Ah yes, there's planning and then there's operations. Rarely do they coincide. What to do? This is one place where risk management comes in.
In an earlier post, I referred to a very large problem here in the Northwest caused by assuming past sales are a good predictor of future sales. Utility planning's failure to address sales risk led to literally billions in wasted money, money that could have been used to provide goods and service people wanted. This was quite a spectacular event. One result of that event was the creation of a new regional planning agency chartered by an act of Congress. Another result was a change in forecasting methods that contributed to this spectacular failure.
How does a small business with little money for sophisticated resources and guidance navigate these waters? One answer is to seek guidance from organizations like the Small Business Administration, USDA, and local and regional organizations established to provide technical assistance to such businesses.
There are some fairly simple methods that small businesses and start ups can use to try and at least narrow the amount of uncertainty they face. One approach is to develop multiple budgets. As was mentioned in an earlier post, it's often the case that a business oscillates between a conservative budget and a dream budget. This can be 'modeled' using what's called a triangular risk distribution.
Here's the approach,
1. Make a judgment call about what you think your most shaky variable is in your budget (there are likely more than one).
2. For that variable, determine what you think the most conservative value is, what you think a typical - or average value is, and what you think a very optimistic value is.
3. Build three budgets using the three values for what you consider the most risky element in your budget.
This is a very simple approach to do on your desktop in EXCEL. You can easily expand from one to more variables, with not too much more complication using EXCEL.
Now, one very subjective element of this approach is your personal attitude towards risk. What this means is different people have different reactions to risk. This is what underlies portfolio recommendations by age with a younger person advised to hold a riskier portfolio than someone closer to retirement.
This doesn't need to get fancy. When you've developed several different budgets, then step back and consider how you respond to risk. If you're more conservative, you'll prefer the budget somewhere between the most conservative you could think of and what you considered your average or expected budget. If you're more of a gambler, you'll prefer a budget somewhere between the expected budget and your aggressive one.
While this can be made very complex, and there are models that use large amounts of data to include risk in making decisions, that's not what we're talking about here. We don't want to go there. Though, we also don't want to just develop one budget and assume life will in fact mirror that budget. It will not.
Thursday, March 11, 2010
Monday, March 8, 2010
What About When Costs and Revenues Are Interdependent?
In the prior post, it was implicitly assumed that costs and revenues are independent. This is how you can develop costs and then determine needed revenues. What about when costs and revenues are interdependent?
It's not uncommon for costs and revenues to be interdependent. While discussions like those in the prior two posts are easier with an assumption of interdependence, this is not often the case. Some of the links mentioned in the prior post did touch on this issue. For example, one link raised issues like insufficient inventory or sales support staff when sales exceed expectations.
If your business has a fixed monthly payment for a space, such as a monthly lease, then this cost is clearly known. However, what if you rent space as the need arises? What if you're able to have all your costs as flexible - variable - as this? Here then, costs and revenues are interdependent. Thankfully, if you have very little lead time between incurring a cost and meeting a demand for your product or service, there's little problem with this type of interdependence.
However, when this lead time lengthens, for example, with advertising costs, staffing needs, space rental, it becomes more difficult to simplify the budgeting problem by working with costs. In these situations, costs and revenues are linked.
One other implication of this kind of linkage is that to simplify it as much as possible by keeping costs as variable as possible with the shortest lead times possible before needing to commit to a cost.
It's not uncommon for costs and revenues to be interdependent. While discussions like those in the prior two posts are easier with an assumption of interdependence, this is not often the case. Some of the links mentioned in the prior post did touch on this issue. For example, one link raised issues like insufficient inventory or sales support staff when sales exceed expectations.
If your business has a fixed monthly payment for a space, such as a monthly lease, then this cost is clearly known. However, what if you rent space as the need arises? What if you're able to have all your costs as flexible - variable - as this? Here then, costs and revenues are interdependent. Thankfully, if you have very little lead time between incurring a cost and meeting a demand for your product or service, there's little problem with this type of interdependence.
However, when this lead time lengthens, for example, with advertising costs, staffing needs, space rental, it becomes more difficult to simplify the budgeting problem by working with costs. In these situations, costs and revenues are linked.
One other implication of this kind of linkage is that to simplify it as much as possible by keeping costs as variable as possible with the shortest lead times possible before needing to commit to a cost.
Forecasting (Budgeting) When You Have Little Solid Data
In an earlier post, I raised the challenge of forecasting revenues for budgeting noting that it's likely the most challenging step in budgeting for a new business. One link that addresses this issue confirms that perspective. In this link, the authors talk about ways to narrow the range of uncertainty - risk - around what you think will happen by focusing on reactions to your pre-launch marketing survey.
Another link contains an interesting give and take with various people on this issue. One writer aptly notes that it's more art than science when you've really not got any good data. A post by rogercbryan on 1-4-08 contains a good deal of wisdom. Among his sage advice are the following:
- "Start with expenses, not revenues. When you're in the startup stage, it's much easier to forecast expenses than revenues"
He then includes some rules of thumb for cost forecasting that seem on point. Note: Much the same advice is contained in this link.
On revenue forecasting, he proposes that you "Forecast revenues using both a conservative case and an aggressive case. If you're like most entrepreneurs, you'll constantly fluctuate between conservative reality and an aggressive dream state..."
What's good in his advice is the idea of making multiple revenue forecasts. Very large multi-billion dollar businesses have made fatal errors by not forecasting multiple revenue scenarios. These multiple scenarios reflect different sales possibilities. Here in the Pacific Northwest, this very error was committed in the past with electric utility panning that ultimately led to billions of wasted dollars and mothballed and incomplete nuclear plants.
One approach I like is to work your cost numbers hard and gin up several different cost scenarios. Then, for each cost scenario, generate a revenue forecast - in terms of customers, product sold, prices, etc., that supports that cost scenario. Then, you step back and examine the various product sales projections, examine their likelihood, or what would need to happen for it to be true. At the beginning, this is again more art than science.
This is a way of being systematic and structured in your analysis, even in the presence of a great deal of uncertainty about both costs and revenues. Through this process, you'll document your assumptions. At this point, even though you have a great deal of uncertainty - risk - in your analysis, at least you've proceeded with a systematic approach. Now, subject your analysis to rigorous review by some others not involved with your dream. Use them to challenge your assumptions and analysis. Use them to identify what is strong and what is weak in your analysis.
Another link contains an interesting give and take with various people on this issue. One writer aptly notes that it's more art than science when you've really not got any good data. A post by rogercbryan on 1-4-08 contains a good deal of wisdom. Among his sage advice are the following:
- "Start with expenses, not revenues. When you're in the startup stage, it's much easier to forecast expenses than revenues"
He then includes some rules of thumb for cost forecasting that seem on point. Note: Much the same advice is contained in this link.
On revenue forecasting, he proposes that you "Forecast revenues using both a conservative case and an aggressive case. If you're like most entrepreneurs, you'll constantly fluctuate between conservative reality and an aggressive dream state..."
What's good in his advice is the idea of making multiple revenue forecasts. Very large multi-billion dollar businesses have made fatal errors by not forecasting multiple revenue scenarios. These multiple scenarios reflect different sales possibilities. Here in the Pacific Northwest, this very error was committed in the past with electric utility panning that ultimately led to billions of wasted dollars and mothballed and incomplete nuclear plants.
One approach I like is to work your cost numbers hard and gin up several different cost scenarios. Then, for each cost scenario, generate a revenue forecast - in terms of customers, product sold, prices, etc., that supports that cost scenario. Then, you step back and examine the various product sales projections, examine their likelihood, or what would need to happen for it to be true. At the beginning, this is again more art than science.
This is a way of being systematic and structured in your analysis, even in the presence of a great deal of uncertainty about both costs and revenues. Through this process, you'll document your assumptions. At this point, even though you have a great deal of uncertainty - risk - in your analysis, at least you've proceeded with a systematic approach. Now, subject your analysis to rigorous review by some others not involved with your dream. Use them to challenge your assumptions and analysis. Use them to identify what is strong and what is weak in your analysis.
Starting a new Business - A Flight into the Unknown
Where I live - Joseph, Oregon - there's a group of people who want to start a new art school. They're starting a new non-profit group, working to bring in people from other places to teach, want to buy two older buildings, and want to do all of this at the same time with virtually no money. This is a good example of how to start a new business with an immense amount of risk.
Are all these ideas worthy? Sure. Why not? Yet, that's not the question. One good question is what are the priorities? What do you really want to do? What do you really want to accomplish? What is your primary purpose?
Start-ups need cash reserves. Start-ups don't have a track record which significantly complicates budgeting. Under such conditions, budgeting is a shot in the dark. Because of the great many unknowns a start-up faces, there's a need to build in a lot of ability to flex with circumstances you really have very little idea about.
Not only are costs challenging to scope, they are probably easier to scope than revenues. This is especially true when there is little hard data that can be used to firm up the revenue forecasts. Now, people will say "oh, that's not really that much of a problem. There's other places that hold art classes and we can just use their experience." There's a host of reasons why that view is dangerous.
Extrapolating from the experience of other's - which is what that argument amounts to - is problematic. There's a good deal of statistical discussion on this issue - extrapolating beyond your data. By it's very nature, extrapolation is a journey into the unknown. It might be the best you've got. Here's the thing though, you need to look at the broader circumstances of the experience of others and compare those circumstances to your own to come to some sense of how relevant their experience is to your new enterprise.
I'm not saying it's a wrong path to travel down. Rather, that you need to be cautious as you travel down that path. I've seen people who are really just grasping for confirmation grab onto whatever data they can get their hands on as justification for what they want to be true. Whether it's actually true or not is another story, and people who question such approaches are sometimes treated as inconvenient pessimists.
Are all these ideas worthy? Sure. Why not? Yet, that's not the question. One good question is what are the priorities? What do you really want to do? What do you really want to accomplish? What is your primary purpose?
Start-ups need cash reserves. Start-ups don't have a track record which significantly complicates budgeting. Under such conditions, budgeting is a shot in the dark. Because of the great many unknowns a start-up faces, there's a need to build in a lot of ability to flex with circumstances you really have very little idea about.
Not only are costs challenging to scope, they are probably easier to scope than revenues. This is especially true when there is little hard data that can be used to firm up the revenue forecasts. Now, people will say "oh, that's not really that much of a problem. There's other places that hold art classes and we can just use their experience." There's a host of reasons why that view is dangerous.
Extrapolating from the experience of other's - which is what that argument amounts to - is problematic. There's a good deal of statistical discussion on this issue - extrapolating beyond your data. By it's very nature, extrapolation is a journey into the unknown. It might be the best you've got. Here's the thing though, you need to look at the broader circumstances of the experience of others and compare those circumstances to your own to come to some sense of how relevant their experience is to your new enterprise.
I'm not saying it's a wrong path to travel down. Rather, that you need to be cautious as you travel down that path. I've seen people who are really just grasping for confirmation grab onto whatever data they can get their hands on as justification for what they want to be true. Whether it's actually true or not is another story, and people who question such approaches are sometimes treated as inconvenient pessimists.
Wednesday, February 17, 2010
De-Regulation and Economic Implosion
There's been some interesting news the last few days.
1. Evan Byah retiring.
For some odd reason, he's being portrayed as a centrist democrat. I think Bill Mahar is right on labeling him a corporatist.
2. Frontline Program on Derivatives Regulation
They ran a great overview of the political and personal dynamics that underlies how the fierce opposition to regulating derivatives led to the financial implosion. They did a good job of showing how Brooksley Born was demolished in her attempt to promulgate regulating derivatives. Those who have followed this story have known about her efforts for over a decade. This show first aired in October '09.
Frontline on derivatives.
3. De-regulation under Clinton and U.S. Employment
I hope - but sadly doubt - that this story helps to re-write the role of Bill Clinton in de-regulating so much of the economy and thereby help set up the massive financial implosion and job exodus from the U.S. to China. Frontline did a story some time ago titled "Is Wall-Mart Good for America?" That program lays out the domestic economic impacts of the Clinton's trade policy with China that opened the door to massive job exodus to China, largely to the benefit not of consumers but of Wall-Mart stock holders.
1. Evan Byah retiring.
For some odd reason, he's being portrayed as a centrist democrat. I think Bill Mahar is right on labeling him a corporatist.
2. Frontline Program on Derivatives Regulation
They ran a great overview of the political and personal dynamics that underlies how the fierce opposition to regulating derivatives led to the financial implosion. They did a good job of showing how Brooksley Born was demolished in her attempt to promulgate regulating derivatives. Those who have followed this story have known about her efforts for over a decade. This show first aired in October '09.
Frontline on derivatives.
3. De-regulation under Clinton and U.S. Employment
I hope - but sadly doubt - that this story helps to re-write the role of Bill Clinton in de-regulating so much of the economy and thereby help set up the massive financial implosion and job exodus from the U.S. to China. Frontline did a story some time ago titled "Is Wall-Mart Good for America?" That program lays out the domestic economic impacts of the Clinton's trade policy with China that opened the door to massive job exodus to China, largely to the benefit not of consumers but of Wall-Mart stock holders.
Thursday, January 28, 2010
Employment Much Worse in this Recession
Below are three charts comparing unemployment and labor force growth in this recession compared to other post WWII recessions. NOTE: Click on a chart to open it larger in a separate window.
Before we get into the charts, these charts certainly underscore the critical need to do much more for job growth than worrying about debt. The Obama Administration and Congress really need to place a much greater emphasis on jobs. This is both a Main Street issue and is also a key piece of shoring up the housing sector.
Looking at Chart 1, it's sobering to see how much higher unemployment has risen, and how fast it's risen in this recession, compared to other recessions. Keep in mind that the vertical axis is percent so the fact that the labor force itself is larger is not a factor in these results. The unemployment rate is a ratio determined by dividing total unemployment by the total labor force. Chart 1 shows that jobs have been shed at a much greater rate than in previous recessions. I suspect that's due to (a) fewer restrictions on an employer's ability to reduce their workforce, and (b) employer's perception of the likely depth and length of the recession.
What I find even more shocking is Chart 2, the percentage change in the civilian employment by month across post WWII recessions (Charts 1 and 2 aren't directly comparable). Chart 2 is just the monthly percent change in civilian employment and it's a dramatic drop.
Chart 3 shows the percentage change by month of the civilian labor force. The civilian labor force is defined as people 16 years old or older who are not in the military, prison, institution, school and are employed or looking for work. Chart 3 shows that the civilian labor force kept growing, but at a slowing rate, up until about this past October. Then, the civilian labor force actually began to shrink.
A drop in civilian labor force can be due to a variety of reasons though a significant reason right now is it likely reflects people dropping out of the labor force as they stop looking for work. Another factor may be immigrants, legal and otherwise, returning to their prior home since labor force includes U.S. citizens as well as legal and illegal aliens. One aspect of the labor force decline that concerns me is I suspect there's a good deal of older folks (over 40) in this pool whose jobs are not likely to return. This type of unemployment problem is called structural unemployment. It's the most difficult type of unemployment to solve. Another concern with a declining labor force is that it also reduces what the economy can produce, absent an offsetting productivity gain.
Before we get into the charts, these charts certainly underscore the critical need to do much more for job growth than worrying about debt. The Obama Administration and Congress really need to place a much greater emphasis on jobs. This is both a Main Street issue and is also a key piece of shoring up the housing sector.
Looking at Chart 1, it's sobering to see how much higher unemployment has risen, and how fast it's risen in this recession, compared to other recessions. Keep in mind that the vertical axis is percent so the fact that the labor force itself is larger is not a factor in these results. The unemployment rate is a ratio determined by dividing total unemployment by the total labor force. Chart 1 shows that jobs have been shed at a much greater rate than in previous recessions. I suspect that's due to (a) fewer restrictions on an employer's ability to reduce their workforce, and (b) employer's perception of the likely depth and length of the recession.
What I find even more shocking is Chart 2, the percentage change in the civilian employment by month across post WWII recessions (Charts 1 and 2 aren't directly comparable). Chart 2 is just the monthly percent change in civilian employment and it's a dramatic drop.
Chart 3 shows the percentage change by month of the civilian labor force. The civilian labor force is defined as people 16 years old or older who are not in the military, prison, institution, school and are employed or looking for work. Chart 3 shows that the civilian labor force kept growing, but at a slowing rate, up until about this past October. Then, the civilian labor force actually began to shrink.
A drop in civilian labor force can be due to a variety of reasons though a significant reason right now is it likely reflects people dropping out of the labor force as they stop looking for work. Another factor may be immigrants, legal and otherwise, returning to their prior home since labor force includes U.S. citizens as well as legal and illegal aliens. One aspect of the labor force decline that concerns me is I suspect there's a good deal of older folks (over 40) in this pool whose jobs are not likely to return. This type of unemployment problem is called structural unemployment. It's the most difficult type of unemployment to solve. Another concern with a declining labor force is that it also reduces what the economy can produce, absent an offsetting productivity gain.
For a bit of good news, Chart 6 illustrates that the official unemployment rate is nowhere near the official rate of the Great Depression. By official unemployment rate I mean to suggest that the actual unemployment rate is greater. The official rate does not count people who would like a job but have stopped looking for work. These people are referred to as discouraged, despite whatever they might be called on FOX News!
Wednesday, January 27, 2010
Bankers, Economics, and when will Obama REALLY Work for Main Street?
Joseph Stiglitz spoke today at the Davos World Economic Forum. In a wide-ranging talk, Bloomberg reports that he chastised bankers for creating 'negative value' for society. Reuters reports that banks are doubling-down on risk.
No doubt there are those that argue that bankers are just being rational when using government bail out money to make money for the bank's shareholders. These folks argue that it's not the banks fault. Rather, it's government's fault for not instituting the 'correct' rules. Yes, let's blame the rape victim for the rape. What me? I did nothing wrong. I was presented with such an opportunity that any hot blooded male would have done the same thing. Right.
I, for one, supported the bank bailouts. I still do. There was a problem with not putting stringent lending strings and so forth on those bailouts. That's why Tim Geitner and others need to be replaced. They never should have been part of the Obama Administration. Though, law is conservative, and Obama has certainly been conservative in his economic support for the middle class.
The Administration's recently announced measures aimed at the middle class are like feeding crumbs to the people of Haiti. Sure, they'll take those crumbs. What would you do? I would. That doesn't absolve Obama of his insane economic policies, the latest one being a spending freeze. Recall that during the campaign, McCain proposed such a policy and candidate Obama ridiculed it saying it was like using a hatchet when what you need is a scalpel. He's just handed the opposition a gift. As Krugman rightly points out, it's a stupid, cynical, wrong-headed political stunt. In an earlier post, I addressed the need for more stimulus spending rather than addressing the debt. Professor of Economics James Galbraith characterized the spending freeze proposal as like tossing red meat to the sharks in hopes that the sharks won't go after the people. Ouch. He's right, in my view.
Robert Reich hit the nail on the head in saying "...Obama’s package of middle class benefits is small potatoes. They’re worthwhile but they pale relative to the size and scale of the challenge America’s middle class is now facing. Obama can no longer afford to come up with lists of nice things to do. At the least, he’s got to do two very big and important things: (1) Enact a second stimulus. It should mainly focus on bailing out state and local governments that are now cutting services and raising taxes, and squeezing the middle class. This would be the best way to reinvigorate the economy quickly. (2) Help distressed homeowners by allowing them to include their mortgage debt in personal bankruptcy — which will give them far more bargaining leverage with morgage lenders. (Wall Street hates this.)"
Rachel Maddow had a great segment last evening in which she showed a series of bar charts on GDP and job losses by quarter for the last two years of the Bush Administration and the results during the Obama Administration. The results are striking, GDP growth and the reduced job loss numbers are a good start at turning the economy around. The economy has begun to recover, and the banking sector's not on it's death bed. This is the beginning of a recovery. Yet, what's your view of how the Obama Administration has done? They have both houses of Congress, 59 seats in the Senate (more than the R's had at the end of the Bush years) and what does Obama propose? A spending freeze. As Ms. Maddow put it "there he is on the one yard line and what does he decide to do? He decides to punt from the one yard line rather than driving it in for the score."
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