Pitfalls 8, 9 & ?

8. Assuming that process and/or quality improvements automatically lead to improved financial performance. Process improvements create additional capacity! The Moral? The firm must make and sell more to take advantage of the additional capacity (or be prepared to make the difficult decisions associated with downsizing).

9. Failing to take an organization-wide perspective when making decisions. Often managers myopically focus on their part of the business (their product, their department or their division) and forget the side-effects of their decisions. What were the potential side effects of closing the container department at Liquid Chemical?

10. Forgetting the capital budgeting "matching principle" that one must discount nominal cash flows at a nominal rate. A common pitfall in practice is that managers do not incorporate expected inflation in their estimates of future cash flows yet discount these cash flows at a nominal rate (that incorporates inflation expectations). The result is to understate the NPV of the project. The Moral? Match cash flows and the discount rate -- it's probably easiest to use nominal cash flows and a nominal discount rate. Both incorporate expected inflation.

11. [Okay, I couldn't keep it to ten.] Incentive/compensation pitfalls include:

failing to choose a financial performance metric thinking that if we do the other stuff right (e.g., 'delight the customer'), profits take care of themselves.

undermining the long run to make the short run look better. Examples include avoiding cost-effective maintenance or R&D expenditures to boost short run profits. Another example is rejecting positive NPV projects because they hurt short run profits.

using a poor quality financial metric. Among financial performance metrics, earnings and sales growth don't take into account the size of the investment. On the other hand, ratios that do incorporate size (e.g. ROA) can create dysfunctional incentives if you ask managers to maximize them. Residual income-based metrics are good in that they avoid the "ratio syndrome" and make the cost of capital explicit. But all of these metrics are only as good as the underlying accounting numbers, e.g., what financial performance metric would you choose for a development stage biotech firm or a start-up internet firm?