Posted on May 1, 2018 @ 04:12:00 PM by Paul Meagher
Wikipedia defines a fudge factor as an ad hoc quantity or element introduced into a calculation, formula or model in order to make it fit observations or expectations.
A common use of a fudge factor is in project management where you estimate how long a project might take and then multiply that time by some fudge factor to account for events or difficulties you can't anticipate. The size of the fudge factor might vary by task type or by how much estimating skill you have.
Another use of a fudge factor is in pricing your services. You might, for example, price your services differently depending on how busy you are. If you are busy already then you might multiply your going rate by some premium (e.g., x1.20 = 20% more) because you don't really need to add more work to your plate. If the customer bites at that price then it would be worth taking on the extra work but if they don't then you already have more than enough work at your going rate. Many different factors might influence your service pricing and the corresponding fudge factors you might want to use.
Fudge factors are also common in valuation where the value of a company is estimated to be some multiple of earnings (or some other quantity) common to companies in that industry. This reduces a very complex analysis to a simple rule of thumb that may or may not prove to be predictively accurate.
I recently did some year-end accounting for my farm and had to apply a fudge factor to my books to account for some uncertainty in my final numbers. A farm is like a small manufacturing plant that incurs lots of different types of expenses and receipts. The farm accounting fudge factor involved not claiming a certain amount of expenses that my bookkeeping told me I could claim. I left them unclaimed because I wanted to give myself a margin of error in case I was ever audited. The use of fudge factors in accounting is generally frowned upon and for good reason (see below), however, there is a cost to striving for extreme accuracy and there are judgement calls as to whether certain expense should be claimed. There is also procrastination and deadlines that force you to spend less time than you would like re-examining your receipts and numbers. To protect myself, and to terminate the accounting process faster, I used a fudge factor that involved not claiming a certain amount of expenses on the off chance that I might be audited. If audited, the government may end up owing me money. I can sleep soundly at night knowing that.
Fudge factors in accounting are often used to inflate earnings to make a company look more profitable than it is. Such practices are often called "creative accounting". Creativity in accounting is apparently a bad thing but you will often hear people say a good accountant will pay for themself - not because they are "creative" but are good at finding ways to decrease income and increase expenses. See The Ethics of Creative Accounting for more discussion of "creativity" as it applies to accounting.
Does the use of a fudge factor indicate that there is a problem with your approach to estimating, pricing, valuation, and accounting? It very well could be, but I also think that there is just alot of uncertainty out there that that involves diminishing returns to try to tame. You can keep on trying to estimate how long it will take to build a house but mother nature, suppliers, workers and financial institutions can all throw a wrench into your meticulously prepared estimates. People of action may be happy with throwing a fudge factor onto an estimate and getting on with the business at hand.
What causes these adjustments to be called fudge factors is that they seem ad hoc, not based in any solid theory but perhaps based on experience. The definition of a fudge factor does not indicate why we might be tempted to introduce an ad hoc quantity into our calculations. In this blog, I've provided a few reasons why we might be tempted which often comes down to a fudge factor being a strategy for dealing with uncertainty and time constraints. Because entrepreneurs and investors are often mired in uncertainty and have a limited amount of time to get things done, fudge factors may be the key to moving forward.