The business case process is seriously flawed in all too many companies. This is a very important issue, because evaluating business cases is one of the core processes for allocating capital to move the company forward.
On the face, the business case process seems completely logical. The Finance group receives requests for capital, examines the likely cash flows over time, calculates the return on invested capital, and approves those with returns in excess of the cost of the funds.
It is very tempting to simply rely on this process because it is appears to be so quantitatively precise. And it is easy to simply assume that the portfolio of approved business cases yields the set of investments that is best for the business.
Yet in most companies, nothing could be further from the truth.
What Business Cases Do Well
Business cases are very helpful in one important respect. Their role is to provide a methodology to assess alternative courses of action to achieve a predetermined goal, especially when the alternatives (including doing nothing new) have different cash flows over time. The classic example is the decision whether to continue a manual process, or to buy one machine or another to automate the process, when each alternative has different timing of cash flows in and out.
The prospective return on invested capital certainly will inform the decision about whether the predetermined goal is worth pursuing, but it is not the only factor, and often is not the most important one. Nevertheless, it is very common for the business case process, which is good for the assessment of alternatives, to turn into the primary way to assess a company's higher level goals and strategy.
Misuse of Business Cases
How can such a logical process be misused? This typically occurs in six areas.
Boundaries: It is very easy to do business case calculations, but the real art lies in correctly framing the boundaries of the business case.
Here's an example I use in class. Imagine a consumer goods company that is competing on service excellence. The company sells food products known for quality, availability and freshness through supermarkets and convenience stores. One of the outlets is in a remote rural region, and each week the company has to send two largely empty trucks to restock the shelves in order to maintain fresh products. Under any scenario, this is a money-losing proposition.
The business case for this proposition is clearly negative under any reasonable set of assumptions. Should the company do it?
This generates a lively debate in class. On the one hand, some argue that a loss is a loss and it would be very hard to justify to the Finance group. On the other hand, there is a discomfort about the possibility of selling stale products or cutting the route.
The answer to this dilemma is to understand that the boundaries around this hypothetical business case are drawn too tight. The real issue is whether the company wants to allow its employees to "chisel" on its very successful strategy, and if so whether this would start to erode the company's culture of service excellence. At stake in this simple example is the integrity of the brand – not because a few consumers might get turned off, but because the company's employees might start down the slippery slope of assessing when brand integrity is worth the "incremental investment."
The real issue here is the company's culture, not the "business case" for maintaining a route to one rural store. Is there a role here for a business case? Yes, once the Management team underlines the importance of preserving a culture of high service and an impeccable brand, it would be correct to use the business case process to choose between a gas or diesel powered vehicle.
What Counts: An important related issue that often arises is the question of what counts as benefits. Critical benefits that are hard to measure are all too often disregarded.
I remember advising the CEO of a major telecommunications company in the early days of deregulation. This company operated in several major cities where it had well-funded competitors. These competitors were laying fiber backbones in the heart of the business districts, and soon would be selling state-of-the-art services to the company's most important customers. Yet the company was paralyzed, unable to deploy comparable services in response. What happened?
The problem was that the company's Finance group decided that in order to maintain the integrity of the business case process, the resulting benefits had to be measurable incremental revenues: new costs needed to generate new revenues. This meant that investments to keep existing revenues from migrating to the competitors "didn't count," largely because it was hard to measure which revenues the new investments were preserving. This measurement problem, raised in good faith by the Finance group, nearly cost the company its future.
It took a prolonged effort by the company's CEO to persuade the Finance group to change the criteria. After all, the Finance managers argued, how could they be good stewards of the company's resources if they couldn't measure the likely return on investment?
Innovation: The process of funding innovation generates problems similar to the "what counts" issue. Some of the most important innovations come from "showcase" projects. These are opportunities to work with a relatively small, but capable and willing customer or supplier, and to try new things in order to "learn by doing." In these projects, it is impossible by definition to know in advance what the outcome might be, let alone the magnitude of the likely benefits.
A showcase project is a journey of discovery, an opportunity to invent new ways to do things that will transform the company. How can a manager possibly estimate the likely benefits? How can the Finance group calculate the expected return on investment needed to justify the funding? Yet, the most successful companies constantly undertake showcase projects as their core process of innovation.
Assumptions: Even if a business case is framed correctly, there is a huge problem with estimating the costs, and especially the benefits, over the long run. In most cases, it is unrealistic to be accurate even 3-5 years out, let alone 5-10 years out. Too many factors may change, from competition to demand characteristics, to the future availability of new technologies that may obsolete your currently contemplated project.
This means that even the most carefully calculated business case is very uncertain, and the calculations simply give the illusion of precision.
Strategy: In all situations, strategy supersedes business cases. To repeat an earlier point: the role of a business case is to help you choose among alternative ways to meet predetermined goals, not to generate or evaluate the goals themselves. Yet, it seems so logical to assume that funding the set of business cases with the highest returns will optimize the company's business. How can this be incorrect?
An important study conducted years ago probed the criteria that top executives really used to evaluate really big strategic initiatives. Prospective returns were an important consideration, but there always was troubling uncertainty because the initiatives were moving the companies into uncharted waters.
It turned out that one of the most important considerations was a much-discredited measure: payback. Payback is simply the amount of time it will likely take to recoup an investment. It is often discredited because it ignores returns. Consider two investments: One takes three years to recoup the invested funds and then the company makes no more money; the other takes the same three years to recoup the outlay and then the company makes a billion dollars. Both have the same payback, even though the second investment has astronomically higher returns.
The reason top executives considered payback so important, however, was that they understood the great uncertainty inherent in a major strategic initiative. They really wanted to know when they would be in a position to make another major change or to undertake another major initiative if the company's circumstances altered significantly. They valued strategic flexibility as much as, if not more than, prospective returns, especially in light of the profound difficulty of realistically estimating the returns of a major initiative into uncharted territory.
Contrast this with the classic domain of a business case: choosing among alternative machines to meet a know requirement.
What You Don't See: The final problem with business cases is that you don't get to see the business cases that should have been proposed but were not. Let me explain.
In a recent Business Finance article, "Getting Under the Hood of a Flawed Budgeting Process," I explained that in virtually every company the lack of granular profitability information (specific products in specific customers), condemns them to invest in yesterday instead of tomorrow. In virtually every company, 30-40% of the company is unprofitable by any measure, and 20-30% provides all the reported profits and subsidizes the losing business. This means that almost every company has a huge, unseen amount of embedded unprofitability.
The lack of granular profitability information hides this enormous opportunity. Consequently, most budgets focus on initiatives to tune up the business, most often in relatively narrow functional areas. The business cases that propose these initiatives seem to make perfect sense, on the surface. After all, they have quantified costs and payoffs, and they appear to generate positive returns.
The real problem is the opportunity cost of funding a set of business cases for tuning up "yesterday's business," and failing to develop business cases to reverse the company's enormous embedded unprofitability. The really big problem is that the critically important initiatives with the biggest payoffs never even enter the business case process.
What would it take to uncover this massive opportunity and to develop a road map to reverse it? A few savvy managers and a matter of a few months. And profitability turnaround initiatives typically generate a huge amount of cash.
The CFO Challenge
What is the biggest problem with business cases?
It is that they have come to dominate the investment process, despite their many limitations, because they appear to be so readily quantifiable. When misused, they lead to problematic strategic and competitive decisions, and they obscure the most important opportunities for gain.
The challenge for the astute CFO is to restore the business case process to its useful but limited purpose, and to frame imaginative, rigorous ways to search out the real opportunities for quantum gains.
Jonathan Byrnes, a consultant and senior lecturer at MIT, is a frequent contributor to Business Finance. His latest book is Islands of Profit in a Sea of Red Ink.
Thanks to Jonathan Byrnes / Penton Media, Inc. / Business Finance Mag