Tuesday, 2 July 2013

Comparing Apples With Oranges - Introducing the Concept of Relative Complexity

 
Can you compare the complexity of a large company to that of a small one? The answer to this question is fairly simple once you distinguish the following two situations:

1. You analyze both companies using exactly the same business parameters.

2. You analyze both companies using similar but not identical business parameters.

In order to analyze a business (a company, a bank, etc.) one uses financial statements such as a Balance Sheet, Cash Flow, Income Statements or Ratios. Now, because no two companies conduct exactly the same kind of business, the Balance Sheets, for example, will not always contain exactly the same entries. Therefore, from a rigorous and scientific point of view, such situations would not be comparable. Consequently, comparing directly the values of the complexity of two companies would not make much sense. Imagine comparing the levels of cholesterol of a baby to that of an adult.

Unless we're in situation 1 - imagine for example  two branches of the same bank, which are monitored using the same parameters - we will need another means of comparing complexities of business, or portfolios. This is why we have introduced the concept of relative complexity. It is based on the current, lower and upper bounds of complexity and is computed as follows:



CRel = (Ccr - C) / (Ccr - Cmin) X 100%



where Ccr, Cmin and C correspond, respectively to the values of critical and lower complexity bounds and to its current value.


As an example, let us compare the relative complexities of Goldman Sachs, Citi Bank and Apple - click on the Business Structure Maps to see which business parameters have been used in each case to compute business complexity.



Goldman Sachs.



Relative complexity = 41%           




Citi Bank.




Relative complexity =  24%          



Apple Inc.



Relative Complexity =  31%                 



if you navigate the various Business Structure Maps you will notice that in each of the three cases different business parameters have been used to analyze them. Therefore, comparing the various complexities would have been meaningless and misleading. Relative complexity, on the other hand, allows us to rank business complexity even if these belong to different categories, markets or market segments, and, most importantly, independently of size. What this means is that (business) size does not matter and that an SME can be relatively much more complex than a huge multinational corporation.

But the question is, so what? What is the big deal? Why would anyone want to know the relative complexity of a business? The answer is quite simple. Why would anyone want to measure their level of cholesterol? There are many reasons why, especially today, in a turbulent economy, a measure of relative complexity is of immense business value.

A highly complex business is, generally:


  • Difficult to manage, to understand
  • Difficult to adapt to turbulence
  • Able to produce surprising behaviour
  • Exposed
  • Fragile
  • Less profitable
  • Less predictable - it is difficult to make credible forecasts