I’ve been busy answering this question since Tilted Pixel Inc. was founded last year. In my previous ventures spending on growth was sparodic and rarely well planned resulting in seriously suboptimal results. With hindsight being 20/20 I’ve been approaching spending in a much more careful way.
Every business is in danger of the same problem, and many business owners have drowned the seed of their idea by spending like large companies despite having 1% of the budget. Some may cry “this was a necessary marketing expense” even as the repo trucks drive away! I’d like to propose that you avoid this mess by stealing an economics theory and choosing to behave in the manner that it predicts.
First we need to remember that in business there is no such thing as perfect. You never have enough time or money to do what you should, and a major part of consistent success hinges on you being able to create something great inspite of the imperfections that abound. It’s particularly tough to do when starting out as you begin to try to reconcile the vision in your mind with the reality you live in. You can’t have it all so what do you choose?
My economics-based answer is spend the next sum of money that you can afford on the purchase that provides to you the greatest marginal utility.
This is my fancy way of stating two simple ideas:
- Devote your cash to the items that will bring you the greatest return (highest marginal utility per $ spent).
- Don’t make an expense that you can’t afford.
In economics marginal utility (the value that you receive from the next of that item) can be used to predict how resources are allocated between multiple expenditures, with the theory that the optimal mix is the one that gives you the “most utility for your buck”. In other words the sum of the utility you have received from your chosen amount of spending on each expenditure is at a maximum.
Economics isn’t business advice however, it’s a set of theories on how the economy and its participants tend to behave and is thus based on interpretation of real world behavior. The above tells us that rational profit seeking businesses tend to allocate their money in a manner that attempts to maximize the desired return. With the idea of marginal utility it also provides a neat model of measuring this numerically. This leads me to suggest that we consciously attempt to use this model to behave in the manner that economics theory suggests we will behave. How’s that for making you dizzy?
Putting It Into Practice
We have a simple model now to help keep spending wise and on track. We will only focus on new spending and assume that any existing expenses of your business are already optimal. In reality you will want to re-evaluate your expenses to fit that assumption, which you can do by applying this model to each expense and lowering those that do not fit your conclusions. You will likely save a hefty chunk when you analyse your expenses in this way even if your original spending decisions were made carefully.
In addition to making a point about marginal utility I made a separate point about only spending what you can afford. This is technically redundant since academically I could argue that a marginal utility calculation truly mirroring real life could award a negative result to purchases that will harm your business. This is unnecessarily anal and tedious so I will instead say that your spending on the growth of your business must not be done at the expense of your ability to pay your bills right now. This means carefully mapping out your cash flow and achieving a current ratio that lets you sleep at night.
You will now make all your purchases according to the calculation of marginal utility that we will apply. For the most part you will rarely ever sit down and attempt to compute an absolute number for this. Marginal utility is only useful in this spending model when compared to other marginal utility amounts, and in general we are going to care about significant differences such as “an order of magnitude greater” or at least “double that of”. It would be quite futile to attempt to perform such a subjective calculation to any greater accuracy.
When looking at the marginal utility I define it roughly as “the purchase’s ability to make my business succeed in the long run”. Very simple definition, but measuring it is very tricky. I want to use the limited resources of my business in a way that will get me the furthest ahead of the game in the long run, meaning that it is best suited for my business to grow. Beware that timing is implicitely factored into this! A key mistake that businesses make is trying to grow too fast, straining resources to the point of financial collapse. Perhaps buying a fancy 3D sign for your new store will attract more customers in the long run and build strong brand recognition, but if it costs you 85% of your available marketing budget I guarantee you that is not your fastest path to growth (and will likely ruin you). When considering the long run effect of a purchase you also have to consider the short run effect to adequately calculate where this purchase will really lead your business in the future.
This model is effective and worth using because it helps highlight the tremendous difference in your return per dollar on various expenses - the very same problem that I highlighted at the start of this article. I mentioned overlooking critical expenses, those that would have provided me a tremendously high return on my money. Rather than seizing the opportunity of those expenses I made decisions that simply would provide a return, failing to always recognize the tremendous marginal utility differences involved. Since money is finite, choosing to spend it in one place necessarily forgoes spending it elsewhere at the same time (opportunity cost).
I recently upgraded my PDA to a BlackBerry to improve my ability to access the internet from anywhere. Despite the rather high monthly service cost, the device easily pays for itself multiple times thanks to the time I save not hunting for a WiFi access point when I need to reply to an e-mail urgently. It also allows me to compose e-mails in situations where my PocketPC did not thanks to the fully QWERTY keyboard. The marginal utility on this device is very high, but only because I am actually able to take financial advantage of the benefits that it provides. Had I bought this device when my business had first started I would have received very little time savings since the company was far less busy, but I would be paying the same high monthly fee. To add insult to injury that monthly fee would have been draining valuable resources that would be far more beneficial if devoted to printing business cards and attending client-gaining networking events. At that point in time the BlackBerry’s marginal utility to me would have been very low.
That’s all there is to it. I make the purchases that I would be crazy not to, so as to gain the most value from the money that my business invests in its growth. I don’t buy something because my competitors do or because it will be useful to me eventually (beware the trap of making a major expense on something you can get a good deal on now, but which you won’t need for a long time). Regardless of what the long-term prospects of my business my be, I recognize that at any moment I only have a certain amount of money to invest into it, and that money must be distributed to the expenditures that given my current business situation will have the greatest long run positive effect.
Bear in mind that this is primarily a mental mindset to condition yourself into using so that you do not fall prey to ill-conceived decisions or premature purchases. You can apply it in an Excel chart, but you can also run through it in your head while at the store. It is not something that should be scribbled out in long and dreary calculations on paper, as such time-consuming advice is rarely followed (see the lack of business plans for proof).
