The CFO as Corporate Prophet
Long before a crisis hits,
Dan's eyes were gritty; he had already the beginnings of a headache. He had not slept well, waking several times during the night and finally giving up on sleep well before the alarm went off at 5:15 a.m.
Dan was the CFO of Greycor, a manufacturer of domestic consumer goods. He was proud of his achievements since he arrived there three years before, as revenues had grown from $36 million annually to over $250 million. He had also survived the challenges of the SarBox implementation and felt that things were going well . . . Until late yesterday, when he got the preliminary Q results.
He was scheduled now to talk to Marc, his CEO. He was not looking forward to it; Marc did not like surprises.
He had practiced his opening remarks repeatedly on his trip to the office that day. He hoped that a little humor would ease the pain of what he had to report, perhaps save him Marc's rarely seen, but legendary wrath. It did not.
Marc started slowly, "So you are telling me that our sales have declined precipitously, costs are increasing in both SAG and production, income has declined by what, 35% since last quarter?" And we're no longer making cost of capital? Dan nodded unhappily. He started to give Marc some reports that he had been working on late the previous night but Marc cut him off. "Why didn't you tell me about this earlier?
"We just finished the initial cut yesterday and I spent most of the night analyzing the results. I came to you as soon as I knew," was Dan's somewhat lame response.
This did little to defuse Marc. "Dan, I want to know three things from you by the end of the week. First, what happened; second, why it happened; third, why didn't I know about it before. I have to start calling Board members and our shareholder services area to get in front of this, So, go get me my answers. Now."
Dan felt stung and even said, "Marc, I'm just the messenger!
Marc's response was sharp, "That's not good enough, Dan. The CEO and the CFO both have overall P&L responsibility. I need a CFO who helps me stay in front of the curve, not one who tells me when we are sliding down it. I don't know if we are having a mild case of angina here or a heart attack. Get me my answers by close of business Friday . . ." He did not have to finish.
The meeting had lasted nine minutes.
Dan sat at his desk again - at once understanding of what had just happened and, being human, smarting from it - he was haunted by the question Marc had asked just as he left the room: "Are we looking at a corporate heart attack here? Or is it just angina?"
Dan did not know. He did not have the numbers.
As with most human diseases, a corporate heart attack - or even angina - does not really strike out of the blue; without earlier warnings. They may be silent, they may be subtle, they may be hidden from the casual observer, but the signs, the symptoms are there; often for many years. And, the earliest of these are the CAUSES of the disease, the very DRIVERS of corporate performance.
All that is needed to see them are the instruments - the business equivalent of the EKG, MRI, or blood tests - to bring the problems to light. And, of course, the courage to look.
THE PHASES OF CORPORATE DECLINE
Dan knew that as a company declines from its Prime stage to its end, it goes through three well-documented and clearly identifiable phases:
Each phase with its own clearly defined symptoms, its own characteristics. And in each phase, fully a third of the company's competitive value is lost. See Fig. 1.
Working now from the bottom up of Fig 1. . . And from right to left. . .
Phase III Decline - The Overt Phase
When Dan presented the financials that morning he was careful to state to Marc, his CEO, that even though they were still profitable, the company was no longer making cost of capital; something that would, and should, trigger intense board concern. Frequently this stage is referred to as "Early Decline." But both Dan and the CEO recognized it for what it really was, the earliest stage of Phase III Decline. Their board, being professionals, would know it too.
Both Dan and Marc knew that by the time the financial statements pick up the signs, Phase III decline has arrived - right column. And with its arrival, two-thirds of the competitive value of the company has been lost.
Their company had gotten there without apparent warning and without either of them knowing how.
Both knew that running a company out of the financial statements - however timely - is like driving a car by looking only in the REAR VIEW MIRROR: By the time trouble shows there, the car is already deep in trouble. To quote Yogi Berra, which Dan had done that morning to little effect, "Before there wus a problem, there wus a problem." Dan had produced the financials the fastest they had ever been produced, but they were still no better than the rearview mirror.
The previous periods' financials had shown no difficulties either. No hint, no suggestion. If their systems had been better, he might have been able to get some kind of warning from the Z or ZZ Scores. But in their case it would not have been much - a couple of months perhaps - and those measures were iffy for them anyway.
PHASE II Decline - The Subtle Phase
Things would have been different, he thought, if they had recognized earlier, perhaps a year before, that they were in Phase II decline - and heading down. But Phase II is not evident in the financials - even with the most sophisticated analysis possible. Detection of Phase II requires different measures.
Phase II decline, shows in the Key Performance Indicators (KPI's) - middle column; things like time-to-market, process metrics, customer complaints. Factors that are, like the financials, historic expressions of performance. But at least earlier historic measures. KPI's are things that a professional due diligence would have picked up - if they had been for sale. (There is another measure too but we will speak of that later.)
There was plenty of information available in the literature about KPI's and their measures, and Dan knew what needed to be measured and how; he had not been able to develop them yet; the ones they had been measuring before he came, were conflicting and had set one department against another. The proper ones were difficult to measure and expensive too. They had been on his department's wish list for next year; now, unless things got better, they would not have the resources.
But he did admit to himself that there were some GUESSES the senior staff could have made about some of the KPI's that would have raised alarms; guesses that he now admitted would have been close to the truth. But he had not asked them to do so; perhaps because he had not felt empowered as CFO; perhaps being a CFO he was used to measuring only "hard" numbers.
Managing a company from the KPI's (again, even timely ones) was no better than driving a car by looking out the SIDE WINDOW. Better, of course, than the rear-view mirror. But by the time trouble shows there, the front of the car, at the very least, is nose-deep in trouble.
By the time Phase II first shows up, fully a third of the competitive value of the company is lost. Dan had been in this situation before and the loss in Phase I, while not quantifiable by a due diligence in terms of money, would show up the moment the company needed to respond to a crisis - or mobilize itself for a new endeavor.
He knew that this invisible loss was the reason so many acquisitions (70% by some accounts) did not achieve their promised results.
PHASE I Decline - The Hidden Phase
What the company needed, and what Dan needed as corporate prophet, ("Daniel the Prophet" had a certain ring to it and Marc had made no bones about it, that was to be Dan's role) was a set of measures that would indicate problems at the earliest stage possible, at the very beginning of Phase I. Measures that would allow him to go into the CEO and say, "Here are the financials, they look good." Maybe also, when they could afford them, "Here are the KPI's, they look good too." But then be able to add, "Here are some numbers that show a problem coming, a problem that will manifest itself in the KPI's; and the financials soon after that ... UNLESS WE DO SOMETHING ABOUT IT."
As Dan thought about it, signs like these had been evident in the way the company ran since he arrived; he suspected they had been there for years; since before Marc had arrived too. He had just not seen them as IMPORTANT. Certainly not related to the nasty runoff of their more profitable customers that had shown itself suddenly.
He quietly admitted to himself that it was driven by a deterioration in management performance. It was not his place to say that, he supposed - but he would now. And he would take the heat for it too.He was going to take the heat anyway he realized. But Marc was a CEO with enough guts to look reality in the eye. And have his team look at it too.
THE SIGNS AND SYMPTOMS OF PHASE I
The signs and symptoms that show Phase I Decline are attributes of the company called the DRIVERS OF PERFORMANCE - left column. They also show Phases II and III, but that is another matter. Collectively they constitute the Operating Dynamic of the company. And they are entirely within the control of management. They are the very causes of performance - and as nothing can predict earlier than the causes - they are the real predictors of performance.
They fall into just three categories:
The Critical Functions (CF's) are those functions within a company, which have a large effect on productivity, for very little effort. An analogy would be the accelerator on a car or the brake on a locomotive. There are only a handful of these Critical Functions. The important thing to remember about them is that they can be measured very easily.
For simplicity here we will deal with just three*: Talent Management, Lean Operations and Performance Management.
Talent management refers to purposeful hiring, development and turnover. Performance Management refers to goal setting, rigorous follow up, rewards directly related to performance and the like. Lean Operations, which includes cost containment, lean manufacturing, cost control, etc, is of course well understood.
These three were chosen a) because they are indeed important and b) because a few months ago, the results of an eight year study of one hundred companies, showed conclusively the extraordinary impact just these three Critical Functions have on the bottom line. The study was conducted by the London School of Economics (LSE) and McKinsey.
All companies have these functions. They are, by and large, independent of the systems and processes used. And, as mentioned above, they are entirely within the control of management.
Dan had been aware at some level from the moment he arrived that these functions in his company were faltering; the quality of execution and enforcement was generally poor throughout the organization.
Quantifying the Critical Functions - even just the three mentioned above - provides a clear assessment of where the company is. And if the company is in decline, they show broadly whether it is in Phase I or II or III. They also show where the company is on the growth-development side. But that is for another day.
The measurement of the CF's as a whole gives the current status of the Operating Dynamic of the company. For the first time it can be couched as a single number - with underlying details; the Operating Dynamic Index (ODI). This is the full analogue of the balance sheet or income statement. But the financials show the past while the Operating Dynamic is what is driving the future. Unless, of course, management intervenes or a miracle happens.
If Dan had measured the Critical Functions the month before, when the financials showed no trouble, they would have told him the company was somewhere near the bottom of Phase II; even though they did not have KPI's to ring bells. And that would have been a signal to at least do a canvass of management and key staff as to where they thought they were.
If he had measured the Critical Functions a year before (or perhaps two or three) they would have shown clearly that the company was already in Phase II decline; and how deeply.
GENERATORS OF PERFORMANCE
So, what drives the effectiveness of these Critical Functions? Underlying them, and determining their effectiveness, is what are known as the Generators. (G's)
Again, these are few in number - we work with nine. And again, they can easily be measured.
For simplicity we will again deal with just three of the nine here. These were chosen from our experience with more than 200 organizations, going back over thirty years. They are the corporate attributes that have a powerful effect on ALL management functions. Not just the Critical ones. These are:
Decisiveness here refers to the decisiveness of the company: the speed with which issues are brought to the table; decided upon, and executed. It does not refer to the decisiveness of the CEO or manager. Nor to the quality of decision-making. (For the same quality of decisions there is a huge variation available in the rapidity of decision-making.)
Acknowledgement of Work may seem like an odd factor to look at. The question of why people within a company would NOT talk about the work they do begs for an immediate answer; its lack is frequently found. But it is a complex issue and must wait for another paper. Suffice it to say, that this Generator refers to the amount, frequency, and quality of discussions between workers, between workers and supervision, between supervisors and management and between all and clients and suppliers.
Accountability does not require any definition.
As you can see, just these three Generators profoundly determine the effectiveness of the Critical Functions. For example, if Accountability is deficient, neither Talent Management, nor Cost Containment can operate well.
These generators are as easily measured as the Critical Functions. Measuring just the three of them shows clearly, if not in fine detail, the COMPETITIVE TRAJECTORY. Either down or up; fast or slow.
In Dan's opinion, of these three, Decisiveness was the major issue. If he had identified and quantified that, he could have told how quickly competitive and financial trouble was approaching. And he could have gotten very good answers from the managers and supervisors if he had asked. They usually see these very clearly . . . Even if they don't like to think about them.
Measuring the Generators provides 1) the trajectory and 2) the rate of change of the Critical Functions: How fast or slow they are improving or deteriorating.
Between them they make a compelling case that is scarcely ignorable: For management or the board to intervene or to praise; for investors to buy or avoid; for owners to fix or to sell. In our practice, we have seen all of these responses.
The above paragraphs are the good news: Just fifteen attributes to be measured. But now for the bad news: There are more than a hundred possible factors within the organization that can block or impair the Critical Functions and the Generators. They are known as Blockers. (B's) They are the organizational factors that suck the life-blood out of a company. The profile of blockers is unique to each organization, and indeed to each unit within it.
Because of the complexity in dealing with these, just three will be mentioned here: Distrust, Complacency and Bureaucracy. They need no definition. Dan thought that Bureaucracy might be the biggest one for Greycor.
MEASUREMENT OF DRIVERS
Quantifying the Critical Functions gives the current status of the Operating Dynamic of the company. For the first time it can be couched as a single number - with underlying details; the Operating Dynamic Index (ODI). As noted above, this is the full analogue of the balance sheet or income statement. But the financials show the past while the Operating Dynamic is what is driving the future. Unless, of course, management intervenes or a miracle happens.
Quantifying the Generators gives the trajectory of the Critical Functions.
Quantifying the Blockers explains why.
But how to measure these Drivers, the components of the Operating Dynamic: This process can be both sophisticated and complex when a company intends to purposefully intervene so that significant improvements in profits are immediately triggered. However, it is possible to get a quick first-approximation of "status" - one that will mobilize management to confront the issues.
A survey is all that is needed; its construction and use are easy.
For many years, C-level execs have complained that no instruments or measures existed that would provide them with a clear picture of the operating dynamic of the company; that would show its trajectory; that would allow them to measure the current effectiveness of management as a whole; that would enable them to predict future workforce performance. They have also complained that there were no tools for them to use to change that performance. Such things were felt to be in the realm of inspired leadership; or perhaps even magic.
And for many years they were right.
However, starting in 1980, it was discovered that the very CAUSES of performance, the organizational and human factors that generate business outcomes could be identified and could be quantified. Interestingly, the tools developed were measures of the performance of the organizational units (as the KPI's and the financials are) rather than the performance of individuals. (Just as the traditional 360° appraisal is a measure of an individual's performance, the tools developed to measure the causes of performance are 360° appraisals of the organization.)
More interesting still, they PREDICTED, not just workforce performance, but also the bottom line of the company*. And most interesting of all - a discovery of extraordinary potential for any CEO - the factors measured had within them the seeds of their own improvement.
Without the measures, both CEO and CFO must travel blind. With them the CFO can be a prophet. With them a CEO can preempt and change the future.
Dan set to work: He would have his survey. The Accounting Department prepared the financials, everyone knew that; they showed the performance of the company as it had been. Now he would add measures of the Drivers of Performance. They would enable the company to predict. It would cost virtually nothing.
His first task would be to measure the Critical Functions and the Generators. (These were the easiest.) He would issue the survey together with the LSE-McKinsey study*. That would take care of any legitimate reluctance; they would know that improving just three functions by 20% would get them a 40% improvement in profits. Even a 10% bottom line improvement would take them out of trouble. Then he would get to the much more challenging Blockers. But that would be for another day.
Dan would have his survey. Marc would have his answers.
Tom FitzGerald is CEO of FitzGerald Associates www.ManagementConsultants.com. Founded in 1976, they specialize in quantifying and transforming the Operating Dynamic of companies and helping CEO's/CFO's trigger systemic improvements in the performance and profits of their companies. Tom can be contacted at email@example.com .
John Collins has held the position of CFO in a number of companies. Like all CFO's of any tenure, he has had occasion to bring the bad news; and get shot. Over the last several years, he has utilized the techniques and instruments described in this article to head off disaster and reverse trajectories. He is currently the CAO of Mid States Corporate Federal Credit Union. He can be contacted at firstname.lastname@example.org .
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