Managing the Cost -- and Value -- of Failure

Why Successful Financial Managers Seek to Exploit Failure Rather Than Avoid It, by Bruce Pounder

Individuals and organizations experience failure on a continual basis. Most failures are small, a few large, and a certain few catastrophic. Financial managers are quick to perceive the cost of failure, typically in the form of wasted money or lost opportunity. But many financial managers "fail" to recognize the significant value that is also present in nearly every failure.

This article is about managing both the cost and value of failure in business today. As risk and uncertainty increase in our business environment, failures of all kinds are bound to increase. But this is not the threat it seems to be; we can learn a great deal from financial management techniques practiced in industries that have always been immersed in risk and uncertainty.

The Stigma of Failure

To many folks -- especially financial professionals -- failure of any sort is psychologically unacceptable. People avoid failure for many reasons: personal embarrassment, fear of punishment, and the shame of letting others down. Many of us want to always have the right answers, never make a mistake, never attempt anything where the outcome is less than certain.

Decades ago, most people's jobs involved working on unambiguous tasks using tried and true methods. Failure to succeed at one's work was attributed at best to a lack of aptitude and at worst to character flaws. From a managerial standpoint, where the emphasis is on decision-making, a decision with an unfavorable outcome used to imply that

  • we made foolish choices;
  • our decision-making process was flawed;
  • we put insufficient effort into the decision-making process; and/or
  • we ignored an obvious, right decision.

But in today's complex, unpredictable world, the outcome of a decision is an inadequate measure of the decision-maker. Failure isn't necessarily about foolishness, negligence, or irresponsibility, and therefore it need not carry the stigma of a less risky and more certain era. In contrast, as you'll see next, today's successful managers view failure as a valuable stepping stone on the path to success.

The Value of Failure

In the complex, unpredictable world of business today, whoever learns the most, the fastest -- wins. The fundamental value of failure is that we can learn much more, much faster from failure than from success. Of course, the challenge is making sure our failures aren't so costly that they take us out of the game.

It is no mean feat to balance the value of failure with its costs as the incidence of failure increases. Before examining how successful financial managers do this, we'll look at how they don't try to do it.

The Folly of Trying to Avoid Failure

In competitive endeavors such as business, the risk of failure cannot be avoided and is regularly realized. Championship teams rarely have undefeated seasons. Conquering armies rarely win every skirmish. Chess masters never win games having retained all their pieces. What separates winners from losers in competition is not that winners avoid failure, but that they exploit it by accepting low-cost failures in the pursuit of high-value successes.

Ironically, the more afraid you are of losing, the less likely you are to win. In general, you can afford to lose a skirmish if it helps you win the battle, and you can afford to lose the battle if it helps you win the war. But if you insist on winning every skirmish, you're unlikely to ever win the war.

Additionally, attempting to reduce the cost of failure by avoiding situations in which failure is possible is self-defeating. By avoiding situations in which failure can occur, you're avoiding situations in which learning can occur. Successful financial managers focus on identifying endeavors where value can come from both success and failure -- albeit in different forms.

Finally, a little humility goes a long way in dealing with failure -- you're not God and neither is anyone else you work with. You can't control the outcomes of your decisions. You can't control other people.

High-Risk Industries

In industries such as oil exploration and securities trading, failure has always been unavoidable. And as enterprises in all industries face increasing uncertainty and risk, failure becomes unavoidable for them as well.

If 9 out of 10 wells drilled are dry holes, how do oil exploration firms make money? By making more on each successful effort than is spent on 9 failures. "Sure Thing" drilling opportunities occur too infrequently and are generally too costly to identify, which is why exploration firms don't rely on them.

Similarly, successful securities traders are wrong at least as often as they're right when betting on the direction of the market. How, then, do they make money? By making significantly more on the each winner than they lose on each loser. No trader has the ability to see into the future with much more accuracy than could be provided by the flip of a coin. Traders would have to exhibit an extraordinary ability to guess correctly to generate as much profit if the amount gained on a correct position were equal to the amount lost on a wrong position.

It is precisely from the experience of failing that enterprises learn to minimize the cost of failure and maximize the rewards of success. Once a profitable balance between the total cost of failure and the total value of success has been attained, enterprises that "roll the dice" more often will certainly fail more often -- but will also maximize their profitability.

High-Risk Business Functions

While failure is routine for enterprises in certain industries, it is even more routine in certain business functions across industries. Look at your firm's marketing and sales expenditures. The money you spend to acquire the customers you succeed in acquiring is probably a small percentage of your total marketing and sales budget. The rest of the budget is consumed by your failed attempts at acquiring customers.

Of course, margin from the customers you successfully acquire has to cover not only the cost of acquiring those customers but the cost of your failed customer acquisition attempts as well. Reducing the cost of failure -- not necessarily the incidence of it -- has real bottom line impact and is more attainable.

It is the same with Research and Development. In the pharmaceuticals industry, for example, a few "blockbuster" successes compensate for hundreds of R & D failures. More and more industries are starting to realize how much they are becoming like the pharmaceuticals industry in this regard.

Once again, financial managers should focus on managing total value versus total cost, not on maximizing their "batting average." Consider the value of a baseball player who delivers 1 home run for every 9 strikeouts and versus one who delivers 2 singles for every 8 strikeouts. A better percentage of "success" doesn't necessarily produce superior outcomes. In baseball, other metrics (e.g., "RBI") complement and qualify incidence-based metrics; managers should not ignore their financial equivalents.

Conclusion

Our risky and uncertain business environment offers an abundance of opportunities for failure, without necessarily reflecting personal shortcomings. Success in financial management today depends not on avoiding failure, but rather on deriving maximum value from failure at minimum cost.

Failure has value because we can learn much more, much faster from failure than we can from success. And winners in business are those who learn the most, the fastest. Enterprises that can fail more quickly and more cheaply than their competitors enjoy an enormous competitive advantage. The faster and cheaper a firm can make mistakes, the more mistakes it can afford to make, and the faster and cheaper it can learn from those mistakes.

In risky industries and business functions, winners willingly accept low-cost failures in the pursuit of high-value successes. You are much more likely to be successful at reducing the cost of failure than reducing the incidence of failure. Successful financial managers treat the cost of failure like an investment that generates future value. Focus on what you can learn from failure that will increase the value of your next success or at least decrease the cost of your next failure.

Copyright © 2004 Leveraged Logic, All Rights Reserved

Bruce Pounder is President of Leveraged Logic, a professional service firm that provides education and consulting services to accounting and finance professionals. He has 20 years of experience developing innovative IT-based financial management solutions for clients including The Coca-Cola Company, Reliant Energy, and Fidelity National Financial.

In 2003, Leveraged Logic introduced the PREPanywhere Review Course System, the only series of live online review courses available for the Certified Management Accountant (CMA) and Certified Financial Manager (CFM) examinations. As a NASBA-registered sponsor of continuing professional education, Leveraged Logic also offers live online CPEanywhere sessions to help CPAs, CMAs, CFMs, and other certified financial professionals maintain their certifications.

Bruce holds the CMA and CFM designations, a Bachelor's degree from Syracuse University, and an MBA from Rice University. He is a member of the Institute of Management Accountants (IMA), serving as President of the Western North Carolina Chapter. Bruce currently resides in Asheville, North Carolina, where he can be reached by phone at (828) 254-4812 or by e-mail at bpounder@LeveragedLogic.com.

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