Efficiency is free [in the long run]

Efficiency is free in the long run, argues Seth Godin.

I read his post as saying two very different things:

First, shifting costs to other people ends up costing more money overall. That’s what economists call a negative externality (and the genesis of many NIMBY complaints — no one wants to be on the receiving end of a negative externality, like a cement factory or pig farm, the two business endeavors that seem remarkably common in legal casebooks). The idea that one person can do something that’s more profitable because costs fall on a third party generally offends our sense of fairness, and it makes us realize that if a party is not tracking the true costs and benefits of its proposals, it might make a poor decision.

Second, Seth seems to be saying that many profitable investments in the long run are not being made in the short run. As articulated by Tom Nonnenmacher, that’s indicative of a discount rate problem.

The first issue is a big-picture legal/societal/moral/ethical one,that we’re not going to solve today. We have lots of rules that allocate responsibility for things. Laws exist (or don’t) because we want to assign costs for externalities to certain parties. For example, “allowable” limits for discharge of pollutants are set by governments for various reasons, but one legitimate reason is how much the public gains from that behavior. To shift a bit, we have a law that allows persons harmed by vaccines to recover from a fund administered by the federal government, in part because the legislature has determined that the public good is increased so dramatically by the use and prevalence of vaccines that it’s worthwhile for society to bear the costs of those infrequent injuries to persons from vaccines (rather than making the manufacturers directly liable to those persons).

The second issue, though, of discount rates is one that can be fixed, or at least addressed, by good leaders and managers. Firms need to start from a position of understanding about the returns that they’ve actually made from different projects (rather than guessing about overall returns, or assigning corporate-level weighted-average returns to each project beyond the first step of the process). Then, managers should work to understand what happened between the plan for the project and the outcome: what factors affected the variance, which factors improved vs. worsened results, and how much did each factor contribute to the final result? This source of change analysis will eventually become table stakes at the C-level; once you see it in action, you realize that it’s the only way to run a railroad.

Stepping back, though, the question of overly high discount rates (leading to favoring near-term, short-risk projects over longer-term projects) is impacted by different factors as well. One is sensitivity to short-term, i.e., quarterly, financial reporting. Another is understandable but probably not well-understood concern about projections (will we really make that much?) and execution (can we really accomplish those tasks?) and timing (will it really happen that fast?). Those three are all sensible; the issue I think about as a board member is whether the company has really thought through these issues and really “forecast” the numbers vs just throwing them into excel and tweaking them until the bottom line looks okay. Imposing higher discount rates because of internal risks – things that the company should be able to know and influence over the course of the project – is a bit of sloppiness or intellectual laziness. After all, if you don’t understand what the underlying factors really look like and what the variance in the estimates is, then adding a top-level discount factor is probably just as unknowing. It’s like saying, “I don’t know how much that car is worth, so I’ll offer you $100.” A similarly unsophisticated approach is setting a high/medium/low number for some item without any real understanding of why the number might be different, what the distribution of the possible outcomes is, or why any of those three numbers were actually picked other than that one is highest, one is lowest, and the third sits in-between. In other words, there’s too often no information present in that choice.

What’s the point of all of this? The point is that it’s the job of the leaders to dig into the elements of underlying business risks and put them into the plan in some way based on what’s going on. The job of the board is to dig into those risk analyses and think about them in a few ways: what is the distribution of likely outcomes for some factor? How does that change the total outcome? Will we be able to mitigate negative results along the way? How does this range of outcomes fit into our total corporate portfolio of activities?

Ultimately, finding profitable investments and allocating capital to fund them is the job of the CEO, and it’s the board’s job to take a big-picture view and keep the entire corporate portfolio in mind so that each project fits the company’s strategy and strategic plan.

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