Saturday, November 20, 2010

Management by Spreadsheet

For those who didn't already know, there is actually a long running quasi-feud between economists and businessmen over the subject on which they mutually claim authority. It is akin to similar feuds observable in other fields. The one that first comes to my mind, probably because I work in it, is the rivalry between scientists and engineers. While the public tends to view the two as interchangeable groups that wear similar priestly robes granting them authority in a subject often held in awe, actually, the two groups could hardly be more distinct if you ask one of them.

The dichotomy springs up in that scientists tend to be more theoretical while engineers tend to be more practical. Thus, the engineers sometimes regard scientists as useless arm-wavers who can't actually get anything done, while scientists sometimes regard engineers as trained robots who don't actually understand what they are doing.

Likewise, in the world of business, economists are often viewed by businessmen as arm-waving theoreticians with no practical knowledge of how to manage anything in the real-world, especially the academic economists. To be fair, economists often don't help their case. For all their supposed knowledge of markets, how many truly wealthy economists can you name? Truth be told, most live a fairly humble existence, and a few even manage to land themselves in fantastically embarrassing financial messes. For example, Irving Fisher, one of the most influential economists of the twentieth century, squandered an enormous fortune by investing heavily in the stock market -- right around the summer of 1929. With enough blunders like that as evidence, who can really blame them for such an opinion?

For their part, economists sometimes view businessmen as economic savages who are ignorant of many basic economic laws. In case you haven't guessed it yet, that is what this post is all about. I have repeatedly observed one particular behavior that I have dubbed 'Management by Spreadsheet.'

This behavior covers many blunders that might fall under the heading 'well, it looked good on paper, but...' Of course, I'm speculating as to the cause of the behavior, as I'm not privy to actual business meetings to know how such decisions are made, nor have I been to business school to see if this is actually how business students are taught to solve problems, but I'm pretty sure this is how it works.

Business A wants to find a way to make more money. The businessmen get together and pull out spreadsheets that describe revenues, costs, etc. One of them suggests 'hey -- if we change this number to X, the spreadsheet says we can make Y more money next year.' Everybody decides 'Great! Let's do it.'

Next year, all sorts of weird costs show up that nobody anticipated, sales aren't what were expected, and not only did they not make Y more money, they lost Z. The spreadsheets don't look remotely like what they were supposed to, in fact, they don't look anything like last year's either and appear not to have anticipated anything. A low level worker is laid off to reduce costs, and the businessmen gather their new spreadsheets to make more decisions.

I have seen countless examples of behavior that seem to have originated this way, but I'll share just a few. I was at the grocery store the other day and used a coupon for $5 off. This coupon was generated by this very store, mind you, probably to get people like me to shop there. But the discount it gave was on a sliding scale that was apparently so complicated that it took three cashiers and a manager to figure out how to discount it.

I guarantee you some business egghead (or who knows -- maybe an economist!) figured they would get the best return on this coupon if it followed that schedule -- a schedule so complicated that such coupons are now slowing down checkout lines across the country and will probably show up as a need to hire more cashiers, or reduced revenues as customers migrate to other stores with lower wait times.

At another store I happened to notice a sign instructing their cashiers to 'know their limits!!' Two exclamation points. The store was giving steep discounts on certain goods, no doubt to get customers in the door, but was placing limits on the number of goods any particular customer could buy. You've seen these before -- 'Limit one item per customer.' In economics, we call that a quota, and most of us know it as a form of trade control and a stupid idea, usually in response to shortages of a good caused by deliberately underpricing -- another stupid idea.

Nevertheless, this outfit was making such offers, and was now relying on minimum-wage high school employees to police sales. Naturally, this slows down checkout, especially when grandma brings in her six grandkids to each buy one item and makes several passes to get as many as she can.  It sets up conflicts with customers, confuses and demoralizes employees, and in all likelihood results in at least mild corruption -- willful non-enforcement of the policy by some employees. Whom I really can't blame, actually, as I have little patience with that kind of thing myself. That's always the effect of such policies. Why fight it?

I have no idea how that all plays out on the businessman's spreadsheet, but the point is I seriously doubt it is predictable, or profitable. I heard another story about a grocery store that decided to start advertising high profit items on its highest volume items, so that the most customers would (theoretically) be drawn to the highest margin products to boost profits. Which sounds great in theory, except for the fact that it resulted in, shall we say, ruffled feathers over intimate care/hygiene products being advertised with the milk and bread.

And it has been reported to me (I'm not old enough to know) that Detroit automakers originally alienated American buyers by designing cars to be built as cheaply as possible -- regardless of whether or not this was actually what their customers wanted. Like insisting on producing cheap, efficient front-wheel drive vehicles when customers wanted the better performance of rear-wheel drive. I guarantee it was some guy who said 'look, the spreadsheet says we can cut costs here and make more money.' Too bad these geniuses were more interested in what the spreadsheets had to say than their customers. They figured they could ram the product they wanted to produce down their customers' throats.  Doesn't work that way. We Austrians would call this an attempted violation of consumer sovereignty -- and a very, very bad idea.

All of which illustrates the moral of the story --

Economics isn't math. You can't calculate everything. Put down the spreadsheets for a minute and think about what you are doing.

I'm not sure exactly what leads to this phenomenon. Maybe its a case of looking for your keys where the light is best instead of where you dropped them. How else is one to 'express' a business, except on a spreadsheet? And if that's the tool you've got, it's what you've got to use. Maybe those arrays of numbers and impressive looking formulas gives a sort of confidence because they are all so hard and quantitative, while economic theory is all so theoretical. And dreary, because it says things like 'in the long run, profit margins naturally approach zero' and other things that businessmen don't like to hear. I don't know.

Economists proved long ago the futility of such behaviors as subsidy, mercantilism and quota-mongering. Supposedly. For the life of me I do not understand the persistence of such behaviors. Maybe there's something to them that the businessmen know and we have overlooked.

All the same, I have a humble suggestion that might improve upon the situation. The real role of a business manager, it seems to me as an amateur economist, is to structure a division of labor efficiently to serve customers best. That's about it, although in some ways that is just an easy way of saying something extremely complicated. But if you are doing that, your spreadsheet is going to look about as nice as you can possibly make it. On the other hand, changing your business model on the basis of a pile of numbers can have all kinds of consequences that aren't necessarily apparent to an accountant, until he gets the returns from next year.

Maybe thinking about a business primarily as a division of labor to be optimized through restructuring and using all that spreadsheet stuff more as an evaluative tool and less as a predictive one would lead to some better ideas.

But that's just my opinion.

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