The financial accounts of a business are a single source of information which can signpost you to what you need to do next. You may have a gut feelings and specialist consultants will tell you that if you address their specialism, everything will fall into place. But reality is not like that, things change, everything is in a constant state of flux and you need to constantly be adjusting and refining activities to stay on top of your business. The beauty of the management accounts are that they should be “current” and they allow you to run scenarios before incurring the impact of implementation.
If you do not have a set of management accounts to regularly refer to, what should you consider when setting them up or if you have a set how could you improve the information you can extract from them? The first consideration is, what type of information are you looking for? What are suitable intervals to review the financial information? For the chosen time intervals, what are the particular financial activities should you look at? Finally, what does the information tell you and what should you do with it?
Step 1. The types of information required.
When the accountant does the figures at the end of the year, they are the actual amounts and are therefore accurate and reflect what has occurred. They are backward looking and only provide an indication of performance by comparing them with the previous year. This sort of information is unlikely to help you to manage the business in the future, either in the short or long term. Nevertheless, knowing what has occurred is important and therefore one type of information required is what has in fact occurred, the “Actuals”.
On the other hand, if you are about to pay a bill, you might consider payments you will receive and other out goings before you make the payment. This is a simple example of forecasting and is the beginnings of managing the business. By looking further into the future and by having a structure, managing the business will be greatly improved. Therefore, another type of information we require is a “forecast”, to make informed decisions.
Finally, you hear people say they are aiming to achieve certain goals. The financial targets set to achieve the goals will be referred to as “Targets”. Targets may have a value in time, or they may be related to a change in performance. So, the final piece of information are the “targets”.
By establishing “Targets”, you can compare the “actuals” to them, but when the “targets” are sometime in the future, it is too late, if you get there and find you have not achieved it. To avoid this situation, you will need to break down the “target” into manageable slices and establish a “forecast” to achieve the “target”. You can then monitor the “actuals” against the forecast and take corrective action as you go along, which will enable you to get close to the long term “target”, thus avoiding any nasty surprises at the end of the target period.
To maintain clarity, stick to the terms “Target”, “Forecast” and “Actual” and when comparing one to another, “variance”.
Step 2. Establishing a forecast.
There are natural cycles, economic ones, elections, seasonal ones and your personal ageing from teenager, through midlife to retirement.
The longest is your personal one, where would you like to be in 5, 10, 20 years’ time financially. From which you can work out what you need to achieve in 5 years, which is the first Target. From this you can establish targets for the 5 years leading up to the first milestone.
The annual target can then be broken down into a monthly target, which should then be adjusted for the seasons, Spring, Summer, Autumn and Winter, as trading patterns are impacted by these for most businesses. The adjusted monthly figures become the “forecast”.
Each month a comparison should be done against the forecast to see how things are going. Some months will be better than others, so it is also sensible to track the cumulative progress for each month to see how likely you are to achieve the annual target.
Step 3. What to monitor when?
Starting with the monthly time period, as the big inflows and out flows usually occur in a month, e.g. payments on 30 days terms and monthly salaries, then our focus should be on the calculation of the gross profit. The gross profit provides the funds for the overheads and any residual profits, so the aim should be to maximise. By maximising gross profit, it will give you choices.
Gross profit is “income” less the “cost of sales”. It should only deal with costs which occur as a result of the activity of producing work, it has nothing to do with the costs associated with the business if it was not producing anything.
To maximise gross profit, now and in the future, the sorts of questions you might ask are:
Which are my most profitable projects?
What is the most profitable type of work I do? and what should I stop doing?
Which types of work are the profits decreasing? And which are they increasing in?
Which locations are more profitable?
Which teams are most profitable? and which could contribute more?
By breaking down the “income” into codes and then allocating the “direct costs” to the appropriate income, then the answers to these sorts of questions can be worked out. Project codes for income are useful as they can then be grouped in different ways to answer the questions.
Whilst the profitability of a project in a month is a useful metric, it is too short a time period to detect movements in the market. For this either a seasonal comparison (quarterly) or an annual comparison is required. Time at the monthly meeting which occurs on a quarter, half year or end of year should be set aside for a more general review on what is happening.
The cost of running the business, does not change as much as the cost of the costs incurred in the activity. Premises, IT, fees etc remain reasonably constant. Never-the-less they can change and there can be some large outflows, at certain times of the year if payments are made quarterly or annually.
At the monthly review the focus is at project level on gross profit, but at the quarterly review there should be a review of the overheads, which are taken off the gross profit. Too often there maybe a dip in gross profit, but the business which fails to act quickly and address the overhead, will immediately see the dip translate through to the net profit.
To adjust the overheads, you need to know the direction of travel of the components. Generally, accountants are fairly good at creating the main overhead headings, which they call “expenses”. So coding costs into IT, Marketing, HR, Premises etc allows you to see which are growing or decreasing. Expressing the component heading as a percentage of Gross Profit, can be a shock and will undoubtedly cause you to get control of each aspect, be it outsourced or run by an internal manager.
Running scenarios, of changes to the overhead, e.g. an additional person in accounts, can easily be done if you set your management accounts up correctly. So, when someone says they need additional resources, either you will be able to see that it is justified as the percentage Accounts dept / gross profit will have been decreasing or there will need to be some other justification if the percentage is rising. The justification may be warranted, e.g. implementing a change in legislation, but knowing there is an increase cost, then a discussion can be had as to how it will be dealt with. It may only be a temporary increase; it might require a software change to avoid, there is all manner of solutions. Without robust management accounts, those discussions cannot be had, and a business will become uncompetitive, or lose money.
Finally, there are more subtle changes, those of inflation, market changes, changes in social habits and generational preferences. These will probably not be detectable in less than a year. Nevertheless, they occur and once a year there should be a review of the accounts to reset them. If the management accounts are sufficiently granular, they will be an invaluable source of information to set the targets for next year.
Step 4 - Keeping on track
The establishment of an annual review and action cycle is not easy. The appropriate activities should be reviewed in the appropriate time intervals. During the course of a year the staff will become acquainted with them as they are developed. Once in place and an annual review used for setting direction for a business, proactive management of the business will become lot easier and growth will flow. Review of the management accounts will act as the perfect focus to signpost actions.
If you would like to discuss setting up a robust financial plan and review process, please contact me to see if I can help you. Peter.Searle@ba4cs.co.uk
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