Are you familiar with the Butterfly Effect?
Here is one of many variations: “When a butterfly flaps its wings in one part of the world, it can cause a hurricane in another part of the world.”
This quote is a brief summary of chaos theory. In simple terms, a small change in one state or condition can cause a large difference in another later state. What does this have to do with business?
Actually, quite a bit.
Let’s begin with a real-life example:
Joe looks at his checkbook and realizes he soon will be short of cash. He decides to unleash a promotion to bring in additional sales. The ads go out, and the results are beyond Joe’s expectations.
Unfortunately, the results are not quite what Joe anticipated. Sales did go up, but so did accounts receivable and expenses. You see, not all customers paid cash.
Instead, they charged on their account and will pay off in the 60 days or so that it takes Joe to collect his receivables. Labor costs went up since Joe needed additional staff to handle additional business. And, of course, advertising and marketing expenses were up.
Lest we forget, these additional sales were not as profitable as regular sales because Joe heavily discounted prices to promote the event.
Joe changed one condition: He added an additional promotional event with the goal of increasing his cash on hand.
He perceived a straight-line relationship between the ads, the sales and his additional cash. However, the relationship was not straight-line. A number of conditions were affected, and the result was a decrease in expected cash from the promotional event.
Although this is a simplified example, it accurately represents the results of every business decision. There are many moving parts to a business. Changing one part will affect others, and the effects often are not considered in the initial decision.
The more complex or far-reaching the initial decision, the more complex and far-reaching the result will be. If you ever have faced a cash-flow problem and decided to rectify the shortage by increasing sales, you have shared Joe’s problem.
Did it solve the problem short-term only to become more severe as the effects on other parts of the business machine became apparent? That is the result far more often than not.
It’s probably easy to agree with the premise of this column; it’s undoubtedly more difficult to figure out how to benefit from it. Here’s a beginning point: More sales is not the answer to every business problem, at least not without considering the full effect.
In Joe’s case, his cash on hand probably would have increased more rapidly and with less effort if he had looked at his 60-day accounts receivable cycle and worked out a plan to bring it down to 45 days and ultimately to 30 days.
Software models can help you to understand the effects of financial decisions. Among them are liquidity analysis models, required sales level calculators and various financial projections templates.
Bowser@BusinessValueInsights.com. Dan Bowser is president of Value Insights, Inc. of Chandler, Arizona, Durango and Summerville, Pennsylvania.