Running a business involves a certain amount of risk. Whether you're starting a business or launching a new product line, you need to know you're not taking a bigger gamble than you can afford. Economic analysis looks at the potential costs and profits of your business decisions and gives you an idea of which way to go.
TL;DR (Too Long; Didn't Read)
Economic analysis starts by raising a question, such as whether expanding production will increase sales revenue. To answer the question, first gather data about projected costs and revenues. Weigh them against each other and decide if your net profit is enough to justify expansion.
The Use of Economic Analysis
As a business owner, one of your goals is maximizing your profits. Whether you're looking at starting a company, expanding your workforce or launching a new product line, you need to know what it will cost you, what the potential revenue is and whether you'll gain enough to justify forging ahead.
Even if you're already experienced in business, eyeballing the situation and going with your gut is not the best tactic. The use of economic analysis is that it crunches numbers to give you hard data you can use for an objective assessment:
- What are your fixed costs? If you buy a new factory, for instance, your fixed costs include the mortgage, insurance and property taxes.
- What are your variable costs? The more workers you hire, the more salary and benefits you have to pay.
- What are the marginal costs? Suppose you're thinking of hiring new workers to ramp up production. Economic analysis may show that hiring a dozen will maximize your production; hiring more people than that results in a slight increase that's not worth the added variable costs.
- How much should you produce? Your ideal output depends on how big you think the market is. It's also affected by the cost of raw materials, manufacturing and storing your inventory.
- What are the alternatives? It's rare in business you have only one possible path forward. Opportunity cost is a measure of how much a decision costs you in terms of giving up alternatives. For example, what's the effect of expanding sales into a new territory, rather than increasing sales in the territory you already have?
- Cost-Benefit Analysis. Suppose you currently make your company's widgets in your own factory. A cost-benefit analysis asks how much it would cost to outsource manufacturing vs. how much you'd benefit financially by shutting the factory.
- Cost-Effectiveness Analysis. Even if the financial benefits of shutting the factory outweigh the costs, it's possible your own workforce would be better at producing a top-quality, defect-free widget.
- What does the external economic environment look like? Current trends and economic measurements influence whether consumers will participate in your new business venture.
Steps in Economic Analysis
There are multiple different methods, formulas and approaches for making an analysis. Whichever approach you go with, however, the same basic steps in economic analysis apply.
- Define your scope. The use of economic analysis involves multiple related factors. For instance, the costs of increasing your workforce vary depending on whether you expect to use full-time employees, temps or foreign workers on visas. You may need to narrow the number of factors you consider to get usable answers.
- Gather data. If you're opening a new restaurant, you'll need projections of both the added costs and the revenue you'll earn. Depending on your scope, you may want short-term economic analysis, a five-year projection or both.
- Crunch numbers. Once you have the raw data, you can run it through the relevant formulas to derive useful intel. That could include total revenue, total costs, net revenue, opportunity costs, return on investment and time to recover your investment.
- Make different decisions. If the number crunching takes you to a dead-end, consider some alternatives. For example, if expanding production won't increase widget sales revenue to cover the added cost, will changing widget prices increase revenue enough to fix things?
Economic Analysis Problems
A common problem with the use of economic analysis is looking at issues in a vacuum. Suppose you're thinking about slashing prices on your products and the steps in economic analysis show customers will buy more from you. But you need to consider the possibility your competitors will cut prices to match yours, reducing your advantages.
Another problem is seeing cause and effect that isn't real. If you increase prices and sales go up, that doesn't mean raising prices caused higher sales. However, with many economic analyses, the seeming correlations look much more believable, even though they're unconnected.
- Consider time frames when weighing costs and benefits, and recommending courses of actions. Some alternatives may have limited short-run effects, but beneficial long-term impacts, or vice versa.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com