A Simple Mental Model For Business And Finance

February 6, 2015
Estimated reading time:
3 minutes

This is the simplest mental model in all of business and personal finance.

Any business or personal finance issue, and the solution to it, is inevitably contained somewhere in this model.

You ready? Here it is:

Profit = Revenue x Margin

Let that sink in for a minute.Every issue your business faces, and everything you hope to accomplish with your own finances, can be tackled with that one equation. First, let's look at how this applies in business.

Business

So you're running a company, and you want to make more money. Good for you. Well, how do you do that? You can either increase revenue, or increase margin.

Increasing revenue means either increasing the number of customers, increasing the number of transactions per customer, or increasing the average order size per customer.

Increasing margin means either increasing prices while keeping costs the same, or decreasing costs while keeping the price the same. It's that simple.

Increase revenue while keeping margins the same, or increase margins while keeping revenue the same. Either way, the result is more cash in your hand.
Increase revenue while keeping margins the same, or increase margins while keeping revenue the same. Either way, the result is more cash in your hand.

That is almost every single business problem contained right there. In fact, it's what a management consultant would call a Mutually Exclusive, Collectively Exhaustive set of solutions. Of course, there are multiple ways to increase the number of customers, or their transaction frequency, or the average order size, just as there are multiple ways to decrease costs. But this gives you a framework to think about your problem.

Personal finance

Most people don't think about their own personal finances as if you were a business, but you should. You might not think that profit, revenue or margin are relevant to you as an individual, so let's substitute in some words that you might recognise:

Increase in net worth = income x savings rate

There it is: everything you need to know about getting richer. Your personal income is your revenue; your savings rate is income minus expenses, aka your margin. And the difference is your profit.

So if you're living paycheque to paycheque, spending money on credit cards and slowly racking up debt, you're no different to a business that continually spends more money than it brings in through sales. You will inevitably go bankrupt unless you either a) increase your income, or b) decrease your expenses.

More to the point: in a business, you might be able to blame other people for this. "Sales aren't hitting their quotas!" "R&D spent way too much money and produced nothing!" But when it's just You, LLC, then you're the only one responsible for the result.

Income can take many different forms: the income from your job, a bonus, a severance package, an increase in the value of your assets, like your home, or your stock portfolio, rents, dividends, royalties, unemployment cheques, etc. They all count towards your top line.

And everything else--mortgage interest, credit card interest, food, drink, petrol, tuition, student loan repayments, clothes, DVDs, movie tickets--eats into your margin.

Therefore, the fastest way to get rich is to increase the gap between income and expenses.

This may seem obvious, and in many ways, it is. But like a lot of mental models, its simplicity is part of what makes it so profound.

Anyway, now you have a framework to start thinking about every problem in your business or your personal finances. You're welcome.

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