I read with great interest an article in this week’s US print edition of the Economist. It was titled, North Sea Oil: Offshore Fog. The article was exploring the plight of profitability, or lack thereof, of this aged industrial sector. The problem, so the article expands, is that during the heady days of high margins and fast growth, inefficiencies were ignored and became part of standard operating practices.
Now operating costs are more critical as they are being exposed due to fall off in demand and lower gas prices, Those same inefficiencies – once ignored because they ‘didn’t matter’ – now protrude rudely. Worse, as they are now ingrained in how the business operates, it is no easy task to change them or remove them.
This problem- the budgeting for mediocrity in the face growth and profits, is widespread in other firms in many industries. Hindsight is the only one among us that outlasts everyone else and cries foul. I take so many inquiries every week where this ‘budget for mediocrity’ is standard form.
To argue that short-term CEO reward schemes are at fault is not quite right: they work. Many firms siphon off profits nicely in the heady run up the hill. And when the business faces the down-side of the slope, capital will tend to flee out of the current investment and toward the next upswing, perhaps in a different industry. So it’s not the CEO reward scheme alone. The fact that we are successful in the early phases of such industrial cycle is a naturally occurring process. When we start to fail, someone else is just warming up to success.
The real cause is the nature of the return for capital. Short-term and long-term risks are not differentiated enough in the market. Since the rates are quite similar, a rational investor will go for the short-term offer. She will have more time to enjoy the winnings, or correct the fiasco, with a short-term failure. So how do we influence the longer term rate of return?
- Government policy (tax incentive for longer term, increased taxes on short term investments?)
- Change the kind of return with new financial instruments (different kind of share model?)
- Social/cultural pressure?
- Reliance on individual leadership vision?
I don’t see an easy way out of this one. Without an answer, we will forever all be subject to the budgets of mediocrity.
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