Questions the Board Should Be Asking

The recent wave of scandalous accounting events is providing a great opportunity to improve corporate America. It usually takes a burning platform to shake the status quo. Recent corporate behavior of a few have provided the platform, fuel and igniter!

Thanks to Enron, WorldCom and others, the window has been opened for responsible Boards of Directors to toss out some old rules and shift their focus to help insure the company’s future performance is much brighter. Two major concerns of Boards today are:

Integrity: Investors have lost confidence in corporate leadership. Even the reputation of the individual Directors is at stake. Investors are suspicious that what they see may not be what they get. They are concerned that “the books have been cooked” or misrepresented. The skepticism is reinforced when investors, especially “The Street,” are surprised with quarterly reports that aren’t even close to the financial projections.

Performance: Fortunately, we have shifted away from the doom and gloom, “rust belt” mentality and Dot.Com hysteria. While a wave of promising press releases can have a short-term influence on stock prices, shareholder value ultimately is based on real company performance. In the long term, investors only reward companies with impressive performance and those that are void of surprises and suspicion.

These two issues are tightly connected. Let’s face it. If the business is really doing well financially, the temptation to "color outside the lines” with smoke and mirror accounting tactics diminishes. The performance of the business is a direct result of key business processes such as developing new products, managing the supply chain, etc. The key to both integrity and performance is to focus on insuring these business processes well managed. When the processes are not well managed, performance is poor. These weak (poor quality) business processes then drive the bad behavior.

While accounting reform may be called for to calm the investor storm, weak accounting practices are not the primary root cause of poor performance. We can reform the way we keep and report the score, but that won't change the final outcome -- the company's real performance. The quality of these business processes must become the Board's major concern. Unfortunately, this is in conflict with traditional views of the Boards’ boundary of involvement.

A Major Shift in Traditional Board Focus is Mandatory
I have served on several Boards in my career. After talking with peers who serve on other Boards, my experience appears to be representative. Too much Board meeting time is spent on reviewing historical financial performance, i.e. looking into the rear view mirror and not enough time on examining current practices. The details of the operations are often limited to a 50,000-foot view. Brief Executive Officer presentations to the Board about “what is going on” in the business are squeezed into the one-day agenda. This cursory view hardly scratches the surface, leaving the Board with a shallow understanding of how the business is run.

Traditionally, Boards were not supposed get into the operational details and micromanage the business. Micromanaging is an undesirable extreme, but blind faith is an equally undesirable extreme! The challenge is to find a reasonable degree of involvement between the two extremes.

Boards need to insure high quality business processes are in place to provide an honest view into the future, eliminating surprises and insuring high-quality financial and customer satisfaction performance. Boards need to shift to more, not less, of an operational focus and awareness. Boards cannot fulfill the guardian responsibility that investors are justifiably expecting without getting into some of the details.

The Cure for Investor Frustration -- Six Sigma Business Processes
Investors can be brutal when they get surprises in quarterly reports or after a couple of quarters of poor performance. The penalties imposed by investors can be severe, including driving executive options under water. Unfortunately, some managers often deploy questionable business practices to avoid being taken to the financial woodshed for a beating and see their net worth diminish. And the Boards are often unaware of these damaging short-term tactics. An example …

A Fortune 100 company was focused on maintaining their consecutive string of positive quarterly cash flows to impress investors. Nothing wrong with that. The problem was with the hidden tactics used at some of the divisions to achieve this objective.

One large division had a poor track record of hitting the cash flow targets. Variance to inventory projections was high. The company had invested over $6 million dollars in new ERP software that was supposed to fix the problem. It didn’t. They also replaced the Materials Director three times. That didn’t fix the problem either. The pressure was mounting. Out of desperation, they decided to get “clever” and “workaround” the system.

They usually had many purchase orders (PO’s) past due or due in the current month. When summarized in dollars, past due plus current PO’s would often exceed two months usage. In other words, if the suppliers shipped all that was due, the company wouldn’t use it all and inventory would skyrocket. They also had many material shortages that prevented assembling product on time. Some of the material was late and needed. Some of it was not late, but needed. They expedited this material. Other items were late but not needed. They did not take time to reschedule those items because they were too busy expediting! It was open season on these items as far as suppliers were concerned. After all, they had shipping targets to hit also. Suppliers really didn’t know what was needed unless it was expedited. The supplier schedule was of little help. Measuring supplier performance was a joke! In fact, their biggest fear was suppliers shipping everything that was due.

When the suppliers shipped to the schedule, the inventory went up. Inventory also went up when they didn’t ship. The material in inventory waited for material they didn’t have! The assembly manager commented, “we have most of the parts for all the products, but we don’t have all of the parts for any of them.” Cash flow was really managed by the suppliers. It depended on how much the suppliers decided to ship -- or not ship! You have to question why they bought an ERP system -- at least the Board should have!

Lack of credibility in the scheduling system was the root cause of the uncertain cash flow and excess inventory problem. There was really nothing wrong with the ERP software. (Of course, some camps campaigned for new, even more expensive software). The ERP software was driven by an overstated, unrealistic assembly build plan. Rather than attack the root cause of the cash flow problem and fix it, they created a costly, “workaround process.”

A quarantine area was created by stretching a yellow ribbon around some trees in the parking lot near the receiving docks. It looked like a crime scene area. During the last 2-3 weeks of the quarter, all purchased material was unloaded into the quarantined area and not officially “received.” It was neither in inventory or accounts payable, since it was never officially received. When the Assembly Department needed material, they searched the crime scene (no pun intended) and then officially received it. A week or so after the quarter was over and the cash flow pressure was reduced, they would “receive” the balance and start all over at the end of the next quarter.

Later, the company replaced (with Internal Audit’s insistence) the physical quarantine approach with a “virtual” quarantine approach. Phones were manned by several experienced planners. The suppliers were instructed to call a special 800 phone number when material was ready to be shipped. The experienced planner would check and see if material was still needed, usually by scanning an assembly shortage list, not connected to ERP software. If it was not on the shortage list, the supplier was told not to ship, in spite of what the purchase schedule said! Of course, this enhanced supplier relationships. They also had their own financial projections to meet and were counting on this business.

Many people were duped into believing the “system” was working. However, the real system was the “crime scene approach” and later, 800-number authorizations. Meeting cash flow projections, shipping product on time and hitting revenue targets all depended on the informal workaround process, not the megabucks ERP software investment the Board had authorized. Not only was the informal process risky and costly, it was also unpredictable. What are the odds that the Board was aware of the real process used to run the business? Zero!

What should Directors do to uncover and prevent this practice? Insure the scheduling system is a Six Sigma process by asking …

• How many purchase orders (in dollars) are past due?
• How many are due this coming month compared to the monthly projected consumption?
• How is the process of scheduling (and rescheduling) suppliers done?
• Where are the stats on the supplier’s performance to schedule?
• Who is responsible for Six Sigma supplier delivery performance?

In this example, the supplier scheduling process was broken. But this is only one example. Here are a couple more:

Many decisions are made every day in a business based on anticipated product demand, i.e. sales forecast. Planners decide to commit the company to more inventory based on some estimate of future demand. The total of these individual decisions (hundreds of them) mount up and result in inventory on the balance sheet. Other managers also frequently make critical decisions such as hiring or not hiring people, buying capital equipment, projecting cash needs, predicting financial performance for shareholders, etc. on the sales forecast. The sales forecast is a crucial number in running the business. Yet the disturbing reality in almost all companies is that many individuals use their own forecast to make these key decisions. The result is often bad decisions, misinformation, extra costs, unpleasant surprises and overall chaos. See “Spin-proofing the Sales Forecast” in the Articles section of our website.

The Board of Directors must make sure this does not happen. They should insure that a sales forecasting process is used to establish ONE company sales forecast and individuals are clearly accountable for execution of the forecast. Sales forecasts will never be 100% right, but they can be reasonably close and everybody should use the same forecast. I assure you that the forecasting process in 90% of manufacturing companies is broken and many Board members don't even know about it. Allowing this practice to continue represents a significant risk for the business. Directors can mitigate this risk.

What should Directors do to uncover and prevent this practice? Ask …

• How do planners get a sales forecast to decide when to order more material?
• How does that forecast tie into the financial projections?
• What is the quality of the forecast and who is responsible for Six Sigma execution of the forecast?

It’s a New Millennium. How are your R&D Dollars Being Allocated?
New products are a vital lifeline for the company's future. Companies often spend 5-15% of sales on R&D while only 2-4% is spent on direct labor. Yet the performance of the new product development process is dismal in many companies and the poor productivity of this process is a bigger threat to company profits than direct labor productivity. An MIT study on new product development found only 1 of 10 new products launches are successful. By the time the failures show up on the income statement and balance sheet, it is too late. The money is spent and the slow-moving (or obsolete) inventory has soaked up a lot of cash. Temptation sets in to avoid a hit to earnings by not writing off the obsolete inventory caused by the weak new product development process. This dismal process performance represents a huge risk to the future of the business and should make Directors question the how new products are developed. Just think of the impact on the financial performance if the success rate can be increased to 2 or 3 of 10!
New product development processes are frequently broken. For example, a solid basis for selecting the next idea to pursue does not exist. Top priority shifts in reaction to the most recent event -- phone call, competitors new announcement, lost sales order, bosses latest inspiration, etc. Some call it a BFO process ... Big Fantastic Order.

Another problem is that available resources are not considered when deciding how many projects to pursue. The result is an overstuffed pipeline of new ideas being developed. The overloaded resources end up working on wrong ideas, hopping like a water spider back and forth as priorities are constantly shifted, working hard and spending big bucks on many projects, but completing very few.

The criteria for selecting projects to pursue are often based on customer wants, not market needs. The result is valuable resources are wasted on designing products that customers do not buy. Engineers charge ahead designing the product when the definition of what they are designing is incomplete and constantly changing, leading to costly delays while they redesign and redesign and …

The Board should make sure a well-defined new product development process is in place. This process should include careful selection of new ideas to pursue that focuses on market needs and respects the size of available resources. The Board should get frequent reports on key new product development process performance measurements. Email us for a free new product performance report template.

What should Directors do to insure a quality new product development process is used? Ask:

• How is the next new product idea selected?
• How are resources to develop products determined and not overloaded?
• What percentage of sales are new products?
• What is the definition of a "new product?"

All three of these examples had a few common threads. In each case:

• Poor quality process were put in place out of desperation to get better performance, not malicious intent to deceive.
• Processes created the illusion that they were working. In fact, they were not.
• The impact on the business was dilution of profits, dilution of cash flow, customer frustration and surprises in financial projections.
• Directors (and often Executive managers) were not aware of these weak processes and the impact on the business.
• None of these will be fixed with accounting practice reforms or SEC reporting reforms.
• All of these problems can be avoided. Proven solutions are available to raise the processes to Six Sigma performance levels.
I could easily provide a hundred more examples of critical business processes that are often broken and hinder profitable growth. Productivity of these processes is much lower than direct labor productivity. A tremendous amount of money is being spent to compensate for poor quality business processes.

A Shift in "What Is Important" -- Going Beyond Financial Audits
Integrity in the numbers (no surprises) and profitable growth are clearly the mandates for Boards from the investment community. Both of these are direct results of the effectiveness of the operational business processes. Boards need to shift their focus to insuring the company is run with Six Sigma business processes.

Responsible outside Directors should have assurance that the critical operational business processes are in compliance with "good practices," just as the financial data conforms to GAAP. In fact, they should be more concerned! If the operational processes are poor quality. It will be only a matter of time before poor results show up (or try to get covered up) in the financial reports. I am not suggesting we stop financial audits. However, by the time the financial data is available, it is often too late and the "game" for that fiscal Quarter is over. An effective baseball manager watches more than the final score.

Validity of the historical financial performance is essential. However, it tells the Boards about history. The Boards should be more concerned with the future performance. The good news is that business process technology has made tremendous improvements in the past couple of decades. There are proven solutions to reach Six Sigma. It won’t come easy. Directors must take the responsibility to get the ball rolling. They must start asking a whole new set of questions. We will have a handbook available soon to help Directors focus on the right questions to ask Officers and a list of operational performance metrics to meet this objective. This booklet is intended exclusively for Board members and CEOs and will be available in the Fall of 2002.

Director Dilemma
The recent Sarbanes-Oxley Act has rewritten the Board of Director Rule Book. The Act made it very clear that Directors are more directly responsible for company practices and raised the stakes if the company does not comply. This responsibility cannot be fulfilled without a significant amount of detail knowledge of operational processes. At the same time, traditional practice has discouraged Directors from getting into operational details. Therein lies the dilemma.

Directors have two choices:

1. Accept on blind faith what the management team tells them and put their destiny in this trust. Or ...
2. Get more involved and get a first-hand view how the business is run, making sure the business processes comply with Generally Accepted Operating Practices.

When it comes to financial compliance, every Director opts for choice #2. In fact, they hire independent auditors to back them up! It seems logical to do the same for operational compliance.

A New Opportunity - It's Time to Get Proactive!
The rash of recent corporate scandals has obviously raised the awareness that Boards need to be more responsible, particularly outside Directors. I question if a Board member can listen to a 15-minute presentation by a company officer and have sufficient depth of understanding to insure the company is run with one forecast, cash flow is not managed by suppliers, new product development projects are selected based on market needs, etc. ISO certification doesn't do it. Financial audits don't do it. In fact, the Audit Committee should insist on an annual, independent audit of operational practices.

Maybe the time has come for a GAOP (Generally Accepted Operating Practices) to be used for compliance reporting. Financial reporting reform may be like rearranging the deck chairs on the Titanic. Let’s get to the root cause of the problem. Everyone will be better off.