This is the fourth in an 8-part series especially for new subscribers to the Creative Finance & Management email newsletter. Every week we are sending you an article aimed at helping you to think about a different aspect of the financial management of your business. This is in addition to the normal bi-weekly newsletter. We are doing it to give all new subscribers the same orientation to the way that Charis FD thinks about small business performance management. That way we can have confidence that all our subscribers have been given the benefit of foundational advice in all aspects of business performance management.

If you miss any of these articles, don't worry. They are on the Creative Finance & Management blog. Just look for the "New_Subscribers" tag.

These are the articles in the New Subscribers series:

1. The ingredients for success in Finance
2. Strategy and Planning
3. Business Change - implementing your strategic plans
4. Measurement and Management go together
5. Paralysis without analysis
6. Your Finance team - a valued asset
7. Stakeholder management - the importance of keeping people happy
8. Internal Control - 3 fallacies that add risk to your business

Here we go: ...

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Measurement and Management go Together

"What gets measured gets done!" is often quoted as a truism. The other way I would put it is, "if you don't measure it, you don't manage it". What I want to do in this article is show you the principles of how to apply that to managing the performance of your business. You do want to manage the performance of your business, don't you? You know that if you don't manage performance then your business will almost certainly underperform?

I've tried to say in the last three new subscriber newsletters that you have to be intentional in managing business performance, or in managing a business in general. If you want your business to perform well, you have to know and specify what you want it to achieve and have defined strategies for achieving those goals. You should also have given yourself targets for what each of your strategies should achieve.

But you can do all that and still not succeed. One of the main reasons that happens in smaller businesses is that they don't check regularly to see whether they are succeeding or not. They don't measure the outcome of their strategies, or at least not regularly enough. It's no use getting to the end of the year when the auditors come in, or when you sit down with your accountant, to find out that you haven't grown your business as much as you wanted to, or you spent too much. It's a bit late then. You need to measure outcomes monthly, weekly, and daily in some cases.

Getting into the nitty gritty for a minute, the basic financial performance reports you need to have on a monthly basis are the income statement (or "profit and loss account") and the balance sheet.

The income statement should not be in so much detail that you can't see the wood for the trees, but should be in enough detail to see where your money is coming from and where it is going to. For example, if you sell the same small set of products to a few regular customers, then show your income by customer or customer group. On the other hand if you have a varied product set you may want to show your income by product. This depends what your marketing and sales strategies are - segment your income in the same way you segment your sales for strategy purposes. Then you can see if your strategy is making any difference.

Similarly you will want to show your costs in the income statement in a way that makes sense. You may show them by type (e.g. premises, people, insurance, IT, etc) or by department (e.g. operations, sales, finance, IT, HR, etc) or both. It depends how complex your department structure is and how you manage your business.

The balance sheet shows the value of what the business owns, what it owes and what it is owed. It is useful to see particularly the cash balance, the debtors balance (what your customers owe you) and the creditors balance (what you owe suppliers).

But this is just the basic level. Every business should do those without question. You need more. If your strategy is targeting increasing sales, then you must also get more detailed reports on sales. If your sales cycle is less than a month, then perhaps you should be getting sales reports weekly or daily. If your strategy depends on production quantities and operational efficiency, then perhaps you need daily or weekly reports on those things.

And again, don't just look at financial performance. Performance measurement and management are much broader than that. If you are a service business, perhaps you need to measure that utilisation ratios for your consultants (time spent generating revenue divided by time available). If you have a long sales cycle, perhaps you need to get weekly or monthly reports on leads generated and sales pipeline reports. If these things are critical in your strategy to achieve your vision for the business, then you can't manage them properly without measuring how you are doing.

To sum up, what are the key things to think about in performance measurement and reporting? What, how and how often - those are the three key questions. What to measure will depend on your strategy, the things you are doing that are important to getting the business towards achieving its vision. How to measure it will have to be thought through carefully - it could be a figure, a ratio, a traffic light, a pie chart, etc. How often will depend on how often things change. You want to be able to make decisions and adjust your strategy and tactics on the basis of what the information is telling you, so the information has to be timely.

Finally, all this measurement will be worth nothing if you don't use it, if you don't make decisions based on the information. No strategy is perfectly infallible. The information you get may tell you that you are not quite getting it right. If you are learning from the reports you get, you will investigate further and tweak or change your strategy depending on what you find. This the feedback loop complete. The business performance management wheel that I talked about in the first of these articles depends on completing the whole cycle - develop your strategy, carry out your strategy, measure your performance and learn from the information to develop your strategy... and so it goes on.

I'm worried that this all sounds complicated, because I've condensed so much into a short space. If you do a healthcheck on what you actually do at the moment, I think you will find that you already do some of this, but it may be ad hoc, disjointed and disorganised. As with other areas, putting some thought into it and having a rationale for measuring things about your business will get you a long way forward. Just the act of being intentional about performance measurement is big progress.

The final thing I would say is that this is probably one of the areas that someone like a Finance Director would add the most value. They are skilled in pulling numbers together and in interpreting what they mean for the business. If you haven't got anyone like that in your business, then give it some thought. And it doesn't have to be full-time headcount. There are part-time options available, which are more affordable for smaller businesses - one of these options is Charis FD's own services. That's a gentle plug for my business, but I think it's appropriate. See our website for more details.

If you are worried about the cost of such a service or the cost of taking on a full-time FD, think of it in terms of the financial benefits it could bring. They would work alongside you, helping you to put in place the finance and performance management disciplines we have been outlining over the last few weeks. So I would be surprised if following all this advice with help could not help to improve your sales by more than 5%, or improve your gross margins by more than 5-10%, or your net profits by 10% - especially if you have not employed one before (either full-time or part-time). If you look at it that way, it doesn't seem so expensive. That's obviously not making any promises, but it's food for thought!

Why not contact us today?

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Until next time...

If at any stage you want to talk to us, we're quite happy to give you a call to talk more about your business and the challenges you face. And you may be eligible for a free Finance Strategy Review session. To set that up either email us at enquiries@charisfd.com, remembering to leave your phone number and email address; or go to our website and complete the contact form.

Thanks again for subscribing to Creative Finance & Management. We hope you find it helpful.

© Charis Business Consulting Limited 2009

The best way to cut overhead costs in big companies

This article describes the way that the principles of Activity Based Costing were used to cut overhead costs by approximately 20% in one large group that I worked for.

Activity Based Costing is the term given to a particular way of analyzing costs in order to manage them more effectively. It arises from the premise that costs are driven by activities. In other words you don’t just decide to employ a new person or buy materials or engage a consultant for the sake of it. You do those things in order to perform activities in the business. The more complex the manufacturing process, the more things have to be done to make the product (activities), and therefore the more people and materials have to be purchased to make it.

So thinking in this way is different to the normal way of looking at costs. Normally you have a profit and loss statement that says you spent so much on employing people, so much on occupying a building, so much on raw materials, etc. Looking at things that way is not completely useless, but it only goes so far. In a sense it answers that “what?” question. What have we spent money on?

Activity Based Costing (“ABC”) goes deeper to try to answer the “why?” question. Why do we spend money? What are the things we are doing that mean we have to employ this number of people, or buy this much raw material?

Now, in my experience, ABC is usually applied to manufacturing processes and direct costs. It allows insights to be gained into the costs of products. For instance, you may find that a costly activity in the process of making a particular product is the initial set up of the equipment. Therefore, you can make that activity more efficient be lengthening production runs. ABC therefore tends to go hand in hand with process analysis, because you can’t do ABC without analyzing the process. ABC is simply putting a cost on each activity in the process. Then disciplines such as Six Sigma, Total Quality Management, etc, come in to help to identify how the process can be improved. ABC leads to product profitability analysis and customer profitability analysis. In fact, it opens up many new ways of looking at the profitability of the business.

The one thing that is normally set on one side in Activity Based Costing is overhead cost. Overhead cost is primarily fixed or long term step costs, such as business management, Finance, HR, premises, legal, insurance, and so on. Old school management accounting would have said that if I want to work out the profits of each product, then I would have to allocate some of these overheads to each product on some basis. However, when I studied ABC I was told that allocating overheads to units of product (or anything, for that matter) was pointless, since products do not drive overhead costs. So it would be misleading to say that I make £2 profit per unit of a product, because it suggests that if I double my sales of that product I can make additional profit at £2 per unit. And that’s simply never going to be true. Doubling output may not lead to doubling overheads (one would hope not normally!). Or it may lead to more than doubling overheads if the additional volume takes the business past a major step (e.g. warehouse capacity). The point was that overheads should be left out of the analysis because it distorts things by including them.

That insight was music to my ears when I first heard it! At the time my monthly management reports were divided up with a page for each product. The direct costs were easy (in my case) to put against each product. But at the bottom of each page was an overhead allocation. Guess which bit of each product profit statement drew the most attention and argument each month? Yes, the overhead allocation! How much management time and energy was being wasted over something that was, to be honest, fairly arbitrary?! Overheads should be managed differently, and product managers should not have to justify the profitability (or otherwise) or their products with overheads arbitrarily allocated to them. I came straight back from my ABC course and took the overhead allocation out of the product profitability statements! Then we really started to focus on the real issues for the products – sales, margins, operational process efficiency.

But having set aside the overheads when looking at product or customer profitability, one cannot just ignore them. Having said they should be managed separately, how should they be managed? Certainly when I studied ABC, it did not seem to provide the answer. Perhaps I missed something!

Later on in my career I worked in a large utilities group, supporting their HR function in Finance and analysis matters. Across the group we spent hundreds of millions of pounds on overheads. And when the time came to tighten the proverbial belt, we had to find a way of getting to grips with the costs of overheads in different functions across different parts of the group. For example, the costs of HR did not just consist of a central HR department. There were about 12 different central HR directorates (ranging from Talent Management and Learning and Development through to Health and Safety and Occupational Health). Then there was the group HR Service Centre. And then each business unit had its own HR functions.

At my suggestion, to tackle the challenge we used the principles of Activity Based Costing to analyse the cost base and guide the decisions over where to make cuts.

First we asked each department manager to complete an Excel template. In this they listed each activity undertaken in their department, and against each activity they put a cost and headcount. The total cost and headcount for the department had to add up to the annual budget for the department. We also asked them to complete the latest forecast.

Since that information was still a little too granular we also asked the functional heads to categorise each activity in different ways. First, the activity driver – legal/compliance requirements; services required by other parts of the business; strategic initiatives; and “other”.

Speaking for the HR function, the analysis was pulled together practically by my Management Accountant, categorised by a 3-4 person working group, consisting of a couple of BU and central HR directors and myself, and then validated by the HR Leadership Team (the Group HR Director and her direct reports, including the Group Directors and the BU HR Directors). There were more than 400 rows of information, adding up to around £75m+ if I remember correctly. But, using the activity information in the data received, my Management Accountant and I came up with reports that could show the costs summarized in a few different ways to help the rather painful discussion.

The painful discussion was, having analysed the costs and categorized the activities, going through and further marking proposed savings against each activity. This started with senior HR Directors in each business unit discussing their own straw man proposals with the BU Managing Directors and their management teams. Then more pooling of thoughts and opinions within the HR Leadership Team. Then culminating with a presentation of a proposal by the Group HR Director to the Group Executive Committee.

The target cost saving had been given at the outset – there were to be 2 or 3 different proposals – small, medium and large! In other words they wanted to know what activities would be lost or cut back if they asked for cuts of 15%, 25% and 40%. So we knew what we were aiming at, at least in terms of analysis. The unknown was what the final savings figure would have to be. Each proposal to cut activities had to be accompanied by an assessment of the impact, strategically, operationally and tactically.

So you can see that ABC can be applied to overheads very easily, and gives a valuable and effective way of examining overhead spending especially when drastic cost savings are required.

The discussions that resulted from the analysis were very focused, well-informed and pitched at the right level of detail. The decisions were made confidently, in full knowledge of the impact.

… The sting in the tail of this story is that my own department was one of those where cuts were proposed in our activities, and the process resulted in my own redundancy (amongst many others)!!

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