What’s your magic number?
The world we face is chaotic, immense, even overwhelming. Facts and misinformation come at us like the roaring gale in a hurricane. Standing up and growing a successful business or other entity in this ongoing maelstrom is a big challenge. No wonder 20% of new businesses fail during their first two years of life, 45% during their first five years, and 65% during their first decade, according to the U. S. Bureau of Labor Statistics. The path to success is, at best, uncertain and changing, and, at worst, block by obstacles and shrouded by fog.
We use shortcuts
As humans, we are programmed to use heuristics, that is, mental shortcuts, to enable us to act without knowing all that could be known and taken into account to shape our actions. Examples of heuristics, which I write about in my book, BIG DECISIONS [1], include:
The familiarity heuristic, believing that our behavior is correct if we have done it before.
The representativeness heuristic, judging the likelihood of an occurrence by matching it with a category or past circumstance.
The availability heuristic, basing judgments on available information.
The scarcity heuristic, enlarging the value of opportunities that we perceive to be limited and competing with others to obtain them.
The commitment heuristic, our tendency to believe that a behavior is correct to the extent that it is consistent with a prior commitment that we have made.
The social proof heuristic, our tendency to believe that a behavior is correct to the extent that other people are engaged in it.
The attractiveness heuristic, attributing socially desirable traits (e.g., altruism, warmth) to attractive (vs. unattractive) individuals.
The sunk cost heuristic, considering the sunk costs of an activity – instead of its future costs and benefits – when deciding whether to continue the activity.
The affect heuristic, relying on our emotions, rather than concrete information, when making decisions.
The be fair….in the middle heuristic, making decisions that "split the baby" and are sub optimal in the effort to be fair to both sides.
The zero-sum heuristic, intuitively judging a situation to be zero-sum (gains and losses are correlated).
The wrong path?
Using heuristics can move us ahead…or lead us down the wrong path. That’s because a thinking shortcut does not consider all the evidence nor does it consider all the possible actions and their potential consequences. Nonetheless, despite the risks that using heuristics pose, we need to rely on them because we can never know all the facts, all the possible roads, nor all the possible outcomes.
We use the heuristics listed (and those that aren’t) subconsciously as part of our routine decision-making process. The wisest counsel I can offer to limit bad outcomes from subconscious use of heuristics is to slow down your decision making when you recognize that you are faced with a big decision. By pausing, stepping back, and then kicking in the logical, analytical part of your brain, what Nobel prize-wining psychologist Daniel Kahneman calls System 2 [2], you are less likely to make the immediate jump to less informed and ill-reasoned assessments, judgments, beliefs, and decisions that unconsciously applied heuristics can produce.
Further, I suggest that developing and using consciously-applied heuristics, what in other settings might be called rules of thumb, can be useful, both for focusing on what is likely more important for decision making success and for unsticking and speeding up the decision-making process.
Here are examples from my business life:
When I was a magazine editor, my first boss introduced me to the “ad/ed ratio,” that is, the ratio of magazine issue pages that contained editorial content to those that contained advertisements. The “magic number” he observed and I subsequently applied for the years in which I was a magazine editor and then publisher was 50/50. That is, if the half of an issue (“the book,” in publishing parlance) was editorial and half was advertising, this balance would deliver sufficient net income after expenses and would leave the reader satisfied with sufficient editorial content.
As a consultant, my value is a mix of my expertise and the time that’s needed for me to apply it to produce results for the client. An easy, rule-of-thumb way to determine the fee to charge a client for an engagement is to multiply my hourly rate - however I have developed it - by the estimated hours that client work will require.
When I ran the American Fence Association, I learned from the best contractors that a magic number for them was their close rate on job bids. If they won more than, say, two-thirds of bids, that told them they were underpricing their work and that it was time to raise prices.
As a coach, for my for-profit clients a magic number typically is net margin, that is, the percentage of top line revenue that remains after all expenses but before taxes. For all of U.S. business, average net margin is around 9%, but that varies widely by business sector. Most times, we zero in on what will be a healthy net margin for the client’s business sector as their magic number.
You can see how focusing on your “magic number” can dramatically simplify the challenge of growing a successful business. If you are a magazine publisher, tend to the ad/ed ratio. If you are a consultant, make sure your fees appropriately compensate you for your time. If you are a contractor, keep track of your close rate on bids to assure that your pricing is correct. If you run a business, manage to your net margin target.
However….
Beware bad outcomes!
Just as with subconscious heuristics, using conscious heuristics - rules of thumb - can lead to bad outcomes if care is not taken. For my conscious heuristics examples:
The ad/ed ratio target of 50% presumes that advertising pricing is sufficient to cover expenses and achieve the net margin target if 50% of the book is advertising. But if rates are too low, then this “magic number” won’t deliver the desired balance of sufficient revenue and sufficient editorial. Even if rates have been properly set, a change such as soaring paper costs that drives up expenses can negate the validity of the rule of thumb.
The validity of the consulting hourly rate times hours required rule of thumb for fee setting presumes that both my hourly rate is competitive, that it is not so high that I won’t get the business, and that it is not so low that it won’t give me sufficient income to make a profit and meet my net margin requirements.
The winning bid ratio rule of thumb works when margins are sufficient and the appropriate work is being bid on. If the contractor is bidding on work that will not cover expenses and deliver the needed margin, then the share of bids that are won is not the relevant metric. The contractor either needs to streamline operations and reduce expenses or bid on work that will produce higher margins.
Managing net margin to meet a target seems straightforward, but just focusing on this “magic number” can produce sub-optimal results. It’s possible to construct a very high net margin business whose absolute profits do not meet the needs of the owners and whose impact on the market is negligible. Also, a company that attains high margins by underinvesting in people, automation, training, controls, etc., may be setting itself up for failure in the longer run, in essence, digging its own future grave.
No question, simplification is essential in developing a business. Nobel prize-winning economist Herbert Simon wrote [3], “We humans spend most of our lives making decisions that are far beyond any of the levels of complexity we can handle exactly.” We face “situations that are complex and in which information is very incomplete i.e., virtually all real world situations.” We are best served “by finding optimum solutions for a simplified world, or by finding satisfactory solutions for a more realistic world.”
Organizations are systems
Indeed, relying on a “magic number” may make management’s job easier. But the devil is in the details. Relying on a consciously applied heuristic without understanding that organizations are systems invites undesirable outcomes. When using a “magic number,” consider the possibility of:
Second-order effects. Josh Kaufman, author of The Personal MBA, explained [4], “Every action has a consequence, and each consequence has another consequence. These are called Second-Order Effects. Every change you make to a system will have Second-Order Effects, which may affect the system’s functionality.” Be careful!
Exponential results. “Sometimes it can seem as if drastic changes happen at random… [This] can be explained by the concept of critical mass, “ explained the Farnam Street blog. [5] “Also known as the boiling point, the percolation threshold, the tipping point, and a host of other names, critical mass is the point at which something (an idea, belief, trend, virus, behavior, etc.) is prevalent enough to grow, or sustain, a process, reaction, or technology. The result is often…non-linear, or exponential.” The overloaded supply chain in the Pandemic can be seen as a result of critical mass. Kevin Indig of Shopify, wrote [6], “Effect is rarely proportional to cause. Complex systems can cross ‘tipping points’ that cause dramatic and often irreversible changes in their behavior.”
A magic number is not really magic. It’s a tool. Use with care.
Footnotes
1. Crumbaugh, L., BIG DECISIONS: 40 disastrous decisions and thousands of research studies tell us how to make a great decision when it really matters. Forrest Publishing, 2022.
2. Kahneman, D., Thinking, Fast and Slow. 8th edn. Farrar, Straus and Girou, 2011
3. https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1978/simon-lecture.pdf
4. https://www.techtello.com/second-order-thinking/
5. https://fs.blog/mental-models/
6. https://www.nbs.net/articles/making-systems-thinking-more-than-a-slogan
