Category Archives: Decision Making

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Company Pulse Brexit blog

How can your business plan during the Brexit process?

We have heard a great deal about the Brexit process since the referendum, but most businesses are still unclear about how it will affect them and how they should (or indeed whether they can) plan for the future.

We now know what the government’s objectives are (a “clean Brexit”), what the position of the EU27 is (no “cherry picking”) and what the process and broad timetable should be.

But there are three main areas of uncertainty: which of its objectives the government can achieve and what trade-offs each side will make during the negotiations; how the negotiations will be affected by political events, including UK and EU parliamentary votes and upcoming elections in France and Germany; and, when we get to the end of the negotiations, what happens next in terms of implementation and any transitional period.

The economic background is a little clearer than when we posted our last blog on this subject. Sterling has fallen by around 15% from pre-referendum levels on a trade-weighted basis. The fall in the exchange rate is driving up inflation, which can be expected to rise above the official 2% target. The labour market remains tight and skills shortages abound, so we expect greater pressures for wage increases in response to rising prices. Overall UK economic activity has held up well during 2016, mainly due to consumer spending, but the rise in inflation and elevated levels of consumer-credit means that consumption is unlikely to sustain the economy so strongly over the next year or two.

And then there is a new major external factor – the Trump presidency and its unpredictable impact on international relations, global trade and the global economy.

So what can you do plan for the period of change Brexit will inevitably bring when there are so many uncertainties?

Probably the best tool in these circumstances is scenario planning. Scenario planning can be a detailed, rigorous, laborious and lengthy process. But, in the case of Brexit, we think a less formalised approach will quickly give you the insights you need to prepare your business.

We recommend that you start by identifying possible outcomes for uncertainties (in the case of Brexit, one uncertainty is whether or not the UK remains a member of the customs union) and group these together to form a coherent scenario. Each scenario must be internally consistent – a plausible future reality. Next you reduce the number of scenarios to a manageable number of alternatives for analysis, perhaps 2 or 3, which, to be useful, should be markedly different. Then you need to work out in reasonable detail what each of these scenarios would mean for your business, including how your business could respond, what resources you would need, and how other market players (suppliers, customers and competitors) might react.

Having analysed and war-gamed the shortlisted scenarios, you should be able to identify a set of weaknesses, risks, threats and opportunities some of which may previously have been hidden. These can be classified by impact (from existential down to minor) and whether they arise in all scenarios or are scenario-specific. These insights should give you a clear set of priorities for de-risking and improving the ability of your business to deal with Brexit.

We can help you work through this scenario planning process and we recommend you start by taking one of our business health checks. A business health check will help you understand how your business is currently doing, what your main strengths, weaknesses, opportunities and threats are, and how prepared you are to face the impending challenges.

We’ve also set out some key Brexit-related questions to help start your planning. These should give you a better understanding of any immediate problems requiring attention.

We think that the best ways to face the challenges of Brexit are to map out and plan for all likely scenarios, keep your options open, and to maximise the agility, flexibility and adaptability of your business.

Click here to start a Company Pulse business health check.

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Company Pulse Brexit blog

How should your business plan for Brexit?

Four weeks on from the EU referendum vote and the details of how Brexit will proceed are still unclear. Whilst the new government has said that “Brexit means Brexit” and given some indications that it won’t be hurried, solid information to help businesses plan for the future has not yet emerged.

We are unlikely to learn anything concrete from the government until the autumn, and perhaps even until the end of the year. Official data relating to the post-referendum period will not be published for a few months. Market reaction and surveys of business sentiment may give some guidance – a downturn in the short-term is the current consensus – but these based on hunches, not data.

So what can you do to prepare your business for the inevitable changes Brexit will bring when useful information is scarce?

The first point to recognise is that the Brexit process is likely to take two or three years and its full implications will not become apparent for some years after that. So this is a case for long-term planning.

Second, this lengthy timescale is not an excuse for doing nothing. Waiting would mean missing opportunities and playing catch-up later. Nor should you necessarily defer investment decisions. What is needed is a realistic assessment of potential outcomes and how your business could react to Brexit. You should use the current period of uncertainty to take stock of your business, develop ideas and work up game-plans for a range of scenarios.

A third concern is not to jump to conclusions without hard evidence. Over-reacting to limited data is also dangerous, particularly if that cuts off other possibilities. If you do need to make any big decisions in the near future, be rigorous in your analysis and critical of all assumptions.

We’ve already set out some questions to help you plan in an earlier post. These will build a better understanding of your business strengths, weaknesses, opportunities and threats.

The next step is to consider how the business environment will develop. All aspects of the economy will probably be affected by Brexit, so many established assumptions around your business may need to change. External factors to review include macro-economic (consumer demand, price inflation, labour mobility, wage rates, terms of trade, interest rates, credit availability and the relative value of Sterling); governmental (regulation, public investment and taxes); and market-specific (competition, new entrants, substitutes, productivity and the supply chain).

Taking one of our business health checks will help understand how your business is currently doing and how prepared it is for the challenges posed by Brexit. Our Gold business health check specifically includes the scenario planning that is most beneficial when faced with great uncertainty.

We think that the best ways to face those challenges are to plan ahead, keep options open, and to maximise the agility, flexibility and adaptability of your business.

Click here to start a Company Pulse Business Health Check.

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Company Pulse Brexit blog

What does Brexit mean for business and for small businesses in particular?

The result of the EU referendum vote has taken many by surprise and the financial markets, at the time of writing, have been marked down sharply. Those who are running small businesses might find the prospects confusing and worrying, with little hard information available to help plan for a post-Brexit future.

We have to assume that Brexit will proceed but, at present, it is far too early to know what the full implications are for business as the political process hasn’t begun and negotiating positions are unknown. We don’t know which of the free-trading or anti-immigration aspects of the Leave campaign will predominate. If it is the former, and the ‘Norwegian model’ is adopted, many things will remain the same and business to could expect to recover to something like pre-referendum norms. However, that doesn’t reflect what many voted for and we may end up with higher trade barriers and consequently greater challenges and uncertainties for business.

While most people in business dislike uncertainty, there are some things that businesses can at least think about to prepare themselves for the inevitable changes to come. We have addressed these in the form of questions you could ask yourself under our 5 Pulse topics

People + Processes

  • If we employee EU nationals, what do we need to do to ensure we retain them? (at least until the legal position becomes clearer)
  • If the current skills shortage is unlikely to improve, and may well get worse, what can we do better to attract new employees?
  • Wage rates may come under pressure: the pound’s fall will raise the cost of imports, feeding into inflation – what can we do to ensure we remain attractive as an employer?

Utilisations + Outcomes

  • Productivity is likely to be a key ingredient to future success, especially if wages rise – what can we do to improve productivity?
  • Sales to overseas markets: can we take advantage of a lower pound and enter new overseas markets? And are there good alternatives to existing EU markets if our trading relations with the EU deteriorate?
  • If market conditions are depressed in the short term, what are the implications of a lower growth trajectory (e.g. on staff incentives, investor relations and banking covenants)?

Logistics + Infrastructure

  • Is our supply chain at greater risk of disruption (especially if we currently rely on EU suppliers) and what can be done to mitigate those risks?
  • Do our business continuity plans adequately reflect increased business risks post-Brexit and during the transitional period?
  • Do we need additional intellectual property protection to cover EU countries post-Brexit?

Strategy + Finance

  • Do we need to update our business strategy for Brexit, and have we considered the implications of any short-term recession?
  • When trading conditions are tough, cashflow management can make the difference between failure and survival – what can we do to improve working capital and cashflow?
  • UK banks are likely to be under greater pressure in the short and medium term – what alternative sources of finance are available to the business?

Ethos + Relationships

  • If we currently serve EU customers, what can we do to reassure them and retain their custom?
  • We should bear in mind that many of our employees will be confused and anxious about their prospects – what do we need to do to reassure them and how could our employee communications be improved?
  • In due course regulations will change (but probably not very quickly) – are we fully compliant today and how do we ensure we keep abreast of regulatory changes?

Taking one of our business health checks will help understand how your business is doing in each of these areas, and help you plan for an uncertain future.

The businesses that are most likely to rise successfully to these challenges are those that are well-prepared, by thinking through the implications and developing appropriate responses to each scenario, and are agile, adaptable and flexible to implement change quickly and effectively. So let us help you be one of those successes.

Click Here to Start a Company Pulse Business Health Check

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Company Pulse gold silver or bronze

Which health check is best for my business?

Perhaps you’re about to make an important change in your business: entering a new market or launching a new product line; considering an acquisition or merger; or planning for succession or an exit. Or maybe you know there’s a problem but you can’t quite put your finger on it. Perhaps you just want to take stock of your business and plan for the future. In any event, you think it’s a good time to check the commercial and financial health of your business. But which business health check should you choose?

Obviously, we hope that you’d choose one from Company Pulse. All our business health checks:
• Provide an independent and objective review of your business
• Present our findings in the form of a balanced scorecard
• Use intuitive graphics and charts to highlight relative performance
• Benchmark your business against other businesses of a similar type and size
• Evaluate your business strengths, weaknesses, opportunities and threats
• Identify areas for improvement and sources of untapped potential
• Help to develop action plans and set priorities for implementation

But we offer three different levels of business health check, so you need to find the right one for your business.

Our Gold and Silver business health checks are all-round business reviews that provide you with a detailed and comprehensive report using our unique PULSE evaluation framework:
People + Processes
Utilisations + Outcomes
Logistics + Infrastructure
Strategy + Finance
Ethos + Relationships

Our Gold business health check is our premium service in which:
• Our experienced advisors will meet your senior management on-site to review your business in-depth, giving you plentiful personal contact time
• We use scenario analysis to review forecast financial performance and highlight a range of potential outcomes
• Our advisors present and discuss our findings in person with your Board
We think our Gold service is most appropriate for more complex businesses, such as those with multiple brands or product categories, or those trading internationally in several territories.

Our Silver business health check has the same scope as our Gold service. The key differences are:
• Only one of our experienced advisors will meet you to review your business
• A simpler review of forecast financial performance
• The presentation and discussion of our findings is via video-conference
A Silver business health check is cheaper and quicker to complete than the Gold and is most appropriate for smaller and/or simpler businesses, typically with a single brand and product category, and probably not (yet) exporting to a significant degree.

Our Bronze business health check is a distinct service that:
• Covers only the financial aspects of your business, notably analysis of the current financial position and forecasts of future financial results
• Includes a review financial planning and controls
• Is conducted exclusively online
A Bronze business health check is the cheapest and quickest to complete and is most appropriate for businesses whose prime concern is their finances.

Of course, if you can’t decide between our business health checks or want to sample our services before you buy, you can always start with our Free Trial Diagnostic!

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Company Pulse business health check

Prevention is better than cure

Most of us recognise that preventative care is cheaper than curative care (or treatment), and more effective than palliative care (which just reduces the impact of symptoms). And not just in medicine, but in many activities. That’s why we have routine services for our cars, planned maintenance for our infrastructure and quality assurance in manufacturing.

It’s the reason why at Company Pulse we offer business health checks as the primary tool for improving the commercial and financial health of businesses. We think that if you want to help a business grow, step up to the next level, or even just survive, you need to know its strengths and weaknesses and how it can use them. One of our business health checks is the first step in understanding business potential, helping the management team think strategically about their business and actively planning its future direction.

The easy option, of course, in not to check your business health. But can you afford not to?

Back in the day, most people thought quality management systems were a nice-to-have that added costs to a business. But Armand V. Feigenbaum (in a 1956 Harvard Business Review article) showed to the contrary, that the costs of NOT taking preventative actions were almost always higher. The cost of quality failures generally far outweighed the costs of prevention. Feigenbaum’s work lead directly to the development Total Quality Management and Six Sigma. He defined four main cost areas (with typically increasing overall cost to the business):

Costs of Control
Prevention (planning, training, process control)
Appraisal (inspection, testing)

Costs of Failure
Internal failure (scrap, rework)
External failure (complaint handing, servicing, warranty, reputation)

A business health check falls under the costs of control, with elements of both prevention and appraisal. Analysis of the business environment is an essential element of strategic planning, and such elements of a business health check are pure prevention, as is the review of business capabilities. Benchmarking business performance comes under appraisal in the quality costs model and will highlight potential deficiencies and areas for improvement.

A Company Pulse business health check is an independent and objective review of your business that should lead to real performance and profitability improvements, enhancing business value and delivering a positive return on investment. And because our business health checks are low cost and fixed-price, the initial investment will probably be less than you expect and almost certainly less than the costs of not taking a precautionary check-up.

Unlike an MOT or filing your accounts, there’s no fixed schedule for checking the health of your business. Best practice is to take regular (say, biennial) health checks of your business. But if you haven’t got into that routine yet, when is a good time to take its pulse? The two main triggers are whenever you are considering major change; and when you know there is a problem, but you’re not exactly sure what it is.

The sorts of major or strategic change in your business, when a prior business health check is advisable, include:
• Entering a new market
• Launching a new product line / category
• Acquiring or merging with another business
• Raising new finance or refinancing existing debt
• A fundamental change to existing business strategy
• Implementing a turnaround
• Succession planning
• Seeking an exit (through selling your business)

If you’re about to embark on one of these potentially risky ventures, a modest investment in a business health check, which should alert you to any hidden problems and steer you towards a better outcome, is likely to be time and money well spent. After all, prevention is better than cure.

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Company Pulse financial planning

What is the correct assumption? Or how to choose a good set of baseline assumptions

In a meeting to review business case projections, the discussion ranged over various assumptions in the financial model and someone asked “But what is the correct assumption?” For those with a background in analysis, this question was an amusing distraction, but it raises an important point – what assumptions should you use in your business forecast?

One of the problems of any forecast is that it reflects the biases of the forecaster. And when you build a financial model of your business you are also making potentially biased structural assumptions about key business drivers. So, even though you’ve constructed a ‘rational’ financial model, it will inevitably be biased and the assumptions potentially unrealistic or inconsistent.

So what should you do to minimise bias? The best approach is to view all assumptions as just that, assumptions, and not facts, and to use sensitivity analysis to refine your understanding.

Sensitivity analysis helps answer the “what happens if…?”questions, such as sales X% down on forecast, payroll inflation up by Y%, or overheads reduced by Z%. A good financial model will have the capability to do this quickly and easily, perhaps with switches for key variables or scenarios.

The main benefits of sensitivity analysis are to evaluate the range of potential outcomes, to understand better the relationships between inputs (assumptions) and outputs; and to test the robustness of the model by revealing potential errors (as highlighted by unexpected, counter-intuitive or non-linear relationships between variables).

If you use sensitivity analysis systematically by adjusting your assumptions incrementally away from a central value, rerunning the model and reviewing the output, you can start to understand which variables are the most important to your business. A more sophisticated version is to use the Monte Carlo method to generate a large number of outputs having randomised each of the key input variables. Ideally you will automate this process and then run the model through a large number of iterations.

However accomplished, reviewing the range of outputs will give you a sense of the most likely outcome, and the potential range around that expected outcome. This process also provides a ‘sense check’ for your baseline assumptions.

There is another useful variant of sensitivity analysis to consider before finalising your baseline assumptions: break-even analysis, which allows you to find the levels for key variables where the model breaks even, for example sales volume, selling price or cost of sales (whilst holding all the other variables at their central assumption). Break-even analysis is a simple and powerful concept, but surprisingly under-used.

So, having reviewed your sensitivities and evaluated the break-even points, you have arrived at a better understanding of your assumptions. You may find that something previously considered insignificant is a critical, or the impact of some variables is reduced by self-correcting mechanisms, others may affect timings but not quanta, and yet others will be much less significant than the received wisdom would have suggested. You should also consider each assumption in the light of the others: are you assumptions mutually consistent? Such insights may provoke further research and debate as you home in on your baseline assumptions.

You will probably have realised by now that there is no such thing as a “correct assumption”. The best you can have is a baseline set of realistic assumptions that are internally consistent. What you do need is a management process: a progressive approach to a better understanding of your assumptions leading to a better forecast of the outcome.

This review process should continue every time you update the model with actual performance. After an update that results in a step change from the original plan, ask yourself “Is this the start of a trend, a blip, or a timing issue?” Keep running sensitivities (especially those suggested by recent actual performance) and, if necessary, update your assumptions. You should converge on an increasingly accurate forecast which, after all, is the goal of your modelling.

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Company Pulse business health check

Start improving the commercial and financial health of your business

The turn of the year is a good time to reflect on past achievements and to plan for the future. For most business people, that means thinking about how to improve the commercial and financial health of their business.

As we’ve discussed previously, a healthy business needs more than just good financial results. The healthiest companies are characterised by strong performance across a range of measures, including sales growth, profitability, balance sheet, employee skills and motivation, supply chain efficiency and customer satisfaction. This all-round fitness allows them to reap sustained, long-term rewards.

Long-term success in business means being better adapted to your environment than your competitors. This requires fitness in the past, present and future – as demonstrated by recent performance; current capabilities; and adaptability and flexibility.

So if you want to take stock of your business and start preparing for a prosperous new year, how should you start? The best way is to see how your business shapes up by taking a business health check.

A Company Pulse business health check uses our unique PULSE evaluation framework: People + Processes; Utilisations + Outcomes; Logistics + Infrastructure; Strategy + Finance; and Ethos + Relationships. We benchmark your business performance using this framework against other businesses of a similar type and size to help you understand your comparative strengths and weaknesses. As good business health derives from a combination of factors, we present our findings in the form of a balanced scorecard showing your benchmarked performance across multiple dimensions. We will also develop with you a prioritised action plan of how to improve the financial and commercial health of your business.

A business health check is the ideal start to improving the commercial and financial health of your business. Once you have established where you are and what you could do to improve, you can start implementing your action plan. And that would be a really rewarding way to start the year.

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Company Pulse business health check

Top tips for financial modelling

Financial models are useful business tools. In our view, they are the only reliable way to quantify a business plan. The model may be of a specific business case, perhaps to evaluate a proposed investment, or of the whole business. Financial models come in all shapes and sizes, including short-term cash forecasts, annual budgets and 5-year business plans.

However, financial models have come in for some bad press, particularly as the essential underpinning of complex financial products. And some financial models quickly fall out of use through being unrealistic, overly complex or too cumbersome to use.

But these negatives shouldn’t put you off financial models – they are very effective in helping you understand your business better, and allowing you to make more informed decisions about strategy, plans and investments.

Here are our ten top tips for business owners in how to build and implement a financial model:

1. Don’t be afraid to take an unconventional view
A financial model doesn’t need to follow your current chart of accounts, although it is advisable to reconcile the model back to your accounts. Businesses often find themselves constrained by current accounting practices, and a financial model is a low-risk way to start realigning the accounts – if you are considering doing something different, your financial model should reflect this.

2. Keep it simple
Models are simplifications of reality. To work efficiently and well, they need to encompass all the relevant factors as straightforwardly as possible. Over-elaboration leads to complexity, opacity and mistakes. Unless you specifically need to evaluate a longer period, limit your model to a maximum of five years.

3. Integrated and commercially-based
Build the model up from commercial activities, so unit sales are based on resources, turnover is based on sales units x price, cost of sales is based on sales units x costs, gross profit is turnover less cost of sales, and so on. Commercial performance should be translated in the profit and loss statement, which is reflected in balance sheet movements which in turn give you cash flows. The four elements: commercials; P&L; balance sheet; and cash flow, should be fully integrated.

4. Model each category separately
Keeping each product category, line of business or territory separate allows you to evaluate differing performance (and in the case of overseas territories, allows you to model exchange rates effectively). Your model should have a single layout that applies to each category, each having its own commercials, P&L, balance sheet and cash flow. These can then be consolidated into a set of whole company views. If you have a number of (relatively) immaterial products or activities, it’s probably best to lump these into ‘Other’ – but be prepared to break out any that are found to be material.

5. Separate logic from numerical assumptions
Hold your numerical assumptions together on one worksheet and label them clearly: these can be single point assumptions (e.g. a discount rate) or variable assumptions, by time (e.g. annual pay increases), product category (e.g. cost inflation) or territory (e.g. distribution costs). Separating the logic from (numerical) assumptions means that assumptions can be changed easily if required – this also makes sensitivity analysis a lot easier.

6. Provide summary output and use charts
The summary output should be boiled down to a few top-level lines shown on an annual basis. It’s easy to drill down into the detail if you need it, but it can be difficult to spot the key messages if too much output is presented. Use charts to illustrate and complement numerical analysis – a dashboard-style usually works well.

7. Ensure easy updating
You should update your model regularly with actual performance, so consider ease of updating at the design stage (even in a one-off business case, as you’ll want to review what the actual results were). If the financial model is to have any longevity, you should also permit new products (etc.) to be added easily.

8. Reconcile the starting position
It is essential that you can reconcile the model’s starting position to your accounts, personnel records and any other key inputs, and that the initial balance sheet balances. Whenever you update the model with actual data, you will need to check it still reconciles.

9. Include sensitivity analysis
Every financial model should include some form of sensitivity analysis: what happens if sales are X% down on forecast or payroll costs up by Y%? You may need to provide for scenario analysis, looking at a number of scenarios, each of which has an internally consistent set of assumptions. You may even want to use the Monte Carlo method to generate a large number of outputs with key variables randomised, and then review the range of outputs to get a sense of the most likely outcome.

10. Testing, more testing, documentation and sign-off
Test the model thoroughly before use, and have someone other than the modeller carry out the tests. Initial testing should include calibration of the model to ensure it reflects what is currently happening in the business. Stress testing should be employed to check whether the model breaks within its normal operating range and what happens when you push assumptions outside a ‘reasonable’ range. Sensitivity analysis tests allow you to check input-output relationships and be confident that key assumptions and variables behave as expected. Once you are happy the model performs well in testing, it is useful to allocate a business owner for each of the main assumptions, and reflect to them in the model’s documentation. Finally it is essential to gain business sign-off for the model ideally from the board or, in an owner-managed business, from the business owner.

Financial modelling is an essential tool for all but the smallest of business and it is vital that business owners and managers understand how to deploy a financial model and how to get the best from it. We hope these tips are a useful start.

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Company Pulse business health check

What is known and what is unknown? Or how Donald Rumsfeld, the Johari window and a business health check are linked

Donald Rumsfeld’s famous quote about “knowns” and “unknowns” (reproduced in full below) was illuminating in that he missed out “unknown knowns”!

The Johari window is a useful psychology tool for understanding relationships between a subject (self) and others (peers) that categorises awareness of information (in the psychologists’ case, character traits) into 4 quadrants:

• Open or Arena, where both the subject and others are aware;
• Hidden or Façade, where information is known by the subject but not by others;
• Blind Spot, where the subject is not aware, but others are; and
• Unknown, where neither the subject nor others are aware.

This tool can also be applied to companies in respect of knowledge in the business environment. The Open quadrant contains information in the public domain, such as statutory accounts or demographic trends; the Hidden may include trade secrets, commercially sensitive data and pricing algorithms; the Blind Spot could comprise customer sentiments being aired on social media, new entrants or processes that you are not (yet) aware of; and the Unknown hold anything from future fashion trends to undiscovered new technologies.

As in personal relationships, the main benefits to business from using the Johari window are in becoming aware of things in the Blind Spot and tackling them appropriately.

In business, many items of information move from one quadrant to another, whereas your personality traits tend not to change much. Your new invention will start in the Hidden quadrant until you register a patent, when it moves into the Open quadrant (albeit protected from exploitation by others). Much information moves from your Blind Spot to the Open quadrant as you learn more about your customers and competitors. But things can also get forgotten or overlooked and move the other way – material once considered important but now buried in a dusty file. And, of course, new technologies, business processes and market trends emerge from the Unknown. Because of these movements, businesses should not consider their Johari window as a one-off exercise, but should keep reviewing it for changes, perhaps annually.

One major benefit from taking one of our business health checks is that it will normally reveal to you things currently in your Blind Spot. These are issues that you have never been aware of or not paid much attention to, but that our market and industry intelligence can bring to your attention. We may also remind you about important factors that have dropped off your radar. Whilst, as Rumsfeld acknowledged, you can’t do much about things that are Unknown, you can improve your business performance by minimising your Blind Spot.

When Rumsfeld talked about “known knowns” (Open quadrant), “known unknowns” (Hidden) and “unknown unknowns” (Unknown), he failed to mention “unknown knowns” (the Blind Spot). Perhaps this was his subconscious Blind Spot?

So don’t get caught out by things in your Blind Spot. Uncovering them and dealing with them effectively is vital, especially as the business environment changes an “unknown known” becomes significant to your business.

Donald Rumsfeld quotation (Feb-2002 at a US Department of Defense briefing)

“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

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Company Pulse business health check

One bad decision begets another

Category : Decision Making

If you haven’t already read Daniel Kahneman’s excellent book ‘Thinking, fast and slow’ you might want to put it to the top of your ‘to read’ list. It fundamentally challenges much of the received wisdom about decision-making. Anyone who needs to make significant business decisions should understand the implications of Kahneman’s work (which earned him a Nobel Prize in economics).

The fundamental point he makes is that most people don’t make most decisions rationally.

Kahneman explains that we all have inbuilt biases, most of which we are unaware of – and when we are aware of them, we often find it difficult to overcome them. This doesn’t make us irrational, it just means we don’t conform very well to the ‘rational agent model’ which underpins classical economics and traditional theories of management decision-making.

Some of our main biases, which mean we don’t evaluate potential gains and losses equitably, are:
• Loss aversion (the fear of losing is greater than the hope of gaining)
• The endowment effect (the maximum price we would pay to acquire something is less than the minimum we would be prepared to sell the same thing for)
• The sunk-cost fallacy (taking into account sunk costs, which should rationally be set aside, leading to ‘throwing good money after bad’)

The title for Kahneman’s book refers to our two natural ways of thinking: ‘System 1’, the automatic, fast and intuitive way; and ‘System 2’, the slow one we use for complex problem solving which also can, with effort, overrule the quick and easy suggestions made by System 1.

A recent article in the Economist (see link 1 below) describes research into gambling which adds to this thinking. Winning gamblers tend to choose safer and safer odds, which often extends a winning streak, whereas those on a losing streak take ever riskier bets, making it more likely their losses will continue.

Furthermore, research published in Neuroscience (see link 2 below) suggests that rats ‘regret’ decisions – implying that our decision-making behaviours have evolved way back, are shared with many other animals, and are deeply embedded in our subconscious (these form part of System 1).

Taking all this together it is clear that there are significant risks that we don’t always make a ‘rational’ business decision (i.e. choose the option with the best potential outcome, given the information to hand). And in a tough business environment, particularly if an earlier decision has not turned out well, the temptation to make a riskier decision is greater.

Just because things are going well doesn’t mean we will naturally make better, more rational, decisions – then there is a tendency to be conservative, potentially missing out on a good opportunity by being too risk-averse.

The implications are clear if you are a decision maker – you need to work at making rational decisions. Use quantitative techniques and apply them appropriately. But most of all, be aware of yours, and others’, biases and try to set them aside.

1. The Economist:

2. Neuroscience:

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