By definition, managerial decisions are choices between at least two alternatives. For example, should I hire another salesperson or not? In order to compare the profit impact of various alternatives, we need to use what-if analysis. The results of such analysis are never right or wrong, but enable a discussion about the most critical variables to be considered.
- By definition, managerial decisions are choices between at least two alternatives. For example, should I hire another salesperson or not? Should I open three branches or five? Should I buy the new machine, outsource the production, or buy a production company? In order to compare the profit impact of various alternatives, we need to use what if analysis. For this I will share with you an experience from my family's restaurant business. Together with my three siblings, I pretty much spent my childhood at table 11, watching my parents running the business and trying hard to keep us busy with all sorts of chores.
While the restaurant was well-known in the region, advertising was important to attract new guests and to invite back our loyal customers. My father spent about 20,000 francs per year on all advertising, including flyers, newspaper ads, and events. We had about 5,000 guests who visited the restaurant an average of six times per year with an average consumption of 30 francs. In addition, my parents hosted about 80 parties, weddings, birthdays, anniversaries, with an average bill of 3,500 francs.
The margin for the parties was 40%, and for individual guests it was 30%, mainly because party guests consumed more alcohol because they did not have to pay the bill. In order to increase profitability, which would finance the children's education so that they can get a PhD and become famous authors on this site, my father had several options. He could spend 5,000 francs more to get more customers, or he could spend 20,000 francs more to get even more customers. He could reduce the advertising budget and hope the guests would come to the restaurant anyway.
Or he could do what Swiss people typically do, wait and see and hope for the best and that nobody gets hurt. (laughs) In a more economic perspective, the question is, what if I spent 20,000 francs more on advertising? How customers do I need to win to increase my profit? Let's calculate first how many additional customers he must win to cover the additional 20,000 francs. If the advertising costs go up by 20,000, 371 more guests are required.
Please note that we do not consider the long-term effect of this advertising. In reality, the additional guests will also be profitable in future years. What if the advertising is targeted toward the party business? How many more parties do we need to cover the additional expenses? With 94 parties, the profit stays the same. The calculation shows that with 95 or more parties per year instead of 80, this budget increase is profitable. In the real world, is it most likely that advertising effects both segments, individual guests and parties, and that there is a positive spillover effect.
Some party guests will become regular patrons, and some of the new individual guests will choose our restaurant for the party. So let's do a mixed calculation. If we spend 20,000 more on advertising, we need to win 186 new guests and host seven more parties to be more profitable. I think this example is so simple and easy to understand that we run the risk of underestimating a very important principle here. Economists try to identify the relevant variables, define the relationships among them, and then figure out what happens if one variable changes.
In our example, my father could have asked different what if questions. What if I increase my advertising costs? How many more visits must I generate to increase profit? He could also ask, what if I give special discounts? It would reduce my margin, but will increase my customer base and the frequency of their visits. In any case, in order to make better managerial decisions, we need to have clarity of how the different variables are related before we can calculate and compare different scenarios.
What if scenarios are an excellent way for managers and entrepreneurs to evaluate their options. I suggest that you never make a financial decision before doing a few what if analysis.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action