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The Folly of the Three-Bid Model: A Thesis on How SOX Grounded a Dream

Since these are currently parked at airports around the globe we felt the immediacy of the issue justifies the interruption in our five tool player series. Look for our the next installment of the five tool series next Monday.

The Folly of the Three-Bid Model: A Thesis on How SOX Grounded a DreamI just read about about another emergency landing for a 787 Dreamliner in Japan. Apparently, they have grounded them all. I don’t know about you, but I will find it pretty hard to set foot on one of these flying Rube Goldberg contraptions. The Dreamliner name seems to be somewhat on track from a naming perspective; however, I think Nightmare-liner would have been a little more accurate. The product from Boeing has been horribly late to market, had an incredible amount of publicly reported issues through design to production (just imagine how many issues weren’t leaked to the public), encountered union issues during the build, was way over budget, etc.

This story is a classic scenario in which the well-intentioned meaning of legislature leads to law of unintended consequences. Huh? What the heck are you talking about, Crosby? Is this some Libertarian rant? No please, let me elaborate. In 2002, the Sarbanes-Oxley Act was signed into law as a bi-partisan legislative response to major corporate and accounting scandals with companies like Enron and Worldcom. By golly, we needed to “do something”, and Washington, DC did.

The SOX 404 Audit requirement came as part of that legislation. The audit did a lot of things, but one of those items that fell into the “best practices” category was the three-bid model. The theory was that in order to ensure that no conflicts of interest exist between a company employee and a vendor, the “best practice” was to always get three bids from three different vendors. Now, if you do not do this practice and the SOX auditor find out about it, they will interview the senior management in charge to find out “why” and will present their findings to the Audit Committee on the board. While there are no “penalties” involved with this, phone calls from SVPs and auditors generally fall into the same category as calls from creditors and law enforcement officials – you don’t want them.

After 10 years of having this “best practice” beaten into your head through auditors and unfriendly senior executive phone calls, most folks give up and do the “best practice” as it is the non-headache way. The question is: who exactly is the genius that invented this best practice? Business is fundamentally best when there is a relationship of trust between the two parties. Even commodity-like items trade on a trust premise (will the company be able to deliver what I buy – that’s why you choose Amazon.com over JoeBlowsCheapo.com). The problem is that, like Chinese water torture, SOX created a path of least resistance that eliminates trust from the equation. Not overnight, but overtime.

In the 1982 book Out of the Crisis, Dr. W. Edwards Deming highlighted point number 4 of his 14-principles of management is as follows: “End the practice of awarding business on the basis of a price tag. Instead, minimize total cost. Move towards a single supplier for any one item, on a long-term relationship of loyalty and trust.” Total Quality Management (as well as the supremacy of the Japanese car manufacturers in the late 70s, 80s and 90s) came from Dr. Deming. His principles are the foundation for programs like Total Quality Management and Six Sigma. He theories turned into reality helped to solve the paradox of Low Cost and High Quality. Here’s an example of the impact of Deming, courtesy of Wikipedia:

In the 1980s, Ford Motor Company was simultaneously manufacturing a car model with transmissions made in Japan and the United States. Soon after the car model was on the market, Ford customers were requesting the model with Japanese transmission over the US-made transmission, and they were willing to wait for the Japanese model. As both transmissions were made to the same specifications, Ford engineers could not understand the customer preference for the model with Japanese transmission. Finally, Ford engineers decided to take apart the two different transmissions. The American-made car parts were all within specified tolerance levels. On the other hand, the Japanese car parts were virtually identical to each other, and much closer to the nominal values for the parts – e.g., if a part was supposed to be one foot long, plus or minus 1/8 of an inch – then the Japanese parts were all within 1/16 of an inch. This made the Japanese cars run more smoothly and customers experienced fewer problems. Engineers at Ford could not understand how this was done until they met Deming.

Now what does this have to do with Boeing? I guarantee you that the Boeing that came up with the high quality, best selling 737 did not follow the three-bid best practices that SOX dictates. I cannot prove it. But I do know that the Dreamliner was bid seven ways to Sunday, with engineers dictating the design tolerances. A computer model put it all together just fine, or so they thought. Too bad the dozens of new vendors who had the lowest bid had no real ownership in the end product. The compartmentalized, three-bid, “ethical” approach led to a friggin’ disaster for one of America’s great companies. You see legislation can fix stuff, unfortunately, they are using the 7th definition of “fix” according to Merriam-Webster: “to influence the actions, outcome, or effect of by improper or illegal methods (the race had been fixed)”. As I seem to be saying more and more each day, “Gee, thanks Washington. I am really glad that you ‘did something’.”