Book of the Week: Good Profit

09 Jan 2016

After writing about buying elections, I wanted to learn more about Koch Industries, which is the 2nd largest private company in the United States in terms of revenue ($115 billion). Their CEO, Charlie Koch wrote a book about their management philosophy called Good Profit. The first part of the book goes over the history of Koch and Charlie’s father Fred, the founder, and the motivation and background behind Market-Based Management® (MBM). In true corporate fashion, MBM is trademarked. This book reminded me a bit of Zappos’ Delivering Happiness, which mixes corporate culture and company history. After reading this book, I can see why Koch Industries is the 2nd largest private company. Koch Industries

Remember that often adversity is a blessing in disguise and is certainly the greatest character builder -Fred Koch

What does Koch Industries do? They are composed of 9 business groups.

• Flint Hills Resources - Petroleum refining, chemicals, polymers, lube stocks, asphalt, liquefied natural gas, grain processing, ethanol, and biofuels
• Koch Minerals - Bulk solid commodity trading and distribution, exploration and production, and oilfield and clean coal services.
• Koch Supply & Trading - Commodity trading and risk management services.
• Koch Pipeline - Crude oil, refined products, ethanol natural gas liquids, and chemical pipelines
• Koch Ag and Energy Solutions - Nitrogen fertilizer, other plant nutrients, and enhanced efficiency products manufacture, distribution, and trading. Natural gas and power services.
• Koch Chemical Technology Group - Mass transfer equipment, burners and flares, pollution control equipment, heat exchanges, membrane separation systems, and engineering/construction services.
• INVISTA - Nylon fiber, polymer and intermediates, engineering polymers, airbag fibers, spandex, specialty chemicals and materials, and process technology
• Georgia-Pacific - Consumer products, nonwovens, packaging, containerboard, bleached board, fluff, market and dissolving pulp, structural panels, wood products, gypsum products, chemicals and recycling.
• Molex - Electronic, electrical, and fiber-optic interconnection system.

Usually things around chemical processing that turn raw materials into useful things. Also, things required to support that infrastructure and ecosystem. Marijuana Bombs

One interesting project was designing a plant for the government to product a potent marijuana derivative. the idea was to make war more humane by controlling opponents with marijuana “bombs” rather than with weapons.

Charlie Koch avoided the draft after MIT to work on marijuana bombs. I still think this is a great idea. People will not fight you if you drop free marijuana on them. This would definitely stop people from fighting by mellowing them out. Good Profit

The economic means of profiting involves voluntarily exchanging your goods or services with others for money. Parties will not voluntarily enter into an exchange unless both believe they will be better off. Therefore, you can only profit over time in a system of voluntary exchange (a market) by making others better off.

Koch is heavily influence by economic theory and Nobel Prize winning economist Friedrich Hayek. He also had some experiences in his youth that showed him the horrors of communism. Koch is against any government regulation such as tariffs and subsidies and prefers to let markets and capitalism do their thing. A counter argument to markets is when you have public goods with a free rider problem. Also markets are a problem if you have morals and don’t want people to go hungry. Other than that, markets are awesome.

In a free market with property rights and beneficial rules of conduct, profitability through voluntary transactions is not a signal that one party is taking advantage of another. Quite the contrary, “good” profitability is the appropriate measure of an enterprises’ contribution to society.

When you have a working free market, any profit you make is a measure of how much good you provide to society. Since you are creating value for someone else and selling it to them at a price less than what they value it at. If the price is more than what they value it at, a rational person would not engage in such a transactions. Any transaction that occurs will benefit both parties. It is a win-win scenario. Market-Based Management® MBM is built around five dimensions and the bulk of the book goes into each dimension.

• Vision - provides direction to align everyone through fundamental principles
• Virtue and Talents - need skilled people with right values
• Knowledge Processes - metrics, sources and sharing of information
• Decision Rights - right people empowered to make the right decisions
• Incentives - encourage desired behavior

Decision Making Framework The right decisions need to be made by the right people. As a company grows, bureaucracy slows everything down.

1. Briefly describe the authority being requested.
2. Give the background and a summary of the value proposition.
3. Outline the objective with the strategic fit.
4. Prepare an economic summary with a base case, as well as other plausible scenarios that could make the project much better or worse.
5. Identify the key value drivers.
6. Describe the key risks and mitigants.
7. List the alternatives considered and why the one shown is best.
8. Project the timeline for future steps.

Let’s consider a simple, obvious decision like replacing a $1 million heat exchanger needed to keep a plant running. If that decision is treated the same as a $1 billion acquisition the framework is being misapplied. The decision for a a heat exchanger requires only steps 1 and 2 and needs no more than a one-paragraph justification for the the funds requested and explanation of the benefits.

When you have a $115 billion company, people only need a paragraph to spend $1 million. Sometimes you can make bad decisions. Charlie also lists cognitive bias traps that prevent the DMF from being applied effectively.

• Overconfidence - people are bad at predicting things
• Framing - not looking at the whole picture
• Anchoring - irrelevant information or first impression affecting decision
• status quo - we’ve always done it this way
• sunk costs - you don’t care about money spent in the past, only about money to be made in future
• confirmation bias - people only look for evidence that supports what they believe instead of trying to look for evidence that might prove it wrong
• recency bias - affected by what happened recently
• confusing random events with patterns - again, people are bad at predicting things
• leader’s past rejections - if you say no, people will remember
• conservatism - employees are too risk adverse

Innovation and Risks

Even successful companies struggle to keep up because, given human nature, we all tend to become complacent, self-protective, and less innovate as we succeed. It can be far more difficult to overcome success than adversity.

This is the Innovator’s Dilemma, where you want to continue milking the cow instead of raising the calf. The cow will die and somebody else’s calf is now a cow and you have no calf, so you go hungry. To get around this problem, Koch embraces Schumpeter’s creative destruction. In order to advance, you need to destroy the old to let the new grow or be outpaced by your competition.

Should an employee work on an investment with 90 percent chance of making $100,000 rather than one with a 50 percent chance of making $1 million?

The expected values are $90k and $500k respectively, but most people would go with $90k since they don’t want a 50% chance of failure and walk away with $0. People are naturally risk adverse, but in relation to longer term value to the company, they need to take on more risk than what they would personally be comfortable with. The advantage of a private company is being able to take those risks without shareholders complaining.

Another problem is that employees will sacrifice activities that lead to long-term value creation to meet these short-term targets, such as not pursuing an opportunity that won’t be profitable for several years.

People don’t think about the long run. It’s like drafting good picks and eventually having a good team several years down the road. The person who drafted them may not get credit. Instead draft somebody flashy to make the fans happy now. Future success depends on planting seeds earlier. Good Profit

Good profit can only result from creating value for the customer. It is the manifestation of the entrepreneur’s respect for what the customer values

Charlie tries to lead of life of meaning, which means providing value to people. Value can be measured in good profit. Under MBM, people vote with their money, which is just like a super PAC. Your votes are proportional to the money you have. if you are doing things right, you will get more money. By that measure I don’t contribute much to society. Purchase Good Profit on Amazon.com or check it out from your local library.