Simon sets me a puzzle
September 6, 2008
In response to my post about cost saving, Simon Wardley set me a puzzle:
For example, on one project I helped the client determine the end value (in this case revenue) of the user and showed that this vastly exceeded the cost. For every $100 of calculated sales, I would in essence be charging $10. Whilst the system was growing we were all doing rather well. Unfortunately, whilst the growth in users created more value (the $100 bit), they also created more costs (the $10 bit). A problem then occurred when it was realised that the total cost would exceed the original fixed budget constraint.
Now, amazingly, it is not that unusual for a value generating activity to be terminated because it has been too successful and the cost has exceeded the constraint. This usually occurs because no-one has been able to identify the value. However, you can also find yourself sitting there pointing out that every $10 of cost means $90 more gross income and yet still hear those dreaded lines:-
“we only budgeted a $100K for this project, we can’t exceed that.”
So I agree with Dennis on the shift from capex to opex, but I’d be curious to see what sorts of problems this then causes.
This is a common problem but one that I believe is readily solved. In Simon’s use case there is a clear ROI but on the other hand the company only wants to spend a given amount. Where Simon’s model fell over was in the beginning where he showed the calculations. What he doesn’t say (and I doubt was done) is whether a sensitivity analysis was performned to test whether his method was likely to gain more customers than the client had in mind. The results and subsequent problem suggest I’m correct. In other words, expectations were not set at the correct level and a discussion about the fixed budget never happened. Or if it did, neither side considered the consequences of a higher uptake.
On this occasion, I think Simon has come to the wrong conclusion but I do see a simple remedy. After all, if the expectation is an extra $1 million in revenues at a cost of $100,000 - who in their right mind is going to give up the potential for an extra (say) $200,000 in revenue. It’s $180K they didn’t have on the bottom line. That will delight shareholders and prove the risk based model upon which Simon priced to be one that absolutely delivers value. And not a penny wasted on capex.
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Hi Dennis,
You’re correct that the system was more successful than expected and there was an assumption made on our side was that “who in their right mind is going to give up the potential for an extra (say) $200,000 in revenue. It’s $180K they didn’t have on the bottom line.”
That assumption however is not always correct. The problem is that $180K on the bottom line also causes $20K in costs that hadn’t been budgeted for. When people have targets for budgets then the $180K on the bottom line can soon get dropped in order to reduce costs by $20K and keep within budgets.
I’ve seen this more than once and it drives me nuts every time.
[Reply]
Agree with Simon, Dennis. I also agree with what you’re suggesting, but the sort of logic-free zone that Simon describes is all too common. Apalling, but true. It’s like the power companies, not being able to absorb electricity back from the edge — in the example Simon describes, the extra revenue is literally more trouble than it’s worth (for the “deciders”, not the shareholders, of course, who will never know). The system isn’t designed to handle it.
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