You can’t beat arithmetic!

You can’t beat arithmetic!
23 February 2009

There is some simple arithmetic of which people running a business (including big businesses) ought to be aware if they want to survive.

What is compelling about arithmetic is its inescapable logic. Two plus two always equals four. There are motivational people who try to convince us that two plus two can equal five, but arithmetically, that is not possible. The consequences of accurate addition and subtraction are inescapably determined by the rules.

When things get tough (and they can get tough in good times as well as bad) many think of phoning the bank or cutting costs. They might be appropriate strategies. However, there is often a tendency to accept as inevitable that sales are slowing. Particularly when the economy is in a downdraft, it is a convenient way of skating over underlying problems by saying "hell, it is the economy, we can't do anything about that, we will simply have to cut costs".

Now, supermarkets often say that they operate on a 1% to 2% margin (whether this is the case or not I am far from certain when I visit the local store and buy milk for $4.16 a litre and the supermarket has the same milk for $4.55 a litre; but that is another story). The immediate reaction to this low margin is "how can they turn in the amazing profits they chalk up on such low margins?" Let us do some arithmetic.

Let us say a supermarket sells a tin of soup for say $1.02 and the margin is 2%, while a shop down the street sells the same product for $1.20. The supermarket turns over, say, one hundred tins of soup a day and let us say the supermarket is open for 360 days. They make 2c x 100 a day x 360. The sum looks like this: 0.2 X 100 X 360 = $7200.

Then of course, there might be say 100 stores across the country, so you multiply the $7200 by another 100 and you get (arithmetic is compelling) $720,000.

The shop down the street sells five cans a day if it is lucky, which amounts to a profit of $1. Multiply this by 360 and there you have it; a massive profit after charging a margin of 20% of $360.

One summary of this phenomenon is "the higher the volume, the lower we can fix our margin" but that would be erroneous because volume sales follow price rather than the other way around. The more accurate summary of this little exercise is "the lower the margin, the higher the volume of sales".

Nor should we overlook that merely on a margin of 2% a supermarket is making a massive profit, which means that the lower the margin, the higher the volume of sales and the better the profit.

Now that is fairly simplistic, but nevertheless is the theoretical basis of how businesses work and it is called the "cash business cycle".

There are many factors at play in determining the ultimate profit. However, the aim of business ought to be to maintain their cost base while increasing their sales base. I have found that this is a counter-intuitive argument and people really get upset when you suggest that they ought to look at lowering their price. "We will go out of business if we lower our prices."

So I then suggest another exercise in arithmetic. Suppose a business is selling a product or service (and this applies to people in the service industry such as lawyers, as we shall shortly see) for $100. The question is "do you have to increase your cost base to sell another one product?" The answer is inevitably and emphatically "NO".

It is then easy to demonstrate that if you sell the next product for $1 you will increase your profit because your sales have increased by $1 but your costs haven't increased.

When sales are going south and if this has not been associated with "downsizing" (or, to use the politically incorrect crude word "sackings") then it is obvious that the business has capacity to increase sales without increasing costs.

How do we use up that capacity to increase sales? One way is to lower the margins; or to "bundle" products like "buy two and get the third free" (I note that this is commonly used but I am unsure of its effectiveness in relation to the straight margin reduction).

On the other hand, if we reduce costs, it may seriously damage the ability to increase sales. That is not to say that we ignore costs. The point is that if we do our arithmetic before giving everyone the pink slip, we might find ways of actually protecting our market segment, and if this is done say, in a downturn, then it will not cost a sheep station to win those customers back when the economy turns again.

I mentioned the service industry and particularly lawyers who tend to work on an hourly rate. Let us take a simple conveyancing transaction.

A person engages a lawyer when they buy a house. The lawyer charges a flat fee. They see the lawyer down the street charging a lot less and they convince themselves that the lawyer down the street will go out of business.

You ask the question, is your conveyancing section capable of handling more transactions? If the answer is "Yes" then it is obvious that if you do the next conveyancing transaction for $1 you will increase your profit by $1. The law firm down the street had done its arithmetic.

"But this doesn't apply to me, my work is so complex and the outcome can't be predicted and so I have to charge an hourly rate." That firm is locking itself into a prison cell. In good times, the cell may not look like a prison cell, with the Bollinger champagne in the fridge and the chef in the kitchen putting on 24/7 salmon and turkey sandwiches, but that is just an illusion.

Do the sums. If a lawyer charges an hourly rate of $500 (my goodness, some people don't get that in a week) and, without cheating, the lawyer can bill say eight hours work in a day, then the lawyer will be able to bill $4000 per day for say 44 weeks in a year, which totals $880,000. Sounds great!

It doesn't matter how efficient that lawyer is, her billing ability is limited by the amount of hours she can stay awake and her charge our rate (which has certain competitive constraints).

Suppose that thIS lawyer puts through 50 cases a year when her competitor puts through 40 cases a year, but charges the same hourly rate and stays awake for the same number of hours. They both make the same total amount of billings.

However suppose the first lawyer charges a fixed fee for each case, scraps the time sheets (which take an inordinate amount of time and creates a lot of unhappiness with their customers) and puts through 60 cases a year at a guaranteed fee of $20,000 a pop ($2000 less than on an hourly rate); that lawyer is generating $1.2 million a year with very happy customers because they know precisely what they are up for before they start.

The lawyer is happy because he or she doesn't have to waste a lot of time filling in time sheets and keeping the managing partner happy, and the Courts are happy because a lot more cases get settled.

In good times, there is a tendency for everyone to get busy, money is flying around like blossoms in late spring and the response often is "we can increase our margins". This rarely results in dramatically increased sales.

However, there is often a fear that to increase sales it will be necessary to increase costs. This frightens a lot of people because they have not done their sums.

Strangely enough, you can increase your costs and reduce your margins and make more money.

Of equal importance, the business can extend its market share. However, in the good times, it is often feasible to contain cost while lowering margin. The difficulty in good times is that management often feels that the easiest thing to do is just throw money at a problem rather than revisit systems.

The real value of a business is in repeat customers. Accordingly, in good times, instead of taking the easy route to profits by increasing margins; a business can increase its competitive price position by rejecting the temptation to increase price. As a result, sales increase as does the market share and the longevity of customer loyalty. That is not to mention the profit and the return on investment.

I have seen some dumb things done by people who do not understand the arithmetic of business and I have seen businesses actually go belly up by pricing themselves out of existence. IBM was one company that came perilously close to death for this reason. Fortunately, they got a guy called Louis Gestner, who could add up and subtract.


Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.

To read more Louis Coutts blogs, click here .

http://www.smartcompany.com.au/the-growth-doctor/you-cana-t-beat-arithmetic.html

The Growth Doctor

How doth your business grow? This blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Lead writer Lou Coutts left law and became a successful entrepreneur. He has qualifications in Advanced Management from Stanford; turnarounds and strategic alliances from Colombia; International Marketing from the University of California and Changing Strategic Direction from the Kellogg Graduate School of Management in Chicago.