Economic Model Part 5: 8 Characteristics of the Best Spreadsheet Models
January 6, 2012
This is the Fifth in a series of posts that I am writing aimed at helping entrepreneurs maximize their economic performance. You can find a summary of the economic model series here. My last post described the pros and cons for waiting to build out your economic model. This post describes the characteristics of the best spreadsheet models that help you to better understand your economic model and better predict your economic performance.
Characteristics of the Best Spreadsheet Models
Companies that really want to build a great economic model build spreadsheets that help them to understand and manage their business from an economic perspective. The spreadsheets can be used for many purposes, including answering questions like:
- What will my business look like several years from now if we stay on the same trajectory?
- What happens if we add more resource or reallocate resources in a different way?
- What happens if we are able to improve the key drivers of our business performance?
- What are the capital requirements for the business under different scenarios?
- What is the best scenario for us?
How do you know that you have a great spreadsheet model?
The best spreadsheet models have several characteristics:
1. The Model is Predictive. Most importantly, your spreadsheet model can actually predict the actual economic results of your business. If you really want to test your spreadsheet model, then run it on the last 12 months and see if you can predict your results from the last 12 months using the model.
If you have a new business or new components to your business model, then you won’t be able to figure out if your model is predictive (you won’t have the data), but you can still make reasonable estimates, use those estimates in your spreadsheet, and try to pin down more accurate estimates as the data becomes available. This will allow you to start developing an understanding of what you might be able to achieve, and you can iterate on the estimates over time to develop a more predictive model.
2. The key economic drivers are separated, clear and measurable. For the most part, your economic drivers are the 3-7 key components of your model that drive the majority of your economic performance. They should demonstrate the key resources that you pay for and how your customers respond to the the market interactions created by your key resources. In other words, your key resources generate market interactions that drive your customer results and that relationship needs to be clear in your economic model.
The best models truly clarify the few important economic drivers, allow them to be viewed and changed separately, and the drivers themselves are measurable. You need to make sure that you have drivers that you actually measure operationally so that you can monitor and manage the performance of those drivers over time and use the measurements to update your economic model.
For example, if your sales and marketing resources are a key driver because they generate new customer revenue, your model estimates the relationship between your sales and marketing resources and the new business that they generate and you can to track and manage the true relationship over time. If your customer attrition rate is a key economic driver, your model estimates the attrition and you track and manage your customer attrition rate over time. If your new customers drive more help tickets, and therefore the need for more customer service staff, then having this relationship in your model would be beneficial.
The key point is that identifying your key drivers, measuring and managing them, and then updating more accurate measures in your spreadsheet model is key to both having a great spreadsheet model and also key to maximizing your economic performance. You will better understand how your business works and be in a position to better manage it!
3. Your level of confidence in your drivers is clear. It is relatively easy to model your resources (a.k.a. expenses, headcount) and to manage to those resources so your confidence in predicting your resources over time should be high if you are good at managing your resource levels. But understanding how those resources stimulate the market and result in revenue to you is more difficult, particularly if you have a new business model or new parts of your business model.
Understanding your confidence level for your key drivers is really important. By better understanding which of your economic drivers are hypotheses (low confidence estimates) vs. which are well understood (completely calibrated drivers), you can then work to better understand the drivers that are less well understood and you can do some sensitivity analysis on the drivers that are hypotheses (more on this below) so that you can better understand the possible range of your future economic performance.
4. You can do a sensitivity analysis, particularly for the drivers that you are less confident in, so that you can see the range of possible outcomes going forward. You also can use this sensitivity analysis to help you to prioritize the economic drivers that are most important to your performance so that you can work on improving them.
As an example, if the relationship between sales and marketing resources and new customer revenue is an important driver, you can adjust the number (a.k.a., parameter of the model in your spreadsheet) that describes that relationship and then see how that change creates different future results. A more sophisticated sensitivity analysis would be the ability to have different numbers at different points in time so that you can see the effects of phasing in improvements (or deterioration) of new customer revenue per unit sales and marketing resource.
5. Your investments are separated from the core economics of your model. This is a somewhat confusing point to a lot of people, but you can have a great economic model without being a profitable company. You can also have a profitable company while having components of your economic model that are not very good. A huge part of the difference between your economic model and your profitability is the investments that you are making in your business.
For example, the most important investments for most growth companies are:
- sales and marketing resources so that you can acquire more customers (current sales and marketing expenses aiming to generate more customer revenue in the future) and
- product development resources so that you can attract more customers or generate more revenue per customer in the future (current product team expenses aiming to generate more customer revenue in the future).
From your spreadsheet model perspective, the key is to be able to see your core economic model results separately from the investments that you are making in your business. You need to do this so that you can make sure that you can ensure that you have core economics of your business that are sound and, separately, want to make sure that each of your investments and the result that you expect from them are sound.
Not keeping your investments separate and distinct will just muddy your understanding of the business.
6. Your spreadsheet model can be evaluated with real-world questions, particularly for models that have multi-year projections. You want to make sure that you are not predicting crazy results in your model, so it would be good to make sure that your model calculates some real-world numbers so that you can use your management judgement to make sure that your model is reasonable.
For example, how many people you need to hire in different departments in order to execute according to the model? If you need to quadruple your staff every year, you probably have a problem. Also, is there enough market to realize your results (if not, you might want to consider something else!)? Can you reasonably raise enough investor money to execute against your model?
Being able to look at your spreadsheet model using real-world numbers is really helpful.
7. You can gain clarity around the economics of building your competitive advantage. While some of your competitive advantage won’t cost you extra money, you will generally have extra resources associated with helping you create competitive advantage. It is important that you clearly separate these resources in your spreadsheet if you want to understand what your effort associated with creating competitive advantage is costing you.
For example, if you have a competitive advantage around customer service, you may have extra or more expensive customer service staff to ensure that you have great customer service. If you have a distinct positioning around “easy to use” then you may have extra user experience staff or extra user interface or design staff to ensure that you have the best user experience.
Knowing what you are spending on building and maintaining your competitive advantage is helpful and separating out your separate resources may also help you to think through additional resources that you need to truly create competitive advantage.
8. Finally, your spreadsheet model should be as simple as possible– The simpler the model, the fewer the cells, the easier time you will have managing your economic model. You will have fewer things that you need to think about and remember and it will be easier to make sure that your model is accurate. A simple model will also help you to develop “rules of thumb” that will help you to manage your business without needing to revisit your spreadsheet.
It is really difficult to create a spreadsheet that contains all seven of the above characteristics and is also as simple as possible, but if you put the time into it, you will get there.
Spreadsheets that describe your economic model are part science, part art. A lot of thought needs to go into them to make them work and I have described 8 characteristics that can help you evaluate your economic model. I will be going into a lot more detail in this series that relates to these 8 characteristics, so if you found this post to be to conceptual then stay tuned for more details.
My next post is on the “Characteristics of Attractive Economic Models”
If you want to learn more about economic models, keep reading. I would also appreciate any comments or suggestions that you have, as I plan on turning this series into an e-book and I want to make sure that it is as clear and complete as possible.