What are your essential expenditures? What dollars go out and never come back, making no impact on your financial health? Which expenditures are good investments yielding a positive return? Some spending is a waste and some makes a contribution. Do you know which is which?

I've had the good fortune of having some amazing financial mentors and teachers as clients over the years. On a trip up North to work with his team, Rich Thompson spent almost the entire flight to Whitehorse explaining his most important metric–adjusted funds flow from operations (AFFO) an alternative to EBITDA as a measure of profitability in a real estate heavy business with extensive sustaining capital costs.

The result of this conversation was a very simple matrix made up of 4 things: price, utilization, operational expenses and capital expenses. The matrix is a tool useful in making strategic decisions: what operational and capital expenditures create a sustainable and commensurately larger increase in either price or utilization or both and which do not. Does renovating a floor of hotel rooms increase the number of room nights sold or the rental rate? What about a raise for the hospitality staff, a new IT system or a new ad campaign? AFFO is a useful metric because it relates the expenses required to run a business (opex) and the investments required to build, sustain and grow the business (capex). It gives a more complete picture of both the short and long-term financial health of an enterprise.

How does every dollar that goes out come back (and maybe bring a few friends back with it)?

The last major project I did as an industrial design consultant was a computer-controlled baby bassinet. The product could easily lull a crying newborn back to sleep in the middle of the night. We manufactured the product for $65 and sold it at wholesale for $95. Contribution margin is the difference between what a product or service costs to make and deliver and the price it fetches at market. Each bassinet we sold contributed $30 to pay for opex and capex.

One day I was about to send a FedEx package to one of our suppliers for $30. My client asked me how many bassinets we had to sell to pay for that package. One. I had never thought about that way before then. I then started thinking about every dollar I spent and how many bassinets would be required to pay for each one. I sent the drawings by fax instead. Saved a bassinet.

Lean thinking is a way to think about the economic impact of every dollar out the door.

In a tightening economy a common knee-jerk reaction amongst anxious managers is to start cutting costs without regard to the impact each dollar might have on profitability. It is possible to cut a dollar on the cost line or out of the budget and end up cutting the top line even more, having a downward effect on AFFO and defeating the purpose of a lean initiative.

Each of us better make sure we know the ROI on our offers in the eyes of our clients. I want to be an essential service provider. Don’t you?