We sometimes consider business purchases in the following way: if we are currently x percent profitable, then for every dollar we spend in a purchase, then the additional sales the company has to achieve to fund the purchase is equal to 100/x.
This is a handy way to check yourself when considering an outlay.
But it’s also weird and pathological. If for some reason the business is running at zero profitability, buying a paper clip requires somebody else to land infinite additional sales. And, if we’re losing money, we actually have to get vendors to pay us to take their products, by this guideline.
Maybe this is a better thing to think about when making a purchase that amounts to a luxury without business benefit, like perhaps parties or donations (and yeah it’s hard to say whether something truly has no business benefit, but humor me).
Obviously a startup is losing money and has to be investing heavily in things that will return profit later.
This criterion I’m describing is at least sometimes weird. Is it just flat out dumb? Is there a name for this kind of thinking? Is there a better substitute that is similarly tidy, as opposed to the math of investment and IRR and all that?
Well, the guideline should use your expected long-term profitability. And if you expect to be losing money long-term, then it’s absolutely right not to buy anything; you should be shutting down the business so you stop losing money.
Let’s take an easy example. Our business is 50% profitable. IOW for every dollar of sales we make 50 cents. And for every dollar of profit we make it took two dollars of sales to do so. (I sure wish it were this easy / fat IRL.)
So now we want to buy a $100 coffeemaker for the office to improve morale. And we intend to expense it completely this year, rather than depreciate it.
If a magic sales fairy bonks our office with her wand and $200 of sales suddenly appears for no apparent reason, we will have same annual profit as we would have. We would have reduced our profit *percentage *a smidgen, but we left our total profit intact.
The magical (read “moronic”) thinking is that the coffeemaker is somehow connected to the incremental sales. You coulda got bonked by the fairy just as easily without the coffeemaker. And buying the coffeemaker in no way guarantees the fairy will obligingly show up on cue.
If the thing you’re buying is *reasonably *expected to directly contribute to increased sales, e.g. advertising, then at least the magical thinking is replaced by bad accounting.
IMO/IME there’s a lot more of the former than the latter going on when folks trot out this particular bit of business/finance math wizardry.
I’ve heard this kind of reasoning used sensibly by a friend of mine who ran a running store and was considering changing locations. It was like: “If I change locations, the rent will increase, and I will have to make X additional profit to cover that – is it reasonable to believe that the new (better) location will spur that much additional sales?” Seemed like a perfectly sensible way to think about the decision.
I don’t know how to sensibly apply that reasoning to a coffee maker, though.
leahcim’s friend’s reasoning is perfectly sensible. The hard part is projecting sales when you change such an important variable as location. That’s what risk-taking is about in business. There are multiple reasons the rent could be higher, such as more retail shopper traffic, so sales could increase. I saw this happen in a small New England town where a boutique moved about three blocks and greatly increased volume. Most of the shoppers were tourists passing through and walking through the shopping district, and the whole “downtown” area was only about five blocks long. So being in the heart of that made a big difference vs. being on the fringe. But it could be because of the market: Rent is high on Worth Ave. in Palm Beach, but that doesn’t mean you should move your Dollar Store there to get more business.
The coffee maker investment cannot be directly tied to profit, but LSLGuy said it was to improve morale. Also it keeps people in the office rather than running out for coffee. These two things can improve employee retention and increase productivity, so there could be an impact on profit but you’ll never be able to tie it back dollar-for-dollar to the coffee maker. Again, this is how business people really make decisions.
You can’t make every decision just by counting beans.
As a manager I used to justify any out of the ordinary purchase in relation to how long it would take to pay for itself. I need a new truck… The maintenance costs of the old one are increasing and it’s reasonable to assume that expensive repairs may well be needed. The new truck will not need any unusual maintenance and repairs will all be warranty. It will also carry more goods and use less fuel…
All these statements would be quantified with numbers and illustrations. Some of them true, some m̶a̶d̶e̶ ̶u̶p̶ best guesses. I would get my new lorry.
That is basically a return on investment calculation. Is the additional expected revenue enough to cover the new rent and the moving costs and return something? In my understanding that is the way it is usually done, though you might also have to figure in a deteriorating sales and profit picture if you don’t do it.
Hard to do this for a coffee maker but in my experience organizations get expense budgets based on size and profitability, and they are free to spend within that. Which you do once a year, not for each purchase.
A basic question about this odd strategy. How do they figure additional sales? Is it compared to last year? Compared to an estimate? Compared to the forecasts of the salespeople?
And if some salesperson does make $1,000 in additional sales, however it is calculated, who gets the money? I’ve usually worked for R&D divisions, and we don’t sell nothing. If you are working on a project which will come to market two years from now if you are lucky, it is going to be hard to get anything.
Which is understandable, because it’s hard to determine what time horizon the cost reduction will appear on.
Some things are easy: You pay to get your company cars’ tires rotated because if you don’t do that simple, cheap thing, the odds of a complex, catastrophically expensive thing happening go up measurably. You can’t predict when a driver in a badly-maintained car is going to go off the road or plow into an ice cream truck (and be liable for a felony in New Jersey), but the maintenance is cheap enough you just budget for it and forget about it unless you’re a total moron.
Other things are hard: Refactoring code can be expensive. Tens or hundreds of hours’ worth of a programmer’s time expensive. However, making some kinds of changes to a badly-factored codebase can be ten or a hundred times as expensive as the refactoring would have been, and by the time you have to make the change you’re typically on a clock, with a client who wants working code they can then get you to change further on a decent timetable. Will that ever happen? Well, the people who design missile software can usually say “no”, and not just because they have missiles and missile software in stock. Most development houses aren’t that lucky.
This is a case where laws can be helpful: If it’s the law to do certain kinds of maintenance, it’s an easier business decision to make and fewer companies can get a leg up by skating on that and driving around with four bald tires on an oil-burner which occasionally ignites some gasoline.
Reduce or avoid. They are different.
Back when I was working for the Bell System we needed to show that our R&D budget paid off. We did this by show both cost reduction and cost avoidance. Cost reduction was easy to calculate - last year it cost $X million to make a product, this year it cost $Y < $X million.
Cost avoidance was saying that if we hadn’t done our work new products would have cost a lot more to make than they did. (Or would, since we worked some years in advance.) Much more slippery a calculation.
One manager included the entire value of a product, since he claimed it could not be manufactured without the work his group did.
Luckily for us no one looked very closely at these numbers, since the way the Bell System worked they more they spent on us the more the regulators would let them charge and thus the greater the profit. They don’t make systems like that any more.
Most development houses aren’t that lucky.