunity cost of capital. They devote two chapters to explaining these terms in accessible English, for those of us who have long since forgotten how to discount the opportunity cost of capital.
Companies that adopt this ‘value approach to management’ follow the ‘Blue Line’, and will, according to the authors, “last because they are focused on long-term value. Other companies, which we refer to as red line companies, inevitably die because they are focused on other misguided definitions of value.”
If this were as far as the book went – it would be an interesting idea, but little more. However the authors have devoted a great deal of research to how ‘Blue Line’ management can be implemented, and crucially, what are its main blockers. The main blocker is a cultural one, with its roots in human psychology. The most frequent cause of ‘red line’ management is that managers are driven to pursue inappropriate targets because they are tangible; they are incentivized on KPIs that while connected to value do not actually drive it.
In a simple diagram Kaiser and Young list out some well accepted ‘value drivers’ that deliver value. ‘Attention to customers’, ‘Motivating employees’, ‘Learning from failure’, ‘Shortening product development cycles’ – and they then list the commonly used ‘indicators’ that go with those drivers ‘Customer satisfaction’, ‘Employee productivity’, ‘Employee turnover’ and ‘Time from patent to product’ respectively. A quick review of these will show the weakness of the system – take the last one: if you are incentivized by ‘patent to product time’ you will not select the most beneficial products for the company in the long-term, but those that are quickest to get to market. They cite Goodharts’s Law ‘Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes’. That is, once people you know you are measuring something, they will treat that something differently to give you the desired result.
But Kaiser and Young accept that while identifying value drivers is not impossible, trying to measure them is, as ‘future free cashflow’ is by definition in the future and intangible – and people have a natural desire to find tangible things to make decisions by, so measurable KPIs quickly fill that void.
The central message of this book is to resist this temptation. Do not allow inappropriate targets to replace well-founded, though intangible, value drivers as the purpose for the business. To prevent this situation arising requires a huge change in culture – and a clear shift to make your organization a learning one.
Learning Organizations are often referenced in leadership literature these days, Kaiser and Young explain them well. They are organizations where the emphasis is on experimentation – every activity should be subjected to open-ended questions on how they can be improved, and the experiments monitored against tangible data - KPIs. In this environment KPIs stop being targets and become, what they were always supposed to be, indicators of success or failure – not reflections on individuals, but information that can be used to adapt and improve – to learn from.
This approach leads to the Three Pillars of the Blue Line Imperative: Fairness, Trust and Learning. ‘The logical cornerstone of fair process: the willingness and ability to change’. These are words associated with management and leadership more than finance – and as the authors note these are the culturally critical skills organizations need to foster to create real, sustainable value.
The Blue Line Imperative: What Managing for Value Really Means by Kevin Kaiser and David Young, published by Wiley/Jossey-Bass, August 2013, ISBN: 978-1-118-51088-9