When I work with engineers in my day job, I often find that they struggle with articulating their work in financial terms (or of thinking in financial terms period). So I’m going to consider some of the dynamics at play in businesses from a microeconomic perspective through the example of considering whether to invest in a “Learning from Incidents” program. This inspired by an analogy with the 2nd Law of Thermodynamics and some financial theory. Consider it a schematic. There’s definitely more details required to make it adequate to any actual situation in a determinate context.
Let’s assume you have two balls, one warmer than the other. Put the two balls into contact and heat will flow between the two bodies until they reach a state where the free energy is at a local minimum. (Actually it’s also dissipating into the surroundings, so I’ll start qualifying my statements.) Entropy has increased and the two-ball system is now relatively stable (aka mostly dead); it has little to no potential to do anything on its own.
In order to stave off this outcome one needs to put in effort to keep the system in disequilibrium, i.e. maintaining the order of magnitude difference between the balls’ temperatures, which requires ingesting energy from outside and converting it into a usable form. The usable form of energy is mostly put into keeping things in a running state, i.e. metastable, and the rest is put into new growth or is dissipated externally. Then that resource is utilized to maintain metastability. This is how metabolism works.
In an organization, the “keeping things in a running state” is mostly recognized as maintenance of the ‘technical components’: repair, integrating new technologies that become available to the organization, and replacing or updating things as needed. The flip side of this is the formal and informal processes of information exchange between the people, which keeps them up-to-date with the status of things and alert to changing priorities and signals of what’s important to pay attention to or what’s no longer relevant. This is the baseline upon which organizations assume they can rely when they think about increasing capacity (aka “scaling”).
For most organizations in this day and age the keystone resource that’s analogous to energy is its cash on hand or available liquidity. Organizations have choices about how to use this asset, and it’s a consequential decision because the value of the available liquidity isn’t just the dollar amount taken on its face. It’s also valuable because it’s exchangeable for anything saleable. That flexibility is an additional value on top of that face value (aka a derivative). To understand this point, consider why getting cash as a present is more valuable than getting a gift card: the flexibility of cash, given certain social conditions, makes it more useful to you because it can be spent on potentially many things, whereas a gift card is in a sense money-already-spent.
Now, in order to maximize a business’s value it will want to make as few long-term commitments as possible and hedge where and how it can when it does have to make expenditures. That’s because the derivative value of the liquidity only exists as long as that underlying asset (cash) isn’t spent. Now this expenditure can actually vary, so it’s an important nuance to consider the terms and duration of the expenditure. A total amount can be committed up front in a contract and paid out in full or not actually all spent at the time of that commitment, e.g. doled out in installments or in apportionments conditional on the receipt of certain commodities. To give an example, if an organization rents an office space it probably have to make a monthly payments distributed over a given time frame; however, if certain legal or contractual terms aren’t met then it could ask the landlord for a discount on the remaining amount to be paid or even for money back.
If a business, projecting ahead, seems to have favorable prospects in the form of a steady or growing revenue stream then it will feel more comfortable making longer-term commitments with fewer strings attached. That’s because it believes it will be able to at least maintain that derivative value if not grow it in spite of its expenditures due to replacing the underlying cash with net new revenue, or if the total expenditures does become a net negative then they can replenish that reserve with the projected future revenue. In contrast, if a business believes there’s trouble in its future then it will want to take a more conservative approach and will prize that derivative value all the more. Note that this is all speculation, and people have been trying for years to create quantitative models which give better or worse predictions of how a business will fare and how to quantify its total value.
The preceding was all a big setup for getting into the example of examining some of the trade-offs a business might consider if it wants to learn and change its operations. As I said before, one way to do this is by investing in a “Learning from Incidents” program. Indeed.com has been cited as a credible model for this approach. We see here that the business has essentially decided to build a means of self-reflection into its operations and it uses the results of that reflection to scaffold its progress. This gives its people more capacity or flexibility. What that means is that their priors are updated regularly (making them more attuned to the organization’s status and thus they are better aligned with the “fitness landscape” which the organization embodies) and the inflow and outflow of resources like new technologies or colleagues with different insights and skills. They’re able to work better individually and collectively. And as I mentioned, it provides the grounds for new ideas and ways of operating.
This recycling process is great but also expensive from a resource utilization perspective because it means the organization is committing cash towards hiring and supporting staff to do this work. That commitment means the business loses the immediate derivative value of the cash, which may or may not be made up from new revenue. Furthermore, the investment is in people who may act as autonomous agents. There’s no guarantee that the people will use their new knowledge in ways that the business recognizes as immediately benefitting the bottom line, or that they won’t leave and take that investment with them.
The alternative is to buy learning and knowledge. In this case, they may hire new staff either as full-time employees or as contractors (including consultants). These folks will come in and perform the work of gathering evidence, synthesizing it, and reporting it out and up, or perform certain technical tasks with special skills outside the rest of the business’s established competencies. In the short-term this lets the business hold onto its cash until what it thinks is the very-last-minute, although the one-time payout will be relatively high and there will be a long tail of integration costs. In the case of hiring consultants, for example, the firm that is contracted will demand a fairly significant down payment and the consultants will need to gain the trust of and take the time of the regular employees, and at best will produce a report that reflects what those employees could have told the organization themselves. It’s also unlikely that those employees will actually read the report, since it’s the business’s management that is paying for the service and so it’s tailored to them as the audience (it may not even be shared outside that group).
On the other hand, the expenditure is better for maintaining that derivative as long as possible as opposed to the on-going commitment to staffing and supporting an in-house program. It’s also typically easier to discontinue working with an external vendor than full time staff if the financial outlook sours. If cuts to general staffing levels do happen and the business still wants to try to maintain the same levels of output, it may be able to just exert more pressure on whoever remains and ask each person to do more with less.
This has been an exercise in thinking through trade-offs that businesses must make in what I hope has been a clear framing. The Build vs. Buy dynamic obviously isn’t a binary choice, as organizations as socio-technical systems are in constant flux and the relations between the terms of the debate often change unexpectedly. Hence why one should take it as a pared down representation of the situation meant to showcase some key facets. There’s much more to say about the workings within and without of a given organization. If someone wants to consider those aspects, I hope this may serve as a useful starting place.