There is an apocryphal story in accountant circles about Lee Iacocca’s first day as CEO of Chrysler. As the story goes, Mr. Iacocca’s very first act was to call in the Chief Financial Officer and ask how many day’s cash was on hand. The CFO responded that the company had 3 day’s cash available. Mr. Iacocca responded, “Where shall we spend it?”
Last week’s commentary “A Horrifying Revelation About Price” addressed more than one concern I have about our profession and touched off a flurry of comments. All of the responses were well thought out and worthy of reading. But they made me aware that I need to drill down a little deeper on my points.
The Iacocca Lesson
In a limited resource environment Mr. Iacocca understood the vital importance of optimizing his resources. Like most funeral homes, he knew the answer involved livelihoods. It was no abstract theoretical question. His query of the CFO understood principles I think are largely misunderstood in funeral service.
With so many funeral homes struggling to maintain the same profitability year over year (assuming they are profitable at all) it is vital that limited resources be used in ways that shorten and optimize returns. You can bet that there was a lot of demand for that cash among vendors and creditors. Iacoca knew they would rather get $1 than the ten cents they would get in bankruptcy court. So, he just blew right past them and wanted to know where he could get the fastest and highest return. He needed to make his dollars generate more dollars and quick. As John Horan observed in his comments to last week’s commentary, Iacocca knew he could not afford to: “Step over dollars to pick up nickels.”
Opportunity Cost
The need to generate more dollars from limited resources brings us to the central point of Mr. Iacocca’s strategy and one of my two points in last week’s article: this week I will address Opportunity Cost. This concept means that there is always more than one opportunity and what may seem like a good opportunity because “everyone is doing it” may not actually be the best opportunity. In my response to Colleen Ellis’ comments I observed that Pet Care might be a viable strategy for some practitioners (if, and only if, it generates more human calls). For others struggling to survive it could in fact be a fatal strategy. Fatal because it overstretches limited resources with insufficient returns to make the risk worthwhile.
Opportunity Cost recognizes that if you choose to invest resources in an option so that another option cannot be pursued because you have exhausted your resources then the difference in return of the lost opportunity must be added to the cost of the option you chose. An example might be that you have 3 different options for investing in ways that will improve your business as follows:
Option A Option B Option C
Investment $50,000 $150,000 $200,000
Payback period 7 years 10 years 4 years
Annual cash return $7,000 $15,000 $50,000
You choose Option B because everyone is doing it and it is less expensive and less boring. The actual cost of Option B would be as follows:
Investment: $150,000
Unrealized cash from Option C $ 35,000
Payback period for option B 10 years
Opportunity cost $350,000
less: incremental cost of option c ($ 50,000)
Actual cost of Option B $450,000
My apologies to accountants and economists. In order to simplify this illustration I have purposely ignored a number of other variables like the time value of money and risk.
To summarize this point:
- Warren Buffet and Lee Iacocca would demand that for every dollar invested an additional dollar beearned
- All options and opportunities should be weighed against other opportunities no matter how unsexy or boring they might be.
To illustrate further: During the 90’s it was common for funeral homes to invest in the neighborhood of $50,000 in upgrades to selection rooms anticipating significant increases in sales revenues. Interestingly, at the time, no one was investing even a fraction of that amount in staff training (an alternative investment option). Here is how I would have looked at that scenario.
Before Selection room upgrade Staff Training
Calls 200 200 205
Avge svce chge $2,500 $2,500 $2,750
Average Csket sl $2,000 $2,500 $2,500
Total Sales $900,000 $1,000,000 $1,076,250
Cost of Sales @ 17% ($153,000) ($170,000) ($174,250)
Gross Margin $747,000 $830,000 $902,000
Incremental margin $ 83,000 $155,000 Investment $ 50,000 $ 50,000
Opportunity cost: ($155,000-$83,000) $ 72,000
Less: Incremental cost of Option C ($ -0- )
Total Cost of Selection room upgrade $ 152,000
ROI 54% first year 310% first year
I think I know what Warren Buffet and Lee Iacocca would have done.
Post Script:
It was not my purpose to bash Pet Care but it stands as a good example of what might seem like a good idea but may not be the best idea. Investing $150,000 to generate unit margins of $125 or less on a stand-alone basis is one thing. But when you consider that investing $30,000 to $75,000 in a program that will train your staff in ways that will improve yield on existing customers whose margins are already in excess of $5,000 and improve services that will generate even more of those customers makes more sense to me.
