Tuesday, December 18, 2007

Make Sure You Consider Magnitude *and* Percentage

Loyal reader Foobarista had a great comment on my recent post on capital efficiency:

"Pay attention to the right spending. In a company I worked at, the CEO paid close attention to things like printer cartridge expenses and other office supplies while running up huge bills on unnecessary lawyer consultations and expensive "business consultants"."

When you're analyzing things like revenues and costs, make sure that you consider both the magnitude and the percentage.

It might be that your printer cartridge expenses are 50% higher than you expected. After all, a swimming pool of HP ink would have a street value of $5.9 billion. However, if that 50% variance represents $100 per year of additional spending, you might be better served to pay attention to a 5% variance in the $1,000,000 per year you spend on McKinsey engagements.

On the other hand, you can't simply ignore the percentages--these are critical leading indicators that tell you a lot about the nature of your business. If your business has a profit margin of 10 basis points, then you need to run through $1 billion per year just to generate profits of $1 million. This works fine if you're talking about the Vanguard S&P 500 index fund, but not so good if you're trying to scale up a chain of specialty retailers that sells accessories for pet ferrets.

1 comment:

chriscla said...

There is a major reason that people often overlook the big stuff in favor of the small stuff. The reason being that it is much easier to track changes and benefits in the small items. In your example above, the CEO can easily tell that his ink expenses have gone down and that has impact the bottom line by $X. With the fancy CEO or lawyer engagements it can often be hard to tell how many dollars of revenue that consultation generated or protected.