Thursday, August 11, 2005

Two types of numbers

A number's a number, right?

Well, sort of. In business and organizations, it's sometimes handy to divide numbers into two categories.

Here's a simple question for those of you who live in the USA (if you live elsewhere, you can probably rephrase this slightly and have it make sense). Answer quickly: if we reduce the federal government deficit to zero, are we done? Have we eliminated the need to pay interest each year?

Don't look down the page yet; write down your answer first.

No, we aren't done; we still have to make interest payments. Making that distinction between debt and deficit illustrates why it's important to think about the two types of numbers. The deficit is what some would call a flow. Instead of saying the deficit is $616 billion, we should more properly say it is $616 billion per year. It's the imbalance between government revenue and government expenditures each year.

We won't get rid of interest payments until we've gotten the other kind of number, the debt, to zero. Some would call that kind of number a stock.

Why is that distinction important?

For one thing, you can't really compare the two directly. If you say the debt is $7.9 trillion (as of July 31, 2005) and I say the deficit was only $616 billion last year, we're truly talking about two different things. If I want things to seem worse, I might talk about the debt, because the number sounds more horrifying. If I want to make things sound better, I might talk about the deficit, for it's a smaller number, and we stand a chance of getting that to zero in our lifetimes (it did turn into a surplus not that many years ago), even though the debt may not get to zero until much later, if ever.

The same thing is true when you look at a company's financial statements; some numbers are stocks, and others are flows (or, more precisely, usually the sum of the flow over a quarter or a year). You can probably begin to categorize other numbers as stocks or flows, too—your bank account, your salary, the number of cars you have, and even less tangible concepts like your satisfaction with your career.

To help make that distinction clear, recall that each flow has an implied "per year" (or "per day" or whatever) attached. Make that explicit by saying it when you speak: "The Acme company had a profit of $100 million per year in 2004."

I'm just being picky and academic, right? Well, not quite. In addition to helping others (and yourself perhaps) remember what kind of number you're talking about so people don't make mistakes, you can help set yourself up for making better decisions. How? By helping us remember what levers we have at our disposal for affecting our situation. We don't directly control stocks; we only control them by changing the flows that add to or subtract from their associated stocks.

To explore the idea of stocks and flows and the idea of debt and deficit interactively, see a simulation Chris Soderquist and I did almost four years ago.


Blogger veqz1ldwo93iidd said...

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14 August, 2005 01:27  

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