Chapter 4 Handling Interdependence Between Resources

Decisions Affect Resource Flows

In fact, most of your own decisions—at least those that are likely to affect performance into the future—work by affecting resource flows, either directly or indirectly. You recruit more salespeople to win customers faster, add service capacity to keep customers from leaving, take on engineers to develop products, dedicate human resource (HR) staff to hiring, and so on.

If we start training people today, for example, we do not instantly get better bottom-line performance. The training improves the overall skill of the group over whatever time it takes to cover everyone in the group. Only those people who have been trained can start to deliver improvements, and this takes time. The one impact we do see immediately, of course, is the extra cost! Consequently, it is all too common for organizations to decide on beneficial changes, only to abandon them because they do not see enough immediate benefit to continue. What often gets cut first when performance falters? Training and marketing!

Let us look back at what happened to your restaurant over the past 12 months. Figure 3.6 "The Separate Flows of Customers Into and Out of Your Regular Customer Group" showed the inflow and outflow of regular customers. The decisions involved were to increase marketing spending but then cut back later in the year (Figure 4.1 "Marketing Decisions Change the Inflow of Customers").

Note that we are not looking to explain the impact of marketing on profits, not even on sales. The immediate effect is on the customer win rate, and we need to focus on the numbers: the rate of marketing spending and how much impact it had on the rate of winning new customers. It also seems that our marketing decisions are not quite enough to account for the customer win rate, since we had a trickle of new customers even when we were spending nothing.

Figure 4.1 Marketing Decisions Change the Inflow of Customers

We must not forget that such a change in a resource flow is not the only consequence of our decisions. Many will have cost or revenue implications, too. In this case, marketing spending has an immediate impact on profits, as well as causing other changes (Figure 4.2 "The Impact of Changed Marketing Spending on Profits").

When you increased spending in month 7, profits dropped by the amount you decided to spend. Profits grew quickly after you implemented this decision, so something else must have happened. But the immediate effect was a sharp drop: no delays or bathtubs filling in this part of the system, just simple arithmetic. The same applies to the decision in month 10 to cut marketing spending. The profit rate immediately jumps by the $3,000 per month cut in marketing. Again, however, something else happens soon after to wipe out that profit increase.

Figure 4.2 The Impact of Changed Marketing Spending on Profits

Outside Forces Affect Resource Flows

Competitors and other factors also affect the flows of resources into and out of our business. Competitors can even help us develop resources, as we will see in Chapter 7 "Managing Rivalry for Customers and Other Resources". External influences are generally looked at under four categories:

1. Political changes, such as privatization and deregulation, open up entire industries. Some may even act directly on specific aspects of performance, such as price regulation in utility markets.
2. Economic changes constantly bring new customer groups into existence. Fast-developing economies can create conditions in which the inflow to the “potential customer” pool grows extremely rapidly. The opposite occurs when economies contract, as many companies experienced with the banking-led recession of 2008.
3. Social changes drive the migration of consumers, employees, and others into and out of the resource base of different industries. Simple demographic changes bring new young consumers into a potential market each year and of course take them out again as they age.
4. Technological progress largely manifests itself in two ways: changing the functionality of products and reducing the unit cost of offering them. Growing Internet penetration helped Alibaba.com but hurt Blockbuster Inc. in our examples from Chapter 1 "Performance Through Time".

The systematic examination of these forces is known as PEST analysis. While the concept of PEST influences sounds right, that is not sufficient for strategy development. Once again, numbers matter. You need to understand the scale and timing of the changes affecting your future. Imagine you run a company producing electronic goods, and you face an economic downturn. You need to know roughly how severe it will be, at what rate it will remove potential consumers from your pool of resources, and to what level.

In addition, factors changing other markets can have powerful spin-off effects. TV viewing has fallen as viewers switched their time to online activities, with damaging consequences for advertising revenues. Internet usage in Europe has in turn been depleted by the time people spend sending text messages by mobile phone. These are both examples of quantifiable dynamics—that is, rates of change through time—concerning the influence of substitute products that feature in standard industry forces approaches to strategy (see Chapter 1 "Performance Through Time").

Resources Determine Each Other’s Growth

The most important point about what drives resource flows, however, is that current levels of resources determine the rate at which other resources fill up or drain away. This is the mechanism for which the system dynamics method is ideally suited (Sterman, 2000, chap. 8).

This is the reality of how resources work together, creating a system that can either perform strongly or constrain its own development. Interdependence can even bring about an organization’s self-destruction. Since we know that performance depends on resources, and that only flows of resource can alter these quantities through time, it follows that the only means by which management decisions can change your resources through time is by influencing what happens to the inflows and outflows.

However, as Chapter 2 "Resources: Vital Drivers of Performance" highlighted, you cannot build any resource without using resources already in place. This interdependence has two implications:

1. The more of a resource you currently have, the faster others can grow. (It is even possible for a resource to generate its own growth, as when, for example, customers recommend their friends become customers.)
2. Conversely, having too little of a resource right now can slow or stop the growth of other resources. If this shortage is too severe, it can even cause other resources to be lost, which is where self-destruction can arise.

There are many examples of this principle:

• The more salespeople you have, the faster you can win new customers.
• The more development engineers you have, the faster you can improve the range and quality of your products.
• The more donors a charity has, the faster it can acquire the cash it needs.
• The more good clients a professional firm has, the faster it can win the best staff.

In the cases listed above, if you had none of the first resource, the second would not grow at all unless some other resource could replace it. If you have no salespeople, for example, you will need agents, a Web site, or some other alternative to capture customers. If a charity has no donors, it will need government funding or some kind of endowment to carry on its work.

So how does a new business ever get started? It turns out that entrepreneurs too must have some stock of experience, contacts, and personal credibility to allow them to raise cash and hire their first staff. (Experience and credibility are intangible resources, which we will look at in Chapter 8 "Intangible Resources and Capabilities".)

Resources Can Stimulate Their Own Growth

The simplest case of mutual support is when a resource drives its own growth. This process can be seen in an everyday situation: cash and interest. The more cash you have saved, the faster more cash is added to it. Another obvious case is word of mouth among consumers. Our basic principle of reinforcing feedbackCurrent levels of resources that determine the rate at which other resources increase or decrease. still applies: The more consumers there are, the faster they can win new ones (provided, that is, there are plenty of potential consumers left to be won).

This is much more than a qualitative notion; as we keep emphasizing, numbers matter and can be worked out. Figure 4.3 "The Arithmetic of Reinforcing Growth From Word of Mouth" takes us back to the start of Chapter 2 "Resources: Vital Drivers of Performance" and the simple customer stock at your restaurant. Let us imagine this time, however, that there is no loss of customers at all. In fact, you are winning more, thanks to the positive word of mouth from your existing clientele. Every 10 customers you have leads to you winning 1 new customer every month. Starting with 500, you win 50 during January. February then starts with 550, so that month you win 55, and so on.

You can see just how powerful reinforcing growth can be. By the end of the year the business is growing at almost three times the rate it was at the start. This may seem an astonishing and unrealistic rate of development, but it is very common indeed—look back at Alibaba.com in Chapter 1 "Performance Through Time", or think how quickly Skype took off. The reason it seems unusual is that we do not often experience it ourselves, and other organizations we see around us may be too small to be noticed while the process is in full swing.

It seems, though, that apart from cash and people-based resources, there are few other examples that are capable of this self-replicating behavior. This is because most other resources are inanimate and just sit there unless we do something with them. So we need to turn our attention now to the way one resource drives growth in others.

Figure 4.3 The Arithmetic of Reinforcing Growth From Word of Mouth

How Existing Resources Drive Growth in Others

Consider the example of the consumer brand introduced in Chapter 3 "Resources and Bathtub Behavior". Building awareness and interest in a brand is essential, but if we actually want to sell anything, we have to get stores to stock it. A new brand thus needs to drive the inflow to the resource of stores stocking the brand. What other resources are required to achieve this?

First, we need consumers who want to buy the product. Retailers will not stock a product that is unlikely to generate profits for their stores, and these profits will only arise if consumers are likely to buy. A stock of interested consumers is not enough. Retailers need to know about the product and its potential profitability and must be constantly reminded of its attractiveness relative to other uses they might have for their shelf space. This requires a sales force. In this case, then, two resources are required: consumers and a sales force. If either is missing, stores will not be won. Figure 4.4 "Growth in the Number of Stores Stocking a Brand Depends on Sales Force and Consumers" shows how these two resources drive growth in stores.

This may seem a daunting mix of numbers to get your head around, so let us think through how a product manager might estimate these numbers, based on either experience with previous brands or from seeing what competitors have accomplished.

Figure 4.4 Growth in the Number of Stores Stocking a Brand Depends on Sales Force and Consumers

Our 50 salespeople can each make about 100 calls per month; that is 5,000 calls per month in total. However, it takes several calls to persuade a store that the brand is attractive, so perhaps only one call in four might be expected to achieve a sale. At first, so few consumers want the product that stores do not see much profit to be made, so sales calls are not successful at all. As consumer demand grows, the rate of sales success climbs.

Later, stores are won increasingly slowly because we are running out of stores to win. Figure 4.4 "Growth in the Number of Stores Stocking a Brand Depends on Sales Force and Consumers" is therefore incomplete; we need to see the falling stock of potential stores as well, as shown in Figure 4.5 "Limited Potential Slows Growth in Stores Stocking the Brand".

Running out of potential stores is not the only reason for the limited win rate, however. The product manager needs to go through a few steps in order to estimate this win rate over the 2 years of the product launch (Figure 4.6 "Estimating Sales Force Success Over Time").

• The horizontal solid line shows the maximum that could be achieved if all sales calls contributed to winning stores and every store found the product sufficiently profitable to stock.
• The solid curve grows toward the maximum store win rate as our advertising gradually reaches the consumers whose demand makes the product desirable to stores.
• Unfortunately, by the time we get close to this maximum rate, our salespeople are busy looking after existing stores (dashed line).
• Finally, as the remaining potential stores become scarcer, the win rate is reduced still further (dotted line).

Figure 4.5 Limited Potential Slows Growth in Stores Stocking the Brand

Figure 4.6 Estimating Sales Force Success Over Time

The product manager can use the same process to estimate how rapidly consumers might be made aware of the brand. Two factors drive awareness: the firm’s own advertising expenditures and the brand’s presence in stores.

We now have some circularity in our reasoning. Growth in consumer awareness depends in part on the resource of stores, and growth in stores depends on the number of consumers. Putting these two together gives us a precise picture of what we mean when we say that our resources are complementary.

Finding the Drivers of Resource Flow Rates

In the case of winning stores for a brand, it is relatively easy to identify and confirm the main factors in the win rate: namely, stores that will profit from the brand, the number of salespeople, and available stores. The explanations are not always so clear, however, so you will need to discuss with colleagues the factors most likely to drive a flow.

Imagine that staff turnover is causing you concern. There may be many reasons for this. How have your salaries changed, as well as those offered by your competitors? Has there been a change in the number of other job opportunities? Have competitors been increasing their hiring efforts? Has there been a change in your employees’ workload?

It is possible that by putting the history charts for these items around the flow you want to explain (staff lost per month), you will easily see what has been happening and why. However, it may be necessary to go further. One place to start is to ask people why they chose to act as they did. In this case, exit interviews will provide some information on why staff turnover is happening.

It may be that you will need to use statistical methods to see if your expected drivers really do explain the resource flow rate. Beware! The accumulating behavior of resources makes it unsafe to use correlation to explain resource levels. Remember that today’s customers are precisely the sum of all you have ever won minus all you have ever lost, so no other causal explanation can be meaningful, however good the correlation may seem to be.

However, you can safely use correlation to confirm possible causes of resource flow rates. One retail bank found an astonishingly close relationship between certain factors and the rate at which any branch was likely to see customers closing their accounts. Among these strong causes was the bank’s history of making mistakes with customers’ accounts.

Limits and Pitfalls With Reinforcing Feedback

As long as the growth rate continues, this self-reinforcing mechanism generates positive expansion. In the absence of any constraints, this growth will be exponential, increasing by the same proportion in each period. This is clearly a favorable situation for any firm to create, but there are three precautions to note:

Reinforcing growth is not free. Something has to create the resource in the first place. In our brand example, this kick start came from the advertising, without which nothing would have happened. Salespeople can only persuade stores to stock the brand if consumers are interested. In practice, salespeople might conceivably persuade stores to take a product on the promise that consumers will become interested, even if they are not yet. But this relies on the reputation and credibility of the sales force—another intangible resource that has to be built. There is no free lunch!

Reinforcing growth cannot continue indefinitely. Growth will inevitably come up against limits, either external (no more customers to win) or internal (not enough capacity to supply new customers). Even apparently unstoppable firms like McDonald’s and Coca-Cola hit the limit at some point, although that limit can be very high indeed.

Reinforcing feedback is capable of driving collapse. This problem arises when a decline in one resource leads to another resource draining away. This may in turn mean lower marketing spending, more people leaving the business to go to competitors, damage to the firm’s reputation, and possibly other related problems. In essence, the difficulties facing the business escalate and reinforce each other.

How Interdependence Causes Collapse

Organizations that rely on professional staff run the risk of self-reinforcing collapse. Examples arise in both businesses and public services: lawyers in a legal firm, information technology (IT) department staff, hospital nurses, police officers, and so on. Collapse happens through a sequence of events. Staff can initially cope with the demands made on them while their workload remains constant. However, this group gradually depletes through normal staff turnover. As numbers decline, the pressure on those who remain increases, leading to further turnover and yet more pressure.

In such cases, the system needs at least a temporary reprieve from the pressure to arrest the loss of staff. This can come from two principal sources: using temporary staff such as contractors, or reducing the workload, either by turning work away or simplifying what is done. These fixes come with their own dangers. Contract staff can actually make matters worse by needing guidance from the already pressured staff and by further demoralizing them. Turning work away may be advisable, but it can be an uphill struggle to persuade managers to do this when they are already facing business collapse.

Work pressure is not the only trigger for collapse. One consulting firm serving the finance industry lost just a few key clients. With less rewarding projects to work on, and with their professional reputation to worry about, key staff resigned and moved to competing firms. This loss of key consultants caused still faster loss of clients, some of whom actually moved with the consultants to the same competitor! And so the process continued until the firm effectively collapsed.

Critical to solving this problem is to decide quickly what to do, when, and how much. Diagrams like those in Figure 4.4 "Growth in the Number of Stores Stocking a Brand Depends on Sales Force and Consumers" and Figure 4.5 "Limited Potential Slows Growth in Stores Stocking the Brand" clarify the problem and shed light on the path out of trouble. They also provide a map of progress as the solution develops.

It is better, of course, to have a plan for solving these troubles before they ever arise. But best of all is to have a mutually supporting set of resources whose interdependence is so positively embedded that the risk of a complete collapse is always remote.

Checking for Reinforcing Feedback

To see if your situation will reinforce growth or decline among one or more of your resources, the question to ask is, If this resource grows (or declines), will it have consequences that lead to further growth (or decline)?

We know these mechanisms as virtuous or vicious cycles. To find out, sketch the resources, flows, and intervening factors, and work through the story.

Figure 4.7 "Checking for Self-Reinforcing Growth and Decline Among Interdependent Resources" tells the story for our consumer brand. Starting at the bottom left, if the number of consumers increases, the potential profit available to stores increases, causing more to stock the product. As it becomes more visible, additional consumers are won more quickly. However, do not forget the self-limiting effect that comes from running out of both resources.

Figure 4.7 Checking for Self-Reinforcing Growth and Decline Among Interdependent Resources