Michael P. Landrigan, B2B CFO®
Providing B2B CFO® services in Fort Wayne, IN and surrounding areas

So, how do you spend your time?  It’s an important question and I’ll guess your success or lack thereof may be directly related to this question.  The Founder of B2B CFO®, Jerry Mills, wrote in his book The Danger Zone, about three types of people in business: Finders, Minders and Grinders. Jerry defines these types on their activities.

Finders are successful leaders and owners who spend most of their time thinking about the future:

• What are we going to do?
• What do we make?
• How do we increase sales?
• What skills are we going to need?
• Where should we be located?
• How do we separate ourselves from the competition?

The focus is on the future, planning and strategy.  This is a special talent and very few people possess the skills and foresight to do this well. The primary responsibility of a Finder is to increase the value of the firm.

Minders, a somewhat larger group of people focus on the past. They spend their time on what has already happened. They ask a different series of questions:

• Did we produce items within specifications?
• Did we follow proper procedures?
• Were the activities properly recorded?
• Were the items produced within cost?

Typically, these folks work for quality control or accounting.  Those who are particularly skilled can also think in terms of creating controls that help monitor and track the ability of the company to implement new strategies.  In other words, they can operate as minders and finders.  A good CFO should be able to straddle both worlds.

The final group focuses on the present. Grinders, the largest group, ask questions about today:

• What do I make today?
• What is the schedule today?
• What do I invoice today?
• What do I do today?

Today! Today! Today! Their focus is totally on the present.

Unfortunately, too many leaders and especially too many owners of small businesses, spend too much of their time Minding and Grinding and not enough time Finding. Finding is hard work. It forces management to plan–a process that can be difficult. But it is necessary.  Without planning, companies count on continued good luck. So, instead of leaders and owners working to create the desired future, their companies face haphazard futures devoid of plans.

Part of what makes Finding difficult is that many owners find solace in working on invoices and creating products. For many small owners, Finding means letting go. Those owners were the original laborers responsible for creating products for sales when they started the company. Over time, employees were hired who became responsible for producing those items or providing services, but the original owners may still enjoy working in those areas. In essence, this may be where owners are most comfortable.  However, this isn’t where they are most needed by their companies.

Let me give you an example.  While working with a small company, I became convinced the company needed to focus on increased sales.  I asked the owner how much he could increase sales if he devoted half of his time to going out and meeting potential new customers. He felt he could increase sales by $1,000,000 a year.  I pointed out that half of his time was about 1,000 hours.  One million dollars divided by one thousand hours means the owner’s time was worth $1,000 an hour to his company.  In this case, it easily made sense for the company to hire more people to complete the daily tasks to free up the owner’s time. That way, he could focus on Finding to increase sales.

We started on this process about two years ago. In that brief time, the owner has increased his sales by more than $3,000,000. By the end of 2012, I expect his sales to increase by 220%. Since I started working with him, the biggest difference is he is focusing on Finding and he lets other folks Mind and Grind.

I enjoy the strategic part of business or working on Finding activities with my clients. Much of what I provide is support for owners and managers so the Minding activities can be removed, or dramatically reduced for the top executives. The personnel who are best able to increase the value of a company are at the top of the organization. If they can keep their focus on the future, they are doing what is most important for their company.

I’m a strong believer that you learn more from mistakes or failures than from your successes.  Often, those mistakes may have been very painful experiences, but very valuable.  I also think my father provided very sound advice: “Learn from your mistakes, but it’s cheaper and less painful to learn from other people’s mistakes!”

I was involved with a company that determined the wisest course of action was to increase market share.  Their goal was to become the dominate entity in the industry.  This particular market segment was made up of a few primary players, but dominated by three organizations.  One of these dominate companies was my employer.  As we discussed  our plans, we reviewed the industry, talked about our ability to increase our market share through “organic” growth or through more sales of our products and determined that the quickest way for us to become dominate was to buy the competition.  We set our sights on one of the competitors and approached them.

They were aggreable and we proceeded with the purchase.  We put together a plan that included consolidating the two organizations and identified who would remain in specific executive positions in the consolidated organization.  The plan was sound and I felt made sense.  However, as we proceeded, we were forced to search for a new president to lead the company.  After a long search, a replacement was hired.  Unfortunately, he wasn’t involved in the creation of the original plan and he headed in another direction.  We never had the opportunity to initiate our plan and the company struggled for a number of years.

 From this excercise, I learned that not only do you need a plan, you need to follow the plan unless you find the plan is not working.  Give your organization time to allow your plan to succeed.  Our mistake was not following the plan.  Have a plan, then follow it!

Back in 1989, I led what was then called an MPR II implementation project for Thunderbird Formula boats  (http://www.formulaboats.com/).  We had many objectives that we wanted to reach and one of them was to be able to look at the quantity listed as “On Hand” and trust the number was correct.  For too long, our purchasing personnel simply didn’t trust the numbers.  Instead, to be certain that they knew the right quantity on hand, they would go find the inventory and make sure the quantities were right. 

While this was understandable, it was also exceptionally inefficient.  Why not get correct balances and keep them correct instead?  Now, you may be thinking, okay, they’ll take a full physical inventory and everything will be correct.  Unfortunately, it isn’t that easy.  There are a number of problems associated with a physical inventory:

1. Often firms use whatever personnel might be available so the person counting may not be familiar with the parts they are counting.  This means there can be errors in quantities or part numbers.  For example, if the standard unit of measure is pairs and the item is counted as “each” the total quantity will be overstated by a factor of two!
2. Often there is too little time or lack of available resources to investigate discrepancies.  As a result, wrong quantities are posted to inventory.  Wrong quantities lead to lack of faith in the numbers and the cycle of distrust starts all over again.
3. Confusion over open order and allocations can cause personnel not to count items that should be counted or to conclude that the parts are included in WIP when in fact the parts are still located in Raw Materials.
4. Often companies call items “inventory” but they don’t have a good method to identify these parts so they become part of an accumulation of unidentified inventory.
5. Entry errors can be another source of problems causing incorrect entries to be posted to inventory and the general ledger.  These can be errors such as typing in a wrong quantity or typing in the wrong part number.
6. When you can’t trust the inventory numbers, morale often lags because you question the ability of the company to perform even the most simple of tasks.
7. Research indicated that in general, a physical inventory created more problems than it solved!

 So, how does a company reach the point of trusting their numbers?  You start by taking one final inventory.  About 1989, Thunderbird did just that and there hasn’t been another physical inventory at Thunderbird since!

 We started out with one primary goal: we had to maintain a minimum of 95% inventory accuracy. 

We probably should define inventory accuracy.  In general, if, when you count a part, the quantity you count is plus or minus 5% from the actual counted quantity for the part. As long as the quantity counted is close enough to be within the acceptable range that count would be considered a hit.  If the count falls outside that range, it would be a miss.  If you count 100 items and 95 or more fall within the acceptable range, then your inventory is above 95% accurate.   There may also be times that you can’t afford any variation.  For Thunderbird, those parts were boat engines.  We felt that boat engines should always be 100% accurate without any variance range allowed.  Typically, these parts that fall into this category are very valuable and have a ready market to buy the item.

We kept track of our inventory using a class system.   For example, at Thunderbird, we established four classes:

1. Control group – This is a group of parts that are representative of the inventory in general.  In other words, these parts helped us identify parts that were not being relieved properly from inventory or if we were failing to record activities properly.  These items were counted at least weekly and in some cases daily.  If these parts were off, it typically meant that we had failed to record some activity properly such as relieving a manufacturing kit from raw inventory.  A manufacturing kit is a collection of parts that were needed to manufacture an assembly or subassembly.  
2. “A” items were high value items that were counted once per week.
3. “B” items were generally more readily available and not as expensive.  We would count these parts about monthly.
4. “C” items were usually inexpensive and readily available like nuts, bolts and screws.

Using this process, we would count every item at least 4 times each year.  We assigned an individual as our cycle counter.  This person needs to have certain traits.  They must be very detail oriented, enjoy the challenge of digging into to a problem and figuring out what happened and then capable of helping to develop procedures to help avoid having the problem continue to occur.  Our first cycle counter was a gentleman named Richard Black. 

 Richard was excellent at what he did.  Each day, before production began, he would go out and count the items.  Enter the data into our software system and then review the results.  When there were problems he would do research and feed solutions back to the proper individuals.  If the problem was in our bills of materials he would make sure the bills were updated.  If we had failed to record transfer of inventory he’d get that problem corrected or if we had not recorded the proper number of items received from a vendor, he knew how to make those adjustments as well.

 The key here was to find a person with the motivation and drive to get to the root cause of the mistakes and fix them.  Also, Richard knew all our parts, knew the unit of measure for each part and then graphed and published the results so we could visually see our cycle counting progress.  We didn’t face the errors generated by a physical inventory and that created trust in the numbers.  When purchasing trusts the numbers, purchasing becomes far more efficient.

Many years ago, I went to work for a rapidly growing, successful company.   One of the first items presented to me was the company’s effort to move production of the top two selling items in the firm to a production facility in Mexico.  Management was really excited about this opportunity.  I remember distinctly being told that the company would save 15% on these products once transfer of production took place.

Finally, the day came and production of these units was transferred to the supplier in Mexico.  Management was very anxious to see the effect on the financial statements.  Results the first month were poor.  Profits dropped but a quick analysis seemed to indicate that this was probably a result of initial costs associated with transferring production to Mexico.  However, when our profits dropped in each of the following three months, we became concerned.  Management had signed a long term contract and we were stuck. 

So what was wrong?  Management paid attention to total costs.  They had not understood how their costs were configured.  Put another way, they didn’t understand the difference between fixed costs and variable costs.  Their original variable costs were less than the new variable costs from the new supplier in Mexico.  All the fixed costs still remained with the company, only now; we were not able to offset the fixed costs with the same contribution margin, previously enjoyed.

So what is contribution margin?  Contribution margin is the difference between your selling price and your variable costs.  In the simplest form, imagine a retailer hat buys merchandize for $5 and sells that item for $11.  The contribution margin is $6 ($11-$5).  The calculation for a manufacturing company can be more complicated but the general premise remains.  The key is to know your variable costs.

Unfortunately, this isn’t my only example.  In another instance, the firm sold most of their product through large retail outlets.  However, about 10% of sales were sold through a professional installation network.  When the gross margin for this product was examined by non-financial personnel, they saw a gross margin of only 10%.  They demanded action!  It was obvious we needed to “axe” the drain on our resources and profitability.  There were also outside pressures on the firm seeking the elimination of this distribution network. 

Eventually, the company made the decision to eliminate this professional installation division.  The results were disastrous.  Almost immediately, all our dealers moved to our biggest competitor, significantly strengthening our competition.  Worse still our profits began to suffer considerably.  Why?

The answer was obvious once we began to dig deeper into the numbers.  We had focused on the gross margin of 10% and ignored our contribution margin.  In this case, our contribution margin was about 70%.  This meant that our variable costs were only 30% of sales.  So this division with only about $2 MM in sales was covering $1.4 MM of fixed costs for the company.

$2,000,000 – (.3 X 2,000,000) = $1,400,000

We had failed to look at the costs that mattered.  We didn’t understand how much this division affected our profitability by covering our fixed cost.  In the end, the company was sold to its biggest competitor.  The competitor consolidated all activities to the national headquarters and the company ceased to exist.  As a business person, know your cost so you can calculate your contribution margin.

I’m not a tax expert.  In fact, I admit that I prefer to avoid questions related to taxes. .. that doesn’t mean I ignore taxes altogether though.  Fortunately, I have a pretty good idea of what I know well enough to provide advise and that line where I need to get help.

Unfortunately, many firms or business managers ignore or are ignorant of activities that can create significant potential liabilities for their firm.  Nexus is a legal term that essentially means an event or activity has ocurred that allows a state or city to have the right to tax the company.  In recent years, states have become more aggressive in their efforts to find new revenue streams.  Or, put in other terms, to find a means to tax new entitities, especially if those companies have out of state addresses.

 To create “Nexus”, each individual state makes the rules that determine when Nexus takes place.  This event can vary by state.  Unfortunately an item that creates Nexus in one state may not create Nexus in another.  this means that you could be surprised or een schocked by what events might trigger Nexus.  For example, in some states, Nexus can be created by having a sales person call on potential clients or even display merchandize at a trade show.  In other states, hiring or more precisely paying an employee that resides in that state can be a triggering event for Nexus. 

The question that may be asked is, “What does this mean?  Does it matter at all?”  There isn’t a clear answer to those questions.  Once Nexus is established, the new state now has a right to tax and potentially audit the company.  In theory, the state has a right to only the portion of their income that relates to sales within their state.  The practical realities can vary however;  my home state is Indiana.  Some years ago, I recall a situation where Ohio was able to establish Nexus.  At the time, I said to our tax acountants “Well, this really menas, doesn’t it, that Indiana can no longer tax 100% of our income but not the portion in Ohio?” 

I remember her reply well, “In theory, Mike, you are correct.  Unfortunately, it never seems to work out that way.  One state may not recognize some portion of the claim of another state.  Usually you end up paying taxes on more than 100% of your income.”

Paying taxes in another state also means the time and cost of preperation of another return.  Regards of whether the return can be completed by internal personel, or use of external tax experts, there will be time consumed to gather the information and cost for preparation.  These are costs in addition to any costs prior to this new return.  In the case I experienced, the equivalent Ohio tax rate was also higher than the rate we previously paid in Indiana.

What steps should you take?  The primary thing to remember is— don’t forget the potential for new tax concerns.  Talk to your tax advisors before you make a decision.  It is always easier to fix a problem before it happens than after the problem occurs.  Sometimes you can’t put the genie back into the bottle.

I remember it like it was yesterday, I was involved in a full scale argument with my wife of about 3 weeks.  Now, understand, I grew up in a house where I never heard my parents argue.  It just wasn’t done.  Sure mom and dad had discussions together when they disagreed, but a raise-your-voice-heated exchange?  Never happened, never has.  The consequence of our argument was clear to me… my marriage was doomed.  Arguing was a clear sign, in my mind; this marriage was a huge mistake.  So I asked, in a very tentative voice, what seemed to be logical at the time…”So…do you want a divorce?”

At that point, my wife gave me a tremendous gift.  She was incredulous.  Yes, absolutely incredulous and absolutely livid.  “What are you talking about!?!?” she demanded.  “I don’t want you to EVER, EVER use that “D” word with me again!!!”  If I remember correctly, her voice became even more shrill and her volume increased significantly!  “ I am married to you, Michael Landrigan and I will always be married to you.   Nothing, absolutely nothing I say or you say will make me stop loving you!  We are married and that is the way it will stay!”  Succinctly and pointedly, she let me know that she was absolutely committed to being my wife and no matter how harsh the words or how pig-headed either of us might be (typically that would be me), she was determined to make our marriage work.  What a blessing!  That was over 30 years ago and I now remember it with a chuckle. 

Everyone that enters into marriage brings their own particular views of what a marriage is and their own expectations.  I naively thought married folks never argued, primarily because my parents provided us with a remarkable example.  My wife knew better and had a clearer view of what was necessary to make our marriage survive in the long term. 

Business partnerships are much the same.  Each person joins the partnership with certain ideas or concepts about how the partnership will operate and unfortunately, when the partnership doesn’t live up to their idealist impression, the partnerships often fail.  These partnerships lack the absolute commitment and determination to do whatever it takes to make the partnership succeed.  I’ve been around about a half dozen partnerships.  Unfortunately, most partnerships became exercises in futility.  Often, one partner perceives that another partner had somehow wronged him.  This leads to accusations, often exacerbated by external personnel, like attorneys, accountants or spouses, each adding their opinion and often creating new demands and more hard feelings.   It is a terrible, awful, disgusting downward spiral which ends up in failed communications, silence and bitterness, loss of capital and probably failure.  What a shame!

On the other hand, I have witnessed a couple of partnerships that work incredibly well.  In these companies, you’ll hear the principals say things like, “Let me talk about that with my partner,” or “Before we go any farther, I’d like to get my partner involved.”  In each case, the commitment to doing the right thing for their partner is of higher importance then taking care of themselves.  There is an absolutely selfless aspect to their actions and total dedication to maintaining the health of the partnership.  They are willing to forgo their own needs rather than limit their partner and there is complete financial transparency and constant communications.

In perhaps the best partnership I ever saw firsthand, the partners had adjoining offices with a door through their common wall that allowed them easy access to each other.  It was the norm for either of the partners to actually yell through the door, asking questions or getting caught up to date.  To an outsider, this would have seemed unusual, but for those partners, it was absolutely essential and allowed them to communicate effectively. 

In another partnership, the partners have divided up the work based on activity.  One partner is primarily responsible for sales and another is responsible for operations.  However, they constantly communicate with brief updates during the day.  They are also absolutely committed to making the partnership work and you can hear it with phrases like, “I’d like to move ahead, but let me get some input from my partner. 

Another key element is the concept of forgiveness.  I’ve seen brothers, and fathers and sons who come to an impasse over some sloppy or dumb activity undertaken by their partner.  Unfortunately, they haven’t been willing to “give the benefit of the doubt” and the partnership suffers and eventually decays and dies.  The lesson is this, if you have partners and there is the possibility the other person has done something foolish, talk with them and give them the benefit of doubt.  The worst thing partners in conflict can do is stop communicating.  Shutting off communications may well lead to a total “war-like” environment within the firm.  This often spills over into personal lives and in at least one case I’m familar with, led to the end of what had been a solid marriage and complete estrangement of parents and some of their children.  Instead, you must talk to work through your situation or disagreement and be willing to forgive!

Business partnerships are like a great marriage…it takes absolute, tenacious commitment to the partnership and a willingness to sacrifice!

As a business person you need to have goal clarity.  One of my B2B CFO® partners, Rick Daigle wrote a great blog on the importance of goal clarity that I strongly recommend (Osprey parenting).  In his blog, Rick points out that the male Osprey knows that he has to catch six fish every day to support his mate and hatchlings.

In business, too often, the CEO may not know what information is really important and key for their business to succeed.  As a result, they may jump from one really exciting piece of information to another without consistently looking at the data that really matters.  Fortunately, after going through this struggle they may find that as long as this activity is happening, everything is going well.   Once this becomes important to the owner, president or CEO it is easy to get other members of the company to pay attention to the same data. 

One of the most telling experiences I ever encountered occurred when I was leading an MRP II implementation (today we would call it an ERP implementation).  For MRP to be successfully implemented, you need 98% bill of material accuracy, at least 95% routing accuracy and at least 95% inventory on hand accuracy.  When we started the project, our accuracy was abysmal, hovering around 35%.  We had a long way to go.  We made changes in our processes, felt that we had the accuracy necessary in routing and the bill of material, and should see a dramatic improvement.  We took a full inventory and our accuracy had improved but was still only around 70%.  We continued to count but had no improvement in our accuracy.  We needed to do something different.

First, we chose one afternoon and almost all members just under the “C” level of the company went into our stockroom and started counting.  I imagine it was embarrassing for the folks who ran our stockroom to see us out there on their turf.  We set a date to repeat the action in a week.  When we returned seven days later, the stockroom had already counted the parts and made it pretty clear we would not need to repeat the effort in the future.

The second thing we did was to begin graphing our results and posting the results in the cafeteria.   Each week, we would update the information and management paid attention to the graphs.  It did not take long before the pride of the individuals in the stockroom took over.  They wanted to succeed.  They offered a number of suggestions to help improve our processes and they became determined that they would achieve the goal of 95% inventory accuracy.  Almost immediately, the numbers started to improve; within 30 days we saw 95% accuracy for the first time and the numbers stayed there.  The real key was making the goal visible. 

Some years later, I was working for a company in the automotive industry that was attempting to implement QS-9000.  Like ISO, QS-9000 requires that a company set goals and then measure the ability to meet those goals.  This requirement forces companies that want certification to set goals that can be measured.   But another truism becomes obvious when you follow this requirement: if you want a specific outcome, measure it, graph it, and change it.

For management to have a good idea of what is taking place with their company, they need to have access to all the information related to the company.  Many firms are satisfied looking at information after the fact, when they review the financial statements.  Unfortunately that is almost always too late. 

I’ve seen it happen in construction too many times as an example.  A project is nearing completion, all the reports look like the project will finish under budget when all of the sudden several invoices arrive that the project manager forgot about and the accounting personnel didn’t know about.   Suddenly the project that was a winner becomes a big loser and now the company has to find a way to pay for the additional unexpected costs. 

In manufacturing, a similar problem would occur when a physical inventory is taken.  For example, if goods are received but the company has done a poor job of recognizing goods that have been received but the invoices have been processed into the general ledger.  This means the cost for those goods won’t be considered in the inventory balance in the general ledger.  Inventory is understated and the company understates the cost of goods sold.  When the invoice does arrive the company will be forced to recognize   additional expenses.  Depending on the size of the invoice this could have a major effect on profitability.

If your company falls into that trap, how do you break free from this negative cycle?  You need to close the loop.  “The loop” is the ability to monitor what is taking place within the company.  For example, if you don’t have the ability to use the software system to identify what is on order for inventory or for a project you have an open system.  Your system forces you to guess about the dollars you have committed to purchase, either as part of a project or as part of purchase to replenish inventory, or for other company needs. 

Why is this important?  Because it affects two key aspects of your business:  cash and profitability.    Eventually you’ll need to pay for anything you order.  With a closed system, management has the ability to forecast the specific cash requirements of the company while having the ability to recognize the costs that will occur.  For example, in construction, it is typical for a company to bid or make an estimate related to specific projects.  As construction begins, actual costs begin to be recorded against project and can be compared against the original bid.   As the project develops and later nears completion, management attempts to estimate the profitability of the job.  However, if all purchases are not being recorded and collected within the software system, management is effectively blind to any costs which have not been received into the payable system.  This can lead to poor decision making.

Closing the loop means that not only are purchases recorded so that management can tell the cost associated with those orders, but also that visibility of purchase orders are always present.  In other words, when orders are received, recognition of the receipt and associated liability is recorded in the general ledger.  In a good system, upon receipt, a debit is generated immediately for the goods or services received and a liability, typically called something like, “received not yet invoiced”, is also immediately generated.  Then when the invoice is received “received not yet invoiced” is debited and accounts payable is credited.  At no time is any liability “invisible” within this system.  Management is always aware of all costs associated with the company and surprises are virtually none existent. 

Without this process, large expenditures may be incurred by the company without management having any knowledge that the company has incurred this liability.  The results can be devastating.  Save yourself and member of your company from headache: close the loop so that you can know your costs and your cash requirements.

Early in my career, I had a narrow view of budgeting.  To me, budgeting was a very constricted exercise that an organization plodded through annually.   At the end of the process, the company would generate a very defined budget that was “hard-coded”.  By hard-coded, I mean a set number or desired number for each account on the projected income statement, by month, for the budget year.  Then, when this process was generated, these numbers would be entered into a “budget” file, typically within some module of the general ledger operating system.
As the year would proceed, we would compare this information to the actual results and measure the difference between actual and budgeted expenses.  Typically over time, the gulf between the budget and actual sales and expenditures would grow as the year progressed.  Over time, this difference began to make the budget process feel more like the writing of an unnecessary piece of fiction, than a necessary management tool.
Fortunately, I was introduced to the folks at Oliver Wight and, in particular, to Tom Wallace.  I was lucky because Tom was able to show us that there was another, better way to budget.  He pointed out that the problem with most budgets were they were based on a sales forecast.  Usually, these forecasts were generated by some member of senior management.  Almost without fail, these estimates were the best guess or desired sales goal of the organization;   almost equally without fail, we would miss those numbers on the low side.
Tom pointed out to us that essentially there are three kinds of expenses:  fixed, variable and semi-variable.  Fixed expenses do not vary.  For example, depreciation expense remains fixed unless the company buys or sells fixed assets.  Regardless of whether sales go up or down, fixed expenses remain constant.  Variable expense, on the other hand, is entirely tied to the fortune of sales.  If there are no sales, then there is no variable expense.  As sales rise, so does a variable expense.  An example of a variable expense would be ice cream at an ice cream stand.  The vendor buys the ice cream and that purchase remains an asset on the books of the firm until someone comes and orders ice cream.  Once the ice cream is sold, the cost is shown as expense under materials sold.
Occasionally, an item will act as a semi-variable expense.  These costs run somewhere between a fixed cost and a variable cost.  Semi-variable costs act like a fixed cost up until there is some triggering event.  A triggering event is some decision or action that forces the company to add expenses, such as additional supervisors when a shift is added to a plant or additional indirect personnel to meet the demands of production.  In my experience, these expenses are almost always treated as fixed and then the budget is adjusted if the triggering event occurs.   Or, rather than having expenses increase, a company decides to downsize.  Essentially, these costs are reductions of semi-variable expenses.  In fact, almost every fixed cost is actually semi-variable.  Given some event, those costs can and will go up or down.  That is why controlling the discretionary decisions related to fixed costs are often key for companies to reach or regain profitability.
Eventually, we were able to develop a process that allowed for “flexible” budgets.  A flexible budget means that rather than comparing the budget against a constant sales figure, sales are adjusted as well as variable expenses.  Then the budget is compared against figures that are consistent with the actual results.  The end result is a budget that is consistent with sales; far more realistic when compared with actual sales and expenditures and a budgeted bottom line that, not only is understandable, but plausible. 

This reasonableness creates “buy-in” or acceptance from budget managers and gives owners, CEO’s and CFO’s a much better ability to generate “what-if” scenarios.  In essence, you create a model that provides a roadmap for the organization showing the effect of increases or decreases in sales.  With that roadmap, the company can begin to improve their ability to forecast future profits. Once the company is able to master this process, closing the financial statement becomes an exercise in verifying the profitability the firm expected instead of closing the books to find out the financial results each month.

Once a budget for revenue and expenses for the year is established (see last month blog, Flexibility-The Key to Sound Budgeting), I strongly recommend that you continue on and also budget for balance sheet items.  To be honest, there was a time in my career that I viewed trying to budget assets and liabilities as a tremendous waste of time, and if the budget was stagnant and we missed our sales targets, it was!  However, using flexible budgeting, you can build a budgeting model that ties the income statement and balance sheet.  Even if you miss the sales target, you can still link assets and liability to revenue and expense accounts.

My favorite software for developing a budget model is MS-Excel®.  Put all active asset and liability accounts into your model.  It is important that all your revenue and expense accounts be linked to some account on the balance sheet.  As an example, if you typically sell on open account with 30 days turnover, you must link to net revenue to accounts receivable.  If you manufacture a product, you will need to build the purchasing and production cycle into your model.  Materials will need to flow from raw inventory to work-in-process and through finished goods. 

This process also provides the ability to create a detailed capital budget that includes the timing for your purchases.  You can also tie depreciation expenses to accumulated depreciation.  I’ve found that the process works best if you have separate lines for the beginning balance, debits to the accounts and credits to the account.  When transactions are complex, you can add a line for each level of detail.  Total the beginning balance, debits, and credits (credits should be negative numbers) together for the ending balance.  Using the ”sumif” function makes calculating totals for balance sheet information easy.

Why is this useful?  Imagine that you sell a product through a commissioned sales force that is paid 5% commission.  By tying the commission expense to the accrued commission liability account, you can watch the liability go up with additional sales or fall on lower sales.  That is the beauty of this process.  Not only does this account reflect what happens in a “what-if” manner, but done properly, all accounts move up or down in relation to activity within the organization.  Taken as a whole, companies can anticipate the future movement of asset and liability accounts based on reasonable assumptions.    In total then, cash needs can be forecast.  Anticipating future cash movement goes a long way toward managing cash and making sure your organization has the cash necessary to grow and be successful.

Using this information allows you to forecast the balance sheet by month.  Once a forecasted balance sheet is in place, you can have your internal accounting personnel generate a formal projected statement of cash flows by month.  This becomes particularly useful when you want to know the effect of reducing accounts receivable days outstanding or the effect of increasing inventory turns by a full turn annually.   The changes created by these improvements become very visible and often this visibility helps drive organizations to realize these benefits.

If all this sounds like a process that would really help your company but you don’t know who or how to go about developing, our partners at B2B CFO® are experts at putting together business models.  Our experience makes the process much easier for clients and provides a sound business tool that helps companies understand the effect of incremental changes on the business.  Feel free to contact us.