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:

1. Devote your cash to the items that will bring you the greatest return (highest marginal utility per $ spent).
2. 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).

First year micro and macro economics have been one of the most genuinely educational university classes that I’ve taken. I enjoyed them so much that I tutored both courses while I was still taking them. Regardless of whether you are a business, philosophy, or music student, getting this knowledge under your belt is useful for more than just a better understanding of CNN.

One concept I especially enjoy is opportunity cost, which I’d like to explain quickly and then dive into why I love it. I’ve applied it to my business planning, philosophy, and choosing directions in my life with great success.

The Theory

Opportunity cost is just a way of measuring the true cost of something by looking at your next best alternative. Its power comes in not being limited to measuring cost in terms of money, allowing you to take into account significant factors that are difficult to quantify in dollar values. For example if I choose to take a business class as an extra credit for the term, I am foregoing the use of $500 tuition and 6 hours per week that I could use for funding and working on my venture, or broadening my horizons by learning something that isn’t already my main subject. My opportunity cost would be the most valuable way I could have used that time and money (the two things I identified here as being my costs).

The Real World

Like most really useful lessons, opportunity cost seems critically obvious yet isn’t applied often. It’s just a way of approaching a problem or looking at things, so who cares. Well changing the way you think is your greatest key to success, a lesson that Yaro Starak and Pamela Slim both hit on today (Mondays are great days for blogs).

Allowing myself to think in terms of opportunity cost has made it possible to gain perspective and sanity over some tough decisions. Thanks to the next best alternative idea, it’s possible to view a choice based on its cost in relation to the benefits of the other choice rather than attempting a pros/cons approach that separates benefits from cost (and requires looking at four sets of points). Let’s see why this works.

I write about entrepreneurship often as it’s my passion and this is an entrepreneurship blog. So let’s take the example of Bob starting a new business vs working a reasonably interesting job.

By starting a business Bob will forego:

• $50 000 per year salary ($700 000 in ten years, taking raises into account)
• Purchasing a cottage anytime soon (the money he saved for the cottage will go towards the business)
• Traveling around the world on business
• Not working after 5pm and enjoying lazy weekends
• Low risk of retiring poor
• …

By choosing the job Bob will forgo:

• Ownership of a business projected to be worth $1 million by year 10
• $25 000 per year salary for the first five years (based on projected earnings and re-investing non-essential money into the business)
• Turning his woodworking hobby into a way of life as he’s always wanted to
• The only realistic chance of owning a Ferrari (Bob’s dream car)
• Early retirement
• …

Based on Bob’s priorities and philosophy on life some of the above costs will seem much greater. I find that when major decisions are put in this form I can immediately perceive a difference in cost, even if I can’t quantify it all in dollars. Since each decision is framed in terms of forgoing the other’s benefits, the perceived lower cost decision is automatically the right one (at least if you’ve identified all the major factors).

This same process can be applied for anything from choosing a university program to deciding how to best spend the morning. In theory you could apply it to everything, but I prefer to use it as yet another tool and to apply opportunity cost where I find doing so is natural.

The internet continues to grow at a rapid pace, not only in terms of the amount of websites online, but also internet use and business done online. A very natural and good thing has happened as a result - the cost of “space” on the internet has gone down. Virtually everyone wins in this situation, with the exception of those attempting to make money in the web hosting business.

Having operated websites long enough to be complaining about web hosting costs in 1999, and also having headed a web hosting business that is alive 3 years later and now part of my Tilted Pixel venture, I’m going to take you on a tour of the web hosting industry and show you what happens when you choose to start a business that is snowballing towards commoditization. If you know what web hosting is skip the next two paragraphs and jump right in, otherwise I have a little intro to help you along.

In case you aren’t completely familiar with how internet services work, the internet is literally run by a whole bunch of computers. Some computers at the very top of the hierarchy hold the whole thing together, but beyond that anyone with a computer and internet connection can not only go online, but they can also make their computer a part of the internet by providing services such as a website. By providing services your computer is now deemed a server. This architectural quality of the internet is great because it allows anyone to contribute and makes it very difficult for any single entity to assert control of what the internet contains.

If you are running a website you typically don’t want to run it on your machine due to the administration involved, high bandwidth requirements (a cable modem doesn’t stand a chance), and increased hacker risk, so you purchase a set amount of space on a machine run by a hosting company. Reputable hosting companies have special equipment operating in data centers - large facilities with incredibly high speed connections, redundant power systems, and 24/7 technical staff.

The Business and Economics Behind Web Hosting

Renting space on a hosting company’s server 10 years ago was far more expensive than it is now. This is primarily a result of the fantastically decreasing costs of computer equipment powerful enough to operate a website server and the shocking price cuts in bandwidth itself - the cost of actually being hooked up to the internet pipes capable of handling web server traffic. Alongside this a host of web server administration products was released and evolved, making it far easier than before to operate a web server.

So prices fell and hosting became cheaper. Why the hell are you boring me with this Matt? Well these price cuts and user-friendly software eliminated the barriers to entry, an economics and business concept defining the obstacles to entering a certain market. These obstacles include everything from government regulations, cost of start-up equipment, patents held by competitors, special expertise, etc.

The brunt of this occurred several years ago when the cost of renting a web server suddenly plummeted drastically. At the heart of this was Server Matrix, a new venture by capital-heavy Texas company The Planet. Leveraging economies of scale and an aggressive growth strategy, Server Matrix pulled a Walmart and started renting web servers at insanely low prices. The rest of the major providers quickly fell in line behind them and began providing the same. The funny thing is that by this time computer technology was advanced enough that these new cheap servers were more powerful than far more expensive web server equipment bought two years ago.

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