Is your profit data misleading you? Part 1 – valuable insight

Developing good products and services is important, but it is not everything – commercially there are a number of pieces of the jigsaw that need to come together if a business is to achieve its potential and fulfil the owner’s dreams. Ultimately, profitability must be a key consideration – if you are not making a profit then the longer-term viability of the business is doubtful.

Most businesses have a reasonable handle on the overall profit and loss position, but it is important that this analysis extends beyond simply “are we profitable?”. Successful businesses have a much deeper understanding of financial performance and are able to analyse profits made by product or by service. An ‘agile’ business uses this insight to focus and direct resources between their offerings, which will enable them to improve the overall performance, identify efficiencies within the business and contribute to short and long term strategic thinking.

The SME’s Challenge

Despite the obvious benefits from detailed performance information, we find that very few SME clients have this information to hand. We recently worked with a small family owned business who were in the process of selling to a much larger national UK operation. As part of the due diligence process, they received a long list of financial information requests from the acquirer including sales and margin by customer and product. Whilst sales detail per customer was easily generated, it was not possible to report in respect of margins; insight which the larger more established acquirer expected as the norm.

One of the main reasons for this lack of detailed analysis often comes down to the purpose of SME record keeping; primarily to ensure compliance with tax and statutory obligations.

There is no doubt that the functionality of accounting packages available to the SME market have, in recent years, improved considerably and most “off the shelf” packages allow cost centres or other tracking categories to be utilised. If used properly, this functionality allows revenue and costs to be allocated and a degree of analysis applied. Furthermore, many “apps” that link to accounting packages – such as Xero – provide potential insights to further interrogate the data.

We often find limitations on data availability where an organisation is relying on just accounting records for detailed profit reporting, and cost analysis.

Organisations who utilise specific operational systems, will have more detailed performance information available. For example, Solicitors utilising time recording software will have a much better understanding of how long was spent on a specific matter or client and accordingly better understand the return achieved.

The key issue remains that the accounting systems are there to record transactions, not how costs are allocated.

Getting the data correct

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As advisers to SME Businesses, we do see significant value in this information and encourage clients to better understand the costs associated with products or services. However, for many smaller businesses the cost of delivering a product or service is difficult to accurately calculate as often there are shared resources between what is being delivered. When allocating any costs that are not 100% attributable to one product or service, the outcome will vary quite significantly depending upon the basis applied.

An inappropriate basis will potentially distort the analysis, which in turn is likely to drive the wrong behaviours and decisions.

For example:

The following business is a foreign currency broker, who supplies both corporate and retail markets.

Number of bank transactions10,0001,5008,500
Profit on currency transactions100,00040,00060,000
Bank charges80,000??
Net Profit20,000??

If the business wants to understand the profitability of each market sector – there is a need to allocate bank charges – a common approach might be to simply allocate bank charges on the basis turnover. Unsurprisingly, many businesses choose to apportion costs on a “turnover” basis, this would mean net profit was identified as:

Net Profit20,0008,00012,000

However, given that the underlying basis for bank charges are transaction volumes this analysis is flawed. If the allocation is revisited and transaction levels are used to allocate bank costs the overall result becomes very different.

Net Profit20,00028,000(8,000)

Although very basic, this example illustrates the basis for allocating costs can have a marked impact on the profit and loss identified for each market sector. In this example, the business allocating costs based on turnover would not realise the loss making nature of their retail arm and could be encouraged to invest further in this market sector. However, the stark reality is that they could increase profits by simply ceasing to provide retail services.

Unfortunately, this arbitrary approach to cost allocation is all too common and as a consequence we’ve seen many businesses make decisions based on misleading data and analysis.

Meaningful analysis – one size does not fit all

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There are many schools of thought about how costs can be allocated and indeed how detailed your analysis should be and many accounting text books will talk at length about “activity based costing” and overhead absorption rates”.

There is often a fine line between useful analysis and over analysis and trying to apportion every cost line and often adds little value compared to the time spent and can distort the picture. For example, trying to allocate rent costs between services delivered, will always be hit and miss as it is a genuine fixed overhead, coming from a lease commitment that cannot be changed.

There is no right answer in terms of how detailed your analysis needs to be. Similarly, there is no prescribed formula of what you should analyse and how shared costs should be apportioned. It is important to recognised that every business is different and the analysis you do needs to be right for you. It needs to meaningful to you and any allocation of shared costs needs to reflect the “driver” behind the cost being incurred. We recommend that any apportionment of costs should stop at genuine direct variable costs.

So, you’ve established what valuable insight you want to collect and how you’re going to collect it, but what are you going to do with all this new data?

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