Monday, November 2, 2009

Build Your Business Model Around People

This is a real situation experienced by a real emerging company.  Names and figures have been altered to protect anonymity.

A company has a new opportunity and they create a financial model to try and forecast how their general assumptions for this opportunity will materialize.  Specifically, they made significant assumptions about the direct labor costs of the opportunity based on the historical performance of their other product lines.  Less than two months into receiving real data against which they can either validate or invalidate our assumptions, they began receiving feedback that the employees were under-paid and that their competitors had better compensation programs available.  How was this missed in the model?

First of all, let's be clear that this is not the first or last time something has or will be missed in a financial model.  They are based on assumptions, not fact, and, therefore, are subject to error.  The most inaccurate assumption made was that the number of units per direct labor cost was off by a large margin.  We could break it down to show that on average during the first 2 months 1.33 units were produced per person per day.  The model assumed that a minimum of 2 units would be produced per day.  With a piece-rate structure to the compensation program, this meant the employees of the company were taking home about 1/3  less pay for the same amount of work as the company's other products.

This company quickly made adjustments to the business model, and realized that even with a change in the production rates the new opportunity would be very profitable.  As such, they changed the compensation program, the employees were happy again, and the company is profiting from their new product line.

So, what take-away can we gain from this story?  Labor is almost always one of the two most expensive inputs into a business.  It, unlike any other asset of the firm, is often the most critical of all of the inputs.  If we want the best output, then we need to make sure to help our employees win within the structure of our business and financial model.  If our employees cannot win in a model that helps only the company win, then the company should not pursue the opportunity.