Rules of Thumb - Are they good or bad?

November 23, 2009 · Filed Under Business Ideas & TIps · Comment 

Often in business there are industry rules of thumbs for profits, costs and valuation.  There are many examples of these however to illustrate professional service firms often use the one third rule which is 33% wages, 33% operating expenses and 33% profit. Commercial cleaning business try to only have wages as 55% of income.  There are plenty of examples but are these useful.

My belief is that these rules of thumbs can be useful if they are used as a guide only. If we rely on them to make significant decisions they we can be led astray. The rules of thumbs can trap you into certain assumptions about the industry. These assumptions may become self limiting. To take the business to the next level it is important to think about business lessons from outside the industry that could significantly accelerate the business.

Before Fedex came into the delivery business it was considered normal to have a delivery rate of 95%. Fedex changed this. They were not happy with the industry norm. Now the delivery rate of Fedex and also the other companies is 99.95%.  This does not sound a lot until you realise the number of parcels that are freighted each year. This difference has meant that millions more parcels are getting to where it is meant to.

In Australia financial planning firms have an industry rule of valuation of about 3 times recurring revenue. Financial planning firms are still being sold for these figures. This is despite the fact that there is significant regulatory changes coming to the industry which may significantly affect the recurring revenue. Also this is despite that this method of valuation gives no regard to what the business is actually earning. So the rule of thumb could be a starting guide but then we need to consider the hard facts.

The next area of rules of thumbs is those that a business creates over time for internally use. I have seen businesses where they have determined rules of thumbs for when they are pricing a quote. Again these rules are useful but we need to be constantly reviewing these rules against the hard facts.  So for example when the quote is accepted we need then to examine the resulting job profitability and determine whether that pricing rules are still relevant.

So I see rules of thumbs like fire. In its place fire can be extremely useful but if it gets out of control it can destroy all. Use rules of thumbs as a guide but always check the hard facts on a regular basis.

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