Monday, 15 February 2016
What do you do when you know your initiative is crucial for the future of your firm – but the business case looks mediocre at best? Suvi Nenonen and Kaj Storbacka offer an alternative view.
You invest to have a future. If you run your own company, you are probably painfully aware that you have to continuously spend money to make money. Upgrade the equipment, fix the wear and tear, develop new products, keep building your brand – and the list goes on and on.
The technological progress of the recent decades, labelled by some as the next industrial revolution, has made continuous investments in the future even more important. However, it seems that our ways of assessing investments haven’t really changed since the 19th Century, and this is causing surprising challenges for managers and entrepreneurs alike.
Investments are increasingly cost re-allocations
The heart of the problem lies in the fact that investments increasingly are not investments at all, in a strict economic sense. Traditionally, investments are viewed as the purchase of some goods or equipment that create wealth over a future period of time. Hence, they are recorded in the balance sheet and depreciated over time.
But nowadays most investments are intangible in nature: we decide to spend more time and effort to develop some particular aspect of our business. And these types of ‘investments’ are only visible in the profit and loss statement, meaning that we have to take the cost of the investment in one financial year, although the effects may be long-term.
As a result we all too often we hear stories of executives fighting their boards of directors to get a green light for an investment that is more akin to temporary cost increase rather than something that results in a new item in the balance sheet: “Are you expecting us to OK a plan that lowers our profitability?”
Intangible and unpredictable investments defy business cases
These frustrating discussions are often made worse by the dominant way of assessing investment opportunities: the business case calculation. Business cases work reasonably well when we are making investment in tangible production assets (sheds, tractors, factories) that help us to generate a relatively predicable return in the future.
Unfortunately, most business cases fall apart when you are investing in something more intangible (software, design, customer relationships) or if your operating environment is highly unpredictable.
So, what to do: you know your initiative is crucial for the future of your firm – but the business case looks mediocre at best?
It seems that entrepreneurial managers are skilled in finding highly creative ways of surpassing the official investment processes to keep such vital initiatives alive: skunk works, office politics, bootstrapping, and sometimes plain deceit.
Usually these stories end well, but they beg the question: what is the point of investment processes that both eliminate winning ideas and force good people to act in questionable ways?
Creating better investment processes
Luckily, there are two alternative assessment methods available. First, some companies approach investment decisions as real options. There is a veritable science about how to do the math to calculate the value of real options (how much to invest, that is), but you can manage with simpler heuristics and ask two questions.
How much are we willing to pay in order to reserve a right to play in this promising new game – and when do we have to place our first bet to make sure we are still in?
The real option approach works better than business case calculations in unpredictable situations, but it still requires some understanding about the future.
What then to do if the visibility into the future is zero? In such instances many entrepreneurs have successfully used the affordable loss principle. According to this principle, you shouldn’t invest more than you are prepared to lose. This tends to lead to small consecutive investments, just enough to keep the initiative afloat.
On the other hand, this approach is very effective in avoiding making premature and oversized commitments to uncertain ventures.
So, when you are next faced with an investment decision, spend a minute considering the nature of that investment.
- Are you investing in something intangible?
- Is the venture very risky? Perhaps it is the time to leave the (false) sense of security stemming from ‘rigorous’ business case calculations, and use more appropriate decision-making methods.
Associate Professor Suvi Nenonen and Professor Kaj Storbacka work at the University of Auckland Business School’s Graduate School of Management. They teach in the MBA programmes and thei ovation and market innovation. They are passionate about building bridges over the academia-practice gap.
Column in New Zealand Management
Magazine Issue: March 2016
Page Number: 22