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Distress by Over-Optimization

Dhirendra Kumar believes that businesses are suffering today because they were too efficient. He explains further

One of the fundamental problems in modern businesses is that they are too efficient. That sounds strange, right? How can anything be too efficient? Efficiency is the god which the modern world worships. Everything should be maximally optimised. These are supposed to be universally accepted principles on which the world of business is run today.

However, I think that these ideas are wrong and the heedless pursuit of the ultimate in efficiency has left business unable to cope with crisis. One of the unlearned lessons of the global financial crisis is that businesses are suffering because they were over-optimised. Let me explain clearly what I mean by over-optimised by giving an example from automobile design. Some years back, I met someone who was working as a design engineer in a large automobile firm. During the course of our conversation, he described how his company was using advanced computer-aided design techniques to optimise their vehicles.

They were simulating the stress and strain on various auto parts and then reducing the strength of those parts to optimise the weight and raw material used.

The whole effort ended up in producing vehicles that were lighter, but broke down in actual use. Real on-road usage of the vehicles inevitably ended up stressing the components more than seemed possible theoretically. 99.9 per cent of the time, there was no problem, but every once in a while, a vehicle encountered some unforeseen condition which led to a breakage.

In a similar fashion, it's easy to over-optimise a business. In fact, the stock market's relentless chase after the last possible decimal point of earnings drives all listed businesses towards over-optimising. In their manufacturing, marketing, staffing and most of all in financing, businesses have optimised themselves to such an extent that there is no room for error. One of the factors that drives over-optimisation is extreme short-termism. Many businesses seem more interested in looking good in the short-term than making themselves immune to unforeseen problems in the future.

Take the example of financing. An extraordinary number of businesses have raised as much debt as was possible. The repayment of this debt can only happen only if everything turns out exactly as planned. The projects financed by the debt must get executed as planned. The products thus produced must get sold in the quantities and the prices that were expected. Interest rates must stay within the expected range. The foreign exchange rates must stay within the predicted range. And so on and so forth.

In such a situation, if everything goes as planned, then there will be fabulous profits. But if the real world deviates even slightly from what these companies' management had predicted, then there will be trouble. Unfortunately, the real world has deviated not slightly, but by a very large amount. The result is there for all to see.

The results of over-optimisation mean that companies perform wonderfully in good times but they are always sailing close to the wind. One misstep and they could be heading for a disaster.

Unfortunately, the bubble-like business environment of the last few years has meant that a lot of businesses have ended up over-optimised. It's easy to mistake over-optimisation as a problem of incorrect forecasting. It isn't. The solution does not lie in being able to forecast more accurately, but in admitting that unforeseen things happen and it's better to have something in reserve for a rainy day.