Some businesses complain that it is difficult to realize the hard benefits of digital programs. In fact, hard benefits seem elusive in many transformation initiatives. Why is that happening? Let's dive into the dynamics of typical corporate finance decisions for the answer.
Some businesses complain that it is difficult to realize the hard benefits of digital programs. In fact, hard benefits seem elusive in many transformation initiatives. Why is that happening? Let's dive into the dynamics of typical corporate finance decisions for the answer.
Some businesses complain that it is difficult to realize the hard benefits of digital programs. In fact, hard benefits seem elusive in many transformation initiatives. Why is that happening? Let's dive into the dynamics of typical corporate finance decisions for the answer.
At their essence, hard benefits are easy to grasp. They are simply a reduction of cash spent or an increase of cash collected. Super easy, right?
The companies clearly believe the value is there at the beginning of digital transformations, yet research shows only 20% of them consistently get the hard value, that is cash savings and cash gains in the end.
In fact, more than 2/3rds of the CFOs have given up on driving hard value beyond their own minimum project return, known as the hurdle rate. For this discussion let’s say that the hurdle rate is the company’s cost of capital. Basically what it costs the business on average to borrow or get money from investors. It drives almost every aspect of financial decisions from borrowing through stock issues to approving improvement projects.
So when it comes to funding digital programs the cost of capital, say 10% for this particular company, often becomes the hurdle rate, the rate of return the project needs to produce to add hard value for the business. Savvy value creators listening know this as the formula that project IRR must exceed the cost of capital. Ideally far exceed it.
In simplest terms, a great way for a business to make investment decisions is to get a return from its projects at a much higher rate than that hurdle rate. So if your hurdle rate is that 10% and your projects consistently deliver 20% IRR returns that you are doing great as a business. It is a bit more complicated but that's the basic idea. Some companies have this hard value rigor for all projects, while others only their capital expenditures.
Now, for companies to do a really really good job, they should keep investing their capital in the highest return projects, whether that is building a new plant, making a new acquisition or launching a digital transformation program.
That's where the finance theory ends and real life begins.
Research shows that most companies tend to favor familiar investments with lower returns than unfamiliar say digital projects at higher ROI. In fact, in a survey most CFOs said they stop looking for higher returns if they have enough projects delivering minimum returns at the current hurdle rate.
This makes no sense, you could say.
Why wouldn't they pick an unfamiliar project that has a 100% rate of return over a familiar project that will only deliver 12%?
In my experience, there are many reasons why this happens.
One argument CFOs often have is that estimating familiar projects is easier because existing metrics like demand or capacity or sales conversion rates are more predictable than outcomes of a digital program.
Now, anyone who lived through crises in 2000, 2008, or 2020 knows how unpredictable business results can actually be. Even in the best of times, companies may miss demand or production forecasts by 10-15%. There is nothing certain about the familiar.
However, this is the most persistent reason why under-performers underinvest in digital and perpetuate their laggard state. It is understandable and human. Taking risks and assessing risks is hard work. Even if the higher risk is rewarded with outsize potential returns. Most executive teams are not incentivized in taking outsize risks for outsize returns. They are expected to keep a steady ship and maintain returns just above the cost of capital.
Now with that out of the way, we are ready to discuss why hard benefits are actually hard to realize.
1) The biggest problem is that project teams consistently overestimate the savings they can realize. I don't mean they exaggerate or get sloppy in their analysis. What I mean is that they may assess the art of the possible correctly and assume the business - this time around - will be making the hard choices to actually realize the benefits, like renegotiating long-time supplier contacts, canceling unprofitable customers, or reducing manpower.
CFOs often discount the benefits, not because the analysis is faulty but because they know the business will not make the hard choices. This is the hardest thing about hard savings.
2) The second hard problem companies face with initiatives is that they provide localized benefits in one department and may cause other parts of the company to have to change and compensate with their own resources. So savings in one area become increased costs in another.
There are so many examples of this. The IT department would cut their support costs by 50% and causing productivity issues at the entire organization far exceeding the savings. Another example is a product team reducing testing or QA resources to save money but increasing support costs or even causing the business to lose revenues through customer issues. The same is true if one department reduces its workforce needs and the other one has to hire contractors to deal with the downstream effects. The list goes on. Pushing the bubble from one department to another can make hard savings become soft ones very easily.
3) Hard savings seem to work better around the edges of the value chain. What I mean by that is that supply chain and sales tend to be more successful in driving measurable impact than core operations or back-office. A big part of the reason is that they can push the efficiency gains to an outside party. It is a lot easier to demand a vendor to cut prices and reduce cost and people on their end than produce the same efficiencies and headcount savings internally. The same is true for customers. Creating premium services or upselling new solutions generates higher margins easier than streamlining inefficient sales operations internally. So it gets much harder when efficiencies are expected internally in the back-office as the suppliers or customers cannot chip in.
4) Another problem with hard savings is making them stick long-term. The cost structure of any business is a reflection of the efficiency of its processes. You can create a lean cost structure if processes are smooth and predictable. The less efficient the process the more you will have to augment them through people or contractors, that is labor cost or indirect spend. Research after research shows that all the cost-cutting that happens in a crisis disappears in recovery and especially SG&A gets typically worse than it was before the crisis. Inefficient processes will bring back inefficient cost structures. This happened in the ERP days where early cost savings disappeared and happen even in cloud-native businesses where manual processes augment digital processes at high levels.
Several studies were looking back at the last 20 years of cost savings. Despite all the technology innovations, lean projects, and digital transformations a shocking fact remains. Almost all profitability improvement from transformations came from Cost of Sales and none from overhead or SG&A costs. The long-term trend of internal overhead costs is simply unchanged in the last 30 years.
Having lived through waves of process reengineering, ERP programs, lean initiatives, and digital transformations - my conclusion is this - transformation initiatives generate the hard savings, take out the costs, gain the benefits, and then the businesses slowly return to the same spend levels. Why? to compensate for inefficiencies in their processes.
In the same way, as inventory levels are a reflection of the efficiency of the supply chain, and accounts receivable levels reflect problems in your fulfillment, the same thing is true for SG&A. Its level reflects the overall back office process efficiency of the business.
To get hard benefits, you have to make your processes as efficient, digital, and automated as possible. Digital programs have to focus both on getting the short-term value and create more efficient processes at the same time.
Otherwise, the hard benefits you gain short term will vanish longer term and the value will no longer exceed the cost of capital. Just like our CFO friends predicted. Let's prove them wrong, shall we?
Talk soon.