PSU Insight

The Importance of "Running the Numbers"

Calculating Project Costs

One of our first examples of “running the numbers” had, as one of its factors, the production cost of a CD. It probably doesn’t surprise you that the cost of production is important; but it may surprise you that, once again, the “obvious” answer can be the wrong one.

Here’s a real-life example. Several years ago, I presented a workshop over a period of several months to a group of entrepreneurs. The subject was writing business plans for small businesses, and each member of the class developed his or her own business plan as the course progressed.

One member was the owner and operator of a high-end pastry shop. She had been in business for about 5 years, and over that entire time her business had been almost profitable. That is, she managed to pay the bills, but every six months or so her husband had to throw a few hundred dollars into the business to make up for the shortfall.

He was very proud of what she was accomplishing, but he was also tired of her almost making a profit. So he insisted that she attend the workshop so she could fix the problem — whatever it was.

She didn’t think she needed to attend the class, because she already knew how to solve the problem. (It was “obvious.”) She knew exactly what she needed to do — she needed to buy a bigger oven so she could make more pastries, and she needed to be open longer hours so she could sell more pastries.

The way she saw it, she wasn’t making enough money because she wasn’t selling enough pastries — so increasing her volume was the solution to her problem.

I persuaded her to wait on implementing her changes until she could run the numbers. She didn’t like it, but I’ll give her credit — she did it! She calculated the costs of making her pastries, everything from the flour and sugar that went into the recipes, to the power to heat the oven. And she was shocked when she finally calculated her production costs —

She was losing about 1 cent on each and every pastry she sold.

Now, a penny loss on each pastry wasn’t noticeable. But it did add up, and that was why her husband had to reach for his wallet every few months.

Once she understood the problem, she had two possible solutions — she could raise her prices, or she could trim her expenses. After considerable deliberation, she decided that raising her prices would probably lead to a reduction in sales (due to local competition).

Consequently, she chose to cut her expenses. She shortened her hours of business, delaying opening until almost lunchtime. She also made a few other cost-cutting measures.

About 6 weeks later, she came into class with a smile that lit up the entire room! She had just run the numbers for the preceding month, and — for the first time in five years — she had posted a measurable profit. (She said her smile of joy was nothing compared to her husband’s.)

By running the numbers, it turned out that her “obvious” solution — increasing production — would have only caused her to lose money faster. The way that she increased her profits was to cut her expenses… by actually cutting back on her production!