What could possibly be wrong with opening your books to employees? Power to the people and all that. If your employees know and understand your business, how can you fail? You can fail very easily as it turns out. Open-book management is a term that is normally credited to John Case, then a senior write at Inc. Magazine. However, the concept was popularized in the book, The Great Game of Business, by John Stack, which was published in 1997. Stack took a moribund division of a large manufacturing company and turned it into success by turning the employees into motivated company advocates. He did this by training the employees in reading and understanding key financial details that were keys to turning around the company. The book is a magnificent read and converted me into a devoted open-book management fan.
The key principles of open-book management are deceptively simple. First, train your employees in basic financial concepts such as gross profit, overhead, and reading balance sheets. Then identify the key financial indicators that are controllable by your employees. Finally, tie employee compensation to improving the key indicators that will drive your company's success. Execute the principles well and success is assured – or is it? Opening your books to employees has risks as well as potential rewards.
I won't quibble with the argument that many companies, who have failed at open-book management, have done a poor job executing the basic concept. I also won't challenge the idea that many companies that failed to implement the concepts successfully really weren't totally devoted to the idea. What I would like to do instead is start with all of the possible outcomes that could arise after successfully training your employees to read your financial statements. Then, let's evaluate which outcomes are most likely.
Let's start first with Jack Stack's experience as relayed in his book. The employees learn the financial concepts, apply them to their everyday job duties, and propel the company to new heights.
Outcome number two – the employees successfully learn about the financial concepts. When they find out just what terrible financial shape the company is in, they leave for other jobs with more successful companies.
Outcome number three – the employees learn about the financial concepts. When they learn how financially successful the company is, they begin figuring out how to divide the largess among themselves.
Outcome number four – the employees learn about the financial concepts. They yawn, since making the company successful is really the job of management not the workers. Just pay me dammit and leave me alone after 5 PM.
Which if these outcomes is most likely? We can't say definitively. Open-book management has been a great success at some companies and a brutal failure at others. Is there a way to predict the success or failure at any given company?
If we take a close look at Jack Stack's company, Springfield Re-manufacturing, two characteristics stand out in the company's pre-turnaround environment. First, the company was in horrible financial shape. The company wasn't completely broke, but Las Vegas odds makers wouldn't have bet a dime on survival. Second, the job prospects outside the company weren't very bright. If employees lost their jobs at Springfield Re-manufacturing, finding similar paying replacement jobs was unlikely. There weren't a lot of comparable manufacturing jobs available in the area to say the least. When you combine those two factors, you would expect the employees to make a significant effort to save the company.
What happens when financially profitable companies adopt open-book management? I found out the hard way. Back around 2001, I read Jack Stack's book and was smitten with the idea that empowering our employees to act like business owners would lead to an ever growing profit stream. Once of the first principles of open-book management is that you must train your employees in the basics of reading financial statements. What employees could be easier to train to read financial statements than the employees of a CPA firm? Presumably, they are already financially savvy. Many of our employees are CPA's, and the ones who are not at least have degrees in accounting. Reading financial statements, in theory, is something they should already know.
The second step was to devise a compensation system to reward our staff for increasing profits. The partners settled on a relatively simple and easy to manage system. We selected the year 2000 as our base year. Our bonus system was implemented in 2002. Each month we compared the company's profit or loss to the same month in the base year, 2000. If profit was higher, half of the increase in profit went into a bonus pool to be divided among the staff according to a formula based on relative salaries. If the monthly profit was lower in the bonus year, the shortage had to be made up in a subsequent month before bonuses could be paid. That way there would be no gaming the system. Employees could sandbag one month's billings by pushing them into the following month to increase profits in the second month at the expense of the first. You might ask why we would need to do that given that our employees are in a profession that prides itself on ethics. Our previous bonus system aid bonuses based on monthly billings versus a billing quota. We learned in the first couple months of that system that, yes, CPA's will game a system if given the chance – ethics be damned.
Training was done, and we had devised a great bonus scheme. The partners sat back and waited for the cash to roll in. We waited and waited and waited. Eventually, I had to cancel my Ferrari order. Over a period of two years, we only had to pay bonuses three times. By the end of the second year, the bonus pool was under more water than the Titanic. What happened?
I think some combination of outcomes three and four above accounted for the failure of the plan. The company was reporting profits throughout the two year period. As a policy and tax planning strategy, the partners did not take large salaries. So the reported profits apparently looked large enough to our employees even if they were smaller than in the base year. You might expect the employees of a CPA firm to look just a little bit further into our financial statements than say a bunch of janitors. However, after our experience, I might bet on the janitors. The point about the profits, that our employees missed, is that yu have to measure the level of profits against some yardstick. In our case, the company profitability should be compared to the profitably of other similarly sized CPA firms. Regrettably, our profitability was average for CPA firms. Yes, we did train our employees about comparing profitability against an industry yardstick, but viscerally no one seemed to apply that training to our situation. We were making plenty of money in their eyes. The company was in no financial trouble.
Outcome four also bit us in the ass. CPA firm employees tend to make more money than the average janitor. Apparently, our employees were happy enough with their compensation levels that they weren't willing to put forth additional effort to earn bonuses. We also fell victim to a principle well known among economists – the free rider problem. You see the free rider problem in situations where someone can get a benefit as a result of someone else's effort. In our case, everyone shared in the bonus pool regardless of personal effort. Consequently, some staff members were relying on the efforts of others to create a bonus pool. They were making no extraordinary effort, but were waiting to reap the benefits. After two years, we let our Titanic of a bonus plan to sink ignominiously into the abyss. We went back to our system of individual incentives and bonuses based on personal performance.
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