Keep your obligations and promises. Try, if possible, to do business with honorable people. All the contracts and lawyers in Christendom cannot make a dishonorable man hew to the line.
Don’t take counsel of your fears.
Never sue; the lawyers get a third, the government gets a third and you get your business destroyed.
My father stressed the importance of humility and hard work. When I arrived in Wichita, his first words to me were: “I hope your first deal is a loser, otherwise you will think you’re a lot smarter than you are.”
At this point I began to immerse myself, not only in building the company, but in understanding the principles that lead to prosperity and societal progress. I spent virtually all my spare time studying history and the humane sciences.
This brief company history may leave the impression that our experience has been one of ever-improving results, with one success after another, each building on the one before. Nothing could be further from the truth. Progress, whether in business, an economy or science, comes through experimentation and failure. Given that a market economy is an experimental discovery process, business failures are inevitable and any attempt to eliminate them only ensures overall failures. The key is to recognize when we are experimenting and limit the bet accordingly.
The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring the principles, is sure to have trouble.
Regardless of whether you are an entrepreneur or whether you are an employee of a large company, the absolute prerequisite is that you must know your stuff. There is no substitute for this.
Mental models are intellectual structures that enable us to simplify and organize the myriad inputs we get from the world around us. They shape and support our thinking, decision making, opinions, values and beliefs. They are a necessary requirement of any intellectual grasp of historical events. To be beneficial rather than destructive, our mental models must connect us to reality. Further, they must improve our ability to assimilate new experiences. In the process, they are refined by experience.
Opportunity cost is the value of the most valuable alternative that must be forgone to undertake a given act. In decision making, we must look at opportunity cost rather than book or sunk costs. That is, we must look forward rather than backward.
Personal knowledge is the key to making discoveries. As we study a particular field, we absorb increasing amounts of specific knowledge, including rules, facts, terminology and relationships. At some point, we know these details well enough that we can begin to focus on the whole. We can then begin to see patterns, the meaning of things, and sense when something is wrong, even though we may not always be able to articulate our understanding. This improves our ability to perceive problems and opportunities when doing research, interviewing a candidate or screening acquisitions.
The process of discovery begins when we observe, often vaguely, a gap between what is and what could be. Our intuition tells us something better is just beyond the range of our mind’s eye. To build a culture of discovery, we must encourage, not discourage, the passionate pursuit of our own and others’ hunches. Next, we need to strive to clearly articulate our hypotheses, which, when made concrete and specific, can be challenged and tested. Hypotheses that pass this hurdle can then be put to the broader test of working in practice. The genesis of this entire process is the development of personal knowledge that is passionately applied to solve a problem.
At least two sets of criteria are needed to determine priorities. The first set includes those actions that are required to stay in business, such as meeting a deadline for complying with a government regulation or a major customer’s quality or volume requirements. The second set is determined by gap analyses that estimate the risk-adjusted present value of the opportunities relative to the resources consumed (such as scarce talent or capital).
Laws control the lesser man. Right conduct controls the greater one.
The greatest virtues are those which are most useful to other persons.
Over-specifying and enforcing particulars undermines prosperity by encouraging inaction. It also facilitates corruption and abuse of power, subservience and stagnation.
The greatest obstacle to discovery is not ignorance but the illusion of knowledge.
Market economies are successful, in large part, because they are superior at creating useful knowledge. The main mechanisms of this knowledge generation are market signals from trade — prices, profit and loss — and free speech.
Societies are most prosperous when knowledge is plentiful, accessible, relevant, inexpensive and growing. Such conditions are most fully brought about by trade.
The foundation of trade is mutual gain. People make exchanges because the expect them to improve their well-being, although sometimes one of the counter-parties is later disappointed. We all tend to be better off when trade is informed and free from force and fraud. The sources of this gain over time are:
- Goods move from those who value them less to those who value them more
- Greater production and consumption and a greater variety of goods and services are made possible by specialization
- Higher volume production by individual producers leads to improved productivity of labor and lower production costs
In a truly free economy, profit and loss is the market’s objective measure of the value a business is creating in society.
In developing measures, accuracy should always be emphasized over precision. It is usually wasteful to develop detailed information beyond what is necessary to make correct decisions. Since it is impossible to predict outcomes precisely, trying to do so is wasteful. Even worse, such attempts can create a false sense of confidence. On the other hand, it is critical to measure real drivers of profitability. For example, energy consumptions should be compared to the ideal, not to some budgeted amount.
It is easy to fall into the trap of a single-minded emphasis on cost reduction. Cost is only one component of value creation. If your goal is to lose weight, you could accomplish it by cutting off your leg, but that is hardly beneficial. Cost-cutting for its own sake can be just as shortsighted and can seriously damage future profitability.
Marginal analysis entails weighing the costs and benefits of a change. We call it marginal cost not because it is unimportant, but because it is incremental, occurring at the margin. Marginal analysis looks at the benefits and costs associated with a specific change rather than at the average or the whole. It asks, what is the profitability of one more unit of production, of one more plant, or of a larger versus a smaller investment.
Before doing marginal analysis we must optimize the current state. For example, before estimating the profitability of an investment to improve efficiency, the current waste should be eliminated from the base case. When considering an expansion, it is wrong to conclude that because we already have excess people we don’t need to include the expense of adding any. The economics should be done with the excess people removed from the base case and added to the extent required in the expansion case.
Effective benchmarking requires objectivity, so it must be done with humility and intellectual honesty. Such objectivity is sometimes painful, but essential to understanding the gap between performance and best practices and what is necessary to profitably eliminate that gap.
When Southwest Airlines sought ways to decrease the time it took to refuel, disembark and board passengers, and unload and load baggage, it did not study other airlines. It studied NASCAR pit crews and drivers. Best practices must be sought wherever they are, both inside and outside the company and industry.
John Wooden, the basketball coaching legend, summed up opportunity cost-based decision making when he cautioned, “Don’t measure yourself by what you have accomplished, but rather by what you should have accomplished with your ability.”
It is one thing to wish to have truth on your side, and another thing to wish sincerely to be on the side of truth.
Another form of challenge process is the compliance audit. Some people may resist these because they feel threatened or worry that they aren’t trusted. Instead, audit should be viewed as a chance to learn and improve. Would you rather find out you have a problem this way or by having a disaster?
People tend to take better care of things they own. This is because the owners of a resource not only reap the benefits of its use, but bear the cost as well. When ownership is unclear, such that no one is sufficiently benefit by preserving a resource, the resource tends to be overused, used inefficiently or even extinguished.
Oceans tend to be overfished due to lack of ownership. This example of the tragedy of the commons arises because fishermen only benefit when the fish are in the boat. There is little incentive for fishermen to leave fish in the ocean for someone else to catch.
The power of the division of labor flows from the diversity in humans and in nature. The benefits of specialization and exchange come from variations in skills, knowledge, culture, infrastructure, geography, natural resources, soil and climate. If every person and every part of the earth were equal in every way, there would be much less benefit from the division of labor.
Widespread value creation throughout a company requires: (1) that decision rights are not granted or bestowed, they are earned, and (2) lack of authority is not considered an excuse for inaction in the face of a problem that needs to be corrected or an opportunity that should be pursued.
Proximity to a problem or process does not determine who is in the best position to make a decision. In a world characterized by knowledge-driven rapid change, top-down decision making is commonly criticized as being highly inefficient. It is true that centralized command-and-control business management suffers from many of the same problems seen in centrally planned economies. Those with local knowledge are often in a better position to solve the problem at hand. The ideas and creative energy of all employees should be leveraged, but universally decentralized decision-making has its own problems. Some decisions, if made at the local level, can be unprofitable because a broader perspective is required.
The mindless application of either approach — universally centralized or completely decentralized decision rights — is not the answer. For example, decisions about how to gain optimum throughput from a refinery at any given time probably are best made by people on site. On the other hand, people further removed, but with broader knowledge, may be better positioned to make a decision on what the most profitable product mix will be in five years. Decisions should be made by those with the best knowledge, taking comparative advantage into account.
The problem of management is how to set up social conditions in any organization so that the goals of the individual merge with the goals of the organization. This includes the needs for meaningful work, for responsibility, for creativeness, for being fair and just, for doing what is worthwhile and for preferring to do it well.
To the economically illiterate, if some company makes a million dollars in profit, this means that their products cost a million dollars more than they would have without profits. It never occurs to such people that these products might cost several million dollars more without the incentives to be efficient created by the prospect of profits.
Putting aside the question of the original captain’s lack of character, it is a simple truth that people respond to incentives. Some believe that individuals should not need to be rewarded to do the right thing, that people should be motivated by duty, compassion or loyalty rather than self-interest. Unfortunately, even the people with good character and intentions aren’t always able to resist perverse incentives.
These are not, however, the only reasons for using incentives. Even when well-intentioned and motivated people are eager to succeed, they still face the challenge of understanding where and how to focus their time and effort. Successful entrepreneurs use the incentives of the market to determine the most productive course of action. Likewise, employers should use incentives to guide employees toward areas where their attention and effort can create the most value.
But care must be taken to ensure that such praise is truly earned. As Maslow put it: “To be praised for what one does not deserve or to have one’s accomplishment unduly exaggerated can actually be guilt-producing.” False praise also tends to undermine trust.