To Prosper the Most Measure How You Are Doing with Non-Accounting Measures

Accounting systems are designed to accurately report how a company did financially as a whole, using generally accepted accounting principles to make comparisons easier from company to company. Such systems are often totally misleading when it comes to accurately describing which areas of the company are providing the positive financial results.

One restaurant chain learned this lesson to its chagrin when it sought to improve its earnings. The company received money from operating its own restaurants, from selling supplies to itself and to its franchisees, and from franchising and licensing fees when others owned and operated the restaurants.

The accounting records accurately showed how much revenue each area received. Company-owned and -operated restaurants were the biggest source of revenue, followed by supplies, followed by franchise fees.

The company had a lot of overhead in operating the various parts of its business, both in the home office and in the field in order to supervise its own restaurants, franchisees, and supply operations. After looking at all of this overhead, the company could clearly see that it needed a lot more operating income than it currently earned.

Because the overhead was not allocated by activity area across the company, it seemed optimistically clear to everyone that the company-owned and -operated restaurants needed to be expanded the most because they already provided the bulk of the operating income to offset this overhead. The company was also convinced that it did a much better job of running restaurants than its franchisees did. Almost any company restaurant was newer, bigger, and had better equipment than the franchisees, which reinforced this impression.

Yet a curious thing had been happening. Although the company had been rapidly expanding company-owned and -operated restaurants, its overall earnings were declining. This occurrence failed to make an impression on management when looking at the accounting results, so the company kept redoubling its efforts to expand these company-owned and -operated restaurants even faster. Results grew worse.

At this point, the company asked outside advisors to help improve its profit growth. Working with internal cost accountants, the advisors found that almost all of the company's overhead costs actually were variable costs needed to operate the company-owned and -operated restaurants. In fact, when the costs were properly applied to the activities they supported, the only place the company made money was on the royalty fees from the restaurants that were operated by franchisees, the area that seemed to have the lowest profit potential.

The accounting system had so misrepresented profitability in the company-owned restaurants that the management had not only greatly overexpanded in this area, it had also permitted itself to spend money in unwise ways. The company eventually learned that it had never once made money in company-owned restaurants. The franchisees were usually much more effective restaurant operators than the company was, avoiding overspending in lots of subtle ways and more effectively attracting customers.

To further compound the error, the company was constantly trying to persuade franchised restaurant operators to take on the innovations that were losing lots of money in the company-owned restaurants. The franchisees fought back aggressively, souring relationships between them and the franchisor.

In retrospect, it was clear if you thought about it that all the company's earnings must have all been derived from franchisee income and licenses. There were very few costs associated with those activities, so almost all of the operating income was actually profit before tax. This operating income amount from franchising was always much more than the company's combined pretax income. The rest of the activities had to be operating at a loss.

Why had executives continued to believe that they were great restaurant operators? When asked, they replied that they had hired only the best people, had carefully trained them, and done a great job of supervising them. By comparison, the franchisees were less well educated, less talented, and did a poorer job of supervision.

These executives had missed the irresistible force that someone running their own business will do a better job in most cases than someone who is hired to run the same business. In a restaurant, an owner-manager will often attract 10-40 percent more volume than an average hired manager by doing whatever it takes to please the customers, which makes them want to return.

The marginal profits on that incremental volume will be 60-80 percent of the increased revenues. The professionally managed restaurants will be lucky to overcome that disadvantage with better people and training.

Based on more complete accounting and an improved understanding of its economics, the restaurant company went on to become much more successful by allocating its resources according to their most effective actual use, rather than based on where its most talented people seemed to be.

Highly effective people don't always overcome irresistible forces. The breakthrough solution is always to use irresistible forces as tailwinds pushing your key accomplishments forward.