yet another thing they didn’t tell you in business school

Conventional wisdom holds that: Profit = Income – Expense. Formulas don’t get much simpler than that. Increasing income or reducing expenses increases profits. Intuitively, that sounds right and LOTS of business decisions are made on this basis. Stock analysts and the companies that pander to them love this formula. Announce significant expense reductions (perhaps through massive layoffs) and stock prices jump up in anticipation of the profits to come.

The problem is, this formula is nice in textbooks but a gross oversimplification in the real world. It pretends there is no relationship between income and expense and makes the implicit assumption that the other variable is being held constant. But that’s not how it works. The real interpretation of this formula is this: Increasing income while holding expenses the same OR reducing expenses while holding income the same increases profits.

Income and expense are connected in a very real way and cannot be completely isolated. Why? Income is determined by your customers, not by you. Let’s play with some “what ifs”:

What if you cut your inventory on hand to zero? Your overhead costs would drop tremendously. You’d save a ton of money and your profits would go through the roof, right? Nope. Your customers would get torqued off that you had nothing in stock and they’d go shop elsewhere. Cutting expenses cut income.

What about maintenance expenses? You’ll save a bundle by “deferring maintenance” for a year or two. Bingo! Except you’re going to have a hard time convincing your best customers to shop in a dingy, dirty, broken down building. They go across the street to your competitor’s modern, bright, clean store. Cutting expenses cut income.

What if you laid off all your employees? No salaries or benefits to pay – there’s a major expense gone. Big time profits, yes? No. Without employees to help customers it won’t be long before there aren’t customers. Cutting expenses cut income.

What if you just forced all your employees to take a pay cut or cut benefits? You’ll save some money then, oh yeah! Um, well, no. Disgruntled employees don’t take care of the customers. Your best employees have other options and they leave. Your customers are now consistently receiving poor service. Wait, I mean your former customers. Cutting expenses cut income.

What if you invest heavily in technology and facilities that make shopping easier, convenient, pleasurable, and more fun for the customer? What if you spend more to find, hire, train, and reward outstanding customer service driven employees? Is it possible that increasing expenses could actually increase income? Only if the variables of income and expense are in some ways interconnected.

It’s worth saying again:

Expenses and income are often directly connected. They are not independent variables because your customers determine your income, not you. Customers have choices of who they give their money to so income can never be assumed to be constant. If you cut expenses in ways that negatively affect the customer, your income will go down. Likewise, if you increase expenses in ways that positively affect the customer, your income may go up.

Some expenses are worth reducing, but all expenses are not equal. Choose wisely.

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