Real Business Control
Article posted on 9th September 2006
I'm writing two extra chapters to my book for the reprint. This is the first and I would very much value your comments, critiques, corrections or anything else!
Where next in our helicopter? - well - now we need to get into some left brain stuff.
To run your business effectively it is essential that you have the right financial and other key performance indicators provided to you and you need to remember, however, that (regardless of what others may think) this information is there simply to help you run the business.
You must therefore ensure that you get it in a format, in a level of detail and using terminology that you are happy with.
Accountants, just like most professions, make their activities appear more complex and difficult to understand than necessary - I think it must be some form of self-preservation activity that we all have!
So let's start with the terminology:
Each of these terms mean exactly the same thing:
orders = bookings
order book = backlog
backlog = overdue orders = back orders
sales = revenues = turnover
cost of goods sold = cost of sales
gross profit = trading profit = contribution
operating profit = trading profit = PBIT = EBIT = surplus = EBITDA(sometimes)
earnings(sometimes) = EBT = PBT = net profit
debtors = receivables
creditors = payables
stock = inventory(sometimes)
cash = liquidity
work in progress = work in process
- and there are many more *[see footnote]
So you need to get in your helicopter and take control - you're the boss. Decide which accounting terminology (company finance-speak) you wish to adopt and then make everyone, including your auditors, stick with that in everything you, and they, do.
Having got your terminology fixed the next thing you need to be clear about is the information you need and the way in which you want it to be presented.
All the figures you see in a set of accounts are, by definition, historical but what you need to do to run the business effectively is look to the future. Running a business successfully is much more about looking at trends rather than absolute figures and you need to track key financial, and other, information month on month, year on year and against budget to really see the direction the business is going in.
It is so easy to get bogged down in the detailed numbers and miss the big picture - and I've actually seen this more with large Corporates than with SMEs.
I worked for Burmah Oil at one time and their monthly reporting packs and annual budget papers were up to 50 pages long! - and were not drawn up in any way to help the CEO run the business. When I was at BTR, however, the reverse was true. They had the most outstanding monthly reporting pack I have come across - it was never more than ten pages and the first page summary gave you an instant overview of the business from which you could then drill down as necessary into any areas of concern. I've since used that format in many companies and if you'd like a copy just drop me an email at roger@rogerharrop.com
So what information do you need on this all important summary sheet?
Start with what's most important to you - Profit (assuming your purpose in some way embraces profitable growth)
- If you're in the type of business where there is a time lag between receiving the order and making the sale taking place then you need next Order Input as this is the very first indication you get of what's going on in the business.
- Also have Order Book so you can see what you've got to go at.
- ROS (Return on Sales) - see later
- Depending on the business, one or two balance sheet items always including Receivables.
- Cash Flow is very important
- People Numbers
- one or two non-financial ratios which are relevant to your business for example OTIF (delivery on time in full) and maybe a quality, customer satisfaction, service level or a health and safety measure.
The above information alone shown month on month, tracked against last year and your budget should give you sufficient trend indications to see instantly the health of the business and how things are going.
Next I have always found the need to get in the helicopter and look at the big picture more with financial information than probably any other area of the business because it's so easy to get drawn into the detailed numbers.
Whenever you are comparing year on year or looking a year or two ahead I would recommend that you draw up a simple "helicopter" P&L account with only those 7 elements shown below. In the Corporate environment I've found this particularly valuable whenever you are looking a budget a subsidiary company is putting forward to you for approval:
Orders Sales Materials or Costs (excluding all labour) Payroll & associated costs Depreciation All other overheads PBIT
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If you're in a manufacturing business then as likely as not you will have some element of labour and factory overhead taken into your product costing and your gross margin calculation and I find whenever comparing year on year this can really make true comparisons difficult. So if you have such a business you will need to have a further line included above of labour, overhead and materials going into or coming out of stock (just one figure) and then ensure all people costs are in the payroll line to complete the P&L statement.
If your purpose, like many businesses, embraces sustained profitable growth then a key performance indicator is ROS (Return On Sales) - PBIT as a percentage of sales = and what you are seeking to ensure is that not only your absolute profit figure increases year on year but also that your ROS also improves every single year.
For that to happen, of course, one or more of the P&L elements below the sales level in the P&L must be reducing as a percentage of sales.
The key ratios therefore you should look at in the above P&L when comparing, say, a budget for next year with forecast performance for the current year are simply the individual line ratios against sales - because only by each of those reducing can the ROS increase - it really is that simple!
We've concentrated so far mainly on the P&L but, of course, businesses go bust because of a lack of cash not a lack of profit.
Control of working capital (essentially receivables, payables and inventory) is very important for you to monitor.
You should regularly look at receivables days and inventory days (where appropriate) and have a discipline of doing regular cash flow forecasting -which really isn't hard to do with a reasonable degree of accuracy no matter your business.
Finally in this section I'd like to touch on budgeting for sustained profitable growth.
I have seen, and indeed prepared, many budgets over the years and nine times out of ten growth budgets are predicated on one assumption only and that is that sales volumes are going to increase = which will in turn generate improved profits.
This is not a robust budget and is very likely to be missed - and missed badly since what you find often is that the overheads and people numbers have been allowed to increase on the back of the predicted sales growth and when that growth doesn't happen there is in fact a "double whammy" hit on profitability.
I was taught a great "helicopter" discipline by BTR:
In order for a budget to be robust it needs to represent a three-legged stool.
What this means is that the budgeted profit improvement should come from three areas equally (or the stool falls over!).
They are:
sales volume
price increases & cost reductions (margin improvement)
productivity.
So in your budget you should quantify clearly the profit impact of each and work on getting that impact about equal.
The simplest and most useful way of measuring productivity, incidentally, is just sales divided by total people numbers don't bother with all the most complex or sophisticated productivity measures they simply aren't necessary.
There we are then - a full set of "Helicopter" figures that should work for you to achieve your business purpose.
I can hear you now saying to yourself that it's all very interesting but you can really rely on your Accountant, Finance Director or Controller (depending upon the size of your business) to do all this analysis and monitoring for you and you should not need to worry about it.
Please do not make that assumption - it's very dangerous.
It's your job to run the business, and that means that it's your job to keep a grip on the key numbers and trends.
* When writing this chapter I put this list to about a dozen financial people around the world. I received back from a number of them some very pedantic statements that I was wrong and that certain terms were definitely not equivalent and had quite different meanings. The problem was, however, not all this pedantic statements agreed with each other!
© 2006 Roger Harrop
