Back of the envelope calculations can be powerful in decision making – helping you gain insight into situations that you don’t understand. However, by their nature, they are likely relatively inaccurate, and although they have an important role, you need to be aware of the limitations of your analysis. This article explores some common mistakes with back-of-the-envelope calculations – and how to avoid making such errors.
The issue of extrapolation: Extrapolating from very small numbers
Small success is great – and you should definitely celebrate it. But, it is easy to extrapolate from very small initial success and see very big numbers.
In the early stage of a business you may see quick sales growth: Maybe one month your sales are 20% higher than the previous, and maybe you even see this happening for a couple of months in a row. Quickly you do the math, and realize that if your 20% month-on-month growth continues, you will be about 9 times your current sizes a year from now (i.e., 1.2^12), and an incredible 56,000 times your current sizes in about 5 years (i.e., 1.2^60)!
These hockey-puck, exponential growth projections are not uncommon, but almost never materialize. The key danger is that you are projecting from a very small starting point, and while it is not uncommon to see relatively high growth rates early on, it is a lot less common to see high growth rates continue month after month.
No basis for your assumptions
Another real danger of back-of-the-envelope calculations is the sometimes huge assumptions that are built-in. Some of the most inaccurate market sizings start by assuming that 1% or 5% or 10% of a particular group of people will buy or use your product – with little basis for the assumption.
Projecting what you need or want to happen
Another mistake with back of the envelope calculations is to back work the numbers to give the answers that you need or want to happen. While on the face this seems a silly approach to financial planning, it is an easy trap to fall into. You may yourself know what you need to achieve – and from this, convince yourself that the various different assumptions that you have made to achieve these forecasts are plausible.
Taking your projections as fact
Another danger with back of the envelope calculations is that you begin to take the estimates as fact. The documents that initially made clear that these figures incorporated a lot of assumptions, get forgotten, and suddenly the forecasted market size is considered to be a fact.
While there is often a need to act based on projected numbers (for example setting up appropriately sized operations based on the forecasts), it is also important to be aware of the limitations of the projections and to periodically update the forecasts as new information is obtained.
One of the worst situations to be in is to use your projections as a basis to ignore any information that is not in keeping with what you forecasted. Don’t lose sight of the speculative nature of early estimates – look to verify and challenge your assumptions, rather than dismissing information that is not in line with your assumptions.