Can Modeling a Business Work?

A friend on LinkedIn asks, “Can modeling a business work?” I respond:

For now, or at least until The Singularity occurs, the development of business ideas and plans is a uniquely human enterprise that springs from a combination of intuition, goals, and ambitions. That should not mean, however, that we cannot effectively supplement our intuition and planning with aids to management and decision making. While I think human intuition is a very powerful feature of our species, I’m also convinced it can be led astray or corrupted by biases very quickly, particularly amid the complexities that arise as plans turn into real life execution. This is not a modern realization. The origin of the principles of inventory management, civil engineering, and accounting date back to the antiquities. Think of the seagoing merchants of the Phoenicians and the public works building Babylonians and Egyptians. In fact, historians now believe that the actual founder of Arthur Andersen LLP was none other than the blind Venetian mathematician and priest, Luca Pacioli (ca. 1494). That's right - that musty odor that emanates from accounting books is due to their being more than 500 years old.

Luca Pacioli doodling circles out of sheer boredom after a day of accounting. I made up the part about his being blind.

Business modeling is a tool similar to accounting in that it aids our thinking in a world whose complexity seems often to exceed the grasp of our comprehension. I look at the value of modeling a business as a means to stress test both the business plan logic and the working assumptions that drive the business plan. In regard to the business plan logic, we're asking if the business has the potential ability to produce the value we think it can; and in regard to the working assumptions, we're testing how sensitively important metrics (i.e., payback time, break-even, required resources, shareholder value) of the business plan respond to conditions in the environment and controllable settings to which our business plan will be subjected.

Obtaining such insights from modeling a business, business leaders can modify business plans by changing policies about pricing, products/services offered, costs targeted for reduction or elimination, and contingency or risk mitigation plans that can be adopted, etc. 

However, I recommend awareness of at least three caveats with regard to business modeling:

1. Think of such models as "what-ifs" more so than precise forecasts. Use the "what if" mindset to make a business plan more robust against the things outside your direct control versus using it to justify a belief in guaranteed success. The latter is almost a sure fire approach to failure. 
2. Always compare more than one plan with a model to minimize opportunity costs. Often times, the best business plans derive from hybrids of two models that show how value can be created and retained for at least two different reasons. 
3. Avoid overly complex models as much as, maybe more so than, overly simplistic models. Building a requisite model from an influence diagram first is usually the best way to achieve this happy medium before writing the first formula in a spreadsheet or simulation tool. Richer, more complex models that correspond to the real world with the highest degree of precision are usually not useful for a number of reasons:
• they can be costly to build
• the value frontier of the insights derived decline relative to the cost to achieve them as the degree of complexity increases
• they are difficult to maintain and refactor for other purposes
• they are often used to justify delaying commitment to a decision
• few people will achieve a shared understanding that is useful for collaborating and execution

A requisite model, on the other hand, should deliver clarity and permit making new and interesting testable predictions or reveal insights about, say, uncertainties, that could be made to work in your favor. Admittedly, though, it takes a lot of practice to achieve this third recommendation, but it should be used as a guiding principle.

Double, double toil and trouble; Fire burn, and caldron bubble

This was a great article in The Wall Street Journal today.

For me, the key take away point can be summed up in this quote from Prof. Goetzmann: "Once people buy in, they start to discount evidence that challenges them..." I relate this not only to investing decisions in the market, but also to making organizational decisions--investments in capital projects, new strategies, the next corporate buzz. We've all seen or been apart of the exuberant irrationality that leads organizations into malinvestments.

Let's consider the complementary action--saying "no." Against the tendency toward the irrational "yes, Yes, YES!", learning to say "no" is a very important skill to master. It's probably one of the hardest skills to master when people request something from us that makes us feel important and liked.

I think, however, we always need to be aware that many of our initial reactions are often driven by biases. Reactively saying "no," once we've learned to say it and it becomes easy to do, can emerge from the same biases that urge us unreservedly to say "yes." Both incur their costs: missed opportunity, waste, and rework.

The skill more important to learn than saying "no" is acquiring the skill to consider disconfirming evidence, especially when that evidence challenges our dearest assumptions about what is going to make us rich. Let's not be so quick to say "yes" or smug when we say "no." Rather, let's learn the practice of asking,

• "what information might disabuse me of my favorite assumptions?"
• "what biases are preventing me from seeing clearly?"

Failing to learn these, we all too often find ourselves concocting a witches' brew.