November 11, 2021
I have spent a lot of time over a great number of years talking about various ways of defining variable profits and measuring them against time (throughput and velocity), both on an order-by-order basis and globally within your estimating and financial reporting systems.
From a big-picture point of view, variable profits less fixed costs equal operating profits. The variable profits and resulting dollars per hour can then be looked at by machine center or centers, by customers, by categories of business, etc. The aggregated fixed costs can be divided by the number of shipping days to give you a sense of the variable profits needed to break even. So, if your total expected fixed costs for a year are $25.6 million and there are 256 shipping days in a year, then you need to generate $100,000 per day in variable profits to break even. But what about the $25.6 million in costs? What information do you need to manage them properly?
Most financial statements contain very broad expense classifications such as factory overhead, selling, and general and administrative, and there is no universal method in determining what expenses belong in each category. For example, some of you include customer service salaries in general and administrative expenses, and some of you include them in selling expenses. The real issue here is not which of these categories should contain certain expenses, but rather whether these categories have any real meaning in terms of understanding and managing your business. In my opinion, you should be focused on creating cost centers.
A cost center is an aggregation of costs that pertain to a specific function within your operation. It should be a key function and be large enough to have its own manager, who is in some way charged with managing those costs. In most companies, customer service would be considered a separate cost center, but in a very small company that has one or two customer service reps who are managed by an office manager, this may not be the case. Therefore, the definition of what is a cost center is also not universal and must be determined on a company-specific basis.
Examples of potential cost centers that come to mind are plant, maintenance, shipping, design, sales, customer service, office, accounting, and warehouse — although not all of these would apply to every operation, and some operations might have other departments. Each department should have a detailed listing of its costs, a budget, and prior period data that they can be compared to as well as information as to the key metric that drives the departmental costs and can be used to help evaluate departmental efficiency. For instance, the customer service department may want to keep track of the number of orders processed, the design department may wish to track the number of designs produced, and the shipping department may be interested in the number of trips made or the number of miles driven.
The resulting face of the P and L, which used to look like something like the top table on the previous page, should start to look something like table below it.
Both statements contain the same amount of sales and report the same operating profit, but they contain dramatically different information. The first is very big-picture, and every line item is compared to the same metrics—sales and MSF shipped. Every column adds down and adds across neatly, which we accountants generally like to see, but it doesn’t really offer any actionable information. The sub schedules that go along with the statement are general listings of costs with no real metrics attached to them.
The second statement is a little busier, but it breaks down your costs using the concept of actionable and manageable cost centers. Each expense or category of expenses should be compared to its own key metric and not just looked at as a percentage of sales or per MSF shipped. Every company keeps data on such things as machine hours, labor hours, overtime hours, miles driven, orders processed, maintenance purchase orders, and many others, yet it is very rare that this data is ever utilized to understand the financial results of the company. The sub schedules that backup these departmental costs can contain information such as head counts, hours worked, overtime costs, and information about the output and timeliness of the departmental efforts.
Please give this some serious consideration, and in future articles of BoxScore, we will start to take a look at what the sub schedules that back up these cost centers might look like. We will also revisit how to create meaningful profit centers and how to relate direct costs to each profit center. The bottom line is that financial reporting can and should be flexible and dynamic. The same income statement can be presented utilizing different formats and different metrics while still using your existing systems.
Your software and plant reporting systems are tracking a lot of information and are robust enough to support many different types of reporting. The time has come to get creative and begin to integrate this information into your financial reporting to help you better understand the results of your operations and, ultimately, help you make better decisions.
Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.
