Economic indicators explained in plain English
The success of a business depends greatly on the quality of executive decisions. And while there are many ways to measure management’s operating success, building service contractors need to understand how to identify poor management as well. Two red flags are inaccurate business projections and an inability to adjust to changing times.

These two problems generally result from making business decisions in a vacuum — that is, without considering any external factors. When going on a trip, you wouldn’t just make sure that the car was fully gassed up and the tires properly inflated. You would also need to map your route and check the weather.

The business equivalent to this preparation is mapping your projections and checking the economy’s indicators. Prepared managers need to look at the quality of business projections in light of the expected changes in economic conditions.

Parts of the whole
There are a vast number of published metrics relating to the direction of the economy that contractors can use. Leading Economic Indicators (LEI) is one set of metrics that BSCs might find the most useful.

The Conference Board publishes the LEI in agreement with the U.S. Department of Commerce. The LEI measures factors relating to employment, industrial production, interest rates and money supply. Further, the index uses past, present and future projections that are subsequently called lagging, coincident and leading. Taken together, they suggest the pace of the economy.

To provide some insight into these indices, consider some of the components of the leading index:

  • Average weekly hours in manufacturing averages the hours worked per week by production workers in manufacturing industries. This average tends to lead the general economic cycle; employers usually adjust employees’ work hours before increasing or decreasing their work force. This should sound similar to what an astute BSC does in fulfilling customer contracts and work orders.
  • Average weekly initial claims for unemployment insurance is another good indicator. As companies start laying off people, these claims rise. This is considered a more sensitive indicator than total unemployment counts because changes in claims are more immediately apparent.
  • The index of consumer expectations is the only expectations-based element of the leading index. It is a monthly survey of consumer attitudes toward various economic conditions for which responses are either positive, negative or unchanged.


On the flip side
The coincident index follows two figures — employees on non-agricultural payrolls and the index of industrial production. The former includes full-time and part-time workers, both permanent and temporary, who are not in agriculture-related jobs. This matrix is considered one of the most closely watched gauges of the economy’s health.

The index of industrial production includes the physical output of all production stages in the manufacturing, mining, gas and electric industries. This measurement is useful because, although it measures only a fraction of the total economy, the fluctuations of these markets comprise most of the fluctuation in total economic output.

The lagging index includes the average duration of unemployment and the average prime rate charged by banks. The former measures the average number of weeks that individuals counted as unemployed have been out of work. The latter measures changes in the prime rate, which is the benchmark that banks use to establish their interest rates for different types of loans.

Late in 2000, the Conference Board reported that the LEI had been trending slightly downward since the beginning of the year. Taken together with the reports on coincident and lagging indices, this fact may not have been a big cause for concern. That is because while the leading index had been declining, the coincident index showed a small rise in prior months, as did the lagging index, except that the increase was so small it was considered flat. The makeup of the risers versus decliners of each element of each index prompted the Conference Board to say that “the indicators continue to point toward a cooling in U.S. economic growth. Interest rates and growth restraints will determine how much slower the economy will be this winter.”

Other economic indicators, such as stock market activity, point to a continued cooling of economic growth at a faster pace. When viewed as a whole, these individual indicators point to tempered optimism as a wise business choice. While they don’t show a major slip on the horizon, highly optimistic projections adopted during our seemingly endless economic boom aren’t going to get contractors very far this year.

The quantity of quality
The best overall economic indicator — consumer satisfaction — is a good tool for contractors to use when planning their projections. What matters in the end, after all, should be how well anyone satisfies customers.

In 1994, the first systematic attempt to measure the quality of economic output was made by the American Society for Quality Control. The American Customer Satisfaction Index (ACSI) tracks customer satisfaction in a couple dozen manufacturing and service industries, which account for about 40 percent of the US gross domestic product.

The significance of the ACSI and the lessons it holds for BSCs is in its conclusions about the correlations of factors it measures.

One of those conclusions is that with all the attention on total quality management and the acknowledged importance of customer satisfaction, many businesses have not yet figured out a way to tie in their customers’ satisfaction to measurable financial results. Most conscientious BSCs already survey their customers’ satisfaction level through a written questionnaire, by simply following up with customers after some critical event or by some method in between. But how do they link that survey to bottom line financial results for their companies?

There are three measurable characteristics contractors can look for to determine who their satisfied customers are: price tolerance, increased spending and loyalty.

  • Price tolerance, or the ability of your customer to retain your services even if your competitors are lower, is a great indicator that the customer sees value in the service or product you are providing. The BSC industry is, in general, a low-margin, highly competitive one. This usually leads to commodity pricing, where the lowest bid wins. However, if you realize that a customer usually is under pressure to reduce his costs and become more efficient and if you can help him do that, you can become a value-added partner to him.

Calculating price tolerance is relatively straightforward. You divide your price by the average price of your competitors and this provides the tolerance index. For example, your winning contract had a price of 10 cents per square foot while your other two competitors were 9 cents and 9.5 cents. The tolerance index is 1.081 (0.10 / ((0.09 + 0.095) / 2)). You can also do this for each of your competitors separately.

An index of less than 1.00 means there is no price tolerance and commodity pricing rules your relationship. An index of 1.00 means there is no price tolerance, but that your customer sees something of value to your services over similarly priced competitors. An astute BSC would take the hint and find out what that is.

An index of more than 1.00 means there is price tolerance. The higher the index, the more value you are seen to provide and the more care you should take to continue providing that value.

If historically, the price tolerance index for one of your best customers has been declining from say 1.25 to 1.10, and you know the customer has been happy with your services throughout, this may suggest you test the idea of raising your price back to the 1.25 index level.

  • Increased spending is another characteristic of the satisfied customer. There are two ways to increase your revenues from an existing customer: increase the number of sales, or increase the amount of each sale. Your approach here is, again, the value-added sale.

You’re the expert in your field and have seen other customers in the same situation as your current customer. You know what the customer needs. If this is different than what he thinks he needs, point it out and prepare to explain why. One of the best potentials for a high-margin sale is a custom sale. When you customize your service package to what the customer wants, you are at the epitome of a value-added transaction.

To calculate how effectively you are increasing the amount of each customer sale, make an average sale comparison by taking the total amount of sales to-date for any customer and divide that by the expected number of invoices, as well as the actual number of invoices. (For a customer not on contract, the expected number of invoices is the prior year’s number of invoices.)

For a customer on contract, for example, who has an expected billing of $2,000 per month for the last 6 months, the average expected sale is $2,000. If the average actual sale also is $2,000, you may be fulfilling your obligations, but you’re not advancing your value-added position; you’re not looking hard enough at how else to service that customer.

This metric is commonly used by the retail and hospitality industries. It is used to show how much a customer spends on each visit. It often is used further to compare average spending on particular product lines which indicates a customer’s propensity to that product. This, then, usually reveals an opportunity for targeted marketing and additional sales.

  • Loyalty can be measured by the retention rate. The retention rate is the rate at which companies keep existing customers. The price of acquiring a new customer is five times greater than the cost of keeping old ones. Obviously, it makes financial sense to concentrate on improving your retention rate.

To determine your retention rate, you take the total number of customers you have at year end, subtract from that the number of new customers you acquired during that year, then divide that result by the number of customers you had at the end of the prior year. For example, at the end of year 2000, you had 100 customers; 20 were acquired during the year. You had 90 customers at the end of 1999. Your customer retention rate for year 2000 was 89 percent: (100 - 20) / 90 = 80 / 90 = .89.

Art or science?
Still, no one is suggesting you need to become an economist to decide the direction for your company. With all its formulas and graphs, economics gives the appearance of being an exact science. Many people presume a degree of precision that is just not there. It makes little sense to be paying too close attention to each fractional change in any composite factor or economic indicator.

Take, for example, the non-accelerating inflation rate of unemployment (NAIRU), which is simply the calculated rate of unemployment. The theory behind NAIRU is considered a building block of the economic universe. Economists believe that unemployment tends to settle at a “natural” level. If unemployment drops below that rate (the NAIRU), employers bid up wages for increasingly scarce workers, driving up costs and setting off inflation. Sounds great, except that in recent years when the NAIRU level pointed towards accelerating inflation, inflation actually decelerated. This doesn’t mean that the theory is wrong, but that the milestone level may be off. For a long time, the milestone NAIRU level was thought to be about 6 percent. More recently it’s thought to be at about 5.6 percent.

Furthermore, contractors should understand that while the NAIRU seems scientific in nature, it really is based on a lot of subjective judgement. There are economists who apparently are trying to justify a “natural” unemployment rate in much the same way as many accountants try to rationalize an optimum working capital ratio. There are many calculations involved in justifying your position, but the calculation of the working capital ratio, or the unemployment rate, is the same as it’s always been.

So, while economic indicators are necessary to help a company compare its internal progress with the rest of the world, contractors should be cautious about how much weight they place on any given measurement. While a map can help you find out where you are in relation to your destination, it can’t tell you the best path to take to get there. Only you will know what makes the most sense for your organization. It all boils down to knowing your own company and knowing your customers. That’s when you find out who will provide the continued economic boom for your company in the year ahead.

Jesse De La Cruz, MBA, is a CPA who provides CFO services to Triad Building Maintenance Inc., Austin, Texas.




POSTED ON: 1/1/2001