We will end this essay with a valuable point about costs and prices. We will begin with an enigma about assembling products at home.

As I home-improve my home, I come across products whose directions warn me not to “overtighten” something. This confuses me. How am I supposed to know how much tightening is too much? If something shatters, cracks, or crumbles, I figure I’ve overtightened it, but that information is tardy and not helpful. Remember, I don’t want to undertighten it either. I don’t want it to fall apart and spill a Caution! Awfully Hot! liquid on me.

A pleasant alternative would be “go ahead and tighten until you reach the limits of your strength.” To do that, the item being tightened would have to be strong enough to withstand my formidable strength, and we all know that sturdy is out in these cost-conscious times (which apparently have been in effect for 30 years or so, based on how often we are warned of the delicacy of items about to be tightened).

I think the elegant beauty of “do not overtighten” can only be understood from the perspective of a lawyer. (Your Honors, I hereby state for the record that I am not, have never been, and expect never to be against lawyers. I almost became one myself. Ipso facto. Habeas corpus. De minimis non curat praetor.) Or understood from the perspective of folks in product support, who in turn are dealing with a situation created by cost accountants (about whom I also have nothing against). Let’s replay the scenario.

Customer: “I was putting the product together and it broke.”
Support: “When did it break?”
C: “Sunday.”
S: “No, at what point in the assembly process? Were you tightening something?”
C: “Yes.”
S: “You must have overtightened it. The instructions specifically state not to overtighten it. Bad customer. There is no warranty, express or implied, on overtightened items. We would be happy to sell you a replacement. Want my advice?”
C: “Yes, please.”
S: “Do not overtighten it.”

Businesses tend to overtighten. They do it because they’re led there by simple, persuasive logic, which we can boil down to this: it is cheaper to print “do not overtighten” on the instructions than it is to supply products that can withstand formidable strength. It is even virtuous to do so, because driving excess costs out permits lower prices, which makes customers happy. That’s true. Until we overtighten. Unfortunately, the dividing line between nice-and-tight and overtight is as hard to discern in business as it is in home improvement.

Overtightening in business leads to being unable to get an airline seat for days if your flight is canceled. (See “Police Called to Quell Unruly Passengers at J.F.K.” Notice that the airline blames the weather, not overtightening.) Overtightening leads to being put on hold for hours. Overtightening leads to being vulnerable to hiccups anywhere in a long supply chain. Overtightening leads to nutritional quality gradually being subtracted from food.

Nobody intentionally overtightens. Probably nobody thinks he or she does overtighten. We’re just listening to that eloquent cost analysis showing how much money we lose when there’s an empty seat on an airplane, when phone operators are sitting idle, when we don’t outsource to Mars, and when we compare natural proteins to polyglutamatinousbiphosphorescentcosamine.

You will notice that this essay is not entitled “In Defense of Wasteful Practices.” I am not defending waste; I am in favor of efficiency and productivity. All I’m saying is that cost analysis makes an implicit assumption: if saving $1 is good, then saving $2 is twice as good. It makes another implicit assumption: saving the next dollar is equally good as saving the previous dollar. In other words, the tools we use to gauge the goodness of tightening make it hard to tell the difference between nice-and-tight and overtight.

Some companies, notable for their rarity, explicitly reject overtightness. I had a Sears Craftsman ratchet wrench that I broke, perhaps by overtightening some poor thing. Sears offers a lifetime warranty on Craftsman tools. I took the wrench to Sears, found my way to the tool department, and presented the wrench to a friendly Searsperson. I said that I’d bought it a long time ago, far, far away, and it broke. Before the word “broke” had faded from my lips, I had a replacement wrench in my hand, along with a receipt documenting that there was no charge. Similarly, there’s Nordstrom, and LL Bean, and Chelsea Audio Video, which is even more guy-fun than the tools department at Sears.

So how can you avoid that sickening feeling that comes right after you’ve overtightened?

• Beware of the death of 1,000 tightenings. I believe it was John Allen Paulos, in one of his marvelous books about innumeracy, who gave a terrific example of how we devolve from nice-and-tight into overtight. (If it wasn’t Prof. Paulos, please correct me.) Imagine that customer surveys show product A is statistically indistinguishable from product B, and product B is indistinguishable from product C, and C from D, and D from E. It does not follow that A is indistinguishable from E. If A through E involve successive minor cuts in quality, it may appear that customers won’t notice or care about each cut, but when you add them all up A is far from E. Think about airlines: an inch of legroom here, a baggage fee there, no more meal service, and pretty soon you just want anesthetics. Available for your convenience for a small extra charge. (Update: see “Airline fees: Where will they pop up next?“)
• Don’t filter out what you need to see. “Customers aren’t asking for something else,” you say? How do you know? Multiple-choice surveys make it hard for oddball ideas to get through. People with complaints get shuttled to the complaint department, which emphasizes placating; how do the complaints get to R&D? Comparisons with competitors — “we perform in accordance with accepted industry standards” — are meaningless if you and your competitors behave the same way. Which gives creative upstarts the opportunity to beat coasting incumbents. (See Further Reading, below.)
• Why, oh why? We all make assumptions; the trick is periodically to ask why oh why they work for your business. Here are some examples: We must sell out our capacity; it’s better to sell a perishable good at a low price than to have it go unsold; we should scale capacity to fit peak demand; we should maximize demand; customers are more sensitive to price than quality. I’m not saying those assumptions, and others, are right or wrong. I am saying they are assumptions (possibly supported by data; see Further Reading), and before we continue to risk our businesses on them we should ask why we continue to believe them. I’ve found in business war games I’ve conducted and strategy simulations I’ve built that a good test question is this: will our strategy work if our competitors do the same thing we plan to do?

Competitive strategy. Some assembly required. Do not overtighten.

Update, February 16, 2010: For an interesting commentary on layoffs as an ineffective form of overtightening, see The Case Against Layoffs, by Jeffrey Pfeffer, a professor of organizational behavior at the Stanford Graduate School of Business, published by Newsweek.

Update, May 6, 2010: For a discussion of the effect of the Icelandic volcano on super-efficient transportation and manufacturing networks, see The Days The Earth Stood Still, by Daniel Gross, published by Newsweek. Take what he wrote and add in the time, effort, and money it took to return those networks to normal; for example, stranded passengers waiting additional days. Not to mention the resulting angst. For instance, see Iceland volcano: passengers still stranded vent fury at the airlines.

Further Reading
About overtightening: Gross Galactic Product.

About upstarts versus incumbents: With All This Intelligence, Why Don’t We Have Better Strategies?

About assumptions: House, MBA, More Internet Users than People, and Doesn’t Make Sense.

About being misled by well-intentioned data: It’s Working! and Self-Fulfillment

About the strategy equivalent of the Tower of Babel: Motor Swilling Forbidden.

In today’s Wall Street Journal (October 16, 2009), we find these contrary positions in “Safeway Shifts Tactics in Grocery Price War:”

“Last month, [Safeway CEO Steve] Burd conceded had the chain moved quicker to lower prices, it would be ‘doing a bit better than we are now.’”

“Increased use of promotions ‘destroyed our gross margin,’ Supervalu CEO Craig Heckert said last month at a Goldman Sachs conference. ‘More items really cheap don’t bring in more people.’”

There is truth in the notion that focus is valuable and in the notion that diversification is valuable. There is truth in leadership and in delegation. There is truth in caution and in action. There is truth in mass marketing and in segmentation. There is truth in price and in quality. Pick a business model, pick a buzzword, pick a fad; there’s probably truth in it, and in its opposite.

There’s also falsehood, or at least incompleteness, in each of those perspectives. Both Burd and Heckert expressed dissatisfaction with their results. Each CEO wished, if just a little, that he’d done what the other had done… and what the other was blaming for his dissatisfaction.

Burd and Heckert are experienced, high-powered professionals with plenty of data, analysis, and advice at their disposal, yet they come to opposite conclusions. I’m not criticizing them; quite the contrary, I’m sympathizing with them because they’re trying to cure sick systems with many moving parts.

Let’s consult with Gregory House, fictitious M.D., of the eponymous TV show. If you like House, he’s the witty, incisive doctor whose cool, unrelenting pursuit of the truth cures the patient. If you don’t like House, he’s the nasty, sarcastic doctor whose cold, unrelenting pursuit of his ego cures the patient. Cool or cold, he cures. If I were sick enough to need House, I’d want House.

Yes, House (the show) is fictitious and, I’m told, unrealistic. Still, the show beautifully illustrates ways to get insight into tough questions rigorously and effectively.

(Here I’m going to talk about Burd/Safeway and Heckert/Supervalu as though I know what I’m talking about when, in fact, I don’t. All I know is what I read in that Journal article. Plus, of course, what I’ve learned in 30+ years studying competitive strategy. I’m just using those CEOs and companies to illustrate what we can learn from House.)

House (the doctor) begins by writing symptoms in modest-sized letters on a white board. That’s significant for three reasons: he can add, he can erase, and he keeps everything in view. He writes those symptoms without unnecessary detail or precision; he simply writes “high blood pressure” and “headache.” Partly that’s because watching someone scrawl numbers and details isn’t exciting television. Partly it’s because it keeps him and his team focused on the big picture.

Strategy equivalent: I’ve seen, and I’m sure you have too, strategists spend time debating whether to adjust a price by 1.0% or 1.5%. There’s time for that later. Let’s figure out first if, say, anyone is suffering from malignant prices.

For Burd and Heckert, the symptoms are apparently pain in the profit: sales below expectations and margins below expectations. (It is unclear from the Journal article whether we should say expectations, desires, or targets. We’ll just say expectations.) Prices are not symptoms; their role in the symptoms has not yet been determined.

House writes those symptoms without interpretations. He may write “high blood pressure” and “headache;” he doesn’t write “headache from high blood pressure.” He and his staff are free to link high blood pressure and headache as they search for a diagnosis, but they don’t presume it. Something else might cause both (a side effect from medication, a thrillingly obscure disease). A symptom might even be irrelevant or temporary; the headache may go away after the morning’s 17 espressos wear off. He also collects relevant information about the patient.

Strategy equivalent: relevant business, competitive, and market information, without interpretation. Relevant: we must, for example, understand our competitors because our performance depends in part on what they do. It’s not good enough to study only our business. Without interpretations: notice the difference in assumptions and implied action between “our prices are too high” and “our prices are 10% above competitors’.” Note too that SWOT analysis builds in interpretations. Is it a strength or a weakness to price 10% above competitors?

Burd and Heckert would presumably know that the other is suffering too. They’d know also that they have similar big-retailer business models. They can readily measure prices in their markets.

Then House does something remarkably powerful: he starts fights. He doesn’t hold back his critiques as his staff suggests possible diagnoses. His staff doesn’t hold back their critiques as he suggests possible diagnoses. The fighting gets heated (perhaps inevitable when the boss’s favorite expression is “you idiot”) but everyone is clear that the objective is to diagnose and cure the patient. There are a few rules that guide the fighting: 1) treat causes, not symptoms; 2) find causes that fit all the symptoms; and 3) the way you do your job is to be part of the fight.

Strategy equivalent: resist jumping to advocacy and conclusions, resist anecdotal reasoning. Brainstorming, scenario planning, and what-if simulations help a lot. Business war games are particularly terrific for conducting civilized and highly constructive fights.

Still, in business there is tremendous pressure to advocate rather than debate and to act rather than diagnose. Moreover, strategists simply do not have the business equivalent of a body of medical literature based on centuries of scientific investigation. Without that deep knowledge it becomes especially important to question assumptions and to look for causal mechanisms. What has to happen for a price cut to work for Supervalu and for steady prices to work for Safeway? Hint: it’s not just one or two items. Think it through. Do the assumptions and causal mechanism make sense to you?

Burd and Heckert implemented different price moves, presumably after tracing the effects of price changes on their financials, taking into account fixed costs and variable costs. Both are unhappy. That suggests the price moves might not be the cause, or at least not the sole cause, for the same reason that we’d say 17 espressos might not cause a headache if identical twins both got headaches but only one had 17 espressos. What else could it be? Perhaps they have something else in common that could causally explain their shared unhappiness. (If they don’t, then we’d treat them as separate cases; there are multiple causes of headaches.) Similar business models that are unsuitable for the economic climate? New competition? Demographic changes? Inappropriate performance expectations? Notice that our statement of symptoms — performance below expectations — makes the latter possibility easy to see.

Finally, House adjudicates the fights. He’s willing to make a judgment call but that’s his last resort. He prefers the hypothesis/test method. If the 17 morning espressos are responsible for the headache but not the high blood pressure, then it must be true that the headache will fade as the espressos wear off but the blood pressure will stay high. That approach helps narrow the possibilities. Notice that it doesn’t completely confirm the role of the 17 espressos in the headache. If the patient had sipped the espressos at an outdoor café during rush hour, the headache might be the result of exhaust fumes, not espressos. House would need another test to prove that 17 espressos can cause a headache: administer a new batch of espressos where the air is clean.

Strategy equivalent: think like an experimenter. For example, think of Heckert’s statement as a hypothesis that low prices destroyed Supervalu’s gross margin and didn’t bring in more people. Think of Burd’s hypothesis that they could have done better if they’d cut prices sooner. How can we validate or dismiss those hypotheses? Look at comparable businesses who took those actions. Survey customers. Run simulation-based tests. Be careful how you measure: in a recession, “not bringing in more people” may be success, if other businesses are bringing in fewer people. And watch out for the exhaust-fume problem. What else was going on at the same time that Safeway held its price and Supervalu increased its promotions? The other-things-going-on might have been at Safeway and Supervalu, at competitors, in the economy, and so on, and might have nothing to do with price.

I haven’t conducted any of those experiments; all I’m doing is applying a TV show to a newspaper article so as to make a point and illustrate a technique. Let’s go with my imagination, though, for the sake of that point and technique.

• It wouldn’t be surprising to discover that comparable businesses are disappointed with their results. That would suggest that Burd and Heckert are not doing something uniquely wrong.
• It wouldn’t be surprising to find that customers are cutting back on purchases (buying less and/or buying cheaper) to deal with the economic crisis. That too would suggest nothing unique about Burd and Heckert.
• It wouldn’t be surprising to find that simulations show it’s possible to succeed with steady or lower prices, if the rest of the business adjusts appropriately. (An appropriate adjustment for steady prices might be to reduce capacity to fit a smaller number of customers. For lower prices, an adjustment might be to negotiate lower prices from suppliers or to buy lower-end goods.) We could check to see if Burd and Heckert have made such adjustments.
• We could measure competitors’ results and see if Safeway and Supervalu have gained, held, or lost market share. Their performance might have slid, but if they are outperforming the competition then they might actually be doing well. In other words, the diagnosis might be unrealistically high expectations, and the treatment is to change expectations. They can try to improve performance too, of course, but the role of price cuts is not clear.

There’s much more on this website on the subject of expectations and strategy decision-making, in both the Blog and the Library sections.

I presume you would like to predict your competitors’ moves better than you do now. Say, for instance, their prices. Let’s work on that, perhaps with a surprise, a jolt, or even a shock as we go along.

We structure today’s harangue around a pricing quiz involving simple math. It’s not a math test, and your enjoyment (or not) of this essay doesn’t depend on whether you enjoy math.

Question 1. Your competitor charges $900 for their product. In month 1, they raise their price by 10%. In month 2, they hold their price steady. In month 3, they cut their price by 10%. In month 4, they raise 10%; month 5, hold; month 6, cut 10%; and so on. What is their price at the end of month 30?

Many people say that the competitor’s price will be $900 at the end of month 30. They figure the 10% increases cancel out the 10% decreases. That’s wrong, as we can see at the end of the first three months. Month 1: $900 + 10% = $990. Month 2: $990 + 0% = $990. Month 3: $990 – 10% = $891. It didn’t cancel out.

Answer to question 1. The competitor’s price at the end of month 30 is $814.

Question 2. What will be the competitor’s price at the end of month 31?

We’ll get to the answer in a moment.

The nice thing about patterns is that we can describe them in numbers. The competitor’s price changes +10%, 0%, -10%, +10%, 0%, -10%. We feel validated because history fits the pattern so well. We feel confident because the statistical “explanatory power” is so high; it’s perfect, in this case. We feel we can predict what happens next, as we do with the great ebb and flow of the tides, the majestic rising and setting of the sun, and the news-cycle persistence of a juicy scandal affecting not me.

We shouldn’t feel validated or confident. At least not yet. And we may not yet be ready to predict the competitor’s price.

Answer to question 2. We can say that the competitor’s price will be 10% higher than $814, or $895. That’s what the pattern says, to n decimal places, where n is a number larger than we require. But what’s much more interesting, if we put down our calculators and put on our thinking caps, is to ask and answer question 3.

Question 3. Why has the competitor’s price been rising, holding, falling?

(Did you ask question 3 before you answered question 2? Give yourself a round of applause if you did. I’ve run this quiz with hundreds of managers in workshops I’ve delivered. Everyone turns right away to math. No one asks question 3, at least not out loud. What good is an unasked question?)

We humans do two things with patterns. First, we see patterns. It’s part of how we figure out how the world works. We test perceived patterns with science, we accept perceived patterns as experience, we even enshrine perceived patterns as superstition.

The second thing we do with patterns is assume they will persist. After all, part of what makes a pattern a pattern is that it (seems to) persist. The tides, the sun, the scandals.

Patterns persist when the underlying forces persist. If the moon were destroyed by a Death Star, Earth’s tides would change. Over time Earth’s rotation (and hence the number and duration of sunrises and sunsets) is changing because… well, it’s complicated, and not germane to your competitor’s price. The length of a scandal is projected to rise and fall with the level of a society’s blaminess. Change the moon, Earth’s rotation, or a society’s blaminess, and the tides, sunrises, and scandals will change.

So what’s controlling your competitor’s price? You wouldn’t ignore the world and set your prices according to +10%, 0%, -10%. Neither would your competitor, unless they have turned over control of their prices to a trend-line equation that will next announce $895 in an eerie mechanical monotone.

Now we’re getting somewhere. What’s controlling your competitor’s price is how they make decisions. A strong pattern in prices is likely to mean that your competitor (or you) have linked prices to something. If their suppliers change prices periodically, then your competitor might change its prices to maintain their margins. If your competitor heavily incents its salespeople to make the numbers each quarter, their salesforce might lobby mighty hard for quarter-end price cuts. Or perhaps that’s how you have priced, and your competitor is predicting and responding to changes they expect you to make!

So which is it? Suppliers? Salesforce compensation? Competitive dynamics? Something else? The point is that people, not calendars, control prices.

Notice that the pattern, whatever’s behind it, makes it hard to know what your competitor will do if you make a change. What would happen if you raise or cut your price when you’re “supposed” to hold? Would they follow? If neither you nor they have deviated from the pattern in a while, you have no data to suggest what they will do. You have to understand your competitor, you have to get inside their heads, you have to model their business, you have to figure out why they price as they price.

Sidebar. I’ve run many, many business war games around the world. They always produce surprises (that’s a good thing) for the management teams that participate. Why? Most of those teams have already analyzed their strengths, weaknesses, opportunities, and threats; what surprises are left? Here’s why I think they get surprised. SWOT analysis mentally places you inside your own company and asks you what you think your competitor will do. A business war game, on the other hand, asks you what you would do if you were your competitor. The latter question explicitly encourages you to look through your competitor’s eyes; the former doesn’t. With the latter you understand them better, you get inside their heads, you model their business, you figure out why they act as they act. End of sidebar.

Intellectually we all know that no one delegates pricing decisions to a calendar. That said, take a look around and see how often people (maybe you and me too) assume patterns will persist. You will see people (maybe you and me too) frame problems in terms of patterns rather than understanding. Listen to pundits, read newspapers, look at analyses.

If you understand your competitors better, you can make better decisions. You can understand better how they will respond if you do this or if you do that. (Do you think they will raise their price to $895 no matter what you do?) Which is, of course, the reason why we try to predict them in the first place. We want to make better decisions for the environment we think we’ll face.

Update: See Predicting Competitors. This essay is about illusions about predictability; that one is about delusions of predicting.

Further reading:
It’s Working!
Precision In, Garbage Out
The Rules
You’re Got the Data. Now What?

I commend to you Joel Lovell’s courageous and perspicacious essay “What Do They Know?” Subtitled “True Confessions of a Conflicted Money Guru,” Mr. Lovell muses about what to tell people about finances during the crisis and wonders why some public advisors seem confident despite being wrong. His essay is a fine companion to Sharon Begley’s “Why Pundits Get Things Wrong“.

As my readers know, I’ve wondered for a long time why smart people make bad decisions. Yes, there is the media-mogul preference for sound bites and the public’s clamor for tell-me-what-to-do-oh-oracle advice, but such responses don’t address the question. Public prognosticators don’t give bad recommendations because people want sound bites or oracular advice; the prognosticators would rather be right than wrong. The question remains, why do they get it wrong?

I think there are a few reasons why they (and the rest of us) get it wrong.

• They and we, being human, are prone to all the distortions and biases that we read about in books about social psych. (In addition to books I’ve previously cited, check out Sway: The Irresistible Lure of Irrational Behavior and The Drunkard’s Walk: How Randomness Rules Our Lives.)
• The tools we use to exercise due diligence and thorough analysis can systematically mislead us, giving us positive reinforcement for bad decisions. For example, forecasts that extrapolate the past into the future won’t work if the future is qualitatively different from the past. (See It’s Working! and With All This Intelligence, Why Don’t We Have Better Strategies?)
• The problems we face are more complex than we can handle in our heads. (See When I Was Wrong.)
• Perhaps more subtle: we believe our situations or businesses are different. In other words, we believe in the exceptionalism of our times and/or businesses. (See The Good, the Bad, and the Lucky.)

Note that those reasons suggest in what directions we should seek long-term improvement.

Accountability and oversight, not so hopeful for more than short-term symptomatic relief. The problem is, no matter how sternly we apply oversight and hold people accountable, we’ll continue to make bad decisions if we continue to rely on misleading decision-making techniques.

Regulatory change, more hopeful to the extent that it curbs decision-making that is known or can reasonably be expected to produce negative outcomes. (That’s as opposed to regulatory changes that prescribe specific behavior or technologies, about which I make no comment here.) Profits for today often override prudence for tomorrow (hence mortgages get written that people cannot pay back), so it can be beneficial to ensure that prudence is part of the equation. It’s worth remembering that we already accept such regulations in numerous areas of our lives, including licensing healthcare professionals, FAA safety standards, and insurance on bank deposits.

Just as we’d be better off preventing cancer than treating it, we’d be better off making good decisions than fixing bad ones. We need better-quality decisions, and better-quality decisions come from better-quality decision-making. As we assess proposed solutions to crises big and small, let’s start by asking how each proposal will help us make better decisions.

Executive compensation is top-headline news these days. It commands the attention of the President and Congress. It’s an attractive problem, full of righteous indignation, handy villains (“them”), and clear action plans. And although I’m not against “solving” it, I suggest that it’s not the important problem.

Let’s imagine that the executive-compensation problem has been solved to your satisfaction. Legislation has been enacted, paychecks have shriveled, remorseful CEOs have issued their mea culpas, defiant CEOs have left the building, resilient CEOs have gotten back to work. Or CEOs remain free to negotiate whatever deals they want with their boards of directors. Or something else. Whatever you believe is the perfect solution, so it shall be done.

Now that we’ve handled executive compensation, is the economy back in order? Are we all back to work? Are our retirement funds healthy again? I don’t think so.

Whatever we do with executive compensation, it is the equivalent of sticking a finger into a leaking dike. Giving executive compensation the finger may stop a disturbing (cash) flow, but the dike is still structurally unsound.

(We may want to cut compensation and super-sized bonuses on other grounds, such as the impropriety of using taxpayer money to make bailout beneficiaries rich. That’s a different issue. Let’s not think, though, that cutting compensation makes executives more competent, or less.)

The economy is not in trouble because executives got paid too much. The economy is in trouble because executives (and others in their companies, and people in government, and even we the consumers) made bad decisions. Not just a few executives and not just a few times.

Why did so many people make so many mistakes?

I have written eloquently about problems in corporate decision-making. (See, for example, “With All This Intelligence, Why Don’t We Have Better Strategies?,” “What You Pay For,” “It’s Working!,” and “Suffering was Optional.”) What those essays have in common is that they describe ways in which sober, dedicated business professionals are systematically misled by the tools of the trade. Spreadsheets, for instance, say nothing about competition. Trend lines extrapolated from the past are irrelevant if the future is unlike the past. Doing whatever it takes to make the numbers makes us look good and the performance targets look reasonable even if we hit them by eviscerating the company. (Update to this post: see “When Goal Setting Goes Bad,” an interview with Professor Max Bazerman of the Harvard Business School.)

As I suggested in “To Bail or to Bail Out,” it would be useful — more useful than capping executive compensation, though they are not mutually exclusive — to require the auto industry to use techniques such as business war-gaming as a condition of receiving public funds. War-gaming and other strategy simulations help companies create better strategies, and they would raise the odds that taxpayers will be repaid. I would advocate the same for other industries wanting public assistance. I believe in business war-gaming because I’ve seen it work in the 100 or so that I’ve conducted for Fortune 500 companies.

The point isn’t business war games, though, and if you prefer a different technique that’s fine with me. The point is that we need to get better at decision-making, not dike-plugging. More of the same, only better, won’t do. (See “Precision In, Garbage Out.”) Sticking a finger in the executive-compensation dike merely guarantees we’ll be the first to go underwater when the dike breaks.

“Motor swilling forbidden” is printed on my smoothie-maker and I have no idea what it means. Perhaps I’m not supposed to drink the motor rapidly or disrespectfully; perhaps I should be genteel and contemplative, if you please. Although the consequences of disobedience are unclear, “forbidden” sounds foreboding. In these days of GPS, RFID, and heightened orange security, I’ll just leave the motor alone and wonder in my quiet moments what motor-swilling pleasures I am foregoing.

The words are English and the writer knew what he or she meant to communicate, but English speakers won’t get the message. Of course we can infer or guess, but then we replace the writer’s context with our own.

And so it is with business models. People talk of business models with certain words and meanings in the USA. People may use similar words in France, Malaysia, Brazil, South Africa, and so on, but with different meanings. We may translate the words — motor, swilling, forbidden — but we may not understand each other.

For instance, “price leader” is imprecise even in English to English speakers. Does it mean the company first to change price, the one with the lowest price, the one with the highest price, the one whose price everyone else copies, or something else? The benefits of price leadership and price followership are similarly unclear.

What happens when strategists from other countries are involved? In some countries or industries prices are set cooperatively or by the government. The price leader may be a person, not a company, and that person may be friendly, neutral, or antagonistic to business. Motor swilling: forbidden. Price leading: forbidden, forgiven, given.

It’s not so different with other business-model vocabulary words. Low-cost producer, for instance. Is that a good thing? Does it mean squeezing your suppliers, improving your processes, cheapening your products? Depends on your perceptions of what customers want, how you should treat your workers, which suppliers you should choose, what you think bosses and investors want, and much more.

We can see the effects of different business-model languages. For example, we see different work rules in different countries, which reflects different views of what’s fair and desirable. (I once suggested a weekend business meeting with a client in a European country. They were shocked and, upon reflection, I was envious.) Notice the differences among cars: there is variety among American cars, and among Japanese cars, and among German cars, yet it would not be difficult to discern the nationality of a car even if all identifying badges were removed. In effect, business-model languages are cultural differences that go beyond whether you shake hands or kiss cheeks. We translate the words — price, leader, low, cost, producer — but that’s not enough for us to understand each other.

We live in a period of globalization. Barriers have come down due to technology, prosperity, and policy, and the effects are about as massive as can be on this spinning blue ball where motor swilling is right out. (There we go with language again. Americans don’t use “right out” but the British do. Did I use it correctly? Right on!) With those lower barriers we come in contact with customers, competitors, and suppliers whose language of business models differs from our own. If we translate “low cost” as “affordable” and our new market translates it as “cheap and shoddy,” we might find it hard to get distributors. If we translate “successful” as “net income this year” and our new competitor translates it as “10% market share within 10 years,” we shouldn’t expect them to pack up and go home at the first annual loss. Toyota’s recent ascension (over General Motors) as the biggest car-maker in the world is the triumph of a business model, not a car model or marketing campaign.

When we think of being the price leader or low-cost producer in another country (or even in another industry), we bring with us our whole linguistic context. When we encounter someone else’s actions or negotiations, we encounter their linguistic contexts, which we interpret using our own. If we want to develop strategies that give us the outcomes we desire, if we want to predict how our competitors will act and react, a rich translation of business models is sine qua non.

What does your strategy-development process have in common with the financial crisis gripping us all?

That depends on how you think about what’s working and what isn’t.

Much has been said and written about what’s gone wrong with the economy: indecipherable financial instruments, assumptions that home prices would continue to rise, lack of regulation, and on and on. But those aren’t just causes; they’re effects, too. Complex securities, bad assumptions, and deregulation didn’t materialize out of nowhere, they’re the effects of decisions people made. So why did smart, self-interested, experienced people decide to buy and sell such complicated instruments, risk so much on such unsupportable assumptions, and let the inmates run the asylum?

It’s tempting to say that they’re greedy, short-sighted, narrow-minded, and selfish. Thinking that makes it easy to blame them, to emphasize how different they are from us, and to justify why we should punish them.

Well, maybe they are greedy, short-sighted, narrow-minded, and selfish. Some of them, anyway. But it’s hard to believe that all of them are. It’s even harder to believe that greed, short-sightedness, narrow-mindedness, and selfishness alone could cause the problems we’re experiencing.

We could blame denial and wishful thinking (theirs, of course). But that too isn’t particularly satisfying: it merely labels the problem, it doesn’t explain or solve the problem. After all, no one gets up in the morning and decides to make multi-billion-dollar decisions on the basis of denial, so advising “don’t go into denial” is about as helpful as “have a nice day.”

Let’s rephrase our question. What would lead so many smart, self-interested, experienced people to go down the same path? Greedy denial doesn’t make people behave the same way. What makes people behave the same way is shared beliefs.

In the case of the financial crisis (and perhaps your company’s strategy-development process; we haven’t forgotten that part), the shared belief was that the party wasn’t over. When you believe the party is over, you go home; the people who stay are those who think there’s still fun to be had.

Why did they think there was still fun to be had? After all, smart, self-interested, experienced people, whether or not they’re greedy deniers, know that house prices won’t rise ad infinitum, especially knowing that the engine of that growth is people who buy more house(s) than they can afford. However, they could easily fall into the keep-partying trap for a simple reason: the “evidence” showed that their strategies were working. For years their numbers got better and better. Success! And their intelligence, cleverness, and resourcefulness (plus an “insane drive” for ever-better results) kept the party going. Continued success! You can say that it’s a lousy strategy, party-pooper, but look at my numbers. It’s rational to keep going. It’s working!

And that’s where we can see the parallel with strategy development. We judge the success of a strategy by its outcomes — it’s working! — and we decide to stay at the party because the party has been pretty good to us so far. We extrapolate the past into the future, and we don’t see where our own efforts may be prolonging the buzz.

Consider Blockbuster. It grew rapidly: its first store opened in 1985, and it was sold to Viacom in 1994 for $8.4 billion ($11.6 billion in 2007 dollars). It was “split off” in 2004 after multi-billion-dollar losses, when it had a market value of $2.7 billion ($3.0 billion in 2007 dollars). Its current market value is slightly over $300 million. We note with respect that Blockbuster’s owners, Wayne Huizenga and John Melk, left the party when all was still merry.

(Tangent: Business schools teach that you should sell something when you cannot make it more valuable than it currently is and when it’s worth at least that much to someone else. Often, though, we fall into various emotional and analytical traps, such as “it’s working!,” and finally sell at fire-sale prices at the sorry end of the party. Sound sadly familiar?)

Of course a misguided “it’s working!” isn’t the only cause of bad strategies or the financial crisis. What’s especially interesting about it, though, is that it is closer to the root of the problem than singling out the individuals who fall for its seductive lure. What’s interesting too is that we can do something about it.

My colleagues and I have learned over many years that strategists make better decisions when they look as assiduously for reasons why a strategy isn’t going to work as they look for reasons why it will. I find that business war games are tremendously effective at that process (as I describe in “Learning Faster Than the Competition“), but they’re not the only way. Whether you use business war games or something else, the trick is to stress-test your strategy options, especially because so many conventional tools and discussions focus on why your strategy is going to succeed. For instance, spreadsheets of your business’ future rarely take into account the moves your competitors are about to make.

Who is more likely to fall into the stay-at-the-party trap? Greedy or non-greedy people? Numerate people or innumerate people? Experienced people or novices? I suggest that those at the greatest risk are those who, due to how they interpret experience and numbers, are more likely to be fooled by “it’s working!”

• If you believe that action A leads to result B, then you are more likely to be fooled than a person who believes that result B comes from a whole cloud of activity, some done by you, some done by others.
• If you look at past performance (profits, market share, economic growth, foreclosure rates, product recalls, whatever) and conclude that a desirable trend means that your actions are working, then you are more likely to be fooled than someone who asks questions such as what would have happened if we did something else and do we have fewer product recalls because products are better or because we have cut funding on safety checks.
• If you work in an organization that aggressively values success (however defined), for instance by “weeding out underperformers,” then you are more likely to be fooled than someone who works in an organization that values what-if scenario thinking. I don’t mean we should keep underperformers. I mean we should define and measure underperformance carefully.
• If you look at lagging indicators and effects (sales, profits, etc.), then you are more likely to be fooled than a person who looks at leading indicators and causes (drivers of demand, where you are investing, where your competitors are investing, etc.).

In short, if you focus on nominal outcomes, then you are more likely to be fooled than someone who focuses on quality decisions. And when you are fooled, you are likely to stay too long at the party that is “working” so well.

Update: Newsweek columnist Robert J. Samuelson makes a similar argument in his Good Times Breed Bad Times column from the October 27, 2008, issue of the magazine.

Update: See an interesting article about confirmation bias, How to Ignore the Yes-Man in Your Head, by Jason Zweig in The Wall Street Journal, November 14, 2009.

Although this post seems superficially about stock-market investments, it really isn’t. It applies equally to virtually any competitive-strategy decision.

On August 18 the Wall Street Journal wondered “Why Are Small Fish Still Biting?” because, the article’s subtitle said, “Small-Cap Surge Doesn’t Make Sense Given Fundamentals.”

I don’t have the answer to why the small fish are biting, why the large fish aren’t biting, or other riddles of the piscine kingdom. I would suggest, though, that the article shows people may be swimming up the wrong coral tree.

The article implies a terrific question: can money be smart if it’s contradicting (as in not-following) the fundamentals? Are the small biting fish somehow wrong? The author suggests that both history and at least one small-cap fund manager would say yes, the fish are wrong. Perhaps the fish are wrong, in the sense that they soon won’t like the taste of what they’ve bitten. That’s not my point, though. My point is to note that the doesn’t-make-sense question assumes that the fundamentals are somehow right. If we presume that the fundamentals are right, then the small biting fish must be wrong. No further evidence required.

I submit that we might more profitably ask different questions, such as these two. One: why are smart (or at least self-interested) people buying in ways contrary to what the fundamentals would suggest? Two: is it always smart, or at least is it smart now, to buy on the fundamentals?

I don’t have the answers to those questions, and in any case, the answers (if there even are answers) is irrelevant to my point. My point is about the questions, not the answers.

The question implied by saying the small-cap surge “doesn’t make sense” is when will the small fish come to their senses and buy on fundamentals. The other questions — why smart people aren’t buying on fundamentals and whether it makes sense to buy on fundamentals — are more likely to generate useful discussion about what’s changing in the market, how buyers make purchase decisions, where our hoary assumptions may mislead us, and so on.

“That is not the right question,” former Intel CEO Andy Grove would say. Time is money and good decision-making is the ultimate competitive (and career) advantage. Before you answer a question, ask yourself if it’s the right question.

“Decades ago, GM controlled half of the U.S. market… Last month,… GM’s share of the U.S. vehicle market sank to 19.4%, according to Autodata Corp.” (WSJ, 6/24/08)

We note in passing the “controlled” language, and wonder: If GM really controlled the market, would it have let its share decline so much? Language reveals attitudes, and although in this case it is the Journal’s language, managers often speak the same way.

Language isn’t the important point, though. The important point is what’s behind GM’s malaise and the similar suffering at Ford and Chrysler. Although change was inevitable, suffering was optional.

The diagnosis du jour is that GM et al. are feeling the effects of their reliance on large, inefficient vehicles. It’s seen as a bet gone bad due to increases in fuel costs. Meanwhile, other economic factors, such as the credit crunch and rising supply costs (e.g., steel suppliers are assessing surcharges), further sour the bet.

Those effects may be real and true, but the explanation isn’t satisfying. Why did GM et al. make themselves so vulnerable to energy prices? It’s been clear for years that the world’s use of fuel is rising faster than the supply, and we know what happens to prices when demand approaches or exceeds supply.

Go back a few years. Detroit’s woes then were blamed on healthcare costs. They’ve been blamed on unions and work rules. They’ve been blamed on government regulation. (We note in passing the language — blame — although we’ll pass over it again.)

Go back a few decades, to the 1970s, when Detroit ruled the world and Japanese cars had a reputation for being tinny, cheap, and dull; “econoboxes,” they were called. Detroit might not have controlled the market but they held most of the cards since they were far ahead of the competition and had vast resources they could deploy as they saw fit. And then they proceeded, over decades, to lose ground and eventually to reach a state where their very solvency is in doubt.

GM’s (and Ford’s and Chrysler’s) quandary is not the result of any single external event, or even several. Their quandary did not suddenly spring up. It is the accumulated result of some thirty years of decision-making.

I’ve met some of Detroit’s finest. They are smart, experienced, and motivated. They work hard and they do their best. They want to keep their jobs and help their companies prosper. However, being human they are susceptible to the same decision-making traps as the rest of us: groupthink, overconfidence, denial, and more. Being strategists their tools are susceptible to the same decision-making distortions we see elsewhere: discounting competitors, relying excessively on history, starting from an accounting paradigm, and more. That’s far more than we can cover here. I’ll focus on just one issue, while reminding my gracious readers that it is only one of several. That issue is expectations.

Pretend for a moment that your business has long enjoyed 50% market share. Next, pretend that outsiders invade your turf with what you perceive as substandard products. Due to an economic crunch their low prices attract, oh, 10% of the market, equally from you and the other incumbents. Now you have 45% share. What do you think will happen to your share in the future?

Here are reasons why you may believe that your share will rise:

• You’ve always had a big share.
• The economic crunch will go away.
• Your historical data show 45% is an aberration.
• Customers will discover how substandard the competition is, and come back home.
• You put together convincing plans that say so.
• The senior, experienced people say so.
• It’s your job to make it so.
• The stock market thinks you can do it.
• A little competition is good; it reminds you to work hard.
• Your salesforce is out there and they’re making the numbers.
• You have new leadership, new vision, and new urgency.
• You’ll drive out the usurpers just as you drove out their predecessors. After all, you weren’t born with 50% share; you earned it.

Here are reasons why you may believe that your share will continue to fall:

• There are none. You plan to succeed, and you want to remain employed.

If you expect to gain share you will make different decisions about capacity, budgets, labor contracts, supply contracts, and so on, than you would make if you expect to lose share. Many of those decisions involve fixed costs and future obligations, and they put reputations on the line.

Alas, that substandard competitor is getting better and people seem to like it, and you don’t gain share. Now your costs are higher, your revenue isn’t, and your reputation is fraying. You feel more pressure than before to return to your normal share.

You take decisive action. You spend more on marketing and incentives, you cut your price, you light a fire under the salesforce, you dismiss the managers who are falling short of their goals and bring in new people who can get the job done.

But your competitor continues to improve. Worse, their progress is emboldening others to come in and nip at the lion’s heels. Your inventories are bulging and aging. You begin to feel the elevator is going down.

(I have not consulted with or worked for any automobile company, and the scenario I have painted is not exhaustively complete. On the other hand, I know something about competitive strategy and I have watched thousands of managers in dozens of industries make decisions. You can judge for yourself whether or not the scenario rings true. By the way, I believe that the ending need not necessarily be a death spiral.)

The key point in that scenario is the role of expectations. The expectation of “recovery” can induce decisions that make matters worse. It interferes with thinking through the problem, perhaps because it denies that there is a problem or contends that the problem is already solved. It launches a vicious cycle of desperation. It saps morale and drives talent away.

So, the trillion dollar question — “trillion” because that’s the order of magnitude of Detroit’s lost sales over the years — is how we can develop realistic expectations. That’s a big subject, some highlights of which I will summarize here.

• The past predicts the future only in uninteresting situations. By definition, significant change makes history irrelevant. Think not about trend lines; people don’t buy because of trend lines. Think about cause and effect. How can we build a [fill in your product] that people really want to buy?
• Much thinking and many analyses invisibly assume that our strategy will work. Few spreadsheets, for instance, account for competitors’ responses. Use business war games or other forms of simulation to explore what they might do and how it could affect you. Your business looks different when you see it through your competitors’ glasses.
• Much other thinking and many other analyses invisibly assume that our industry is at an equilibrium; that is, we will neither gain nor lose share unless we or they do something new. That assumption is false. (See next bullet.)
• If you look (to customers) just like your competitors, expect (over time) to perform just like your competitors. Why would it be any different? That statement, by the way, is what we at ACS call a principle of competition, and that principle is a major reason why GM et al. should have expected to lose share when Toyota et al. entered the USA.
• Don’t fret about precision. Few, if any, strategy decisions depend on decimal points. Instead, focus on realism. You may be able to model trend lines precisely, but it is more realistic and useful to model customer purchase decisions and competitive dynamics.

By the way, GM CEO Rick Wagoner said on July 10 that “GM has no plans to close or sell any of its brands.” (WSJ, 7/11/08)