Profit Gaps and Short-Term Heuristics: Systems Dynamics Understanding as a Reinforcement of Operations Strategy

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Increasingly organizations implement process improvement efforts aimed at increasing revenue and/or decreasing cost. While some efforts lead to success (Honeywell, Seagate e.g. Huber and Launsby, 2002), others lead to failure. For instance, Home Depot implemented Six Sigma and their American Customer Satisfaction Index ranking dropped from a top spot to the bottom of their industry. Initially profitability soared at Home Depot, but then their stock price plummeted. Home Depot was able to cut costs with Six Sigma, but the energy and emphasis placed on these efforts at cost containment ultimately lead them to lose focus on the customer (thus threatening their underlying revenue stream).

Our research investigates how organization approach decisions to direct their improvement efforts toward either revenue improvement or cost reduction. We examine this by considering the perspectives that individual managers have regarding the operational and performance dynamics that follow these changes at their firms. Our study leverages a multi-stage survey and interview protocol approach, uniquely leveraging system dynamics simulation as a critical component of the interview process. The surveys provide a foundation for assessing the broad of perceptions held by managers, while the interview provides an iterative mechanism for critical analysis, model calibration and case development. As a result we are able to triangulate areas where certain fateful perceptions regarding organizational dynamics in the face of change and resource tradeoffs exists, as well as areas where more in depth consideration tends to provide clarifying adjustments to managerial perceptions regarding those dynamics.

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  • This project started out as an off shoot from a National Science Foundation project that Kevin had with Roger Schroeder and Andy Van de Ven on sustaining high quality performance.  They were doing a case study at 3M where they describe an interesting dynamic of how one of their divisions lost its quality advantage.  This situation involved behavioral issues about feedback and delays.  At this time Kevin engaged Paulo and Elliot (given their backgrounds) and we extended this case study.  We then talked to Corning where they emphasized an innovation loop. These three loops roughly align with the strategies Cost, Customer Intimacy, and Product Leadership.Increasingly organizations implement process improvement efforts aimed at increasing revenue and/or decreasing cost. While some efforts lead to success, others lead to failure. Our research investigates how organizations make decisions to direct their improvement efforts toward either revenue improvement or cost reduction. By understanding the internal dynamics of how these decisions get made, organizations can make better long term decisions and avoid the fateful outcome that Home Depot experienced.
  • 1st survey – Shows evidence of this proposition
  • Theory? (just my thoughts)Cost reduction: short-term fix, ST results, direct financial impact (direct cause-effect)Revenue improvement: long-term fix, LT results, indirect financial impact (indirect cause-effect, i.e. difficult to prove the relationship between the improvement and the increased revenue)
  • We interview a number of decision makers that launch and champion improvement projects, to capture the decision processes involved in such efforts. To get the quantitative data for our study, we conduct three types of interviews: A structured interview focusing on identifying general process improvement strategy loops and their prevalence within the companyA structured interview, mapping specific parameters in a SD modelA follow-up unstructured interview to discuss findings and dynamic behavior from a model "calibrated" with parameters from the previous interviews. This interview allows managers to reflect on their original strategies and mental models associated with the desired outcomes and confront them with actual model behavior. With the quantitative and qualitative data collected, we will compare stated assumptions (strategies and behaviors) with simulated ones and look for specific clues for poor performance.
  • Profit Gaps and Short-Term Heuristics: Systems Dynamics Understanding as a Reinforcement of Operations Strategy

    1. 1. 6/27/2013 Profit Gaps and Short-Term Heuristics: Systems Dynamics Understanding as a Reinforcement of Operations Strategy Professor Paulo Goncalves, University of Lugano (Switzerland) Rick Hardcopf, PhD Student, University of MN Professor Kevin Linderman, University of MN Professor Elliot Bendoly, Emory University
    2. 2. 6/27/2013 Agenda Research Motivation Case Studies Research Objectives Literature – Behavior Under Pressure Managerial Views Research Method and Approach Preliminary Findings Conclusion
    3. 3. 6/27/2013 Research Motivation National Science Foundation grant 3M – behavior, feedback and delays Corning – innovation
    4. 4. 6/27/2013 A Profitability Gap Leads to Pressure… Desired Profits Profit Gap + Actual Profits - + - Total Revenues Total Costs
    5. 5. 6/27/2013 … to Improve Customer Satisfaction… Desired Profits Profit Gap + Effort Allocated to Customer Satisfaction Customer Satisfaction Focus B1 Actual Profits Pressure to Improve Customer Satisfaction - + - + + + Total Revenues Total Costs Customer Satisfaction Market Share+ +
    6. 6. 6/27/2013 … and Pressure to Cut Costs. Desired Profits Profit Gap Effort Allocated to Cost Cutting + Effort Allocated to Customer Satisfaction Customer Satisfaction Focus B1 Actual Profits Pressure to Cut Costs Pressure to Improve Customer Satisfaction + + - + - + + + Cost Cutting Focus B2 Total Revenues Total Costs - Customer Satisfaction Market Share+ +
    7. 7. 6/27/2013 Cost Focus Reduces Effort Allocated to Customer Satisfaction … Desired Profits Profit Gap Effort Allocated to Cost Cutting + Effort Allocated to Customer Satisfaction Customer Satisfaction Focus B1 Actual Profits Pressure to Cut Costs Pressure to Improve Customer Satisfaction + + - + - + + - + Cost Cutting Focus B2 Costs Cuts Over market Share R1 Total Revenues Total Costs - Customer Satisfaction Market Share+ +
    8. 8. 6/27/2013 … and Generates More Effort to Cut Costs. Desired Profits Profit Gap Effort Allocated to Cost Cutting + Effort Allocated to Customer Satisfaction Customer Satisfaction Focus B1 Cost Cuts Over Customer Satisfaction B3 Actual Profits Pressure to Cut Costs Pressure to Improve Customer Satisfaction + + - + - + + - - + Cost Cutting Focus B2 Costs Cuts Over market Share R1 Total Revenues Total Costs - Customer Satisfaction Market Share+ +
    9. 9. 6/27/2013 Systems Dynamics Models System Dynamics is used to understand the dynamic behavior of complex systems over time Uses feedback loops, stocks and flows, and non- linearities to model complex system behavior An ideal approach to model complex, managerial resource allocation decisions over time
    10. 10. 6/27/2013 Desired ProfitsGap in Profits +Effort Allocated to Customer Satisfaction Process QualityInvestment in Quality Actual Profits Total Effort Effort Allocated to Cost Cutting Change in Allocation Time to Change Allocation Initial Effort Allocated to Cost Cutting Base Allocation for Improvement Indicated Process Quality Time to Invest in Quality Minimum Process Quality Indicated Allocation to Cost Cutting Maximum Process Quality Step Input Step Height Step Time Minimum Alocation to Cost Cutting Unit Costs Initial Unit Costs Effect of Cost Cutting Effort on CostsTable for Effect of Cost Cutting Effort on Costs Initial Process Quality Demand Industry Demand Market Share Company Attractiveness Competitor Attractiveness Effect of Quality on Demand Quality Elasticity of Demand Unit Price Initial Dolar Margin Actual Dolar Margin Price Elasticity of Demand Effect of Price on Demand Initial Unit Price Fraction Cost Reduction to Customers Ratio Cost Cutting EffortFraction of Effort to Customer Satisfaction Fraction of Effort to Cost Cutting Desired Dolar Margin Desired Demand Desired Effort Allocated to Cost Cutting Desired Unit Costs <Initial Unit Price> Desired Cost Ratio <Initial Unit Costs> <Initial Effort Allocated to Cost Cutting> <Table for Effect of Cost Cutting Effort on Costs> Desired Market Share Desired Company Attractiveness Desired Process Quality <Actual Dolar Margin> <Total Effort> <Desired Process Quality> Model Overview: A little more complicated
    11. 11. 6/27/2013 Research Question(s) Current Research Question(s) – How do organizational leaders account for the various complex repercussions of actions designed to resolve profit gap pressures? Are they naturally biased towards short-term resolutions of a particular kind when coping with these pressures? If short-term heuristics are favored, are there typical holes in managerial understanding of system-wide impacts that are likely contributing to the use of such heuristics?
    12. 12. 6/27/2013 Proposition In an effort to resolve profit gaps, managers often over-emphasize cost reduction at the expense of customer satisfaction, and product innovation - and long-term performance Regardless of an awareness of the profit benefits from customer satisfaction and product innovation efforts, manager still show a bias cost cutting System Dynamics complexity and gaps in managerial understanding contribute to biases toward cost cutting
    13. 13. 6/27/2013 Literature – Over-Emphasis on Cost Biases toward cost cutting  Attribution errors – misdiagnose profit reductions as a need to control costs (Onifade et al. 1997, Silver et al. 1995, Johnston & Kim 1994, Staw & Ross 1978; Repenning and Sterman 2002)  Locus of control (internal vs. external) – people focus improvement efforts on areas in which they have greater control, i.e. internal (Stewart & Chase 1999, Ho & Vera-Munoz 2001) Behavior under pressure  Under Pressure, individuals tend to rely more on (are biased towards) heuristics that emphasize, sometime insufficient, subsets of reality (tends to favor the short-term; Bendoly et al. 2010 (Bodies of Knowledge), Bendoly 2013 (Revenue Mgmt)). System Dynamics Understanding (SDU)  SDU appears crucial in developing solutions to complex problems that span time. Mental models that do not effectively account for the dynamics of constraints, stocks and flows, feedback loops, etc., are associated with lower performance in complex multi-functional multi-period decision settings (Bendoly 2014 forthcoming).
    14. 14. 6/27/2013 Research Method and Approach Target Audience – Senior decision makers Survey 1 – Identify strategic resource allocations loops, and their prevalence, within a firm (validate the model)  Qualitative data are recognized as the main source of information to develop system dynamics models (Forrester 1992) Survey 2 – Identify firm specific strategy, industry context, improvement lead-times, and elasticity’s (parameterize the model) Semi-structured (dis-confirmatory) interview –Understand how mental decision models correlate to “disconnects” identified  Qualitative data and judgments are much more used by managers in the development of strategy and decision-making processes (Wolstenholme 1999)
    15. 15. 6/27/2013 Preliminary Findings Survey #1 (78 responses so far)  Individuals were presented with depictions of system dynamics models and asked to rate their belief regarding the relevance of each causal arc in the diagrams  Respondents represent a range of industries (Baxter, Cox, General Mills, Georgia-Pacific, International Paper, Philips Electronics, SubTrust, etc.). Finding #1: There exist general beliefs that profit gaps naturally give rise to cost cutting pressures (both at the respondent’s own firm, and at others)
    16. 16. 6/27/2013 Preliminary Findings Finding #1 addendum: DESPITE general beliefs that a strong causal chain ties efforts at innovation and increased customer satisfaction to profit gains (more so than cost cutting, given the potential for market share impacts). * Biases to cost cutting aren’t stemming from a general lack of awareness of chains of events, but perhaps from a lack of understanding of their nuances in the presence of timing effects.

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