If you follow pop culture even a little bit, you recognize the reference in our title to Ben Stein’s portrayal of the boring economics teacher in Ferris Bueller’s Day Off.
Like the high school class staring vacantly as Stein’s character explains the Smoot-Hawley Tariff and the Laffer Curve*, many of our clients fail to thoroughly consider economics, assuming that it is just financial calculations that should be left to the accounting department.
The scene works because economics is generally considered to be boring. Maybe this is because it is taught poorly, or maybe it has something to do with the terrible track record of macro-economic predictions. In any case, while most businesspeople have taken at least some economics, they tend to leave it behind at university like those nearly forgotten courses in psychology and sociology. Worse yet, many senior managers adopt the language of accountants when describing their businesses, sidestepping a real economic understanding of how their market and their business actually work.
Before we back up this assertion, let’s start with a definition. Microeconomics is the science dedicated to understanding how individuals and companies make trade-offs among scarce resources. Since nearly all-important decisions involve trade-offs and every important resource eventually becomes scarce, microeconomics is in essence a way of understanding how people and companies make decisions.
When it comes to the subset of people and companies that you want to be your customers, building this understanding is key. It is microeconomics that gives us the tools to unlock the code, building an informed and objective view of how customers make trade-offs. While there are other ways to describe how your customers make decisions, we would argue strongly that economic thinking is by far the best way to predict what they will buy when faced with a hypothetical set of options (e.g., how much business will we lose if we raise prices ten percent? How much more can we charge if we add this new feature? Accounting is silent on these topics).
To be clear, good accounting is important. We need an accurate record of how much we sold and how much profit we made, and certainly we need to accurately calculate our taxes. But accounting is historical, not forward looking. When we use accounting terms and assumptions to make projections, it can lead us to bad business decisions.
One example that comes to mind is the phrase ‘margin dilution.’ Managers trained in accountant-speak throw this term about as if it is always a bad thing. It is true that if your business model is not changing declining margins on steady sales are almost always bad; it is typically a symptom of either a loss of pricing power (commoditization) or increases in costs. But when it comes to forward-looking business decisions, ‘dilution’ is not the right way to think about it.
For example, if your base business delivers 12 percent operating income (OI), should you turn down a $1 billion order at ten percent OI because it will dilute earnings? With accountant thinking, the answer would be to avoid this order, but is that always the right decision?
A business leader grounded in economics might start by making sure that the cost was calculated correctly to estimate the profitability of this new order. Accountants love to allocate overheads and use average costs. But if this order is incremental, the right cost to consider is the ‘marginal cost,’ probably much closer to the true variable cost. Depending on the nature of your business, this may be very different than what is shown on the COGS (Cost of Goods Sold) line of your income statement, as this contains allocated fixed costs.
The next step is to frame the relevant options – the choice this hypothetical business faces is not ‘do I want this $1 billion order at 10 percent or another $1billion of base business at 12 percent?’ That answer is as obvious as that question is wrong. And certainly, if we can win the new business at a higher price and get the margin up to 12 percent that is good. But assuming that we have negotiated well, and the 10 percent reflects a ‘take it or leave it’ price, then the relevant question is “should I take this business that is available or not, and what will happen if I decline to bid and the business goes to my competitor?” This answer does not pop out of a spreadsheet, rather it requires an in-depth understanding of how customers and competitors think – in our words, what are their economics? How do they make trade-offs? What is their cost structure? Etc.
Some of the key differences in thinking like an accountant vs. an economist are summarized in the table below:
Economic thinking is the foundation of our approach to customer value and market segmentation. It is critical to understanding your markets and finding and prioritizing opportunities. If you are not thinking like an economist, don’t assume that anyone else is – said differently, economics is too important to be left to the accountants. The business stakes are high – if you fail to understand economics, you may find yourself asleep and drooling on your desk, while your competitors find new ways to add value for customers and gradually eat away at your market share.
*The back story is that the economics teacher character had very few scripted lines, but Mr. Stein, who is an economist (and a lawyer) in addition to being an actor, ad-libbed most of the lecture that made the final cut of the movie, and for many movie geeks, created one of the more memorable scenes is this iconic film.