How Pinching Pennies Can Kill Your Business
Most businesses operate to make money. We’re all for profits, but here’s how frugality can work against your small business or nonprofit.
The Horizons
Many business owners focus narrowly on how they can increase profits now, or next month, or next year. That’s understandable; concentrating on the bottom line can keep a business running and financially functional. But obsessing over short term profit can sink a solid business in the long run - or hinder future growth. This dynamic is often summarized as “being penny wise but pound foolish.”
Organizational leaders must balance short-term needs and long-term possibilities. Knowing when to be frugal and when to invest is critical to the trajectory of your business. Let’s examine some common missteps and the nuances of making sound financial choices.
Purchasing Decisions
Business owners make purchasing decisions at every turn. Buying parts, labor, goods, and services is part of the job. Evaluating quality and cost, often very quickly, with minimal data to inform those decisions is challenging. Shifting the focus to value is the key to making strategic purchases. Ask these questions to help analyze the purchase’s value:
Is this purchase directly related to our sales or is it to help our operations?
You can almost always place an expense into one of these two categories (or both). Purchases for components of your products or elements of your services (cost of goods sold/inventory and certain labor) are revenue related costs. Expenses for sales, promotion, and marketing are also in this category. Operational spending includes rent, repairs, most software, other labor, utilities, and the like. Bucketing expenses this way will help you evaluate the value of your purchase options. Not because you should always spend more on one and cut costs on the other, but because whether spending directly impacts your customers is the first step in answering the next questions.
IWhat is the upside/downside of this decision?
Once you have purchase options narrowed down, run the future scenarios for each. Look at the ‘cheaper’ options first: here you will save on cost but is there a substantial compromise on quality? Would you subsequently compromise your product/service, or would the limitations cause you another headache operationally? Next evaluate the more 'expensive’ options: you spend more here but could you then sell more, price higher, increase repeat customers/retention, or significantly improve operational efficiency? Finally, once you have the future scenarios mapped out, what is the difference in price and what is the expected financial difference in outcome. If the price difference is greater than the holistic future difference - buy cheaper. If the difference in total upside is greater than the price difference - invest in the premium option, it will be less ‘expensive’ in the long run.
How do we evaluate the hidden costs?
Secondary costs and benefits may be difficult to anticipate/estimate. Accepting that you will not have perfect information, or all the necessary information, is an unavoidable reality of business decisions. Not every expense has a direct correlation to profits or losses. When considering employee compensation, a position might seem relatively ‘unskilled’ so you can save by hiring cheap. But also consider whether there is a difference in ability that will affect your top or bottom line, whether better pay increases job satisfaction and therefore productivity, or if added employment benefits increase retention - reducing turnover and training costs. For software services, will the cheaper system necessitate additional manual labor and slow down other processes? For equipment, what is the expected lifespan of each option, how often will you have to repair or replace it? Often the “cheaper” option is more costly in the long run. Thinking through not only the apparent price and benefits but also the indirect expenses and outcomes will help you determine the true value of your options and lead to smarter investments.
The Bigger Picture
How you invest in your products and services depends largely on your offering strategy. If you aim to sell more by beating your competition on price, then it could make sense to spend as little as possible. But most small businesses are not competing strictly on price because larger businesses can almost always price lower due to purchasing power and supply chain efficiency (economies of scale). Most small businesses compete through service, convenience, and quality. To beat the competition, it is critical to invest strategically, buying not just at the lowest price, but at the highest value. Successful entrepreneurs evaluate the true cost and total benefit of every purchase based on both direct and indirect effects of those decisions.
An Example
In the second half of the 20th century, Boeing rose to become the most dominant aircraft manufacturer of its time. Through savvy leadership, engineering, diversification, and investments they became the leader in their field. But in the 2000s a new CEO from a different industry took the reins - he wanted to treat aircraft manufacturing the same way he had learned to lead an industrial energy firm: cutting costs to increase profits. The company soon outsourced fabrication of almost every major component of its new aircraft and sought to save by attaching new engines to an old aircraft model Production and sales soon slowed due to repeated delays. A decade later, Boeing suffered two major fatal commercial airliner crashes that could be traced back to the company’s cost-cutting efforts. Hundreds of lives were lost and hundreds of aircraft grounded for almost two years, and another major grounding five years later.
A move that aimed to save the airline about $5 billion in development and production ended up costing over $20 billion in direct expenses, fines, compensation, and legal fees. A dark story, but a reminder that pinching pennies on your rent, employees, or materials can cost a lot more in the long run.
