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Financial Reports: Useful or Useless?

Finance & accounting departments are ultimately about reporting.  If you are a public company, there is the required reporting to the SEC and the shareholders.  And regardless of whether you are public or private, there are many other external reports that allow the business to meet its obligations to external stakeholders like banks.  But the focus of this post is on the internal reporting within every company.  This is the reporting that is hopefully adding value and helping to provide direction as the business drives towards its goals and objectives.  Unfortunately, all reports are not created equal and many fall far short of the value they were intended to create.

The problem with reports that don’t live up to their expectations is they are time wasters on two fronts — for finance & accounting who prepare the reports and for everyone else trying to decipher what information in the report is important (if any).  When this happens, people begin to question the value of not just the reports but of the finance & accounting group as a whole.  As financial professionals, we are expected to provide information that is valuable to decision-making; clear, concise & accurate in its presentation; and timely to the needs of the business.

Probably the biggest pain is the reports that have been around since the dawn of time.  They are usually the biggest drain on resources because of the way they are structured and where the information comes from.  These reports probably bear no resemblance to where the business is today and focuses on things that are no longer goals of the company.  But if you ask everyone if the report can be stopped, they drag out their pitchforks and want to lynch you for even suggesting it.  How can they possibly continue when the report has been a part of their business life for so long?  I remember one of my employees coming to me about a report like this and asked what they should do.  I looked at the report and, in my opinion, it really wasn’t a valuable report.  My advice — don’t do it for two weeks and see if anyone squawks.  Surprisingly (or not), not a single person noticed the report was missing!  The takeaway from this is every report should be reviewed with a critical eye on a regular basis to determine if it still adds value in the context of the business’ goals and objectives.  If it doesn’t, show it the door.

Equally important is reviewing reports to see if gains in efficiency can be made in preparing them.  Look for reports that contain the same information and see if they can be consolidated.  Determine if detail is really necessary or if the report users just want the summary.  Also, see how often a report is really needed.  If the report users only look at the information once a month before a scheduled meeting, why are you busting a gut getting it out weekly?  Ensuring that reporting is a value-added exercise requires good communications between finance and the rest of the business.  Understanding their needs and balancing it with what we can do given the resources we have can be a challenge.  But if the end result is better reporting leading to better decision-making, we’ve done our job well.

(De)Centralization

Someone once told me a story about a man who only kept two files in his desk — one on how to centralize the company and one on how to decentralize it.  It turns out every time there was a change in leadership, there would be a corresponding shift in the way the company was structured.  Why all the flip flopping?  Is one structure better than the other?  Or is this just a case of someone putting a stake in the ground to put their own signature on the company?

Quite honestly, there is no clear cut answer about what is best for a business.  Whether to centralize or decentralize needs to be evaluated on a case-by-case basis by considering the goals of the company and how interactions, both internally and externally, will get the business to those goals.  What happens more often than not is a hybrid situation.  Sales is decentralized but marketing is centralized.  HR is centralized but operations is decentralized.  However, there are two areas of a company where I think at least some centralization needs to be strongly considered — finance & accounting and IT.

Many of the arguments for centralizing these two functions are similar:

  • There are economies of scale to be gained from managing bulk transactions or company-wide systems with a dedicated group of employees.
  • Consistency and best practices can be filtered throughout the organization.
  • Maintaining controls and ensuring prescribed procedures are followed is easier.

In today’s economy, and with the multitude of legislative requirements especially surrounding the finance & accounting field like SARBOX, these thoughts should be at the top of the list when considering the centralization question.  Centralization of functional areas like A/P, A/R, cash management and payroll is important to consider since these are prime gateways to fraud and embezzlement.  And the recent stories coming out of Koss, Avaya and Bank of America should certainly make us sit up and take notice.  This is not to say centralization would completely protect a company but it’s easier to ensure the controls to prevent it are followed.

Even though it may seem I’m a huge proponent of centralization for finance & accounting, you will notice I said some centralization needs to be strongly considered.  One of the downfalls of having all of finance & accounting run from a central perspective is often the creation of an “us vs. them” mentality.  Finance is viewed as being prohibitive, not working with the business and being more concerned with following the rules regardless of the impact on operations.

There is a way to avoid this — ensure there is good communication between finance and the business units.  One of the best ways to accomplish this is to have a dedicated accountant or analyst working with each group that is actually part of their team.  The accountant can act as a champion for the unit to see their needs are addressed but are still balanced with the requirements from the center.  They also gain a better understanding of the unit and can provide the insight needed when doing variance analysis or business evaluations as part of the reporting process.  This is how I structured my department and each of my accountants became a valued team member whose opinion was sought in day-to-day decision making.

Ultimately, each company must weigh their requirements and their culture to structure the finance & accounting function so it provides the support and value needed by the business.  Just remember, it doesn’t have to be an all-or-nothing proposition when it comes to centralization or decentralization.

It’s OK to Let Go: Sunk Costs

I’m sure you’ve heard at some point in time someone say “but we’ve invested all this money so we have to keep going”.  For the folks that say this, the need to continue on a path is directly correlated to how much money has already been spent.  For them I have two words — sunk costs.

It is essential for everyone in business to understand the concept of sunk costs.  Sunk costs are costs that have already been incurred and cannot be recovered regards of what happens in the future.  In other words, what’s spent is spent.  Now I’m well aware of the fact that sometimes this spend is quite large and someone may have expended a lot of time and energy on a project.  But if continuing to put more money in a project is not going to result in positive returns, by all means stop!  What’s spent is spent and spending more is not the road to redemption.

I remember when I worked for a food manufacturer; they decided to start manufacturing a new candy.  A formula was created and a few test runs were made which seemed to go well.  The concept was presented to the sales group to see if there would be an interest in the market for it.  There was instant enthusiasm and work on a marketing campaign was started.  Then they started full-scale manufacturing.  What happened next was anything but good.  The equipment they were utilizing was really not up to the task of a different formulation causing the scrap rates to be 50%+ and getting a good quality product was very difficult.  They tweaked and played but the reality was they needed to buy new equipment to make this candy.  And new equipment wasn’t an option because the return wasn’t large enough to warrant its purchase.  So guess what they did?  Because so much money had already been spent on R&D and the marketing campaign, they plowed forward.  Eventually, they realized it wasn’t going to work and scrapped the project.  But if they had considered what they had already spent as being a sunk cost and stopped earlier, they wouldn’t have had good money chasing bad.

Most businesses are guilty of doing exactly this at some point in time.  A project that creates a sense of enthusiasm and rallies people to it can produce this blindness because everyone wants it to succeed at all costs.  However, businesses need to be disciplined and have ways of preventing the groundswell of enthusiasm from drowning good decision making.  And they need to ensure they have communicated to their employees that if something fails, it’s OK to let go.

Pay it Right

I’m currently reading “Discovery-Driven Growth” by Rita McGrath & Ian McMillan and came across this quote which I thought was so appropriate for today’s post:  “Whenever you see someone doing something really stupid in business, there’s a good chance that he thinks he’s being rewarded for it.”  We all know this scenario and it doesn’t usually turn out well for businesses.  We want people to go left but they go right.  And sometimes it’s because we set the cheese at the end of the maze on the right, not the left.  Our fault.  How do we fix the problem?  We need to look at the way our pay and incentive programs are set so we encourage the behavior necessary to make the business successful.

Incentive programs at many companies are still tied to the static budget.  You may recall in one of my earlier posts I said the budget represents a best guess about where the business will be, given the set of assumptions made at the time the budget was created.  Tying the budget and bonuses together makes the budget even more suspect as to its value.  This is because it inevitably leads to the back-and-forth negotiating that is such a frustrating exercise during the budgeting process.  Because employee bonuses are tied to achieving a static number, employees are motivated to get the number as low as possible to make the task involved in getting the bonus easy.  Management, on the other hand, has business growth in mind and wants to set the target as high as possible to gain the most.  What we end up with is a compromise of something in between that doesn’t reflect employee capabilities, company capabilities or economic conditions.

What if, instead, we structured the incentive program so it was based on the attainment of short-term goals actually related to the strategic plan of the business or on relative measures of growth year-over-year?  This type of setup keeps employees focused on the things that are important to the company and would eliminate the frustration employees often feel when they know getting to the static budget number is not possible.  For example, if the company wants to grow sales year-over-year, the bonus program could be set so for every 2% in sales growth achieved, the employee receives 5% of their salary as a bonus.  What if we also said there was no cap to the potential bonus a person could achieve?  Do you think the employee would be more motivated to do the things needed to grow the business if they know they will benefit from their efforts?

Now, I know there are pundits out there who will say money isn’t a good motivator and things like promotional opportunities and a good working environment are equally, if not more important, in keeping a work force happy.  I will not disagree these are important.  But for those of you familiar with Maslow’s Hierarchy of Needs, you know getting to the higher levels of the pyramid (love, belonging, self-esteem & self-actualization)  is not possible until you take care of the base needs like food and shelter.  The only way this happens is if you have money to pay for those base needs so they are no longer a concern.

One note about structuring an incentive program around relative measures like year-over-year growth — it is essential the business evaluate the current economic conditions to determine if an adjustment to the base figure is necessary.  This is especially true in situations of large economic downturns or upswings.  If you don’t adjust the base you are working from, you can create the same situation for employees as if they were measured against a static budget.  The number may just be unattainable and the same frustration levels and lack of motivation will return.

Who’s the Best? Benchmarking to Keep Ahead

“Competition is the keen cutting edge of business, always shaving away at costs” ~ Henry Ford

Being better than the next guy is a driving force for many businesses especially in highly competitive industries.  Everyone wants to be at the top of the heap and set the standard for excellence.  And for those who aren’t the best, they want to know how the best got there and how they can improve to surpass the current leader.  This is the essence of benchmarking.  Benchmarking is the act of comparing yourself against others to determine where you stand relative to the competition.  It may seem like an easy thing to accomplish on the surface but there are a few issues that need to be considered.

First, you need to determine who is your competition.  For industries with a few big players this is not difficult but when you are in an industry with lots of small players, sorting out the winners against which to compare yourself can be challenging.  You might want to consider focusing on companies that match your demographic profile like geographic reach or number of employees to make the comparisons of more value.  You can also benchmark against companies that might be national if this is the eventual strategic path your business wants to take.

Second, you need to determine what measures you want to use to compare yourself to the competition.  Do you want to measure market share, employee productivity (like sales dollars per employee), product quality, or other measures?  The selection of measures will be dependent upon your industry and what your motivation is behind benchmarking.

Third, you need to figure out how to get the information you want to complete your benchmarking study.  This may be the most daunting task of all.  Again, when dealing with public companies much information is available because of the reporting requirements they have to their shareholders and the public.  But getting information on private companies and industries can require more creativity and a strong penchant for research.  When seeking out information about other companies or industries, try some of these sources:

  • Industry associations & groups
  • Internet searches
  • Libraries (public library or universities & colleges especially ones that have a business school)
  • Dun & Bradstreet
  • Hoover’s

Most of the major accounting and business intelligence applications provide a benchmarking module or service.  There are also two online products that will provide benchmarking services that have been mentioned in internet searches on the subject.  Although I haven’t used either, in looking at the information about their products, it might be worthwhile to examine them to determine if they could bring value to your company:

  • webKPI (www.webkpi.com)
  • ProfitCents (www.profitcents.com)

You can also try to create a mutually advantageous relationship with your competitors to share information.  This may seem like a bit of a pipe dream but if the information being shared is not proprietary, it might behoove everyone to engage in friendly competition.  Competition spurs on creativity, innovation, and a desire to win.  And depending on the industry, this can serve both businesses and customers well.

Keeping Score: The Balanced Scorecard

Too many times there is a complete disconnect between the budget and the strategic plan of the business.  A strategic plan defines the direction the company wants to go in the longer-term and becomes the road map when making decisions about what avenues to pursue. This disconnect between budget and strategic plan is often the result of the strategic plan not being communicated throughout the organization and leads to situations where the budget is focused on allocating resources to the wrong initiatives or growing sales of the wrong products.

Enter the Balance Scorecard, the brain child of Dr. Robert Kaplan and Dr. David Norton, as a way to help align day-to-day actions with the strategies and vision of the business.  It is a performance management tool that includes both financial & non-financial measures as well as measures that lead and lag.  The measures are selected to reflect the strategic road map of the company to keep everyone focused on what really needs to be accomplished.

Realizing all actions within a business are interrelated, the Balanced Scorecard is created to reflect four perspectives:

  • Customer Perspective –  How should we be seen by our customers to achieve our vision?
  • Internal Business Perspective –  What business processes must we excel at to satisfy our shareholders and customers?
  • Learning & Growth Perspective –  To achieve our vision, how will we sustain our ability to change & improve?
  • Financial Perspective –  What kind of financial performance must we provide in our business?

The perspectives are linked together and are like a tree.  Learning & Growth are the roots of the tree and form the foundation of the business.  Good internal processes sprout from learning and growth, and become the trunk of the business.  By having good internal processes, you will get good customer results which are the branches.  Finally, customer results grow leaves which represent financial returns.

Within each perspective, objectives are set to reflect actions appropriate to executing the company’s strategy.  Measures (both financial & non-financial) are determined for the objectives, a target is attached to each measure and initiatives to attain the targets are put in motion.

This link will bring you to an example of how this all comes together: Building a Balanced Scorecard.

Creating a Balanced Scorecard is not an exercise that will happen within a day if it is done correctly.  In order for the scorecard to become a tool that is used and accepted by the business, its development should involve as many people as possible.  This is not an initiative that should be developed entirely at the top although senior management needs to be involved to ensure the final product is a reflection of the strategy.  Firstly, involving more people will ensure the message of the strategy is communicated to employees.  Secondly, with employee involvement you will gain a better picture of what is actually happening on a day-to-day basis and what information is currently available for the measures that are included on the scorecard.  New information may need to be gathered and the front-line employees might be better positioned to determine how this might be obtained.  Lastly, there is the issue of ownership.  If employees have a vested interest in the Balanced Scorecard because they helped develop it, it will gain acceptance quicker and be used within the business instead of being ignored as another executive program without merit or value.

One of the biggest dangers in Balanced Scorecard development is the selection of measures just because they are easy to obtain.  You must resist this temptation at all costs.  Just because you can gather information easily for a measure doesn’t make it the right measure for the business or the strategic plan.  The Balanced Scorecard is not an exercise of throwing a bunch of numbers on a page to justify current operations.  Every element of the scorecard should be careful considered and should only be included if it will help to move the business toward the strategic mission of the organization.  Also, the scorecard should be revisited at least yearly to ensure that the measures that are included are still relevant to the business and that nothing has changed due to a change in strategy.

As finance and accounting professionals, we will find ourselves needing to gain a complete understanding of the Balanced Scorecard.  Let’s be realistic — if it requires information to be gathered and numbers to be calculated, we become the de facto owners because we are seen as the information holders in the company.  However, we should avoid being the only ones having anything to do with scorecard development and review.  This is a tool requiring involvement from many parts of the business not just finance & accounting.

The Balanced Scorecard is a good way to augment the budget since it ensures the strategic plan of the business is clearly communicated to its employees.  Armed with a better understanding of what direction the business would like to go in, it is easier to ensure the budget reflects the allocation of resources to support the strategy.

Next to be discussed:  Benchmarking

Being Flexible: Using a flex budget

As mentioned in last week’s post on budgeting, the issue with the static budget is that it is out of date before the first month-end makes its appearance.  When this happens, a tremendous of amount of energy is spent month after month “explaining the numbers” when they may not need to be explained or can be explained in much simpler terms.  The solution is flex budgeting.  A flex budget is a budget where costs are adjusted based on changes in activity levels of the business like sales volumes or production output.

Flex budgeting actually helps on two fronts.  First, it will reduce the amount of time to prepare the budget once the model has been created.  Second, once the new budget year starts, it will ensure that more meaningful discussions are the focus of variance analysis instead of arbitrary line-by-line comparisons to a static budget that bears no resemblance to reality.

Preparing a flex budget model does require some upfront work but the end result is well worth the extra effort.  You will need to determine the nature of the various costs within your business.  Are they fixed, variable or step costs?   You will also need to determine what drives each of the variable and step costs.  Is it sales, headcount, machine hours or some other driver?  Once all of these determinations are made, the budget model can be built so it’s only necessary to update the assumptions about the values of the drivers and then many costs will be automatically calculated.  An examination of historical trends will help in verifying the relationships between drivers and costs.

Once the fiscal year starts, actual results are compared against the flex budget which is calculated using the budgeted assumptions and the actual value of the activity level (usually sales volume).  By doing this, there is no variance between actual and budget for sales, and the focus of any analysis work can center around costs.  Yes, it is important to understand why sales differed from what we budgeted but with a flex budget that discussion can stand on its own.  There is no cross-contamination between sales and costs to muddy the analysis waters.  And without complicated analysis work, everyone can get to the root cause of cost issues and how to improve the bottom line much quicker.

A word of caution here — DO NOT take the easy way out and build your budget model so everything is calculated off of a single driver like sales volume. The predictive and analytical value of the flex budget goes into a nosedive when you do this. Take, for example, benefits which are directly related to the number of employees on staff. Yes, there may be an indirect correlation between the cost of benefits and sales volume since a certain number of people are needed to support sales.  But since the number of people needed will probably stay constant over a certain range of sales, the cost of benefits is not a 1:1 ratio when compared to sales.  Therefore, calculating benefits as a percentage of sales will not give you a meaningful number to compare against actual spend.  You are far better off spending the time to have the model first determine the number of employees for the sales volume and then calculating the benefits cost based on the number of employees.

If you are interested in seeing how this all comes together, I’ve created a spreadsheet example that you can access here: How the Flex Budget Works

This is a simple introduction to the concept.  A good flex budgeting model is very robust and requires everyone in the business to determine how revenues, costs and other drivers come together.  This deeper understanding ensures that the focus of each person is on how to improve the bottom line.

Up next:  The Balanced Scorecard