The Cost of Efficiency

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Running a business, is, conceptually, quite simple:

1. Sell something that people are willing to buy

2. Generate enough revenue to cover your expenses

3. Repeat

Issues arise, as we’ll see in a moment, when you try to take shortcuts.

To expand your profits, you need to focus on step 2: either increase your revenues or decrease your expenses. One expense that many companies seek to decrease is inventory, because unlike salaries or manufacturing costs, inventory doesn’t contribute directly to revenue. It represents the cost of storing goods that are not yet generating revenue.

Theoretically, if you could respond to consumer demand instantaneously, or, even better, if you could predict consumer demand with a high degree of certainty, you could reduce your inventory costs to near-zero by producing exactly what is needed in real-time.

Spanish clothing retailer Zara was one company that implemented a low-inventory business model, pioneering “fast fashion.” Zara’s parent company Inditex moved most of their manufacturing back to Spain and lowered their inventory volume so they could quickly respond to shifts in customer demand and push popular items to stores as quickly as possible.

If a new sweater sold unexpectedly well in London, for example, Zara could increase production overnight and ship the order batch of sweaters off to their stores within a week.

This “Just-in-Time” manufacturing plan has served Inditex well, and they have grown from a ~$30B company in 2012 to $130B today.

Hoping to capture similar cost savings, vehicle manufacturers like Ford and GM implemented their own “Just-in-Time” processes too. These auto giants kept a low supply of parts on hand to reduce inventory costs, and they relied on regular, small deliveries of different battery and engine components to stay on their production schedules.

Like Inditex, Ford and GM benefited from lower expenses (and bigger profits).

And then the pandemic happened.

Borders closed, countries around the world issued lockdowns, and international trade ground to a halt. Regulations issued by different governments created bottlenecks throughout global supply chains, and companies that were previously praised for their inventory-light models could no longer get necessary components from Asia.

New F-150s were on backorder for 9 months, and used vehicles, normally subject to brutal depreciation, were selling for more than new vehicles because manufacturers couldn’t produce enough cars to meet demand.

It took two years for these OEMs to resume normal business operations, costing them billions in missed sales.

Personal finance is, conceptually, quite simple.

1. Make more money than you spend

2. Don’t go into debt

3. If you do, for some reason, need debt (such as student loans), pay it off quickly

4. Keep 6 months’ living expenses in a bank account

5. Invest your excess income in broader market index funds

The simplicity of personal finance makes it boring. Cumbersome. We tell ourselves, “I don’t really need to follow all of these steps. I can take a few shortcuts.”

But issues arise when we take shortcuts.

I probably understand “personal finances” better than most people. I graduated from college with a 4.0 in finance. I worked in corporate finance for two years after school, and I have been writing about finance since. I made (and lost) a lot of money trading stocks during the pandemic. I’m an MBA candidate at Columbia, the university that practically invented finance.

And last year, I got sloppy. I knew how much money I was making from Exec Sum, and I knew how much I would make each month from various side projects, so I wasn’t too worried about step 4: “Keep 6 months’ living expenses in my bank account.”

So last year, I took some shortcuts.

Six months’ living expenses felt like wasted money, just sitting there in my account, and I had several expenditures coming up. So I figured, “Why not spend it? I know how much I’ll make over the next few months?” My spending became excessive as I grew more reliant on next month’s invoices, and that cash cushion I had been maintaining disappeared. I didn’t think I needed it.

And then I had a problem.

I’ve written a lot about the benefits of self-employment, but there is one massive advantage to salaried jobs: when your paycheck hits your bank account, taxes are already accounted for. When you are self-employed, you have to pay quarterly estimates on your taxes throughout the year.

I had missed a couple of emails, and I forgot to make two of those estimates. And the government charges interest on late estimates. Then a couple of clients were late on their invoices from October and November. Suddenly, my “money in, money out” lifestyle had a massive issue. I had a larger-than-normal credit card statement, I owed more than expected in taxes, and a couple of vendors were slow to pay me. The numbers didn’t compute.

This was one of my first real money problems, and I panicked. Money problems are suffocating. Fortunately, I was able to sell some stocks, pay everything off, and reset once those invoices were paid, but I never wanted to touch my portfolio, and I shouldn’t have needed to.

I got lazy, took a shortcut, and got burned.

A lot of costs feel unnecessary and inconvenient, but that inconvenience represents security. We like to think that we can predict the future and optimize our lives accordingly, but stuff goes wrong all the time. When you plan for perfection, any disruption can be catastrophic.

Accounting for those unknown disruptions, whether that means maintaining a larger supply inventory or keeping a larger cash balance in the bank, gives you a margin of safety, and you never know when that margin of safety will pay off. While auto manufacturers struggled to re-ramp production during the pandemic, Warren Buffett was buying stocks at firesale prices. Why? Because Berkshire Hathaway was sitting on a $128B cash pile as recently as November 2019. Could Buffett have predicted Covid? No. But he was able to take advantage of the market crash when everyone else was panicking.

Efficiency is great, but it’s only as effective as your ability to forecast the future.

- Jack

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