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The “Flaw of Averages” Causes Havoc for Businesses
Introduction: The Importance of Accurate Data Analysis
The “Flaw of Averages” is a term popularized by Sam Savage, referring to the misleading nature of averages in business decision-making. Averages often misstate the true situation within a company, leading to misallocation of resources and, ultimately, reduced profitability. In this blog post, we will discuss how the flaw of averages can impact businesses, using hypothetical examples to illustrate the consequences and offer suggestions for more accurate data analysis.
- The Flaw of Averages in Product Analysis
Consider a hypothetical business, ABC Inc., which sells a variety of products with different units sold, unit prices, and gross profits per unit.
| Product |
Units Sold |
Price/Unit |
Gross Profit/Unit |
| A |
30,000 |
$ 100.00 |
$ 12.50 |
| B |
7,500 |
$ 90.00 |
$ 75.00 |
| C |
20,000 |
$ 80.00 |
$ 37.50 |
| D |
15,000 |
$ 70.00 |
$ 45.00 |
| E |
10,000 |
$ 60.00 |
$ 25.00 |
| F |
25,000 |
$ 50.00 |
$ 12.50 |
| G |
20,000 |
$ 40.00 |
$ 20.00 |
| H |
20,000 |
$ 30.00 |
$ 25.00 |
When examining the product portfolio, looking beyond the total revenue and gross profit margin is essential. Focusing solely on averages can lead to misconceptions about the importance of certain products to the company’s profitability.
a. Rethinking Product Prioritization
For example, if ABC Inc. were to stop selling its largest revenue-generating product, its gross profit margin would increase substantially. By looking at average margins, the full impact of this product on the business is not apparent. A more detailed analysis may reveal additional costs associated with the production of this product, such as factory space, warehouse storage, staff, and shipping costs.
b. Bundling and Pricing Strategies
With a better understanding of the true profitability of each product, ABC Inc. can explore more effective pricing strategies, such as increasing the price of lower-margin products or bundling them with more profitable ones.
- The Flaw of Averages in Customer Analysis
Examining customers’ revenue and gross profit contributions can also reveal valuable insights. By ranking customers according to their gross margin contributions, businesses can identify the most profitable clients and those that may be dragging down overall profitability.
Now, if we examine the purchase and gross profits of each customer, we get:
| Customer |
Revenue |
Gross Profit |
|
S |
1,899,890 |
869,085 |
|
T |
1,725,700 |
700,983 |
|
U |
1,598,430 |
414,600 |
|
V |
951,540 |
491,173 |
|
W |
1,273,760 |
459,958 |
|
X |
563,430 |
259,640 |
|
Y |
458,530 |
176,880 |
|
Z |
1,103,720 |
452,683 |
|
Total |
9,575,000 |
3,825,000 |
Sorting that into the order of gross margin, we can see the following:
a. Identifying High-Value Customers
For example, if ABC Inc. were to lose its most profitable customer, its gross margin would decrease significantly. By contrast, losing a less profitable customer would lead to an increase in the overall gross margin. Understanding the value of each customer allows the company to focus its resources on retaining and attracting high-value clients.
b. Analyzing Customer Purchase Patterns
In addition to evaluating each customer’s profitability, examining their purchase patterns is essential. Businesses can better target their marketing and sales efforts by identifying clients with higher-margin purchase combinations.
- Improving Business Performance Through Better Data Analysis
To overcome the flaw of averages and make more informed decisions, businesses should:
a. Regularly analyze product and customer data. Examine each product’s and customer’s profitability to identify improvement areas and make better resource allocation decisions.
b. Focus on profitability, not just revenue. While revenue is essential, focusing solely on it can lead to misconceptions about the true value of products and customers. Prioritize profitability to drive sustainable growth.
c. Use data to inform pricing and bundling strategies. Identify opportunities to increase the price of lower-margin products or bundle them with more profitable ones to improve overall profitability.
d. Monitor and adapt to changes in the market. Regularly review product and customer data to stay up-to-date with market trends and adjust strategies accordingly.
Conclusion: The Power of Proper Data Analysis
The flaw of averages can lead businesses to make misguided decisions based on misleading data. By delving deeper into product and customer data, businesses can better understand their true profitability, allocate resources more effectively, and ultimately drive sustainable growth. Don’t let the flaw of averages hold your business back – embrace the power of accurate data analysis to improve your decision-making and achieve success.
Recommended Reading:
-
The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty, by Sam Savage This book provides an in-depth look at the limitations of averages and how they can lead to misguided decisions in various fields, including business, finance, and engineering. It also offers practical techniques for better understanding and managing risk through probabilistic thinking.
-
Why Can’t You Just Give Me The Number?: An Executive’s Guide to Using Probabilistic Thinking to Manage Risk and to Make Better Decisions, by Patrick Leach. This guide is designed for executives and decision-makers who want to improve their understanding of risk and uncertainty. It introduces the concept of probabilistic thinking, demonstrating how it can lead to better decision-making and risk management in a variety of business scenarios.
Copyright (c) 2021, Marc A Borrelli
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