Sunday, May 15, 2022

The (False) Law of Conservation of Effort and Reward

Most people seem to think within the framework of a supposed "law of conservation of effort and reward" (LCER) and its corollary "law of conservation of happiness". One might think of these as a spin on the forever-popular and equally incorrect labor theory of value. 

The thinking goes that somehow there should always be a linear and somewhat direct trade-off between work/life balance--that is, the effort one puts into something should be proportional to what one gets out, and there should be a trade-off between the chosen path and the "obvious" alternative path that together net out. Tightly zero sum. 

People resent the very idea that someone could have it all. The working mother should have delinquent kids who don't love her; the investment banker should long for relaxing weekends and be doomed to an unfulfilling life without meaning. 

The problem with these laws is that they conflict starkly with the magical human ability to tap the power of scale and compounding. The dynamics that these forces bring separate man from nature. Animals cannot coordinate nor plan for the future nor command exponential growth in any meaningful sense the way people can. 

Therefore, it should not be any surprise that some people and organizations can get more out of less and excel along multiple dimensions. In thinking about jobs, sometimes the grass is actually almost always greener

Consider how many people look to sports stars and other icons as “great follows” in social media making them big influencers succeeding in a realm outside of their primary area of success. Many adherents to LCER dismiss this as some obviously irrational behavior on the part of those less enlightened than themselves. The truth is these influencers probably are above average in ways that impact both the direct source of their fame (say basketball skills or acting ability) as well as many other areas. IQ becomes more and more important in sports the higher and higher the level. Dumb athletes don't last long at the pro level. 

Jeff Bezos would probably be an above average gardener. The reason he doesn't mow lawns and trim bushes isn't because he wouldn't be very good at it. He might in fact be better than the people who do the job for him at his own house(s). If you think he doesn't do those jobs himself because he is rich, you're right for the wrong reasons. The reason he doesn't is because of the very real law of comparative advantage

At the same time I think that some of what makes amazing people amazing often has a dark side. This might make them a bit eccentric or frustrating or detestable. It varies and is not always the case. This might sound like a contradiction, but I don’t think so. Rather it is part of the complexity and mystery of it all—what distinguishes elites. This is very much in agreement with point #6 here

Arnold Kling makes related points calling this the "convergence assumption":
What I call the convergence assumption is the assumption that everyone is fundamentally the same, so that it is more natural to expect people to develop the same skills and adopt the same values than for divergence to persist.
... 
We are not all the same. This makes moral issues very complicated. When we acknowledge genetic and cultural differences, what is the meaning of equality? When should we suppress differences and when should we accommodate them?
I think that the great appeal of the convergence assumption is that it allows us to avoid the challenge and complexity posed by these problems. But avoiding complexity is not a good approach if the complexity is an important characteristic of the environment.

Exceptional people are generally and not just specifically exceptional. How this maps onto agreement with you will vary along dimensions of morality as well as taste among others. Those differences are not tradeoffs they are making such that in some cosmic justice sense you and they are on equal footing when all is balanced out.  



Saturday, May 14, 2022

Knowing Your Business Means Knowing Your Costs

[Sister post to The Accountants Can't Make You Rich; consider this the counterpoint to that post.

To understand your business, you have to understand your costs--at a total, average, and incremental level. Many small businesses that would otherwise be successful fail for lack of this understanding. Think of a restaurant that clearly has a sufficient level of customers but that nonetheless closes its doors permanently. 

To be sure, many businesses manage to stay alive and in some cases thrive despite anyone understanding their fundamentals, but these examples are rare and fleeting. More often what seems to be operators flying blind are actually people with some combination of magnificent instincts and great muscle memory honed by years at the treacherous helm. 

Truly understanding the underlying drivers of costs unlocks the ability to guide all manner of vital decisions: what to make and how much, how to shrink when necessary, where you can discount and where you cannot, where to expand operations and what to expect from growth, etc.

Cost per the relevant unit is as essential as it is boring to all but a few of us, an elite group who relish mastering the concept. The good news is there are only two difficult parts to that equation, but the bad news is the same. 

Cost is an elusive concept. Defining cost properly is where economics meets accounting. Here we must understand variable versus fixed costs, marginal versus average versus total costs, the thresholds of cost expansion/contraction (At what point of production must we build an entirely new production plant? If we shutdown a production line, how are costs affected?), cost drivers and probable variances, etc.

Defining the unit(s) that is relevant is the art of cost accounting. For example in hotels it starts with the units for sale as seen in the revenue metric REVPAR (revenue per available room). While there are other important metrics beyond that one in that particular industry, the available room is foundational since that is the essence of what a hotel is selling.* 

In defining the relevant units we must understand if the units are variable or fixed, if the units are fully or partially or not at all under our control, how the units behave independent of cost (think of seasonality, etc.), when certain costs (or revenues) do and do not apply to various units. In the last case consider a restaurant where the cost applied per table seat available might be separated from the cost applied per bar seat available even though we would still want to look at them in totality. Hence a mythical unit might be created to synthetically mimic the real units on an aggregate basis--e.g., cost per customer spot available.

Not complicated enough? Add in a dimension of time. Open a restaurant an hour longer each night--do your relevant units change? Cost certainly will. Depends on how you define units given the objective you're trying to actually measure. 

From cost we next need to know revenue from which point we can understand profit. Allow me to illustrate using a personal anecdote from my time as a financial analyst at a newspaper. 

One of the reasons I was hired was to understand the cost and revenue drivers as profit margins had begun shrinking in the industry. I like to say that a fat profit margin hides a lot of bad decisions. The newspaper industry was no exception. Quite a few things were able to be tried that once a thorough analysis was conducted turned out to not be as successful as expected or believed to be. This isn't a bad indictment per se. Success in business is built on a mountain of well-placed failures. 

Of all the things I was asked to do, I was never explicitly asked to determine the specific attribution of the company's profits--meaning what lines of business were profitable. Yet this seemed a natural thing to want to know. In fact it fascinated me. To everyone else it was obvious or uninteresting. They simply "knew" what was profitable. Profits were so big, heck, everything was profitable, right? That was intuitive to some but not to me. My intuition was the opposite--I knew that it would be highly unusual for everything that went into a bundled product to be profitable in the sense of direct attribution. 

There seemed to be two biases at work: a fear of knowing the answer (what if my area isn't profitable?) and a lack of critical thinking (look at how much revenue this generates/this is an essential part of the business; it must be profitable). 

Once I achieved a strong understanding of the company's cost, it became apparent that everything simply could not be profitable. There were vast differences in revenue by various business lines but very little differences in properly allocated costs. Applying revenue minus cost (i.e., profit) business line by business line would "use up" the profit before all the areas were covered. Before mentioning the areas that were profitable, a caveat is needed. The newspaper was a bundled product meaning everyone got the main section, the sports section, the monthly special sections, the inserts, the classifieds, etc. A point of near religious dogma in the industry was how vital nearly all of these components were to a successful bundle. So I was both risking heresy as well as producing an analysis that the very cost-conscious management team might misinterpret much to its own demise. Loss leaders is a very real and healthy business practice as is cross subsidization. But these concepts can also be co-opted to excuse bad mistakes were money is lost for no actual indirect gain.

Everything wasn't profitable. Out of nearly a hundred different product lines and sublines, only four areas accounted for 100% of the profit of the business: preprint inserts, national ROP ads (when a company like American Airlines ran a full-page newsprint ad), color ink (a big upsale item), and employment ads in the classified section. This meant all the other ads in the main, sports, business, and other newsprint sections including special sections were losing money. All the rest of the classified section outside of employment ads were losing money--ad areas like traditional for-sale listings, automotive ads, real estate ads, etc. The circulation revenue was not covering costs. Subscribers were not paying enough to cover the cost of delivery much less any content production. 

The entirety of this analysis was not a complete surprise to the seasoned people at the helm of the paper, but the details were revealing and eye-opening. To repeat and be fair, this did not mean that people like the guys selling automotive ads weren't adding value--they certainly were. But what they were adding was content value much like the guys writing the sports columns. The upshot was that a limited decision-making mantra could have been "How will it help increase preprints, national ROP, color, or employment ads?" If the answer was "it wouldn't", the right decision would be to reject the proposal.

Knowing cost is not easy; so a good deal of respect is owed the business people of the world who work hard to master it. This might start with the cost accountants I was slighting in the prior post, and it certainly ends with all those entrepreneurs, business middle managers, and captains of industry toiling away so cost is never unknown.





*There are always exceptions. Some hotels are selling experiences outside of the room itself. The room might not correspond tightly to variable costs or to revenue. However, usually even when there are multiple lines of business (think Las Vegas hotels), these still are broken down per available room as it corresponds to cost and revenue as tightly as any other unit.

Sunday, May 1, 2022

The Accountants Can't Make You Rich

In business cost per unit may be the ultimate metric. Accountants focus on in decreasing the numerator. Marketers focus on increasing the denominator. 

It is important to remember, though, that cost containment is not a growth strategy. Accountants almost never remember this. However, it is a necessary but not sufficient condition for long-term success. This is true of economies, firms, and individuals. In a future post I will explore this giving the importance of the metric its due.

You can't grow your wealth by harvesting investment losses--you can't just "write it off" after all. Reducing unnecessary costs is an important part of sustaining a firm, but it is not a complete recipe of a succeeding firm. This is why so many mergers and acquisitions fail to add value. Cost reductions through economies of scale are generally very difficult to realize, and even when they are realized, they are often temporary. Ultimately, successful mergers come down to realizing synergies for new growth without cost exploding. Compounding the problem of pulling off a successful merger (one that justifies the purchase price of the target being acquired) is that the hoped-for synergies prove in many cases to be imaginary and as often unforeseen at the outset--more luck than skill.

Looked at from a broader view, a society with high savings and poor investment will be an impoverished people who are soon forgotten. To be clear the alternative isn't simply live for today, but at least those of the Bacchanalia had a good time while it lasted. The miser who squirrels away his every penny under the mattress has nothing to show but a desire for yesterday's purchasing power.

The cost reduction impetus gets maximized in a recessionary environment. Firms and individuals tend to look inward in times of economic stress thinking more and more about how to voluntarily shrink to avoid forced shrinking. This can be both helpful and healthy. Yet taken to extreme, which can come quite easily, this becomes a self-fulfilling feedback loop. 

The cutbacks one should make are reductions in consumption. This is a lot easier at the individual and family level than at the firm level. Firms shouldn't have "consumption" per se. To the degree they do this is simply excess that should be trimmed away in any environment--easier said than done of course. Investment choices may and likely should change given changes to near-term outlooks. At the same time the risk of overcorrection is very great. 

An asset allocation should be largely immune to changes in the investment near term. The investors "going to cash", "moving to the sidelines", and selling out otherwise in times of stress in the financial markets are almost always making critical mistakes. Sometimes those mistakes are permanently devastating

Back to the general concept of keeping the accounting department happy, accountants usually aren't thinking in terms of calculus--only calculations. What I mean by that is they aren't looking at rates of change and the signs on the derivatives. Lest we degrade them unnecessary, the marketing department's version of calculations can amount to astrology mixed with magical wishes. At least the accountants are doing real math.

Those exaggerations aside keeping an eye on cost is essential. Focusing entirely on cost is deadly.