Choices, choices

22 November 2014
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Categories: Dollars & Sense

Quick, what do these have in common?

  • A car
  • An animated mouse
  • A smart phone

At one point in time, each was only an idea that was in the mind of a person: Karl Benz envisioned the use of the internal combustion engine for vehicles, Walt Disney conceived of Mickey Mouse, and Theodore Paraskevakos originated the notion of combining data and communications in devices, which came to fruition decades later in the form of the smart phone.   And for each person, the idea turned into wealth, which was the topic last week.

But as I look around at my fellow entrepreneurs, it seems that our ideas exceed our capacity (not ability, but capacity) to actually execute, which leads to the question: which idea do I actually act on?  Or do I try to do all of them at once?

Well, I think the answer to the second question is easy: it’s better to accomplish one thing at a time quickly instead of working on numerous projects slowly.  For one thing, we realize the results of the project sooner, and that gives us more time or money quicker.  Not only that, but emotionally we feel better, more accomplished, and satisfied when we see one thing crossed off the list.

But what about the first question–which one do we actually do first?  Well, I think that’s easy too: do the one that makes the most money in sales or by money saved.  What is more difficult is actually figuring out which will make the most money.

Fortunately, the discipline of finance can guide us in making that decision.  We have a number of tools that can be used, but since my goal is to give a simple solution that you can use quickly, we’ll look at Return on Investment, abbreviated as ROI.  Put simply, ROI is calculated on how much are you put in, and how much will you get back.  I’ve seen a several different ways for calculating this, but the most common is (Return – Investment) ÷ (Investment).  Let’s take a look at some examples of how to calculate, starting with easy / obvious to more detailed applications.

1. If you have a spare $100,000 around, and your mutual fund says that the average return is 6%, you invest it for a year, and sure enough, at the end of the year you have $106,000:
ROI = ($106,000 – $100,000) ÷ $100,00
ROI = 6%
Make sense, right?

2. Now, let’s say that you have the same $100,000, but a friend asks you to lend it for 15% interest, and they’ll pay back at the end of the year.
ROI = ($115,000 – $100,000) ÷ $100,000
ROI = 15%
Still makes sense, right?

3. Now let’s get a little more advanced.  Let’s say that your a service firm that would like to raise prices, get better contracts, and think you can do so without hiring additional staff.  Your sales are currently $5,000,000.  You are thinking of hiring a sales manager whose $70,000 wages, payroll taxes, benefits, and expected annual performance bonus add up to $100,000.  You believe that they will be able to increase revenue 5% in the first year.
ROI = (($5,000,000 * .05) – $100,000 ) ÷ $100,000
ROI = ($250,000 – $100,000) ÷ $100,000
ROI = $150,000 ÷ $100,000
ROI = 150%
It would make a lot more sense to hire the sales manager, wouldn’t it?  And that’s just the beginning.  We haven’t talked about cash flow timing (you won’t pay the sales director $100,000 at the beginning of their tenure), long term impact of sales, or risk (how long will it take for increase revenues to kick in, and what if they don’t have a strong impact?), which are factors in more complex financial decision making tools.

I could give a lot more examples of this, but don’t want to go on forever.  My point is this: You need to have some way of choosing the order of your projects, and this a good, understandable tool to use.  I’m actually using this technique to go through my list of projects right now to figure out where I need to start.  The artistic side of me has too many ideas, and I need to get clarity before diving in and tackling them.

For fun (and wealth!), go back to your list of ideas listed from the prior post.  By each, write down how much money you should be able to generate and how much it will cost.  If you are consider how much you will gain / save in time, then the cost is going to be how much you (or your staff members’) earn per hour times the number of hours in question.  Then do the math: (Return – Investment) ÷ (Investment), and see which one will get you ahead financially.