The Modeling Kit

Annie didn’t have a clue. There we were a few years ago in a cozy restaurant just off Via Veneto in Rome and she had no idea why we were there. On this first day out of Boston, all she knew was that we were going back to daVinci Airport in the morning. Bound for where? The unknown.

An adventuresome spirit and blind faith (in me) had allowed my wife happily to survive five months, from Christmas to the end of May, knowing that we were going on an international trip that I had arranged, but not knowing where we were going, what we were doing, who (if anyone) we were traveling with, what clothes she should bring, etc.

That’s not to say that she didn’t ask questions or look for clues. Over the months of uncertainty, she managed to determine that we were heading east by air. Then I admitted that she could plan on our landing in Rome, but only for one night. “Rome?” she said. “For only one night? But why would we want to leave?”

After we gave the waiter our order that first night, I pulled out the itinerary. We were off to the Airport the next day to rendezvous with 40 other members of a university travel group for a seven-day yacht cruise along the isles and shores of Tuscany. Delight by Annie. Such a trip had never crossed her radar.

Everything turned out fine. We had wonderful weather, excellent traveling companions, the right clothes (not a slam dunk – I did the packing selection for both of us!), and an extraordinary itinerary. The model worked; Annie’s faith was rewarded.

The matter of “blind faith” occurred to me with a couple of my clients last week. Each of them is an organization in which key revenue sources have dried up, potentially creating significant losses this year and in the future. In each case, the first response was to say, “We’ll find the revenue elsewhere.” One, in fact, offered benign neglect as a solution: “We may have to run a deficit this year and hope that things will improve in 2007.”

The blind faith metaphor also applied to a start-up company of my acquaintance, one which offers a potentially very useful software service to real estate brokers and their clients. The founders have discovered a need and a want, and they have established a reasonable price to appeal to a large market. Appropriately, they have extended their cash flow forecast for several months to their presumed cash breakeven, at which time they expect that they’ll all breathe more easily, despite their modest salaries. With lots of hard work still to come, they’ll achieve this first stage. But they have little real sense as to whether their service will scale up to a point at which they will ever be able to pay themselves an appropriate wage.

Well-run organizations – even start-ups – don’t operate on blind faith. They each have an economic model which clearly describes the process by which they make money. A number of attributes constitute a good working model:

  • Revenue is not a plugged number – “The industry leader has 20% of the market; it’s not too much to expect that we can get 1% (or 2, or 5) in the next two years. So let’s budget on the basis of $2 million revenue in 2007.” Wrong. Reliable revenues get projected from the bottom up based on sales and marketing strategies, not from the top down based on needs.
  • Expenses will always rise, absent a disciplined effort to attend to the details of every invoice and to seek less expensive alternatives. So a model which simply extrapolates this year’s expense levels into next year without fixed-price supply sources is flawed.
  • Operating surprises more often than not have negative, rather than positive, implications. A good economic model allows for this by projecting efficiencies, productivity, quality, collections, retention, and so on at less than 100%.
  • The model is not immutable. As even General Motors has discovered, when the operating environment changes, the model has to change. The trick is to recognize when it’s the whole environment, and not just your slice of it, that’s changing. Plugging in to industry information sources through trade shows, trade publications, web stats, common vendors, and good old networking will test your modeling assumptions.
  • You – the modeler – are also not immutable. You can change, and your assumptions can change, based on your feedback loop. Don’t get so locked into your beliefs about the model that you misread the data when variances occur between your expectations (the model) and reality (the current results).

Blind faith gets in the way of all of these active modeling elements. Blind faith leads managers to avoid tough decisions, to postpone the inevitable, to hope for the best, and to treat objective issues subjectively. But hard data actually helps you make hard decisions, especially if you work from a well-formulated baseline. So…

Create a reliable economic model, which requires:

  1. That you know the key drivers of your revenue. You know what adjustments in sales and marketing will produce a desired result in the top line;
  1. That you have knowledge and control of the unit costs of your products or services, with overhead appropriately allocated;
  1. That you understand and anticipate the relationship between revenue and cash. Growing companies, profitable though they may be, are notorious consumers of cash;
  1. That you plan ahead for significant capital expenses – machinery and equipment, even a trade show booth – and the funding requirements that go with them; and
  1. That you play out the implications of a variety of “what-if” sensitivity analyses to identify your vulnerabilities.

It turned out that Annie’s faith in me wasn’t so blind after all. In fact, she’s ready to do it again, the same way, any time. In a similar fashion, proven economic business models replace blinders with binoculars and faith with facts.

You may not end up in the isles and shores of Tuscany, but neither will you end up in the swamp, fighting off the alligators and searching for Howe’s Bayou.

Alligator Bites

To expand just a bit on the non-immutable model of the auto industry:

“The comfortable [domestic auto-producing] situation changed abruptly when oil prices soared in the 1980s, and the Japanese gained a toehold exporting attractive, low-cost, fuel-efficient vehicles to America. Responding to that change and the subsequent surge in domestically produced Japanese nameplates…,” [Harvard Business School Professor Malcolm] Salter observes, “…comes down to this: How do you rewrite all the implicit, explicit, and inefficient contracts and relationships that comprise the U.S. [auto] industry? To complete the move from such a protected market into a wide-open hypercompetitive environment is a very difficult process.”

The old model “confirm[s] that difficulty, as GM and Ford close plants, cut jobs and production, and try to deflect talk of bankruptcy… [with] this most recent bout of bad news… ascribed to some or all of the following: excessive corporate bureaucracy, arrogance, and insularity; union obstinacy; exorbitant healthcare costs and retirement packages; bloated product lines and overcapacity; and, of course, globalization.”

Contrast the new model, described by HBS professor Kent Bowen: “The Japanese are very good at two things that are key to success in the auto industry: refreshing their products, and having the flexibility in their factories to do that quickly and economically.” Furthermore, Bowen says, Toyota “strives to use its labor force in flexible, creative, and collaborative ways.” And Toyota’s biggest worry, he adds, “is getting too big, too fast, which they feel would make it hard to find enough good managers, thereby jeopardizing the company’s legendary quality.”

– Quoted in the HBS Alumni Bulletin, March 2006 by Gary Emmons, Senior Associate Editor

Draining the Swamp

The web is full of sites dedicated to quantitative modeling. For financial analysis, one of the most comprehensive sites has been compiled by Matt H. Evans, CPA, of Arlington, VA.

The “Top Five” most popular files downloaded from his web page are:

  • Capital Budgeting Analysis (xls) – Basic program for doing capital budgeting analysis with inclusion of opportunity costs, working capital requirements, etc.
  • NPV & IRR (xls) – Explains Internal Rate of Return, compares projects, etc.
  • Free Cash Flow (xls) – Cash flow worksheets, subsidized and unsubsidized
  • Balanced Scorecard – Set of templates for building a balanced scorecard
  • Excel Workbook 1-2 – Set of worksheets for evaluating financial performance and forecasting.