Strategy Dynamics Briefing 13: Doing it right with accumulating resources

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There is one last thing to do before going on to the implications and uses of resource-accumulation.

Sorry– but it’s just got to be done right! If you get this wrong, everything else you try to do with strategy dynamics will be messed up.

Defining and measuring resources and their flows

We were careful in earlier briefings to make sure the causal connections were arithmetically accurate, for example, that quantity sold per month was equal to customers multiplied by quantity per customer per month. It is just as important to define the units of resources and flows accurately. This is simple, though:

Whatever the units by which a resource is measured, the inflows and outflows are always measured in the same units per time period.

There is never any exception to this rule. The table below lists the major types of resource, the units by which they are measured, typical inflows and outflows for each, and the units for measuring those flows. The only judgment to be made about the correct units for resource flow rates concerns the choice of time period – should it be people per week, per month, or per year? I previously explained that time periods should be short enough for change during any period to be relatively small, compared with the overall time-scale of the situation you are looking at. If, for example, you are looking at how profits have been changing from quarter to quarter, then customer gains and losses can be measured in customers per quarter. If you are in a faster moving business and want to understand why sales rates change substantially from week to week, then you need information on weekly sales, and your measure of customer flows should be customers won per week and customers lost per week.

Table: measuring in- and out-flows for various resources

The last item in the table shows a small complication that comes up in some cases – when a resource itself includes time. Production capacity for, say, a cement or steel producer is measured in “tons/day.” If we change capacity by adding new equipment or closing a plant, the result is an inflow or outflow of a certain number of “tons/day this year.” This is a one-off inflow, but continuous changes in flow rates may also occur. The production rate for an oil field is measured in “barrels per day”, but as a field is drained, its production rate typically falls. This decline would therefore be measured in “barrels per day, per year.”

Depicting resources, flows and the factors that drive them

To continue in our quest for an accurate causal explanation of performance, we must maintain the discipline of depicting correctly “what causes what,” just as we did with the causal connections in earlier briefings. Since the current quantity of a resource is “caused by” whatever we had at the start of a period, plus what was added, minus what was lost, it cannot be caused by anything else. The first figure below must therefore be wrong—the marketing spend of $5 000 per month cannot explain the number of 1 015 customers at the end of the month. It is missing all three of the numbers needed to work out that quantity (the number at the start of the month, and the numbers gained and lost), and the causal link from marketing spend to customers is meaningless.

The second figure shows the correct causal structure. The “stock and flow” structure includes all the values needed to explain the end-of-month number of customers. It also shows the causal link that “marketing spend of $5 000 per month has won 20 customers during the month.

Diagram: a frequent error - marketing creates more customers

Diagram: correction,  marketing drives customers won per month

(If you ever look at simulation models of how an organization is performing over time, you might see links like the ‘illegal’ one in the first figure. Don’t be misled, though, the simulation needs to know the start-value for the resource, and those links only set that value (1000 customers in this case). All values for later time periods are calculated from the in- and outflows.)

It’s just hard!

It’s pretty obvious that if we have 100 customers now and win five during this month, then we will have 105 next month. Obvious, yes, but it turns out the human mind simply cannot take this simple notion and work out how resource levels will change over time if the flow-rate varies. Believe it or not, most Masters students at top-level technical universities cannot look at a picture like this with the time-chart for ‘total customers missing and sketch in accurately what will happen to that stock.

Diagram: it's difficult to see how levels behave

They aren’t dumb – it just seems that the ability to do this had no evolutionary value. If our cave-dwelling ancestors had no food, they went out and got some – they didn’t bother estimating the rate of depletion and how many days they could lounge around before getting hungry. Later, when humanity could store food, this became a useful skill (indeed this need triggered the first use of ‘accounting’ – for stocks of grain!)

This estimation becomes particularly difficult when, as is common, more than one resource flow is involved. Customers may be lost as well as won, so this overall win rate of five customers per month could easily be the net result of winning 10 and losing 5 each month, winning 20 and losing 15, or even winning 100 and losing 95. These alternative situations are not equivalent! A company experiencing the last of these cases will have some serious problems:

  • it requires effort and cash to win customers, so a high rate of customer churn will be costly
  • the large number of customers being lost will likely damage the company’s reputation
  • if there is a finite number of potential customers, the company risks running out of customers

So – it is worth reemphasizing an important implication of this structure:

It is vital to know, separately, resource in-flows and out-flows.

Sorry if you feel I’ve beaten you up rather a lot in this briefing. Believe me – if you take the time to really work at these principles until you have them nailed, you will thank me for it later!

Until next time…

 

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Does this matter?

It does if the confusion makes us mistake the consequences of our decisions.

  • If you are worried about the level of debt on your credit card, for example, and you do not appreciate the distinction between levels and rates, you might imagine that cutting your “level” of spending would reduce your debt. But up to a certain point it won’t—reducing the rate of spending would merely slow the rate at which your debt is rising!
  • A company concerned with falling sales revenue might mistakenly think that reducing the “level” of customer churn would lead to increasing sales. But customer churn is the rate of customer losses (units being customers per month), and sales revenue will continue falling until that rate is less than the rate of customer acquisition.
  • The confusion also matters on bigger issues. Governments are to varying degrees committed to reducing the “level” of greenhouse gas emissions, in the belief that this will “tackle” global warming. It won’t. Greenhouse gas emissions are a rate (units are billions of tons per year) that is adding to the level of those gases in the atmosphere. As long as the emission rate exceeds the absorption rate of the planet’s biosphere, any reduction in emissions is merely slowing the rate at which that level is rising. If you are filling a bathtub with a fire hose, turning the hose down by a few percent is not going to stop your house from flooding!

Strategic Management Dynamics book coverThis has important implications for how management decides on objectives. If you fear that your credit card debt is too high, the only appropriate objective is for your spending rate to be cut to less than your repayments, minus interest charges. The company with falling revenue must aim for the rate of customer churn to be less than its rate of customer acquisition. And if governments believe high levels of greenhouse gases to be dangerous, then the only appropriate aim is for the rate of emissions to fall below the planet’s absorption rate, which is a very large cut indeed.

This briefing summarises discussion from chapter 3 of Strategic Management Dynamics, pages 127-130

Read more about the book on our website

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