This week a prospective business seller said he didn’t run his business according to traditional cost accounting methods. (I had asked about gross margins to get a sense of gross profit. This is an important indicator to me because it often reveals intellectual property and annual growth ceiling.)
He gently said, “that’s just not how we think about it so I don’t have it quick at hand. But, hang on.” I filled the time by asking about allocating direct labor, assuming that was the hang up, because that always trips me up in my thinking. He laughed, agreed and gave me a little bit of a lesson:
When workload changes you don’t lay people off immediately, right? I agreed. Why is that? Well, it’s because there is always some amount of unused labor somewhere in the system. And it’s not practical to vary labor precisely. There’s a little slop between reality and cost accounting. Certainly if the work slows enough that you must furlough people you will. But, it’s not the first response. And within the business, on a day to day basis, the allocation of direct labor is not as important as the overall profitability.
I kind of agreed. But kind of not. It depends on the goal, right?
He then referred me to “The Goal” by Eliyahu Goldratt (1984). I bought a copy and read it. The “Theory of Constraints” reminds me of my work on limiting factors and agile development. All of this traces it’s roots back to the Toyota Production System and before that to Henry Ford and before that to basic ecology. Mikel and I use a lot of these practices at Little Engine Ventures, somewhat by habit. Everything we do is about throughput. How fast can we move an idea through, observe, orient and decide next step?
In complex adaptive systems it’s best to invert the problem. If growth is the objective, flip the complicated on its head and ask, “what prevents growth?” In this way you often find a single constraint. Fix that. Observe. Move on or fix it again. This is common sense, right?
In most cases it is not. In most cases the institutional imperative takes over. Our brains run on autopilot, repeating today what we did yesterday; and following the herd or admired colleagues. While these common practices might be safer for the individual in an ecological system they become detrimental when trying to be above average.
Most people assume that a person must simply work harder if they want to get ahead. This argument becomes louder if you fall behind. ‘Pick yourself up by the bootstraps and plow forward,’ they say. Or, as my grandpa Starr used to say, “if you fall behind today, just get up an hour earlier tomorrow. Repeat until you are caught up.”
Certainly this can be true at times. But, would it not make sense to ask yourself why you failed to deliver in the first place? Can you avoid that situation in the future? Don’t blame others. First, assume you are not immune and it’s your own fault. Find the problem. Fix it. Or, as I like to say, “Work smarter, then harder.” Or (“get smarter while working.”)
Mikel and I have a habit of going to lunch on Fridays. We go to the same place and order the same pizza and the same drinks. We laugh about how dressing the same every day frees up head space for more important things. These little habits pile up. The other habit we have developed is the topics we discuss. We move from business challenges and root principles considered during the week, to challenges at church or with our kids –almost always in that order, and then back around again. During these Friday lunches we move up and down from practical solutions to first principles. I think we try to sort it out over the weekend and come back ready to attempt a refinement. They don’t always work.
This Friday (yesterday), I confessed for the umpteenth time that I am obsessed with building capacity. The root of most of our problems is that I’m obsessed with this. I set expectations on what I believe is possible, and then I challenge us to figure out how to organize the available resources to achieve that lofty goal. I refuse to set goals based on past performance because it inadvertendtly glorifies past practices. I prefer assuming that past practices will not lead to future results; but more of the past, perhaps incrementally better, that just so happens to be in the future. Besides, I know from experience that if everyone else does this and I find a better way, I school them. We need to fight for common sense.
The problem with this line of thinking is that its requires practicality, creativity, deductive reasoning and independence. To effect change it is also constrained by willingness of others to follow you and authority to control necessary resources. I run into the former limits more often than the first batch. The common sense solution? Re-scope the conceived solution to work within the constraints of your resources.
At Little Engine Ventures we are striving to compound intrinsic business value over a period of many years. We have more autonomy than most and this is a huge advantage. We can earn a profit from operations, investment practice or even financing. We own controlling interests and minority investments. We can raise or disperse equity or debt capital. This all adds up to fantastic amount of allocator capacity.
However, our on-going challenge is to prioritize where our focus rests. It’s as if we had an extremely diverse enterprise with options to “go where the deals are” but must find the few items to concentrate resources upon. In this manner, I’ve used a rank-sort of margin of safety as our key method. I’ve also begun to more heavily weight the magnitude of the outcome. This might sound terrifically mathematical. It is not. Statistical? Yes. Precise? No.
I prefer trading precision for control. It’s in my nature. Or, as I used to tell colleagues, “to get a boat into harbor, we must first steer it toward the rocks.” This always gets finance people squeamish. Depending upon their on-going appetite, I leave it there, or comfort them by saying, “We’ll slow it down and steer it so as to assure we avoid fatal damage.”
During lunch Mikel suggested I allow managers to “blame Daryl for looking weird.” He said it gives them more freedom to maneuver. I agreed. But this can be overdone, Mikel (Cosmo Kramer as an investor).
Ultimately, the true genius of any investor is to discover and act upon situations where a constrained resource can produce abnormal results. Good investing is about finding a gold mine in a farm field when no one else knows it there, and then selling everything to possess it, extract it and profit from the deviation from normal. The meta-insight of this post (if there is any) is that we ought to be scanning for unique and temporary constraints hiding in plain site. It’s just common sense.