Subject line: [Flawless Financials] The 80-20 Rule for Models Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode January, 2003 Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: The 80-20 Rule for Models or One Mile Equals One Mile * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * The comedian Steven Wright tells this joke: "I have a full scale map of the United States. One mile equals one mile." I see it all the time. People come up with a financial model that is way too detailed. (Of course, some people have barely any financials at all, but that's another topic.) You've seen these models: there are 25 different components to revenue where there should be four lines. Each of ten departments has 16 lines of expenses. The ten-year model actually has 120 months of detail, so as to delineate expectations for October 2012 from November 2012. This newsletter focuses on how certain details disguise the truth. If you want to estimate expenses for a business, isn't there a better way than listing every expense you can imagine and trying to guess how much you'll spend on that in every month? Of course, and you do it all the time: you might project expense per employee and multiply by total headcount or you might project revenue and budget a reasonable operating margin. First the big picture has to make sense, and then you develop a case to support it. Having hundreds of details doesn't add to your credibility because people need to get the gestalt before diving into the details. These details need to be grouped into a handful of major expenses you can easily explain. This phenomena occurs because you're dealing with people. Listen, if computers ran the world they'd love all the detailed forecasts. Phone numbers started out at seven digits because that's all people can keep in their minds at once. Likewise people can't handle lots of detail in financial models. They begin to feel uncomfortable. What they want is to know that they really get it. This is the essence of Steven Wright's joke. A full scale map is useless! Like a map, a model must be an abstraction, a simplification of the real world. There necessarily has to be less detail in financial forecasts than accounting actuals. The art of developing an effective model is in knowing how to achieve less detail. How do you give people information in 5-piece chunks when you really do have 25 line items? Here's where we bring in the big guns: the 80/20 rule. You see it again and again: 80% of the revenue comes from 20% of the products, 80% of the expenses come from 20% of the functions, etc. It's true in your business, too. (And if you think it isn't then call me or write, because I've found valid 80/20s all over the place, and it would be refreshing to find the counter-examples.) In the last three months, I have had clients: -- where 93% of the revenue came from one line item, but their income statement showed 15 lines of revenue detail --that boasted 35 products but in the end we forecasted four --with 200 lines of expense which we boiled into six There are always people who object to simplifying things. "That's how it really is" remains their rallying cry. True, that's how it really is. But that doesn't mean it should go in the model. If everything true goes in, one mile equals one mile. From my perspective, it's more important that it correspond to reality in as simple a way as possible. Way back in the 1990s there was a little RBOC called Pacific Telesis. The Telesis/PacBell/PacTel culture was very model- oriented, and this was true for the Telesis Tax department too. Telesis tax had a 4.0 megabyte model--that was big in 1991--and all it did was calculate the tax rate the company would face. But in Telesis Corporate Development, we just used 40%. For corporate development purposes, what should we have done? Should we have interfaced with the 4M tax model to determine the exact tax rate that the project would face? Of course not, we used 40% and the board never questioned it, nor should they have. Everything can become infinitely complex. Your job in creating a financial forecast is to visualize what the big moving pieces are and bound the problem. When the categories are the right size, you're able to see all the pieces in relation to each other. Then if you scale any one of them properly, they all scale well. Until next month, all the best, David Brode – Minotaur Financial Helping Companies Create Better Financial Forecasts * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * To find out more or see if I can help with your financial forecasts, call me to discuss your issues at no charge: (303) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2002 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net" * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. Your feedback is always welcome and appreciated. Write in to mailto:feedback@brode.net. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * PRIVACY POLICY: I never rent, trade, or sell my email list to anyone for any reason whatsoever. You'll never get an unsolicited email from a stranger as a result of joining this list. To SUBSCRIBE FREE to this newsletter, send an email to mailto:subscribe@brode.net. And you'll get Minotaur's Financial Forecasting White Paper in the deal. To be REMOVED from this list, send an email to mailto:remove@brode.net. (Please note that this message needs to come from the email address that originally subscribed. If you need help determining this, please email mailto:David@Brode.net.)