You Say You Want to be Excellent

Excellent at what, and for whom? Those are the key questions.

Too many firms pursue excellence without having first defined who they want to be excellent for, and what they need to be excellent at.

Excellence as a generic term has little meaning. It has little meaning because excellence only exists in the eye of the beholder – the customer. Firms who strive to be the best at everything end up being not particularly good at anything. Ask yourself, what is the best restaurant? For the busy mother with a gang of hungry kids to feed, a fast food outlet is ideal. For the businessman seeking quiet surroundings and a superb meal to close a deal, fine dining is preferred. The point is, there is no “best” – it is all dependent upon what the customer values and is seeking. A restaurateur who tries to be the best and satisfy all customer preferences and tastes cannot possibly win in such a game. It is the same for firms.

Operational excellence, that is, excellence in processes, only makes sense when the preferred customer has been defined. Trying to be excellent at serving every possible type of customer is a zero-sum game because it is not possible. Truly excellent firms are only good at some things – the things that really matter to their preferred customers.

There are always tradeoffs to be made in business. Before you decide to be excellent, determine who you want to be excellent for. Then find out what they truly value, and do it better than anyone else.

Raising Productivity

When we speak of “productivity”, we should first clarify what we mean by that term. Economic agents, such as firms, take factor inputs (labour, capital, and raw materials) and convert them into useful products. This relation between factor inputs and output is defined by a production function:

Y = A F(K,N),

where Y is output (real GNP), K is the stock of physical capital (plant and equipment), and N is labor (the number and hours of people working). The letter A measures what we call productivity. A higher value of A means that the same inputs lead to more output, which is a good definition of productivity. More precisely, it is total factor productivity, as distinguished from average labour productivity, which is, Y/N.

Productivity is the foundation of economic growth, whether it be at the firm level or the level of a national economy. Labour productivity is n indicator of economic growth, competitiveness, and living standards within an economy. Labour productivity is usually measured as the ratio between a volume measure of output (output or value added) and a measure of input use (the total number of hours worked or total employment).

Drivers of productivity include the amount of investment in physical capital (machinery, equipment, facilities, etc.), innovation (new technologies, methods, etc.), education and worker skills, strategic choices to leverage new opportunities, and cooperation and competition as incentives to raise productivity.

Firms desiring to raise productivity levels can look to manipulate these key drivers as appropriate. Short-term gains in productivity can be had by moving to leverage worker knowledge and experience to drive innovations in work methods and processes, employing new technologies (especially automation), changing the organization structure to improve core functions and supply relationships, and altering organizational dynamics to promote cooperation between various functions.

This last is often overlooked as a source of productivity improvements. Too often in business, we focus on competition, when perhaps cooperation offers greater rewards. For example, some firms use competition among  a large number of suppliers to try to keep input costs low, when a more cooperative approach with a smaller supply base might actually reduce total costs more by improving quality and delivery performance.

Is Monopolistic Competition Inefficient?

In monopolistic competition, there are many sellers competing, each seller offers a differentiated product, and there is free entry and exit from the industry in the long run. This type of market structure is so named because it combines some features typical of monopoly with other features typical of perfect competition. Monopolistic competition tends to arise in industries that are highly fragmented, with a large number of sellers.

In monopolistic competition, each seller charges a price that is above marginal cost. As a result, some customers who might prefer to purchase a particular seller’s product are deterred from doing so. In short, some mutually beneficial transactions go unexploited.

A further criticism of monopolistic competition is that it is inefficient because of the wasteful duplication that arises from the prevalence of too much variety in products and services. In other words, it would be better if there were fewer sellers, meaning each seller would have lower average total costs due to the higher sales volume, and therefore lower prices. The duplication that arises in monopolistic competition results in sellers holding excess capacity which cannot be sold to the marketplace.

In a sense, monopolistic competition offers a tradeoff. The greater variety of products and services means that consumers gain greater flexibility and freedom in their choice of sellers, while having to pay higher prices for this greater convenience. The net benefit to consumers means that they will put up with some inefficiency to gain greater choice. However, it also means that firms operating in monopolistically competitive industries face greater price competition as a result.

The Oxymoron of Strategic Planning

There is no such thing as “strategic planning.” This term denotes some sort of rarefied, specialized planning activity – as if the planning activity itself was strategic.

Rather, there is the planning of strategies. This term makes much more sense and is much more accurate.

Strategies need to be developed, planned, and then deployed. The planning of strategies is an analytical and synthetical process: the business strategist starts by scanning and analyzing a firm’s current environment, clarifies the forces determining the nature of competition and industry structure, and then seeks to determine how the firm can best position itself to blunt the strong forces and exploit the weak ones. Thus, the strategy formulation process is not a planning activity, it is a creative activity aimed at finding an optimal position from which a competitive advantage can be secured.

The best business strategists don’t plan – they analyze, synthesize, and create. Strategic planning is for those who don’t know any better.

Strategic Leaders

What do business leaders who think strategically do that is different? The following is my own personal shortlist of the essential qualities that a good strategic leader must possess:

• Focus on the big picture. Strategic leaders see the big picture and don’t get bogged down in fine details.
• Outward looking. Strategic leaders look outwards into their organization’s environment and markets to see latent and emerging needs.
• Visionary. Strategic leaders have an image of the future and their organization’s place within it.
• Value-driven. Strategic leaders focus on their firm’s value and how it can be made more unique and differentiated.
• Analytical and synthetical. Strategic leaders can analyze situations to clarify the key elements and then bring those elements together in new business models and paradigms.
• Risk managers. Strategic leaders identify risk factors associated with their plans and develop contingencies to manage them.
• Reflective. Strategic leaders reflect on the outcomes and impact of their actions, adjusting and re-strategizing as needed.

Thinking Demanded

A CEO hardened in the recent recessionary battles confessed to me, “I want to do this Lean stuff so I can cut my costs.” This statement always amuses me. Upon asking him what costs he expected to cut he was blunt: labour.

Here we have a great tension. We are asking people to get involved in continuous improvement, even although those improvements might result in them losing their job. In fact, in the case I just described, that is the whole rationale for doing the continuous improvements. At least the CEO was honest enough to admit it.

To a point the CEO is right – you can only reduce costs be reducing factor and input costs, and labour is one of those. However, this answer is only possible because it assumes demand is fixed. In this CEO’s world, it is the factors of production which are variable and within his control, and that he must adjust those in response to demand. If demand falls, he lays off; if it rises, he hires. In his world,  you focus on a firm’s supply side and let demand take care of itself.

Actually, firms have the ability to influence demand. They can strategize to reposition themselves in the marketplace and create valuable differences that pulls in new demand. Demand is therefore a variable that can be influenced.

Reducing costs or increasing revenue is not an either/or proposition. It is possible to do a bit of both, within reason. Working with demand asks us to think about value – how we can increase it, and make it more unique and differentiated. It also means creating that value efficiently and using resources in value chains that have been appropriately configured to create and deliver the differentiated value.

If Lean and other continuous improvement techniques are really about value, then we should be thinking about their ability to influence demand by improving value, not just cutting costs by reducing waste.

Advantage

Whenever I come across firms that have a competitive advantage (higher rates of profitability than rivals), I always want to know what’s at the root of that advantage. Usually it boils down to one of two things: sustainable differences from rivals in cost or price.

Higher rates of return can be obtained through these essential differences. A firm that is a cost leader will have higher margins, and be able to expand share through lower pricing. A firm who is a benefit leader will have offerings that command a price premium, generating higher returns per unit of sale and attracting marginal customers through differentiated value.

Creating sustainable cost or price differences from rivals is at the core of strategy. It is also the reason why some firms endure over time – these firms have developed the capacity to maintain a unique advantage through differentiation over rivals. How a firm creates and maintains that differentiation is the essence of business strategy and the basis of competitive advantage.

On ISO 9000

Michel Baudin has an interesting blog post (http://michelbaudin.com/2012/07/19/iso-9001-conspicuous-by-its-absence-quality-digest/) on ISO 9001 and the before-and-after evidence regarding its benefits and effectiveness.

I agree with Michel’s point about the problem-prevention aspect of ISO 9001. I’d also add that an overlooked strength of ISO 9001 is the process approach to managing a business system. This aspect of the standard is often overlooked in the rush to get certified and never really gets fully implemented in the way it should within many firms, because the focus shifts to the clauses of the standard and meeting their requirements.

Few firms really understand and manage their businesses as systems of interconnected and interdependent processes. I have always felt that the real strength of the ISO 9000 approach, particularly in the latest (2008) version of the standard, is the process approach and the need for adopting firms to focus on understanding and meeting customer requirements with a well-managed and effective process system.

Stewart Anderson

http://www.andersonlyall.com

stewart@andersonlyall.com

Quality is Not Free

With all due respect to Phil Crosby, there are no free lunches. Every increase in quality requires an investment of some sort – whether it be internal resources used in problem solving activities, investments in new technology, or process re-engineering.

I think I know what Crosby meant – that the costs associated with improving quality are far lower than the costs a firm incurs as the penalty for poor quality, or put another way, the opportunity cost of doing nothing. But improvements in quality can never be free because every decision a firm makes to allocate its resources in one way or another always involves  costs, whether they be real costs or the opportunity cost of foregoing an alternative use against which those resources could be deployed.

What I am really interested in is not how much costs can be saved from improving quality, but how much additional revenue can be generated. Improvements in quality that are not valued by customers may reduce costs, but they will not create additional revenue. And, cost reduction always has a threshold.

The concept of marginal customers is important here. A marginal customer is a customer that has never bought from your firm before – they have either chosen other suppliers, or chosen not to buy. Marginal customers represent new revenue for a firm, in contrast to inframarginal customers – these are loyal customers who will continue to buy from your firm, even if you maintain your current quality levels. Marginal customers, however, may be induced to buy from your firm if an increase in quality represents additional benefit which they value.

The marginal benefit, or utility, of quality is something that firms should know and be aware of. What is the additional increase in revenue that comes from increasing quality by “one unit”? Often, this may be known from a cost perspective, but rarely from the revenue side.

Looked at this way, quality improvement may be an important differentiator for some firms. A firm that can provide a significantly valuable increase in quality may attract marginal customers and increase its total revenues as well as market share. If the quality improvements can be made with little additional investment, firm profitability may be positively impacted.

The problem with quality improvements is that they are often not sustainable as a competitive differentiator – the methods and technologies employed to improve quality can often be readily imitated by rivals. A competitive convergence then results, where all rivals have increased their quality but the overall profitability of the industry remains the same as before.

Every firm must find its optimal quality level – the level that will maintain inframarginal customers while still attracting marginal buyers. A broad definition of quality must prevail – firms should specify quality from the perspective of customer requirements and fitness for purpose, not just conformance to specifications or freedom from defects.

Stewart Anderson

stewart@andersonlyall.com

http://www.andersonlyall.com

Technical Lean or Economic Lean?

It’s always interesting for me to revisit some of the older Japanese literature on the philosophy behind the Toyota Production System (TPS). Two books, in particular, stand out to me – The Toyota Management System: Linking the Seven Key Functional Areas, by Yashiro Monden, and Toyota Production System: Beyond Large Scale Production, by Taiichi Ohno.

The significance of these two books is that they stress the economic, as opposed to the technical, rationale for the principles of TPS.

Western firms have long been seduced by the technical aspects of TPS – one-piece flow cells, pull systems and kanban cards, 5S and visual workplaces, and the like. Yet, the economic rationale of why these things make sense is often overlooked. There may be vague statements about reducing waste and its associated costs, but the clear linkage of TPS techniques to the microeconomics of a firm is generally not well understood.

In my Quality Digest paper, The Economics of Lean Production (available at http://www.qualitydigest.com/inside/twitter-ed/economics-lean-production.html), I highlighted the microeconomic linkages that rationalize Lean as a viable production paradigm for many firms. These are the same ideas that both Ohno and Monden tried to convey in their wiritings.

The title of Ohno’s book indicates that TPS is a production paradigm that allows a firm to exploit the same economic benefits that only large volume producers could enjoy through economies of scale. With Lean, it is possible for a firm to produce at volumes lower than Minimum Efficient Scale (MES), although certain caveats have to be observed.

This idea was the driving force behind TPS: Toyota, confronted with the need to compete effectively with mass producers, developed TPS as an effective response to keeping costs in line with the scale economies enjoyed by those larger producers.

So, let’s not forget the economic underpinnings of TPS. The technical aspects are important, but at the end of the day its firm economics that count.

Stewart Anderson

stewart@andersonlyall.com

http://www.andersonlyall.com