Examples of situations where back of the envelope calculations can aid decision making
One of the most important calculations that quick estimates can help with is market sizing. Gaining an understanding of the possible size of your market that you are considering entering can be useful in:
- Determining resource allocation: Back of the envelope calculations can be useful to determine how much resources to commit to a specific project or opportunity.
- Gaining resources: Estimates of market size and potential growth opportunities can be beneficial in gaining the support of others.
- Prioritization opportunities: Determining which opportunity to approach now, and which to delay until a later point.
Back of the envelope calculations can also be useful in understanding the cost structure of your competitors relative to your own. This can potentially be useful in understanding the extent to which they can match reducing price reductions, or to further undercut your prices.
Another way that back-of-the-envelope calculations can aid in decision-making is by prioritizing the potential market opportunity of each of your customers or market segments. Gaining an understanding of how big the market opportunity each of your potential customers is can help prioritize your time on establishing or growing your larger clients.
A final way that back-of-the-envelope calculations can aid decision-making is gaining an understanding of the likely profit margins (or cost structure) of a product in development. These calculations can aid in determining whether to pursue the opportunity and the resources to commit to it.
Ways simple back of the envelope calculations can be powerful
Some of the way that back of the envelope calculations can be particularly useful include:
- Quick: Calculations in a few minutes: This the real advantage of simple calculations – because such calculations are easy to do, you can do such calculations when you may not have time to undertake more formal estimates.
- Useful insight – can directly impact decisions: In part because of the ease at which these calculations can be completed, you can directly use them during your decision-making process.
- Easy to understand: Simple calculations can be easy to explain and justify – helping to get buy-in into the estimates.
- Provide the basis for more accurate estimates: The back of the envelope calculations also well place you to further refine your estimates. For example, you can triangulate your estimates to increase accuracy.
Improving the back of the envelope calculation
While back-of-the-envelope calculations provide a good starting point for analysis – for major decisions there may be benefits in refining the analysis. Assumptions that embodied initial calculations can be verified to help increase estimation accuracy, and triangulation can be used to further increase confidence in the final estimates.
The key thing to remember though is that no estimate will ever be fully accurate – there are many pieces of information that are difficult to determine, or impossible to verify. Past a certain point, further searching for information to verify the analysis is unlikely to prove useful. The purpose of back of the envelope calculations (and business analysis more generally), is not that the figures used are completely correct (perfect information is rarely possible), but rather, whether it is sufficiently accurate to be useful to aid decision making.