Rules – Success Needs A Playbook

This issue is my final installment devoted to business infrastructure.  In my experience people respond to rules in two very different ways – they rebel or they embrace.  Two opposing perspectives that imply rules function to consent or restrict a particular action.  The job of the business leader is to harmonize these two seemingly conflicting viewpoints so that the business’s fundamental objectives are satisfied.  To do so it is beneficial to have a context for rules.  That is my ambition with this issue of The Business Odyssey.

I use the term Rules to convey clear and unambiguous standards not a convenient excuse to impose autocratic, arbitrary, or oppressive authority.  Quite to the contrary, rules should serve as the foundation to thoughtfully empower people.  Rules do so with explicit interpretations or appropriate actions the business has adopted to guide the response warranted for a particular circumstance.  Rules enable the confident delegation of responsibilities as well as the preservation and routine replication of actions.

The discussion that follows focuses on business infrastructure’s dependency on rules.  Previous issues have described people and things; those responsible and the tools used to effect an action.  Rules are the explicit guidelines specifying what to do and when to do it.  When People, Things and Rules are properly designed and effectively functioning this infrastructure improves performance and protects assets.  So how I am going to define rules?

Business rules are the acceptable or approved actions expected to be applied to specific transactions, activities or decisions.

Business executives expect that certain routine activities will be handled consistently, correctly and timely.  Rules are an explicit statement, best in writing, expressing the allowable or acceptable treatment to be applied to a specific action.  Rules serve four distinct business needs: operations, reporting, compliance and protection.

Operational

The senior business executive’s primary concern is typically focused on making money.  Making money is obviously accomplished with operations that create customer satisfaction, do so efficiently and is adaptable to change.  The business’s operational activities convert the promise the company makes to its customers into the satisfaction the customer expects.  Managing the operations ensures that the fidelity of the product or service the customer receives is consistent with the customer’s expectations.  Moreover, doing so efficiently is required so that the business is profitable and capable of delivering the return expected by owners and providers of capital.  Nevertheless, the executive can’t subordinate other important responsibilities to a single-minded focus on making money.

Senior executives need a frequent barometer to monitor operational effectiveness.  The integrity of this barometer depends on the contributions of others and a common understanding of its meaning.  Monitoring operations requires a shared understanding of the rules and how those rules are applied.  A few examples of routine operational issues that require adherence to specific rules.

  • Order processing
  • Collecting money owed
  • Scheduling production
  • Manufacturing or production methods
  • Product packaging
  • Customer service
  • Routine financial performance
  • Selling

Reporting

Business executives depend on reliable and timely information.  This information may be diagnostic or strategic.  Regardless of the application the business executive depends on the veracity of the information relied upon to make decisions.  Business executives depend on knowing what it is that they are looking at.

A recent client had the accounting staff produce a weekly operating report for its senior executives.  Included as part of this operating report was the cash balance of each bank account.  Pretty simple right?  Well maybe not.  As it turns out the executives thought they were looking at a cash balance reported by the bank at the end of the banking day.  The accounting staff on-the-other hand was reporting the cash balance showing at the time (most often mid-day) and was adjusted by deducting outstanding disbursements.  Either one of these was legitimate.  In this case however, two different definitions of cash balance was used.  Executives thought cash balance meant one thing and the accounting staff was reporting something different.  This is not an example of accounting incompetence but rather an example of ambiguity arising from the absence of clearly defined rules.  And no one, that is until I looked at it, thought to consider the possibility that a discrepancy of meaning existed. A discrepancy that was compromising the reporting of cash balance.  This observation naturally led to suspicion towards other reported numbers.

Another example from the same client.  I was asked by the CEO to provide a comparison of current year billings to previous year billings.  Despite the CEO’s impatience and dismissive demeanor I had a pretty good idea of what he was looking for.  Nevertheless, my job was to advise him and the President of operational deficiencies and vulnerabilities, and I recognized that this simple request would allow me to expose just that.  So I decided to ask a few of the accounting staff, who, had I not been there, would have been the target of that question, what was meant by billings.  This was not a formal term the company used.  And as no surprise to me, I got as many definitions of billings as people I asked, all different I will add.

The point is clear, the absence of rules, in this case the measure of dollars committed to the company collected or promised, would produce misleading information.  The absence of rules dictating what things mean will result in people making-up their own definitions.  Some of these definitions will be approximately correct but there will be subtle and not so subtle differences.  One of the roles that rules play is to eliminate misunderstandings, ambiguities and misinterpretations.  Standardized definitions are but one form rules can be found.

But this application is critical especially when looking at financial reports.  Most of the accounting standards that exist are simply detailed statements of what a term or phrase means.  It is critical that all financial reports be free of ambiguity, errors and other misleading information.  Similarly estimates or projections are often required.  This should be clearly recognizable and qualified with the underlying assumptions.  For a report to be reliable it must be free of ambiguity and errors.  Rules establish the standards used when reports are prepared.  Without these standards the integrity of what is reported is severely compromised.

Compliance

Businesses are expected to comply with many different kinds of legal requirements.  This legal requirements include taxes, human resources, contracts, environmental and safety regulations as well as countless others.  Most of these legal requirements include reporting obligations together with an agency’s right to verify compliance.  When a failure to comply is discovered there are often serious fines and penalties.  Thus businesses are oftentimes required to verify that they operate in a lawful manner and have satisfied legal obligations.  Meaning a business needs to demonstrate convincingly to an outsider that is adhering to legal rules.

Protection

Rules also serve to protect the assets of the business from fraud, manipulation, or threat.  The following are examples of rules applied for purposes of protection.

  • Segregation of duties – separating authorization, custody, and record keeping roles to prevent fraud or error by one person.
  • Authorization of transactions – review of particular transactions by an appropriate person.
  • Retention of records – maintaining documentation to substantiate transactions.
  • Supervision or monitoring of operations – observation or review of ongoing operational activity.
  • Physical safeguards – usage of cameras, locks, or physical barriers to protect property, such as merchandise inventory.
  • Top-level reviews – analysis of actual results versus organizational goals or plans, periodic and regular operational reviews, metrics, and other routine diagnostic indicators.
  • IT general controls – security, to ensure access to systems and data is restricted to authorized personnel, such as usage of passwords and review of access logs; and change management, to ensure program code is properly controlled, such as separation of production and test environments, system and user testing of changes prior to acceptance, and controls over migration of code into production.
  • IT application controls – Controls over information processing enforced by IT applications, such as edit checks to validate data entry, accounting for transactions in numerical sequences, and comparing file totals with control accounts.

Rules take many forms and serve multiple purposes.  It is the responsibility of senior executives, owners and directors to ensure that the business infrastructure incorporates rules that are clear, unambiguous and properly conceived.

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Things – The Levers of Business

 “Give me a place to stand, and a lever long enough, and I will move the world.” 
― 
Archimedes

This issue of The Business Odyssey continues my discussion of infrastructure by introducing business infrastructure’s second component, ThingsPeople act.  Rules influence how to act.  This however begs the question – act upon or with what?  Things are the levers producing or enabling action.  People use Things in specific ways (in accordance with Rules) to produce specific outcomes.

Business infrastructure uses many different levers taking on a variety of forms.  Some levers are obvious and some not so obvious.  I will share a few examples.

I recently advised a maker of precision machine parts on cash flow and capital structure.  Among other things I was instrumental in helping the company restructure their balance sheet and secure an institutional private equity investor.  This engagement required producing meaningful and reliable forecasts of future financial performance.  My client produced parts for Tier One and Tier Two defense and aerospace contractors.  These customers all maintained sophisticated ERP systems that scheduled the delivery of system components years in advance.  This provided my client with a predictable and enviable order backlog.  My client maintained its own ERP system that communicated electronically with its customers producing, in theory, an up-to-date backlog.

My client’s ERP system can serve as a powerful infrastructure lever capable of enhancing financial performance.  Focusing exclusively on order backlog, for purposes of this example, I’ll offer a few thoughts on the specific ways this infrastructure lever could benefit the company.  The obvious benefit is scheduling production.  However, this backlog data combined with a reliable production schedule, not available when I started working with the client, could be used to dramatically reduce inventory carrying costs.  In the case of this client, their inventory days were about 160 days.  That’s an inventory turnover of about twice per year.  Meaning that the company was devoting a significant amount of its working capital as inventory.  This meant that the cash the company needed to satisfy payroll, suppliers and capital providers was unavailable.  This required the company to pay more for its borrowed capital, subjected the company to penalties and made it impossible to take advantage of supplier discounts.  The cost of protracted inventory days produced elevated capital costs, forfeiture of discounts, inefficient use of production resources and most importantly, lost revenue opportunities.

The business needed to manage its inventory more efficiently.  A proper business infrastructure ensures that this happens and happens effectively.  The lever to improve inventory utilization already existed but was unused – customer backlog data.  The Company was failing to understand its infrastructure needs and cost it was incurring because its infrastructure was deficient.

I will point out that inventory efficiency is only one single example of the consequence of failing to understand the value of business infrastructure.  This lever, backlog data, could and should be put to use in many other ways including forecasting and managing cash flow; managing expected growth by identifying revenue gaps, as well as anticipating and evaluating appropriate capital expenditures to name a few.

I use this as an example of a software system (a business infrastructure “Thing”) that was adopted, at no minor expense, to comply with its customers’ requirements.  My client however failed to consider the other contributions this infrastructure could provide to improve competitive advantage, liquidity, and profitability.

This example is not unusual.  There are many business practices and systems that businesses employ to comply with regulatory, tax, human resources or customer requirements.  These systems are adopted mindlessly to comply without taking the time to think about how each might serve the business or in the context of an overall infrastructure architecture.  This commonly produces redundancy, inefficiency, lost opportunity and in some cases even conflicting outcomes.

I’ll offer another more common example – tax compliance.   Companies typically maintain voluminous records to ensure compliance with the morass of tax regulations.  Another recent client conducted business nationwide as well as internationally.  The business was required to comply with sales, use and income tax requirements from many different agencies.  This particular client was very profitable and was thus a target of frequent audits.  I need to digress for a moment to point out that being audited, while hardly a pleasant experience, is not necessarily caused by any misdeeds on the part of the company.  Tax authorities often target successful companies for audits because the likelihood of collecting something is higher than auditing a company in trouble.  I make this digression to emphasize that this client invested significantly to ensure tax compliance.  During my consulting tenure I personally oversaw two separate tax audits and this company ran a clean ship.

My client had invested significantly in accounting systems, record retention and outside advisors to ensure rigorous compliance.  However, tax compliance was considered a silo all to itself with no consideration of how that investment might be used to serve the business in other ways.  The implications of this compliance mentality infected the business’s perspective by distracting executive leadership’s ability to see the bigger picture.  An entire infrastructure, poorly architected I might add, had been established to ensure that the business was capable of responding to requests an auditor might make.  There was a wealth of information being maintained to ensure tax compliance.  Using some of this information I was able to identify the most profitable clients.  Other information was used more rigorously to understanding the flow of cash and ultimately revealed the single most important measure of financial performance and will add millions of dollars to the bottom line every year going forward.  The examples I’m using are meant to show the “ancillary” uses of data already maintained for the simple purpose of compliance.  Needless to say, this more detailed understanding of the systems used to ensure tax compliance could be dramatically improved to free up peoples’ time to do other things, reduce expenditures on outside tax advisors and reduce the anxiety executives experienced every time tax issues arose.

There are many occasions where companies have assets whether software systems, data, locations, vehicles, machines or other Things, that are acquired and employed with no thought towards how they can or should be used to serve the overall purposes of the business.

I’ve spent the last few issue of The Business Odyssey dwelling on the topic of business infrastructure.  My goal has been to address this seemingly nebulous concept by dissecting it into three component parts, People, Rules and Things.  I don’t pretend that my discussion is exhaustive or complete.  That was not my goal.  My goal is to encourage middle-market executives, owners and directors to adopt a broader appreciation of the role business infrastructure serves.  The middle-market business leader need not be an expert in business infrastructure.  Moreover, it is an impossible and undesirable expectation to expect a business leader to be expert in every facet of inner workings – that’s the role of specialists.  It is however the business leader’s responsibility to challenge infrastructure to serve the business and to know when exceptions to the routine require their decision.