Are CEO Compensation Markets Efficient?

Having been schooled at Chicago, considered an institutional icon in espousing free market and efficient market theories, I am always initially skeptical of things that fly in the face of efficient markets. This post by Douglas Smith, however, is excellent and reflects upon a WSJ journal article in which Treasury Secretary John Snow maintains the widening gap between high-paid and low-paid Americans reflects a labor market efficiently rewarding more-productive people.

Of course, I submit (perhaps a little unfairly given recent circumstances) Exhibit 5, to Douglas Smith’s list of exhibits. Joe Nacchio, former CEO of Qwest, was once in the top 10 of all compensated CEOs and earning in excess of $100 million/year. As a former shareholder in the firm, I think I saw my shares slip in value close to 50 times during his term (here’s an article from 2002 that adds some color to the craziness of the compensation situation). Although I recall Nacchio (or folks on his behalf or in defense of his raises) claiming that Nacchio deserved compensation competitive with what he could get elsewhere in the market, all I can say is that Nacchio was neither Larry Ellison nor Michael Dell in terms of delivering value to the shareholders.

This is not to say that I don’t believe in higher pay for senior executives. Executives have a lot of leverage created in part by their span of control. Tremendous value in excess of market comps can be created or destroyed in fell swoops. But questions remain as to whether businesses (and the people that run them) have put in place the right control and reward structures, as Douglas Smith’s post points out.

The Pricing Death Spiral

Today I wanted to write about perhaps one of the most important lessons I learned in managerial accounting (as opposed to financial accounting), and it is something that I have seen improperly applied in many organizations (both profit and non-profit). It can be a very subtle concept related to accounting and pricing, but it can have very bad effects. The situation is called the "pricing death spiral".

Imagine a company that manufactures and sells gumballs. Suppose that the gumball company produces and sells 100,000 gumballs a year. The cost of manufacturing each gumball is $0.01 per gumball and the sales and marketing costs are $1,000 per year. No other costs apply. If one tries to unitize sales and marketing costs, over the number of gumballs produced, the sales and marketing costs are an additional $0.01 per gumball. If the company sells the gumballs at $0.02 per gumball, it makes no profit.

Now suppose that that sales are falling and so the company only produces and sells 50,000 gumballs in a year with the same sales and marketing costs. Now sales and marketing costs are double when one looks at the per gumball price. Costs are then $0.01 per gumball (manufacturing) and $0.02 per gumball (sales and marketing). So the company needs to raise prices to $0.03 per gumball just to breakeven. Herein lies the death spiral of pricing. Raising prices in this context artificially creates less demand for products, and thus, fewer sales. Weak sales seem to generate higher costs which causes higher prices which creates less demand and even weaker sales, etc. If the company (incorrectly) tries to unitize the sales and marketing costs across the gumballs produced and then folds that into the pricing of its products, it can wind up in a self-reinforcing situation where it is raising its prices despite falling demand and without regard to the competitive environment.

Some variations of death spirals I have seen in organizations I’ve worked with:

  • a non-profit child care center has low enrollment (below breakeven) and raises monthly fees for next year’s class to amortize the administrative office costs across all children
  • a professional services firms prices its services too high because it spreads out the costs of G&A of all areas of the business into the cost structure of a services group of a smaller division of the company (which in turns creates less demand for services and fewer subcontractor partnerships than optimal)
  • the standard costing for a construction job is based on amortizing the entire cost of the field force the number of jobs performed – in a weak construction season, the next year’s costs are calculated to be too high to feed the pricing equation.

While the realities of an organization’s financials may dictate how closely cost structure should affect pricing, the error in the above pricing methods come down to this: the organization needs to separate out fixed costs (or sustaining costs) from variable costs. The organization also needs treat excess production capacity (or in the opposite case production levels in excess of normal operating levels) separate from unit costs.

Thus, in the example I had above on the child care center, rather than calculating the cost of providing care for a child by spreading out all G&A costs over the number of children enrolled, a unit cost per child should be calculated by spreading out a proportion of G&A by the child care center’s normal operating capacity. When the child care center runs below normal operating capacity, it runs a temporary loss equal to the costs times the number of children below normal operating capacity. The shortage in income could be made up by assessing the families of the children by a monthly (or lump sum) fee. One key benefit of pursuing this latter pricing mechanism is that the price of low sales is separated from the cost of production. Families of the children are only assessed fees to cover temporary shortages in enrollment, and the situation does not evolve into a case where the "permanent cost structure" is raised (thus forcing ongoing prices to be raised excessively).

The other cases of pricing errors I describe above are a little more subtle. In the second case, the error is that the company should again calculate variable unit costs for producing individual business unit services. While spreading out G&A for the business unit itself may be less suspect, spreading G&A from the entire corporation may be excessive (although computationally convenient) and should be viewed as a sustaining cost for the business. In the third case, the construction company would be better to allocate a portion of G&A to the individual job cost structure presuming that the construction company is operating at healthy levels.

So while there is no single, silver bullet for avoiding a pricing death spiral, first steps are recognizing the situation and then separating out the considerations so that more accurate responses can be taken (i.e., if production problem then solve production problem, if sales problem then solve sales problem -> improper accounting can mask the problem at hand). If one finds that the price of one’s products or services have more to do with the size of the finance organization in your company that the manufacturing or services costs, this may be a good warning sign.

The Nickel Tour

With all the stuff going around about the bird flu, I am reminded of one of the less glamourous management consulting projects I heard about (in general terms) last year in the turkey business.

Now in many operations projects, key goals are to improve business processes in dimensions such as:

  • average throughput
  • inventory backlog
  • peak capacity
  • quality
  • cycle-time
  • cost
  • risk/failure points

A company often has tons of business processes in place. Sometimes there may be a manageable set of predominant process flows, but then there can be a zillion microflows. One way for a consultant to get grounded in a situation in the face of this complexity is to go on a "nickel tour" with the client .

In the case of the management consultant I met with, the goal of current project was to reduce the number of injuries in the processing plants of one of the big turkey producers (I presume to reduce lawsuits, etc.). The automated equipment in certain sectors of the meat business, as I understand things, can be quite scary. Not for the faint-hearted for sure, some of the equipment used can separate the meat from bone (of entire animals) in matters of a few seconds. Imagine what can happen if your arm gets caught in the machine …

So day 1 the consultant arrives on the scene, and one of the plant workers hands the consultant a pair of rubber boots to go on a "nickel tour" of the plant. I don’t think the tour was of the slaughterhouse, but one can imagine that the scene was not everything a recent MBA grad dreams of doing as a consultant.

To generalize, in many nickel tours, the client walks the consultant through the backoffice, introduces sales personnel, has them sit in with customer service representatives, attend working meetings related to information technology user sessions, etc. The purpose is to give the consultant a ground floor view of what happens in the business (plus an opportunity to ask questions). The nickel tour helps to compress a complex view of the business into one short experience. While a lot of the tour can turn out to be a bunch of chit-chat and small talk, I have often turned the nickel tour into a very useful experience. The nickel tour can be a very valuable source for initial checkpoint information for the consultant (e.g., if the consultant sees large piles of inventory, frazzled or distressed workers, disorganized workspaces). A consultant may also meet people on the tour that can serve as useful sources of information later in an engagement.

On the flip-side, a consultant needs to be wary of "stage plays". This is a case where the nickel tour is not a real tour of operations, but a case where someone (within the client operations) has dressed up the situation to be different or better than it really is on a day-to-day basis.

In any case, make sure to think about giving or getting a nickel tour in a consulting relationship. Although it is not always possible or desirable in some cases to give a nickel tour, a nickel tour can really help consultants get a "live" feel for the business at hand.

Somewhere Between Goal Management, Client Facilitation, and CYA

As I work through my own professional goals plan for the year, I am reminded of an early lesson in management consulting. This technique has do more with firms that are implementation-oriented as opposed to strategy-based, and it is related to getting a client organization to move. I don’t know if there is a name for the technique, but for the purposes here, I’ll call it "progress to goal management".

The essence of the technique begins with the consultant working with the client organization to establish one or more measureable goals and then reporting on actual performance regularly with a gap diagnostic. Let’s say a goal is to create $5.5 million in annual revenue for a new start-up initiative (say $500K in Q1, $1M in Q2, $2M in Q3, and $2M in Q4). The consultant then works with the client to put a regular measurement system in place, say monthly. Suppose that by the end of Q1 that the client has only achieved 15% of the goal. The consultant should be working with the manager owning the revenue to report not only the numeric gap in performance but also a diagnostic of why things are off track (from both quantitative and qualitative perspectives).

Although the technique may seem obvious, in implementation consulting, one is often trying to diagnose problems or set up operations for things that happen below a corporate-level or business unit-level. The devil may be in the details and low-levels of the company so-to-speak. Thus, things like board-level measurements and control may neither be enforced nor visible. Other situations where measurements may not be readily available include setting up new business structures (e.g., new business line) or bypassing old business structures (e.g., where old methods too cumbersome or bureaucratic).

Other than trying to help the client (which is the primary goal, of course), the flip side of this is that the consultant is pulling a "CYA" in some sense. One can’t start a project and then six months later show up and simply report to executive management that the goal wasn’t met by the business unit or functional area management. Progress to goal (and gap) reporting is needed every step of the way along with mid-course control and corrections. In this way, the consultant separates the aspects of proper management control from management’s ability to execute.

Adding Some Color (Blue Tone) To The MBA Discussion

David Maister has a great post entitled, "Why Business Schools Cannot Develop Managers". While I generally agree with what David says there, in that business schools can teach primarily only analytical skills, I think that it may be worthwhile to shed some additional light on that subject so that people who are evaluating business school (or those that come from business school backgrounds) can better appreciate the underlying value.

I view business as a bit of a craft and art, so to continue with the color theme, I see the business value of MBA programs as covering three primary color schemes:

  • Blue – the cold hard facts, the analysis aspects, the language, and theory of business (learning WHAT to do)
  • Yellow – knowing where the warning lights are, when something is good or bad, going to work or not, and going to incent parties (learning the HOW to do something)
  • Red – the passion, the leadership, the drive, and the fortitude of business (WANTing to do something)

For now, I will concede that the MBA only works on the "blue tones", and one can’t create a business without other primary colors.

That said, when my one of my kids gets crayons at the local restaurant consisting of black, green, and orange, and my kids want to draw Captain America or Cinderella – I tell them to "please make the best of the situation". You be surprised how creative kids can be with even the wrong tools for the job.

So here’s some perspectives on the "blue aspects" of the MBA:

  1. MBAs Are From Mars and Engineers Are From Venus – Having both MBA and engineering degrees, I can see where parties can misunderstand one another in situations such as capital raising meetings, sales pitches, and executive presentations. The MBA provides a common communication language for business people. Sure there can be too much business-speak going on with MBAs, but I have seen many situations where engineers in start-ups are unable to pitch their stories to angels or venture capitalists because the two are speaking different languages. At the same time, I have seen MBAs better left out of the meetings with venture capitalists because they are just too shallow. All said, recognize that each type of participant has a different communication style and that MBAs add some value. When one tries to do business in Japan, one tries to speak Japanese and not French, right?
  2. MBA Training Is A Portable Skill And Can Facilitate Working Relationships – Just like C/C++/Java programmers follow conventions for putting things in reusable functions or libraries, apply different methodologies for avoiding deadlock or multithreading of executing code, and communicate using different diagramming techniques, MBA have toolkits too. Toolkits may include common frameworks for competitive analysis (such as the 3Cs), profitability analysis (such as 5 Forces), or operational process breakdown (such as ABC or "activity-based cost" analysis). Having these types of frameworks have helped me to quickly interface with other consultants (even ones from other firms), business people, and even overseas folks whom are outsourcing more straightforward MBA activities.
  3. MBA Frameworks As A Way To Make Sure Analysis Is Thorough – One of the common cases covered in business school is one that covers the pricing of a contact lens product for chickens. The purpose of having such an outrageous case is to teach students how to analyze business problems where they may have no prior business experience. Since students can’t leverage past experience and industry-knowledge, the case teaches students to use structured methods for attacking pricing problems. Students are trained to look for things such as cost data, competitive data (such as the market prices of alternative products being used to solve the real business problem at hand – in this case, perhaps the true operational problem is the cost to farmers of losing chickens in a cannibalistic world where chickens kill one other because they can see one another). In the end, students are supposed to get an in-depth look at how pricing can be addressed, e.g., in terms of cost, margin, value, and competition.

A good analysis foundation is invaluable. From that foundation, one can apply other skills to get business "street-smart" and to develop leadership skills. Although I have not pointed out some of the other aspects of the MBA that can help out in these latter areas, I do feel that there are some yellow and red tones to be found in the business schools too. David Maister even goes on to say in his post that the title of his post is perhaps "too pessimistic" on the value of business schools. On this point, I also agree. Perhaps I’ll post more on this subject at a later date if folks are interested.

Musings On Crowd Wisdom

As I have mentioned before, I have been watching the bird flu developments with concern. Seeing how things have spread (e.g., here  and here [animation dated on later link]) – well the graphics help people to visualize what has been going on.

But what draws me to write this post is how markets and polls sometimes seem to diverge substantially in terms of predictions. For example, CNN reports that 60% in the US worry about the bird flu but that less than one-third think it will show up in the US this year. In December of 2005, InTrade (one of the exchange markets carrying futures contracts on whether bird flu will hit) announced, "Trading on Bird Flu — 65% probability of U.S. case by March 2006!".

Although I’m no expert in reading the financial stats associated with the InTrade contracts, what I glean from information is that the predicted probability of bird flu hitting the U.S. by March 2006 (as per the InTrade market) has fallen substantially since December. Of course, I’d venture to say that much of this has to do with the fact that the expiration period of the futures contract is approaching.

There is a general belief that an incented market (e.g., the Intrade market) where parties are financially motivated to make good predictions generates better predictive results than pure polls where people have no vested interest to be right or wrong in their predictions. In any case, betting for or against bird flu seems weird. But I suppose there is value in using these types of markets for planning purposes and for greater understanding.

Taking On A Life Of Its Own

I was emptying my refrigerator as I was thinking about a title for this post, but this post really has to do with something that I’ve encountered in certain consulting environments.

To put things in perspective, a few years ago I was working on a consulting project related to a launch of a new business within a large multinational company – a company that is so large that it had the Russian doll (these are the wooden dolls where you unscrew one and then there is another one inside, perhaps seven nested within one another) equivalent in organizational structures, e.g., three levels of CEOs. The company had a long history with legacy organizations and people and wanted to introduce new products in an entrepreneurial-like setting within the larger organization.

In an informal setting, our team presented some options in terms of potential product line scopes, and the options ranged from simple to complex. At this point, one of the other consultants to the company, an ex-CXO at Booz Allen Hamilton and a person I admire quite a bit, raised a point that he did not think that it would be wise for the client to undertake one variation of the product line incarnations, even though the financials looked much more attractive than the others. This was sage advice in my mind. He did not want the client to get caught up in a business that could potentially "take on a life of its own". An organization that had not yet proved whether it could walk let alone run in a new entrepreneurial market should be discouraged from pursuing the sexiest product line model of the lot.

Another version of things taking on a life of its own … I can think of at least a few cases where a management consulting firm introduced a methodology for running a certain aspect of the business only to find later that the client readapted the methodologies for other purposes (e.g., other business lines, other functions). In concept, this is great as the company should get mileage out of what had been produced elsewhere. All said, some organizations can forget the original premises and goals of the process and/or methodologies installed. The steps and processes aren’t forgotten though. They are followed to the letter. With the goals and premises long forgotten, the organization may be executing a bunch of processes and bureaucracy while accomplishing close to nothing results-wise.

None of this is to say that the client is stupid. I’m not discouraging the use of consultants either. I’m just saying that things can take on a life of their own in business like things do in one’s refrigerator. It’s a special sauce that you have to watch out for in business.

Central Banker Heaven and the U.S. Economy

Last Friday I attended the Business Forecast Luncheon in Dallas, sponsored by the University of Chicago Graduate School of Business. Guest speakers were Dr. Robert Aliber, Professor of International Economics and Finance (Emeritus) at the University of Chicago and Dr. Harvey Rosenblum, Executive Vice President and Director of Research, Federal Reserve Bank of Dallas. The talks were excellent as they were last year.

What really drives me to write this post is that we are seeing Alan Greenspan retire. When I think about things, he’s close to the only central banker that I have experienced during my entire adult/business life, where Greenspan has reigned for some 18+ years. Central banking has an important effect on business and the health of the economy, and this something that the luncheon speakers are renowned experts on.

The general consensus was that Alan Greenspan will go to “Central Banker Heaven”. More on this later.

While last year’s forecasts focused on the deficit and the exchange rates, what came to the forefront this year were three things that will impact the economy for the next twelve months. These are: the (deflating) housing bubble, term structure of interest rates (and the inverted yield curve), and the philosophies and makeup of the new chairman (Ben Bernanke).

Although I will gloss over the individual perspectives of the two speakers, my general takeaways on the three areas were the following:

  • Housing bubble is deflating – Apparently in the areas of concern (e.g., Boston, Southern FL, CA), prices are starting to fall 10%ish. Well-known builder, Toll Brothers, has had its stock price fall some 50% (note I have not verified), plus they have cut back their forecast on building out. More generally beyond Toll Brothers, housing inventories are starting to build up. If one subscribes to a doom-and-gloom forecast, housing bubbles have historically demonstrated price declines of an additional 40%.
  • Inverted yield curve is disturbing – In 8 of 9 times when the yield curve inverted, the economy had slumped into a recession within one year.
  • New chairman philosophically tends towards being a price-level setting person, as opposed to one that takes a long-term view of the economy first – Price-level setting philosophies involve having a target inflation rate in mind and then setting the interest rates to obtain that rate. In some countries, this policy is taken to an “extreme” where concern for other factors, such as unemployment rates, are ignored. Wild cards in the U.S. include the fact that the international world is less stable, and that long-term energy/oil impacts associated with unstable countries (which may each comprise 5% to 6% of supply) should not be ignored when pursuing price-level setting at the central bank.

So all-in-all, the forecast for the U.S. economy over the next twelve months was mildly positive, with some areas for attention. The March meeting for the central bank will be key, as this will shed some light on how the new Fed chairman handles his new role.

Which brings me to my earlier about getting into Central Banker Heaven. Greenspan has been praised by having all of the key skills and a proven-performance record:

  • an ability to show independence from the administration and partisan views
  • deep knowledge of history and economics (which both Greenspan and Bernanke share)
  • inflation-fighting skills with a long-term view.

But in some sense, while Greenspan has had all of these skills, it could be argued that he also got lucky (being good and lucky is the best of all worlds). During Greenspan’s tenure, he did not have to deal with chronic problems. Now, Ben Bernanke has a tough and important job ahead of him. He has a chronically unstable international world to deal with, and he has to show his inflation-fighting abilities with a long-term view that people like Greenspan so carefully considered.

I thank Alan Greenspan for his service. I wish Ben Bernanke the best of luck for our people and future generations.

Update (2/16/06): Bernanke addresses Congress just yesterday.