Exalted Numbers: How good numbers produce bad decisions, by Mark Chussil
Question A: How much should we spend to launch Phlogiston?
Question B: We spent $23 million to launch Etherium. How much should we spend to launch Phlogiston?
An “anchor” is a number against which we gauge other numbers, perhaps unconsciously and perhaps inappropriately. There was no anchor in question A. In question B, $23 million was an anchor.
Anchors influence the way we think. In question A, you probably thought about the market, what you want to accomplish, what research you want to conduct, and so on. In question B, you probably thought about what would make you want to spend more or less than $23 million.
In business some numbers are special. The cost of capital. The rate of inflation. The market average. Last year’s results. The industry benchmark. Six sigma. These and other numbers are so exalted, we rarely question, let alone notice, their unintended consequences as anchors.
One number stands out even in that exalted company. It is a number that we fear and venerate. It is a number that is fluid and then becomes stone. It is a number that defines the limits of what’s possible. That number is the budget.
The exalted budget
My colleagues and I conducted a business war game for a major company. We divided the company’s managers into teams to role-play their own business and their competitors. We told them that they had to allocate their marketing budget among various messages that they could deliver through various media. Their market-share and gross-margin numbers would result from how much they spent and how well they spent it, compared to how much their competitors spent and how well they spent it.
We told them what their budgets were, and we told them that they were free to spend more or less than those budgets. We told them there were no limits to how far their spending could diverge from their budgets.
Every team, in every year of the war-game simulation, spent within a few percentage points of their budgets.
In most companies, the budget is rather like Goldilocks’ porridge scenarios. Spend less than your budget, and your bowl shrinks next year. Spend more than your budget, and you get burned. Spend very close to your budget, and you are just right.
Unfortunately, the meet-your-budget imperative collides with the competitive challenge. If you are (in reality or due to anchors) constrained by your budget when an unexpected threat or opportunity pops up, then you are constrained in your options to respond to the threat or exploit the opportunity. If your competitors work the same way (and, being human, they probably do), you might not suffer too much. However, when new competitors (or newly aggressive existing competitors) charge in, your (real or unconscious) constraints can produce a debilitating competitive disadvantage.
The competitive disadvantage can trigger a downward spiral that’s due as much to the budget anchor as it is to competition itself. A competitor takes share from you, so your sales go down; as sales go down, budgets linked to sales go down; as budgets go down, the ability to respond to the competitor goes down; as responses weaken, the competitor takes more share; and so on. As a strategist in a large company described this conundrum: We have enough money to buy bullets, but not enough to buy a scope for the rifle that will let us aim accurately.
Why do upstarts beat incumbents? Upstarts supposedly “think outside the box” or “break the rules.” What are the boxes, what are the rules, that bind the incumbents? An incumbent thinks of budgets. An upstart thinks of investments.
What to do
Of course a budget isn’t only an anchor. It’s also a corporate reality, and (lack of) adherence to the budget can affect careers. Companies get what they pay for, and sometimes what they pay for is adherence to budgets. Don’t let that happen because of invisible anchors; make sure it’s a clear, conscious, intentional decision. And perhaps those controlling the budget (or the strategy discussions) don’t recognize how much anchors limit your business’ options.
Watch the thinking that goes on in your company’s strategy discussions. Are there unstated assumptions about the inviolability of the budget? Is there an important opportunity or threat that people are trying to fit inside the budget, rather than thinking about spending what’s necessary to deal with the challenge?
What you can do if you believe that the budget does not reflect the needs of an opportunity or threat is to show how a different level of spending would be of benefit. Most strategy analysis I’ve seen ultimately relies on spreadsheets that, in turn, rely on an accounting paradigm. The accounting paradigm is a conceptual anchor that seriously affects strategic thinking, and not for the better. (For much more on that subject, see With All This Intelligence, Why Don’t We Have Better Strategies?) For a different approach, look at your business through the eyes of an entrepreneur or investor.
Finally, note that budgets themselves are partly influenced by anchors and other assumptions. We should spend X% of sales, this year’s budget is last year’s plus an adjustment of Y%, we’ve got to keep spending to $Z to boost the stock price. Other strategy-related issues have anchors of their own: a new-product launch costs $A, it takes B years to become profitable, the pricing sweet spot is $C.
A ship moves only after it raises its anchor.
For more about anchors, please see The market leader, and other ambiguities and distortions.