The consequences of Lean at BP

In his new book on BP, Tom Bergin blames lean management principles for the Deepwater Horizon disaster. Here is a summary of Bergin's argument, taken from a review by Mattathias Schwartz, LRB 6 October 2011.

The beginnings of the Deepwater Horizon disaster, Bergin argues, can be found in the reorganisation Browne undertook, applying to BP the leaner management principles he learned at Stanford. The company was divided into ‘strategic business units’, independent companies within the company, each of which could allocate its capital and manage projects as it saw fit. Managers were held to short-term ‘performance contracts’ focusing on high production and low cost. Those who could extract the most oil while spending the least money were rewarded with promotions and bonuses. Promising junior executives were shuffled between posts all over the world, rarely staying anywhere long enough to bother replacing outdated equipment or rusting pipelines. ‘Go to the limit,’ Browne told his managers. ‘If we go too far, we can always pull back later.’

Bergin argues persuasively that such practices amounted to ‘moral hazard’, with BP not quite consciously rewarding the senior employees who engaged in the riskiest behaviour. The cost-cutting continued under Hayward, who trimmed BP of drillers, geologists and other specialists, outsourcing technical tasks to contractors and filling the company’s top ranks with traders who knew how to allocate capital and whip subordinates into meeting the next quarter’s targets. The demands for rapid production and low cost grew even more intense as Hayward instituted ‘stretch targets’ whereby the results achieved by one outperforming business unit were touted as company-wide goals.

Much the same sort of thing has been going on elsewhere, in manufacturing and retail in particular, since the late 1990s, when a new wave of Taylorism swept through management theory. Under the banner of euphemisms like ‘accountability’, workers’ earnings and job security were linked to ever rising performance goals. For a retailer like Wal-Mart, there were few upper limits on efficiency targets – impossible goals could be passed down the chain of command until ambitious managers felt compelled to lock their minimum-wage employees in stores overnight. But oil and gas extraction were a special case. At the bottom of the production chain were the implacable realities of geology, whose limits could not safely be breached. ‘Thus began a continuous effort to go beyond what BP’s own engineers considered physically possible,’ Bergin says of the stretch targets. One of the most important measurements was raw speed – how fast project leaders could get a hole drilled – calculated in ‘days per 10,000 feet of drilling’. It was as though BP’s senior executives in London had sent their workers into a room full of flammable gasoline vapours with a box of matches and a live chicken, offered prizes to whoever could produce a cooked chicken fastest, then handed the workers safety manuals, closed the door and turned their backs.

Mattathias Schwartz, LRB 6 October 2011 
reviewing

• Spills and Spin: The Inside Story of BP by Tom Bergin 
• A Hole at the Bottom of the Sea: The Race to Kill the BP Oil Gusher by Joel Achenbach

See also my post Black Swans and Complex System Failure.

Inequality and Risk

Business organizations are full of people with strong opinions and weak logic. The ability to examine evidence and arguments critically is an important one; students who wish to get top marks in our course should take every opportunity to develop and practise the kind of critical intelligence that comes from serious debate.

So here's something to get you started. Paul Graham's essay on Inequality and Risk argues that economic inequality is a Good Thing, largely on the grounds that intervention to reduce inequality is a Bad Thing. (See also comments by Tim Bray.)

The question of economic inequality itself is not part of the syllabus of our Business and Organization course. But in the course of his argument, Graham touches on a lot of issues that are very relevant to Business and Organizations. He talks about innovation, risk and incentive, and tries to separate notions of wealth and power. He makes some important assumptions about the possibilities of intervention and change in complex socioeconomic systems. His argument therefore represents a synthesis of economic, ethical, social and systems thinking.

In a free society, people are free to adopt different positions on such important and controversial topics, and we certainly don't expect everyone to agree on the conclusions. But those who disagree with Graham's conclusion may accept some parts of his argument; meanwhile even those who broadly agree with Graham's conclusion may not be comfortable with all the details of his argument. You really have to work it out for yourself.

Economics of Scale

From an economic perspective, one of the most basic differences between large companies and small companies derives from the economics of scale. In its most simple form, the economics of scale says that doing things on a larger scale works out cheaper and more efficient. Meanwhile the sociology of scale says that doing things on a larger scale is often dysfunctional - this is sometimes known as the diseconomies of scale.

Here are a couple of useful economics websites

• Biz/Ed: Economies of Scale
• Tutor2u: Diseconomies of Scale

And here are a couple of software practitioners talking about software economics

• Ross Mayfield: System Economics: Economies of Speed, Scale, Scope and Span
• Jonathan Schwartz (Sun): The Economies of Scale - The Scale in Economy

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From a sociological perspective, large and small companies may differ in terms of power and trust. Some large companies have well-established corporate identity and product brands. From an ethical perspective, large companies are subject to greater scrutiny, and are therefore forced to behave more ethically, at least in some formal respects. (However, when a large company behaves badly, the consequences are much more severe.)

But which comes first? Some people think that the economics come first: social phenomena such as the accumulation of power and trust happen as a side-effect of the economics. Other people think that the economics depend on the social relationships.

Systems theory sometimes helps to explain the complex relationships between the economic realm and the social realm.

• Strong brands typically emerge and are reinforced through social forces (positive feedback loops), with obvious economic effects.
  
• At the same time, there are positive feedback loops that are largely driven by economics, but which have non-economic effects. For example, Learning by Doing.
• There are also negative feedback loops, controlled by social relationships and producing economic effects. And vice versa.

Shares and Options

Some companies have schemes whereby employees are given shares in the company instead of a cash bonus. Some companies have schemes whereby employees are encouraged to buy shares in the company. Such saving schemes may have some tax advantages.

External investors like to see that employees have confidence in the company. Directors' shareholdings are of particular interest; directors are required to publish details of their share dealings, and are not permitted to trade in shares during the so-called closed period while the accounts are being prepared for publication (at which time they have access to inside information).

Terminology: Executive Directors (often just called executives) are managers who are members of the board of directors and also employees of the company. Directors who are not employees are called Non-Executive Directors or sometimes (rather inaccurately) Independent Directors.

Some companies have incentive schemes whereby directors and senior employees are awarded share options rather than shares. This essentially gives the employee the right to buy shares at a given price at some future date. Obviously if the share price increases dramatically such share options are worth a lot of money, since the employee can buy shares for a fraction of their market value.

Ordinary shares confer voting rights and may pay dividends. They represent a real share of the capital investment in the company. But with share options you get no vote and no dividend. It doesn't cost the company or its shareholders anything when the share options are handed out - which is one of the reasons why they like doing it. There is merely a future liability (because at some time in the future, someone will have to give the employee some cheap shares), which is often fudged in the company accounts.

So in terms of organizational behaviour, what is the difference between shares and share options?

Future rewards are more effective as motivators than past rewards. A gift of shares may not encourage an employee to work any harder, whereas share options might. Share options may be included in a recruitment package designed to attract high-flying executives and other employees.

Shares represent a stake in the company. The employee now has a double stake in the company - if the company fails, then this means losing both the job and the savings. An executive director who is thus doubly exposed may tend towards caution when making executive decisions. (But this is a short-term exposure, and a short-term motivation - once you leave the company and sell your shares, it no longer matters.)

Share options represent a longer-stake in the company's future. Employees are motivated to improve the longer-term value of the company, and are not just focused on short-term results. Share options provide the employee with a one-sided bet - if the share price goes up, the employee wins; if the share price goes down, the employee hasn't really lost anything.

And share options are more valuable if the share price is volatile. (This is based on a standard bit of economic theory known as the Brook-Scholes formula.)

In short: share ownership makes executives more risk-averse, but share options encourage risk-taking.

[Update] At least that's one theory. Got a better theory?

Technorati Tags: incentive organization+behaviour risk share+option

Outsourcing

The Advantages of Outsourcing

Lots of material on the internet with this point of view. "Outsourcing reduces cost and risk, stress and anxiety. Increases flexibility and strategic focus."

There are many companies that do much of their business from outsourcing, so we might expect them to promote this point of view. See for example Vertex's Reading Room, which is a significant collection of pro-outsourcing material.

The Challenges of Outsourcing

Meanwhile, there are lots of companies (such as law firms, risk management consultants and so on) that make their money from their supposed expertise in the outsourcing process. So they want to make people aware of some difficulty and risk. Not too much, obviously, because they don't want to put people off the idea of outsourcing altogether.

• Accenture article: Reducing Outsourcing Risk
  
• Accenture Canada

The Struggles of Outsourcing

A third category of internet sites provides support to small subcontractors and freelancers, who may be experiencing some difficulties is dealing with very large, powerful (and sometimes fickle) customers.

• OpenOutsource
  

How the Social interacts with the Economic

Tony DiRomualdo, Outsourcing: Net gain or shifting the pain? Wisconsin Technology Network, April 2004.
"Outsourcing can reduce costs or solve a problem in one area only to increase them or create new difficulties in another area, leaving the business less well off overall. A classic example of this phenomenon is when internal technical support is outsourced to drive down the costs in IT only to have business units create their own shadow IT organizations to deliver the personalized services they no longer receive. If you measure the success based just on the cost of the outsourced service, it appears that the company has saved money. But if you add back the costs of the shadow IT people, the overall costs have actually risen. Critics may point out that this is an organizational problem, not a weakness of the outsourcing solution and I would agree. I would also add that this is precisely the problem with how companies use outsourcing – it is often pursued in response to weaknesses in strategy and failures of leadership that would be better addressed directly through other means. Rather than helping in these situations, outsourcing often makes them worse."

A common pattern of outsourcing is that employees are transferred onto the contractor's payroll. This raises social/organizational issues - especially when public sector employees are being asked to move into the private sector. See for example High Anxiety - a story of public sector IT outsourcing from San Diego.

The Systems Dynamics of Outsourcing

Edward and Mary Anderson, Are your decisions today creating your future competitors? Avoiding the outsourcing trap. Good clear article. There are several more academic papers on outsourcing by Edward Anderson.

Bob Powell, Why Offshoring is Economically Unsustainable (html abstract, pdf). Discusses outsourcing as an example of the "Fallacy of Composition". Useful appendix in which several simple systems diagrams are put together to produce a more complex picture.

Interesting presentation (pdf) using system diagrams to show the possible effect of outsourcing on market dynamics.

Update: See Off-Shore Debate

ChoicePoint

ChoicePoint is in the news this week, because it "mistakenly" sold personal credit reports for about 145,000 Americans to criminals. (I like the word mistakenly - it leaves us wondering whether this was an error of intention or of execution. After all, if you get found out, it's always a mistake.)

Bruce Schneier (Feb 23) writes: "ChoicePoint's behavior is a textbook example of how to be a bad corporate citizen. The information leakage occurred in October, and it didn't tell any victims until February. First, ChoicePoint notified 30,000 Californians and said that it would not notify anyone who lived outside California (since the law didn't require it). Finally, after public outcry, it announced that it would notify everyone affected."

Interesting decision-making process here. Public trust in a company is critically affected by the way it deals or dithers with a crisis such as a product recall or website error. See my notes on Kodak, Sudan 1.

Adam Shostack (Feb 23) suggests we might expect shady behaviour from firms that don't expect to be around for very long. There is therefore a possible link between ethics and viability - poor viability leads to poor ethics. But what about the causal link the other way - what effect does bad corporate behaviour have on corporate (economic) viability?

Adam Shostack (Feb 24) also raises the question, "who notified whom? Reuters claims that the authorities notified Choicepoint, while Choicepoint claims they notified the authorities. Let's see...who has motive to lie?" Gary North posts one theory (Feb 19) "According to ChoicePoint, there was no announcement because law authorities prohibited it." to which IanG (Feb 19) replies "OK, so maybe they wanted to set up a sting. They're the good guys, and they're in control, right?"

Lots of information from EPIC and SourceWatch, and further links from Bruce and Adam.

Optimism and Pessimism

It is interesting to observe companies (executives) making optimistic or pessimistic statements about the company's prospects.

In the current environment, there is a sense that many executives are trying to avoid over-optimistic statements. Recent results from WPP (the advertising and media giant) have been surprisingly downbeat. (Perhaps an advertising company has to try even harder than everyone else to avoid the appearance of spin.)

I wonder whether this reflects a more general caution or risk-aversion, or whether it is merely because of a new sense of asymmetry (directors can go to prison for optimism, but not for pessimism).

It also conveys an appearance of longer-term responsibility and confidence - we are not going to talk up the company - the results will speak for themselves, eventually.

In March 2004, WPP published a rather cautious statement, and the share price fell. But a week later, when another media company issued a much more optimistic statement, it was the WPP share price that then rose.

Meanwhile, Shell has been trying to retract some previously optimistic statements about oil reserves. The share price and the executives have been heavily punished.