Several clients come to mind when I consider measuring profitability. These examples illustrate the challenges that many small and medium sized businesses face when the owner/CEO is not sure what profit/loss the business has made in a given month, or even over a year.
I recently reviewed a new client’s monthly income statements for the previous year. The first thing that caught my eye was the fluctuations in net earnings between months – many months had large profits and others relatively large losses. The client confirmed that the business had some minor seasonal highs and lows, but nothing extreme.
The client is a small custom manufacturer and his controller was apparently recording the transactions of the business as they occurred and attending competently to the basics of reconciling the bank accounts every month, etc. However, she was not reviewing the financial statements at the end of each month and asking herself the critical question: What do these results represent and how will the rest of the management team read these results? She should have realized that the reports that the management team were exposed to were mostly meaningless. If the owner and management cannot even interpret a report to determine if the business is profitable, what is the financial accounting system there for?
These same concepts often apply to most businesses, regardless of size, that buy and sell products or provide services. Labour in a service business is usually the same as manufacturing cost in a manufacturing operation.
An associate of mine asked me how is it that some entrepreneurs can run their businesses by merely “watching” their bank balance? I have come across some very successful business owners who had little time for the accountants in their business, as long as the compliance reporting at year end was done. I have reflected on what sets these very few individuals apart from most business owners. The businesses were small and simple to run; they knew every aspect of their business intimately and every one of them possessed a very high level of cognitive ability (see “Assessing & Selecting People For Cognitive Ability” ) In every case this was accompanied by weak accounting staff combined with an owner that did not know what to ask for from the accounting staff. While I strongly believe that watching your bank balance is astute business practice, to rely on the fact that all the right conditions exist in your business, and will continue to do so, is a huge gamble. This risk is rarely worth the small amount saved by not employing effective accounting procedures.
Here are some of the key steps that should be taken by the person responsible for the monthly financial statements, to ensure that earnings and losses are reflective of actual results:
Ensure that you value inventory every month and adjust it, if it is not automatically done by your accounting package. Most accounting packages have an inventory module and a simple inventory accounting (or estimating, as an interim step) process will enable you to measure your gross margin. Gross margin is the most important measure in every business that trades in goods, and many others. If you do not adjust your inventory, you cannot know the gross margin of your business and you are not running your business, it is running you.
New clients who own small businesses can often tell me what profit they made at a finite level of detail (an invoice or product sku) but they cannot tell which departments or product categories are the most or least profitable. The problem is that this detailed information is often ignored and the fluctuations are lost in the aggregating of the whole business. It takes a large change to notice a fluctuation in the gross margin of the entire business but it is easier to detect a change if the business is broken down into five to ten product categories. This is also invaluable information for your sales and marketing team. So divide your business into product categories that have similar characteristics and measure the gross margin of each and always monitor the fluctuations.
Sales and purchasing cut-off
Many businesses determine when to stop shipping at the end of the month based on a need to achieve their targets. There is nothing wrong with encouraging your production staff to complete and ship as much product as possible before month-end. However, if your computer system does not automatically adjust inventory when goods are shipped, ensure that all goods invoiced to a customer are removed from inventory and that all any product not invoiced is included in inventory. Similarly, it is important to ensure the procedures in place for receiving inventory achieve an accurate recording of what has been purchased in the month. These procedures are elementary but it amazes me how often significant errors occur. Ensure that the inventory cut-off matches the goods included in the month’s sales and purchases.
Work in progress
Many small businesses do not value and account for work in progress as it is “too difficult.” When I hear this, I often think of one of my favourite sayings: “Let’s be approximately right rather than precisely wrong.” It is preferable to have an accurate costing of work in progress, that can be calculated manually or by sophisticated inventory management computer systems. If this is not in place, then at least, use simple estimates. In most small and medium sized businesses one can simply walk around the production area at month-end and record each piece of work in progress with an estimate of its value. This rough estimate will make a large difference to the accuracy of the Gross Margin for the month, while being 10% wrong on the total work in progress will not be significant.
One other process that worked very well for many years at one of my clients was to aim to have zero, or minimal, work in progress at each month end.
Try to ensure that all expense invoices that relate to a given month are included in the accounting for that month. Some market leading accounting packages do not have separate fields for the invoice date and the accounting month. As a result the expense is shown in the month that the supplier gets around to dating the invoice. Ensure that invoices not presented, or those dated after the month-end, are accrued so that you have a reasonable reflection of the expenses incurred in the business and the fluctuations.
Try to estimate expenses that are incurred in big lumps and accrue a best estimate, on a monthly basis, so that the large but predictable expenses are not incurred all in one month. Good examples of these are year-end accounting/professional fees and realty taxes.
Establish and monitor the prepaid portion of expenses that are usually paid in lump sums or installments that do not match your accounting periods. Good examples of these are insurance premiums, software licenses and maintenance and realty taxes.
If your controller is not taking into account the items above that apply to your business, you likely do not have the financial information necessary to manage your business, especially in dynamic conditions. Many controllers will only implement some of these steps when asked, as they do not have the cognitive ability to think of the strategic implications of providing owners and management with information that is not meaningful.
About the Author
James Phillipson is a Chartered Accountant and a Principal of Mastermind Solutions Inc. with over twenty years experience in large and small businesses. He has provided financial counselling to his clients since 1996, often in the role of a Controller or Chief Financial Officer. James has experience in financial roles in a wide variety of businesses and industries.
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