Some Top Issues Facing Closes

Over-Arching:: Manual Processes and Data

• Account Reconciliations

• Real-Time Data Visibility

• Inconsistent Processes and Lack of Standardizations (SOPs)

• Incomplete Data or Errors in Data

First: Integrable Capabilities of Systems and Applications

--Manual Processes and Errors

Not every company has fully integrated ERP systems such as SAP, Oracle Fusion, Oracle NetSuite, MS Dynamics 365, Acumatica or some equivalent. Some of these systems offer a full suite of integrable packages and modules covering all areas of business operations, while other smaller ERPs offer modules for a few functional areas and are expected to integrate with other applications.

An example of a full suite, Oracle NetSuite, has it’s core finance and accounting suite, NetSuite Financial Management, but it also has modules for CRM, Inventory & Order Management, Supply Chain Management, Commerce & Ecommerce, HR & Project Management.

Of course, all the big ones have a similar setup. Not playing favorites, all systems have good points and bad points.

It is quite common to see businesses attempt an amalgamated setup of operational applications, often with a partial ERP package and several other applications. A recent setup I saw had an ERP system that acted as the primary Accounting, CRM and POS tool and they used separate applications for SCM, Logistics, Fixed Assets, Payroll, HR, Tax and so on. This wouldn’t have to be an issue, but the reason I said ‘attempt an amalgamated’ setup, is that the integrable capabilities between applications is one key to smoother financial closes that are often not utilized.

In the recent setup, for example, there was no bank feed integration being used within the ERP system. The staff ERP specialist insisted that there was no integration available until I began questioning it and initiated a process with the bank to develop an API between the ERP and their system. As it turns out, there was a native bank feed integration (as almost all possess) that had been shut down and overlooked because no one questioned how best to leverage the ERP and any integrable capabilities. Can you imagine cash reconciliations without the bank feed integration?

Leverage your systems capabilities. The ERP system I mentioned from the example had numerous integrable, partner applications to assist in automating processes. The next I initiated was an AR/AP natively integrable application with AI capabilities. The AP team, specifically, was still receiving email invoices and processing payments by hand. The AP application had 2-way and 3-way reconciliations and the ability to filter emails and learn to read invoices. This not only reduces manual time, but when a system can input entries across applications, say from an AP vendor account to the ledgers and the bank statement, you reduce manual entry error.

With a simple setup for two integrations, both native, days were shaved off a very manual closing process.

Yes. Obvious. But, how many actually understand their systems, capabilities, or APIs and data connections?

It isn’t too complicated of a topic if we just stick to what they do.

Most applications will list other applications for which they have native integrations. Native integrations are pre-built APIs so you simply need to select the option to connect applications and log-in. Okay … so what are APIs?

Well, from layman speak…

Application integrations are conducted through APIs (Application Programming Interface) written specifically for two applications to communicate information. The connection can be one-way, two-way, read only, or read and write. (Check with your IT) If you have ever migrated data from an application to a database or data warehouse you will be familiar with API usage. In lieu of an API, data transference in many processes is ‘manual’, perhaps keyed or CSV uploads. Plenty of opportunities for errors and lost time.

You will notice that a feature of the large ERP systems and modules covering the functional areas of operations is that they are integrable, they communicate information amongst various modules. Without this capability, you would just have several disparate systems that require CSV uploads, properly formatted, to exchange data. Their entire selling point of reducing period close times and errors is greatly diminished without the integrable functions.

Below is a Mapping I had drawn up at a high-level for an ecommerce platform, although, I believe Square is now Block.

Mappings of processes are useful. Look at how a mapping visual makes a complicated looking setup understandable. I know most understand this; it is my way of supporting, in in my foundational strategy talk, my focus on the use of mappings for a strategy tool and training tool.

I have no affiliation with any of these companies. I was sketching out integrable capabilities for a company and mapping manual steps where integrations might be targeted. You will find that not all companies have native integrations for every other company and a buffer, such as Zapier, might be able to bridge that gap. Zapier isn’t the only company that offers this service, but it is often mentioned in any research done on system applications and integrations.

You may note that this specific example does not include a payment processor for AR such as Stripe. FreshBooks Payment is built on Stripe and FreshBooks can integrate with Google Workspace for invoicing. If you have used QuickBooks, then this might resemble the invoicing functions from its invoicing and payments capabilities. To make a point, this is not a unique setup. It is highly likely your systems have capabilities that are either underutilized or not being utilized that could minimize manual processes, manual errors, and improve closing.

Second: Bookkeeping as a Relational Database

--Real-Time Visualization

I know … this is basic accounting but stay with me for a moment.

In today’s finance and accounting departments it is a rarity to find employees that have an understanding of the process of recording transactions using the old school bookkeeping methods. Yes, I mean the paper journal and associated ledgers. Certainly, some accounting courses still teach students to use the paper method through semester projects, but many just use images in textbooks.

Recall you keep a chronological tracking of all transactions and then post these to their appropriate ledger for ease of balancing and reconciliations later. You see the exact same setup in your accounting software with transaction lists and the various ledgers.

The purpose ? - A paper relational database.

Again, bookkeeping entries also included cross-references from journal number and page number to ledger number and page number so that entries could be easily tracked when reconciliations were needed at period close.

The double-accounting system was essentially a relational database, but rather than assigning entries a unique primary key-foreign key relationship, the journal number or ledger and page number for transactions were listed with descriptions. The descriptions would include sales numbers, Invoice numbers, pr approvals, po numbers, billing numbers, and any identifiers related to a transaction entry. What’s more, the paper receipts had to be organized and stored for ‘easy’ referencing for both reconciliations and audits. Hence ... boxes.

Just because an accounting entry isn’t triggered, it doesn’t mean that you shouldn’t be able to trace the entry’s source for an audit. For example, when the AP accounting entry is triggered on receipt of an order, you should still be able to trace the PO and PR to that order. This is why boxes were often catalogued with the entries in addition to the journals, ledgers and pages.

IF A TRIAL BALANCE was off, the ledger entries had to have a reference to the various items for reconciliation. For example, if AP was off, the AP ledger would have entries for the PO, Billing, and Receipt numbers and may even include the Payment number, which in the old days would be the check number. While all these numbers occur at different times, the use of Subledgers for specific vendors would make it easier to find these entries and identify what process entry was incorrect. (Yes, I have had to track paper receipts for different situations.)

Now imagine ... your identifiers such as PO, Billing, and Receipt numbers created by your system as you upload and store documents, automatically create transaction entries in the accounting system and operational systems and it processes unique primary and foreign keys to identify every line, for every relationship when you need to complete an audit or period close. This is, of course, what happens.

example:

Drawing from a large system and sticking with our AP process:

In the SAP system and referencing the data dictionary. SAP tables

• RSEG : fields (BELNR : Invoice Number, EBELN :: PO Number)

• BSEG : links accounting (invoices) to purchase orders through key AWKEY

• MSEG : links material documents (receipt) to purchase orders through EBELN

The relational setup allows you to join tables and identify the missing or mismatched values.

Almost all applications and systems run a relational database and create tables for storing data. All systems do so in a similar fashion regardless of whether it is Microsoft, Oracle, NetSuite, or some other set of applications. The heart of the matter is that you can use the database structures and concepts to create visuals for matching transactions and reconciliations in the same way you would use the database to create a dashboard of financials even if you don’t have integrable capabilities.

This is where your FP&A team could be utilized for maximum benefit by having them use their data ETL (Extract-Transform-Load) skills and dashboard skills to create reconciliation tables.

Three major areas of the closing process are Cash, AR, and AP reconciliations.

If you have connected a bank feed into your accounting system, then you have seen how an integration helps to identify matching and unmatched or mismatched entries. The bank feed gives you a list of transactions that have cleared and a list of transactions that are pending, but in the system. These transactions are matched against those recorded in your Cash Account. The comparison between the two helps you identify any transactions that have no match. And we all know the manual process could be done by downloading the transactions from the bank accounts and reconciling against the Cash Accounts.

But, again, consider that these are just two tables being compared. For all intents, these could be tables in a relational database. All you need is the ability to connect, extract, and visualize these comparisons, on a daily basis, in a BI tool.

This process would improve visibility of unmatched transactions from AR, AP, and Cash, using a tool such as Power BI, Excel, Tableau or the like and the OData (Open Data Protocol) protocol or ODBC (Online Database Connector) connection. This is the exact method your analysts would use to retrieve data from your warehouse or other applications currently used for dashboards, models, and reporting.

- I should begin by saying that, ideally, you should create a backup of all application data by migrating all of it into a database, data warehouse, or data lake. You would then connect to the database to perform these visualizations. It is not best practice to connect directly to an application or an ERP system, although many offer this capability. Also, migrating your data to a data center creates at least one back-up for your data at a centralized location, but an offsite server backup would meet a risk management procedure for data protection. -

Just to provide a quick example search answer to the question to provide support for my suggestion, Does NetSuite have an OData feed?

I think you will find this is very common for applications. You just need to retrieve your tables. In my use case I might choose Power BI and Power Query Editor for ETL actions.

Let’s look at tables we might gather to track AP and the portion of Cash specific to disbursements on payable. We see three different systems or modules, Bank Feed/Statement, Accounting (Recording), Procure-to-Pay Module.

It is a near certainty that your bank will connect to your Accounting Platform and, due to the competitive nature of accounting offerings, your Accounting Platform will almost certainly integrate with your Procurement Platform, for example QuickBooks and Bill. Also, since Power BI is a major BI tool, API and integrations are possible into these systems to query information.

Each system will present this information with different column headers and different naming conventions, but remember that, due to the requirement to relate transactions for analysis and rollups, you should be able to find the table Keys (Primary, Foreign) on which to perform JOINS (SQL language). If your system does not have keys, you can use the supplier invoice numbers, billing numbers, and other unique identifiers within the reference and descriptions of transactions (just like the old bookkeeping system).

In addition, if you need some planning assistance, any system will have a data dictionary for their database and tables that describes the column, input type, allowable characters, related tables, formulas and so on for a reference.

For my example, I am going to create these tables in Excel, shown below and use the both the ID’s that your system might produce and the unique Supplier Invoice number. Your system might have more detail, but the key columns and dollars are really the focus. The ledgers are going to begin from the assumption that you have filtered for relevant context as the data is imported into Power BI. For example, all GL and AP will be for inventoriable Trade Payables to align with the POs, Supplier Invoices, and Good Receipts tables.

Bank Statement

*I am not going to create a Bank Statement from scratch. I believe most will have reconciled Bank/Cash and could utilize it in their BI tool for reconciliation in the same manner as will be done for ledgers and PO, Supplier Invoices, and Goods Receipts below.

*As you become familiar with the abbreviations used by the Banking Institution for your Vendors and Customers you may want to store them as an added identifier for simplified Cash/Bank Reconciliation.

*Note that if you begin reconciling AR and AP from Order to Pay, Procure to Pay that you will have a good portion of your Cash Reconciliation completed. You then can proceed to Expense and Bank statement items to wrap it up. (Through planning to prevent duplications of steps can also help to move closes along.)

General Ledger

AP Ledger

Inventory Ledger

*In addition to the Inventory Ledger we will have a GRNI (Goods Received, Not Invoiced) account and assume FOB Destination so that any paid invoices that have not had a Goods Receipt will be entered into Prepaid Inventory.

Op Cash Ledger

Purchase Order

Status:

• open active needs either invoice, goods receipt, or approvals

• pending waiting on both invoice and goods receipt

• due payment invoice approved, goods received, due payment

• closed received goods and paid

• partial partial goods received, partial goods sent

Supplier Invoice

Status:

• pending pending verification of goods

• approved approved for payment

• paid payment completed

• partial payment partial acceptance

Goods Receipt

Status:

• accepted received

• awaiting invoice received, accepted, awaiting invoice GRNI

• pending pending inspection

• partial partial acceptance

Please keep in mind, I quickly constructed these sample tables for a sample to spur some thoughts and considerations for use in your systems. I may have missed some details. For example, if your PO includes line-item numbers for purchase orders with a list of items, then you would have to accommodate this in your analysis. I don’t believe that any details that I may have missed would hinder an analysis to the point that this method could not be applied to your data.

Hopefully, you can see where this is going an how we can use this to track inventory quantities and the accounting ledgers as well. I do want to remind you that this matching and structuring could be done in SQL, the Power Query Editor, or from the calculated columns or DAX measures to arrive at the same visuals.

The Top Cover could look like the following:

Of course, I am not doing a full design workup. This is simply illustrating the relationship between the PO’s, Supplier Invoicing, and Goods Receipts with the associated Accounting Ledgers.

Quickly walking through the boxes. The Green PO’s that are Closed or Partials should have the associated Goods Receipt, in addition to the PO’s that are Due Payment and hence should all be entries in the AP Ledger as Recorded Credits, follow the green chevron.

From the AP Ledger, it will equal the Inventory Ledger, Gold, sans the GRNI accrual, Light Blue, since the GRNI won’t move to the AP until the Goods Receipt is received.

Across the Blue row, the Supplier Invoice, comprised of Paid, Partial, or Approved invoices will equal the AP Ledger, Prepaid Inventory (for any invoices paid before receiving a Goods Receipts), and the invoices that have been approved, but have not been paid or received the Goods Receipt (recall FOB Destination). This reconciliation could easily be extended into the details of the Vendor specific AP ledgers as required with slicers.

In theory, any given time that you wanted to conduct a close, your various entries should balance and, by the same reasoning, as your operations progress a tracking system should balance or quickly alert someone to an issue.

You can also set up similar tools that you might find in your procurement system, for example searching for status and 3-Way matching on POs. Granted, those that have access to the system would have this capability, but not necessarily those that sent the Purchase Request.

Or perhaps you want a look at the partials, those orders that were partially ordered, or partially sent so that you could check on a credit or inventory items.

Must like the previous Power BI article that I wrote, we could create detailed links to the Item ordered. Perhaps we have an expected replacement date, or we have a critical inventory item for an assembly process, and while these are a bit outside the range of accounting reconciliation, an expected credit memo is in line with our process.

Integrations and Mimicking Bookkeeping with Operational Accounting Triggers

This is exactly what your ERP system or aggregation of systems is supposed to do for your record keeping. But, if you note the relationship between the AP (procurement) system and the ledgers, we are doing a similar matching and tallying of transactions to run checks between the operations and accounting.

As pointed out earlier, your data is generally stored in a relational database, every transaction needs to have primary keys and foreign keys so that the ERP system can perform the same relationships that we can create in the Power BI report. But not every company has an enterprise grade ERP system with full integration for all areas of supply chain, inventory, sales, leases, asset management, tax, accounting and so on. Many companies will have several applications and manual processes.

I am suggesting that you can utilize your access to the data in the applications through an API, or other connection, and a tool, such as Power BI, to create similar visualizations and reconciliation assistance. Map your accounting process relative to your controls, gather the data and begin your process. This is not necessarily easy given that you may have more status levels or item lines, but it could be worthwhile if you use a BI tool and do not have a fully integrated ERP system. If so, then your FP&A team already has the tools it needs to begin to offer actual assistance to the process in a manner that utilizes their skills with data and applications.

Third: Data at its Source and Clean-Up

A familiar saying that is most often associated with model construction … Garbage-In, Garbage-Out (GIGO). While in a model construction this reminds you to check data, sources, recordings, and assumptions, this same saying can be used when it comes to period end close and reconciliations. Only GIGO for reconciliations can mean tracking down input errors at the source, for example, the POS system.

I will cite a real world example of both vendor and customers input into the POS system, linked to an ERP system at the store front. I know others have seen this very example. You are going to create your schedules for AR and AP. You are going to implement the capability to select a breakdown by vendor or customer so that you know who to target for further analysis, however, you discover that several vendors and customers have multiple entries in the system due to manually keyed entries.

Use the list below as an extreme example.

close up

As you can see, this listing of companies could easily be a list of names for the same company. While in the real world, duplicate entries for a single company usually only number two or three different entries, I had this set available from a clean-up exercise I use for skill building.

This situation is not uncommon for brick-and-mortar companies. A salesclerk takes an order and fails to conduct a thorough search in the system for a customer or is given a name for the company that is a ‘known’ name. For example, Alpha Forge Manufacturing vs Alpha Cast. The clerk may be new or busy but knows that they need to enter the order and then proceeds to create a new ID so this order can get processed. This data is then migrated into the database and often only seen when it gets to the analyst trying to build a model.

The analyst is simply expected to correct the data in an editor or in a spreadsheet so that the correct aggregations are shown. This activity might be so common that the analyst keeps a list of all the alternative identifiers for companies so that a quick mapping can be performed for any reports or visualizations (Yes, this happens). No one bothers to attempt a correction at the source … a standard procedure and training to prevent garbage data from going into the system at the source. It is just expected the analyst will clean it up on the end of the data cycle. While this isn’t necessarily a huge issue when creating models and AR/AP schedules, using this poor POS procedure and resulting data for reconciliations can be timely and therefore costly to a closing process.

Because all processes naturally create data, it is the analysts that could be your best source of process issues that impact your capabilities and benefit potential within information technology.

Closing

The key to creating better processes is to get into the process. Map it. Time it.

Record each application used and each manual need, input-to-output, along the steps to completion.

Take note of the manual processes and the bottleneck impacting the throughput.

The only way to remedy a slow process is to increase the throughput at the bottleneck.

When you have a good grasp of the process mark the accounting triggers and the accounts affected. As you begin reconciliations don’t double up, partition; for example, a reconciled AR, AP and Payroll, can be used alongside the Cash Ledger to clear all relevant cash activity entries. This leaves the rest of the GL cash activity. And, of course, the totals for Cash should match the Bank statement with bank entry adjustments.

Oversimplified … but hopefully it illustrates the partition.

Statistical Methods : This is a quick example of an ARIMA model on a QoQ Revenues dataset that I chose because it is particularly ugly. While QoQ revenues is not typically the period over which forecasting would be done for revenues from operations, it was a readily available set. Statistical ARIMA forecasting is particularly useful when there aren’t easily available and associated variables to use as predictors like you might use in multivariate regression models.

We are going to look at time-series data for forecasting. Time-series simply refers to data that has been collected at regular intervals over a time period. Because it is collected regularly, this data has both its value and the time it was collected as characteristics. Examples are closing stock prices (end of day - daily), monthly revenue (monthly), and hourly electricity usage (hourly). Using time-series data requires an understanding of Stationarity.

The most important thing to understand about forecasts is that they rely on historical data and the composition of that data. This fact is an influential assumption to any forecast since you are utilizing the historical relationships that produced your time-series values and then pushing these same relationships into the future to produce forecasted values. You can certainly adjust these relationships, but then you may have to decompose your values by identifying those relationships before producing forecasts … not always an easy task. This is why nearly all forecasts begin with the assumption that any influence that creates past values will continue in the same fashion into the future.

---

When most people think of forecasting the first thing that comes to mind is the weather and the subsequent models that are derived from the equations of inputs and outputs. While it is true that meteorology is stacked with mathematical equations for the forecasting of weather events, there are also similar forecasting equations and methods that are used in the world of business and finance to forecast outputs of everything from business concerns for unit demands on things like electricity usage, tickets sales, subscribers, and all retail products to financial concerns on things like interest rates, stock prices, bond prices, and derivatives.

Forecasting can be a lot of fun with the right tools. Using a platform such as R, Python, or STATA can easily create statistical forecasts of time series data which, quite frankly, most companies lack. I can’t tell you how many times I discussed forecasting using statistical means such as regression models (models that regress using predictor variables), ARIMA models (models that are lagged regressions of errors and/or observed values), or ETS models (models that use exponential smoothing) and got blank stares. I presented decomposition of data into trends, seasonality, cyclic activity, and randomness and I generally got brushed off because those asking about my forecasting approach knew almost nothing about forecasting. It is truly unfortunate that the planners and analysts, whom through correlated activity would also conduct the forecasting, don’t have the knowledge, and in many instances the capability, to create statistical forecasts. (We must begin to realistic assess the personnel and skillsets otherwise there will never be improvement).

Using a simple moving average, tacking on a “x-% increase for the year”, or the ‘go-to’ of the ‘Delphi Method’, which is the gut feeling of management, are not generally the best methods to use. These models lack the understanding that historical data and its composition of randomness, trend, cycle, and/or seasonality are highly likely to continue and need to be understood individually. Separately, you might forecast your seasonality and cyclic activity first and, secondly, layer in the trend to arrive at an appropriate composition offering more accurate forecasts relative to historic patterns with the added benefit of being able to defend the basis for the forecasted values and offer a confidence interval as a basis to judge the model’s effectiveness. I have seen far too many companies, at the very least, need to continually change budgets because of poor forecasting or, at the worst, suffer financially to the point of straining solvency.

The data that will be used is a dataset of quarterly revenues for a beverage company plotted below. We will simply use the data as-is without looking at acquisitions or divestments overtime, we only use the statistical decomposition.

Forecasting is predictive modeling. When undergoing predictive modeling you have two broad-based routes. First, you can use associated variables as predictors to arrive at a predicted value as in the multivariate regressive models. This is common for predicting housing prices relative to lot size, lot location (corner lot), square footage, number of bathrooms, and number of bedrooms. Second, you can use the time-series data that you would like to forecast and decompose it into its component parts, of residuals, trend, and/or seasonality. From here you can use lagged regression in an ARIMA model or exponential smoothing in an ETS model.

It should be mentioned that either route may utilize linear relationships, nonlinear relationships, or a combination of the two to offer predicted values. The usage is noted in the naming of the model used and it is good practice to record the methods used for future comparisons.

Examples of the notation for the first route may be lin-lin, lin-log, log-lin, and log-log, referencing the linear or nonlinear usage on either side of the regression equation. A lin-lin, a linear-to-linear regression, represents unit to unit changes in the independent variables to the dependent variable. A logarithmic-to-logarithmic is a measure of elasticity as it is percent changes to percent change in the independent and dependent variables, respectively.

Since this forecasting is focusing on the second route, the notation will be covered as the writing progresses.

Check for Stationarity

If you are forecasting time-series data, which is pretty much everything in business, from operations to finance to marketing, then you must evaluate whether you have variables that can be used as predictors for your forecasting focus. In the case of revenues, you may track drivers such as appointments, sit-downs, web clicks, and so on, but these may not be terribly effective at offering a prediction of revenues. A multivariate regression would probably produce unreliable predictions and a low F-stat. In this type of instance, using a lagged regression or exponential smoothing method would be a better option. It is not unrealistic to use the assumption that historic patterns in revenue would continue into the future.

When using time-series data and its patterns to predict its future values, as opposed to associated data as predictors, the first thing we should do is check for stationarity. If you are not checking for stationarity in the data, then you are always going to have incorrect forecasts. Determining stationarity leads you to whether or not your data series has trend and seasonality components so that you can use them for your forecast. Recall the mentioning of decomposing your data into its components of residuals, trend, and seasonality.

Nonstationary data: you have will have a seasonality and/or a trend component in your data.

Stationary data: The mean and variance is constant over time. No trend or seasonality. The data looks like random noise.

Example:

Below are the additive (linear) and multiplicative (nonlinear) decomposition of the Quarterly Revenues.

To get a decomposition in R, you simply need to use the ‘forecast’ package in R and the ‘decompose’ module.

But we are getting a little bit ahead of ourselves. We would, first, like to check to see if the data is stationary. As we can see from the decompositions, it is nonstationary, but how do we know? We use either a Unit Root Test or an ACF (auto-correlation function), but the Unit Root is an easy statistical test.

In R we can use the KPSS Unit Root Test, but there are other tests such as the Dickey-Fuller Unit Root Test. If the test is run for ‘Revenues QoQ’ we see that the test-statistic fails at the 10% (0.6376 > 0.347), 5% (0.6376 > 0.463), and 2.5% (0.6376 > 0.574) critical value levels.

In this test, when it fails, we ‘reject’ the assumption that the data is stationary, this is called a Null Hypothesis. By rejecting this we are saying that the data is nonstationary. We can easily see that this is true from the decomposition. How do we create a stationary data series?

This is where the I in the ARIMA model comes into usage. The I stands for Integrated and while it represents the putting together of the differencing (hence integration), it is easier to think about it in terms of differencing the data series. Differencing will create a stationary series. Since we know how to difference the data series from the Unit Root test, shown below, using arithmetic differencing, but it is good to know that we would use either arithmetic differencing of the values in the data series when looking to stabilize the mean or a logarithmic differencing of the values when looking to stabilize the variance.

For the data is the ‘Revenue QoQ’ series, the differencing needs to be done using consecutive values and seasonal equivalent values. Let’s show these as equations for an example.

arithmetic consecutive differencing (first difference):

arithmetic seasonal differencing (first difference):

Where ‘m’ is the seasonal lag. If there is an annual seasonality, m = 12, a quarterly m = 4, and so on.

Let’s see what the test looks like with only an arithmetic consecutive difference:

This is a pretty good test-statistic, but can we make it better?

Let’s try a consecutive difference and a seasonal difference (quarterly), since we can see that there is a seasonal component in the decomposition.

The test-statistic implies that the time-series, using a seasonal difference and a consecutive difference, is essentially just white noise, a random series. This means that all of our trend and seasonality information is removed from the data series. You can see how easy it is to check the Unit Root in R once you have built some familiarity with the application.

Recall that the naming convention for the forecasting method, such as the ARIMA(p,d,q), enables us to track the transformations to our data set so that we can recreate it and others will follow our steps. We have introduced one consecutive difference along the entire series, d = 1. But we have also introduced a seasonal difference. To notate the seasonality difference another set of parentheticals is used with capital letters, s(P,D,Q), with a ‘s’ to mark the seasonality. It looks like, ARIMA(p,d,q) s(P,D,Q). Since our seasonality is quarters, s = 4 our notation up to this point is:

ARIMA(0,1,0) 4(0,1,0)

We would now like to find out if any orders of AR or MA are beneficial to our model. We can quickly get the orders using the ACF module, (Auto-Correlated Function) on our differenced series, but lets look at the AR and MA components for a basic conceptual understanding.

AR(p) – Auto-Regressive

Auto-regression does exactly what it says, it regresses the data series on itself but in a lagged fashion. An AR(1) regresses the data series on itself, one period back. An AR(2) regresses the data series on itself, two periods back. The first thing you should notice, when recalling that a regression requires equal length data series, is that you will have to adjust the primary series when regressing against a lagged version of itself. The second thing that you should note is that a regression is done to produce coefficients for the variables in a regression equation. In a data series, this would be similar to a linear multivariate regression equation.

Using the AR equation for a model maps out the pattern of time-series data, assigning a coefficient to the lagged data values relative to their predictive ability of future values.

The equation for an AR(p) model should look familiar if you have done any regression analysis:

Instead of seeing ‘x’ variables, you see the lagged ‘y’ due to the fact that the regression occurs on itself. The epsilon is the residual values for the fit of observed data in the series vs the predicted from the equation, they are your error terms that are minimized in the sum of squared errors assessment for regressions. If all available information is drawn from the data series, the epsilon values should look like white noise and, by definition, i.i.d. (independent and identically distributed), normally distributed with mean of zero and constant variance.

Occasionally, you will see AR models of order p = 3, but you will very rarely need orders higher than p = 2, especially when including seasonality.

Again, the orders, p and P, can be found by using the ‘ACF’ module (auto-correlation function). This will be done right after the MA explanation.

MA(q) – Moving-Average

The Moving Average of an ARIMA model is different from the moving average used when computing a 50-day moving average on stock prices. An ARIMA model’s MA component is a lagged regression of the past forecast residuals (also called the error values) to predict the next value in the data series,

where, again, epsilon is our white noise. Note the epsilon in both the AR and the MA. Any stationary AR(p) model can be written as a MA() model through some math but that is beyond the scope and could be found with a simple search.

When we combine AR with MA we arrive at the formula for predicting future values.

If using a differenced series it is written as

where y’ is the differenced value of the series.

Another note. You could utilize the formula and do this in Excel, checking models by comparing error summations for each model. This would take some time depending on how many orders are required for AR and MA, but it is possible.

How do we determine the number of orders of AR and MA? There is another test or two that we can run that will help to determine the orders of AR and MA, the ACF (autocorrelation function) and PACF (partial autocorrelation function) tests.

It is a bit of an art to read ACFs, but give there is a significant value at lag 8 (it touches the line) I could begin my modeling with a seasonal MA(2) or an ARIMA(0,1,0) 4(0,1,2).

This was a good estimate, but I ended with an ARIMA(0,1,0) 4(2,1,2), it had the lowest AIC.

Auto-ARIMA from R

Of course, we don’t have to do all of this work. There is an Auto-ARIMA function in R. If we use it then out forecast for 8 quarters looks is:

Visually:

We could also use a ETS model.

But the AIC is far to high to compare to our seasonal ARIMA model.

Please Remember

ALL MODELS ARE EQUATIONS.

Other interesting basic forecasts …

ARIMA(0,0,0) = White Noise

ARIMA(0,1,0) with no constant = Random Walk

ARIMA(0,1,0) with constant = Random Walk with Drift

ARIMA(0,0,0) m(0,1,0) = Seasonal Naive

A RANDOM WALK

This method was the basis from which several stock price models were developed. You can probably see why. The last observed value moves up or down one unit in each period with a 50/50 probability. An important characteristic of the random walk is the long run mean is zero, however the variance is not constant. This makes the data non-stationary, which means that the data has a trend, cyclic or seasonal component or changing variance relative to the time period. Determining whether the data is stationary is a must when working with time-series data and is often overlooked with forecasting. This point will be reiterated several times.

It isn’t too difficult to imagine using different probabilities to randomly determine the movement up or down in this basic model, just remember that they must sum to one (prob(up) + prob(down) = 1). This basic concept is actually used as one of the computational components for modeling the pricing of options using the binomial method.

The random walk is a Markov Process, which is a restricted process in which its future value is dependent on only its most recent value. Because it is only dependent on the most recent value, it is known as memoryless. ‘Memoryless’ is a neat concept that is also used in the Poisson Process to model the occurrence of events over time. The memoryless attribute comes from the fact that an occurrence has no influence on the timing of the next occurrence. This is unrestricted because there is no dependence on even the most recent observation. There is a lot of interest in modeling randomness.

A RANDOM WALK with DRIFT

Where the expectation is a mean zero for the random walk, the drift component is the amount that the mean shifts each period. This drift component produces a trend which makes it non-stationary, which means that the data has a trend, cyclic or seasonal component or changing variance relative to the time period. Determining whether the data is stationary is a must when working with time-series data and is often overlooked with forecasting.

WHITE NOISE

This component is the residual, also called the error term or difference between the observed values of the historical data and the fitted values of the forecasting formulas. When forecasting people underestimate the value of the information found in the residuals. Residuals are so significant that one could say that forecasting is a study in residuals.

As mentioned before, one measures their forecasting method by the cumulative sum of the residuals. By definition, residuals are to be independent values and are typically normally distributed with mean of zero and a constant variance. If residuals are not normal with mean of zero and a constant variance, then it’s likely that there is additional information to be gleaned from the data to produce a better forecasting model. Set out to find random residuals.

Simply generating a sample set for white noise:

You can see that it looks similar to static that you might hear from a radio, and if measured on an oscilloscope it would also look similar.

Closing

Forecasting is more than automating your ERP system to create future values. There is plenty of math and stats laws and guidance that go into creating a forecast, but like any process, if you know the appropriate steps and applications you can complete the process swiftly and to the best benefit of the company. My hope is always that the process will encourage further study into the method and math. Using statistical methods create an actual, quantitative approach, for forecasting evaluation beyond the very general budget vs actuals so that you might track and improve upon the composition of your data forecasts. There is also more advanced dynamic modeling that includes the usage of additional variables to help improve your ARIMA forecasting. If you are forecasting and not putting int the effort to understand this area of statistics you could add considerable value to your skills and your organizations IT capabilities.

Post Note:

More companies are ruined by the “years of experience” ignorance when selecting a workforce than any other strategic endeavor. The issue that always arises from individuals that have little understanding about skillsets then evaluating and assessing your skilled individuals. This is not a topic that is learned “on the job” and, as a result, those selected for the task of forecasting know very little about the topic or methods for forecasting, have no math or stats understanding, and will only repeat the exact same process that they did in a prior company through their “years of experience”. This is never useful. This individual will never understand how to assess, rank, and adjust forecasts to become better and many organizations have no real way to determine the skillsets because they themselves do not have the skillsets.

If you are lucky, the individual(s) tasked with the forecasting at least understand the basics such as random walks, random walks with drift, trend, seasonality, cyclic activity, white noise, simple moving average, and exponential moving average. If they can define these terms, it at least demonstrates a basic understanding of forecasting since you can’t go through any tutelage on the topic without covering these terms. If they can’t define these topics, then it is highly unlikely that they can explain to you, at a root level, what needs to be done to create better forecasts and therefore it is highly unlikely that your forecasting, budgets and models will improve.

Whenever asked about my forecasting methods for revenues, I always begin by discussing statistical methods. Unfortunately very few understand anything about forecasting or the fact that there is an entire focus on the subject matter.

Statistical forecasts, such as the ARIMA or ETS, can act a a great structural start for time-series data without associated predictor variables, an area where multivariate regressions is often used. The ARIMA can use historic patterns, and a decomposition of the data to carry out forecasts. This can be quite useful since historic patterns are generally consistent unless some systematic event or unsystematic changes the industry, market, or company.

These are useful for the prediction of such as revenues, electricity usage, product demand, or essentially I.S. top line. If you get good with the basic models, the you can also move into more dynamic statistical models and tools such as R, Python and STATA can make these forecasts quite painless.

One company’s financial statements always stood out to me as a great example of a story in numbers. This company is Accor Group, which is publicly traded as is this information. Accor is known globally for hotels, resorts, hospitality, and wellness. At one point in their history the CEO lead a transformation strategy moving from the owner/operator standard for hotels and hospitality to the asset-light leasing, franchising and management fee business model. Within his tenure they also underwent several investments in the digital space, some to compete with Air BnB and the value proposition that Air BnB offered, and some to upgrade their digital platform and booking presence. Today the revenue comes from a mix of management contracts for hotels (60%), some of which were originally owned, franchising (30%), and hotel ownership (10%).

While the key strategic shift of divesting the real estate portfolio is listed to have begun in 2018, you will see these shift beginning much earlier within the layout of trended data.

The primary point is not to display the statements for a hospitality group, but to show that, even with no knowledge about the company or industry, the data tells a story that forces questions and basic conclusions about the strategic changes to the company.

First the tale from the trending of the Balance Sheet

Along the top, the investments and acquisitions are aligned with the year in which they occurred for reference. E.g. Wipolo was acquired in 2014.

I have boldly highlighted the areas that are of most interest and would beg for an analysis of the change. So … let’s read the story the data is telling us.

I labeled a loose beginning for the restructuring, “Start of Restructuring”, due to the dramatic change in the Accounts Receivable. This label highlights the post-2009 period which was actually when the first considerations for a restructure were considered. However, if we knew nothing about this company, we would also have to consider the impact due to the financial crisis caused by MBS (mortgage-backed securities) and derivatives market crash that occurred during this period. If we were to also use the Income statement below, we could conclude that a major event, systemic in nature, occurred that impacted this industry. Often, when data signals major changes to a trend, certain industries will immediately come to mind, but in this case, it would be difficult to narrow to a specific industry. This event impacted every industry much as the economic shutdown shows up as a blip in every company’s 2020 financials.

Moving down the sheet, the two largest changes that are highlighted, first, are the dramatic change to the Current Assets, identified as a cash change, and the change to PPE (Property, Plant, Equipment). Major changes in cash, for a healthy company, usually involve major investment to repurchase shares, pay down debt, or undergo an acquisition. If we were to look at the cash changes with only the drop in PPE, we might conclude a divestiture or massive selling of assets given the book values. This could be double checked with a look at Discontinued Operations, but we should also look at the section of Goodwill.

Discontinued Operations do indeed have a substantial change over the trend periods, but Goodwill is increasing over the same periods, and these are not small changes. Something happened. Large changes usually suggest structural shifts to operations because something in the normal course of business had to change. Let’s continue.

Goodwill increases due to an acquisition to balance out the cost of the acquisition with the value of the assets during the initial recording. We know that Discontinued Operations must represent the selling or disposal of assets. Goodwill has been gradually increasing. This suggests several acquisitions. Discontinued Operations is a two-year blip and lines up with the Cash change. Could the company have underwent acquisitions while selling off assets?

Let’s remember acquisitions do not only consist of tangible assets. If we look at the sections for Intangibles and Long-Term Investments, both of which are increasing over the same periods that Goodwill is increasing, we could conclude correlated activities. We could now ask ourselves what would need to occur to have both acquisitions and a decrease in tangible PPE all while increasing Intangibles and Long-Term Investments. We would have to think of digital assets, patents, applications, platforms … for a company that was once heavily invested in PPE. What might have occurred?

As we continue down the balance sheet we get to Other Current Liabilities and Capital Lease Obligations. We see the familiar decreasing trend in both, and interestingly Capital Lease Obligations to zero. Capital Leases are structured to transfer ownership of assets, but this company is shedding these leases. And given the listing of Current Liabilities, the Other Current Liabilities section would suggest deposits and contractual obligations, unearned revenues perhaps from gift cards, events, or other conditional obligations which are also being reduced.

Our balance sheet story:

Without much further research and without knowing the company or industry, the balance sheet suggests that the business is a service-based business that, as many do, relied on its considerable PPE to deliver its services and that a large portion of this PPE was land and construction in progress. It isn’t too much of a leap to suggest hotels and hospitality would fit these entries.

Over the years the acquisitions and investments into intangible assets coinciding with the drop in PPE, Capital Lease Obligations, Other Current Liabilities and the total Discontinuance of Operations suggests a complete restructuring from ownership of the PPE, and all the obligations that would accompany it, to an asset-lite management over the properties and services with the addition of technological tools to compliment and enhance the management services and most likely offer other lines for revenue generation.

The complimentary tale from the Income Statement

The Income Statement will show exactly what changes occurred, operationally, from Balance Sheet to Balance Sheet and let us know if our assumptions would be correct.

If the business was indeed in hotels and hospitality then we would expect high fixed costs, primarily administrative, and lower variable costs. We would expect revenues to reflect a change from the bookings in the hotels to the management fees associated with managing the properties which would show a significant decrease. As the company restructured then we would expect COGS and depreciation expense to trend down and we would see the operational expenses that would reflect a restructuring. Everything that we see in the trend of the Income Statement is what we would expect to see in a hotel and hospitality company that has undergone a strategic restructuring and change of business model.

Of course, I mention how data tells us a story that could be used to identify the business, industry and strategy without knowing any of this information ahead of time; this same use of the story can be used, and is often used, in the reverse. If you are presented with a known company in its known industry that has either pursued or would like to pursue a particular strategy, then you would be able to put together a rough outline of what the financials would reflect.

You obviously can’t put together the exact numbers, but you would consider operating leverage for those fixed costs and assets that would be required for the business model. You would look for leases, depreciation and maintenance related to the purchase and long-term investments in the assets; and you would look for fixed and variable labor relationships related to the assets and industry. You would expect certain margins on products in the industry that would allow you to construct revenue to COGS relationships. In other words, you are building a pro-forma without necessarily needing the data, just through identification of the business model and industry.

When we put all this together, hopefully, you can see that data tells a story because of the source of the story, in this case the business, industry and strategy. But data would also tell a story relative to a particular operation, e.g. trucks, fuel usage, mileage and idle times might tell you the type of vehicles and suggest the type of service. All data tells a story because the source of the story will create data in a particular pattern and that pattern will always be similar for all sources with a similar story … business model, strategy, industry. This is why there is benchmarking by industry.

Now you might wonder why I mention this or what this has to do with anything, but it is useful. First, if you understand that data can tell a story in its patterns so that you can make identifying remarks about business, industry, process, or strategy, then you should also understand that the analysis of the data has little to do with a deep knowledge of the industry and is in fact unnecessary. It is more useful to understand data, patterns, and the accounting methods from which those patterns are created.

Second, you can easily use the knowledge of patterns related to industry, business, process, and strategy to trend a competitor’s financials over a ten- or fifteen-year period to draw out many of the strategic decisions and investments over the years and conclude the limited options for strategy available going forward.

Third, when working with your company’s financials you can pick out discrepancies in data much more quickly if there is a change in the data and data patterns that do not identify with your business, process, industry, or strategy. You can also work out high-level projections must more effectively when working with strategic changes because you will already know what changes to the data patterns would accurately reflect the strategic changes.

The data isn’t just a category of data recorded overtime for a specific time. The data is a tapestry that reflects the coordinated efforts of an operation in a pattern of categories over a length of time. When viewed as such, a different approach to data analysis, financial analysis and even models, planning, and budgeting will come out in you work.

I have always enjoyed finding patterns in data. Patterns and relationships within data structures tell a story, one that can lead to hints as to the source of the data (business and industry) and even strategies undertaken. The article uses data from a company that underwent a major restructuring and transformation. I believe it is an excellent example of data that tells a story.

TL;DR

You are missing out on your candidates because your are allowing those with no understanding of how to identify skills to evaluate and make decisions on a skilled individual. This means you waste time interviewing those identified as a potential candidate due to their “time” and “keywords” relationship without any consideration to the quality of that time. How does that make sense? You need real skills, and identifiable understanding of the required skills. This is what you aren’t getting. It’s obvious in the repeat postings and time for a reevaluation and overhaul of the system you use.

I am not sure how many people try to track events key to their industry, there are just so many things going on in life. But, I, have my regular routine of tracking events … at least to the degree possible. Every morning I run through various financial websites and news sites checking for stories that may be impactful to the economics behind a business. Of course, currently, we have wars, precious metals, inflation, fraud, datacenters, layoffs (often underreported) and AI. I probably missed more than a few since these are just a broad scope, but one other topic that I regularly check is the listings for positions within finance and accounting.

Sure, finance and accounting interests me, its my wheelhouse, but it is also a sign of the health of a company and the job market. Some of the first companies to layoff in rough times are in financial services or in the finance and accounting department, definitely in the FP&A (financial planning and analysis) focus since it is usually beyond the scope of reporting compliance and therefore trimmed down. This isn’t to say sales and programming (retail/logistics/technologies) hasn’t been hacked to bits, but I can’t watch every area. What I have seen, however, over the past 4-5 years of tracking position postings has been more than interesting, something I believe few upper management are even aware of …

The same companies post the same positions over and over again, every 6 - 18 mos. And these aren’t just any positions, these are the mid to upper mid skilled Directors and Managers and Analysts for Finance and FP&A. In the current market for finance professionals, it is unlikely its turnover. So… you have a couple of possible reasons, one is that they aren’t hiring and they are just spending their budget and attempting to justify their existence in the organization. Another possibility is that they, like nearly 85% of companies’ HR out there, hired DEI candidates that never had the qualifications in the first place and either have to replace them or hire a buffer to make up for the skillsets that they are not able to manage themselves.

—(I don’t care what you look like or believe, I care that you can do the job. Years ago when I worked for a major clothing retailer I got in trouble for hiring individuals who were great salespeople and fun workers because they weren’t ‘So and So’ collegiate-frat brand types. I just looked for great ability)—

The final possibility is similar to the second but the key factor is they hired someone that had the requisite amount of “time” and “keywords” of “experience” on their resumes and were probably very likeable, nonthreatening to the manager in terms of skills, and hired, only to find they too did not have the competency to complete the position.

—(I recently saw this in several companies, with “analysts” of 5-7 years “experience”. I call it the process trap since years in a company rarely means you actually develop anything. You maintain models and help with reporting, perhaps trying to implement very naive analysis every so often, but because no one else has the tech skills to do it … you keep your job. You even get pushed up the ranks if you are likeable and relatively competent, knowing their standard system for reporting. Yet you never actually learn any skillsets because that requires external avenues of education, something that is never considered or seriously undervalued. This is why, even with 5-7 years of “experience” the recruiters still have to ask if you can use a VLOOKUP function.)—

There really can’t be other reasons. Either the position is real or its not. If not, see above. If yes, and it is listed over and over, see above. The far-fetched reason is that the position wasn’t ever filled. However, if in the current marketplace, you can’t find someone to fill a finance roll, then you have no idea how to judge requisite skillsets and do not understand the competencies nor how to find them during questioning or on a resume. And this brings me to the ridiculous state of recruiting and HR that we see today, one that is quite literally creating a mess that will collapse companies from the inside if it is not addressed.

It is well known and discussed in strategy that parallel services will arise in a marketplace when someone can provide a competency more efficiently than a company can do for itself … hence outsourcing. What we have seen over the past decades, 30 years of witnessing for me, is the rise of firm that provide recruiting/hiring searches for companies. In a time when there was much less technology, and minimal internet usage, this could be understood; firms in smaller towns may have had trouble finding executives. But companies still managed. There were walk-ins, and people pounding the pavement carrying their resumes with them to hand over to personnel. Only personnel didn’t filter them, they went right to the department and someone within the department who was well versed in the subject matter went through the resumes. Some of the best times for the US economy were through the 80s and 90s … with none of the garbage that we see today.

Today with the number of internet platforms there should be no reason this couldn’t be done. Only the system changed. And one can discuss AI filtering resumes for keywords or AI writing resumes for candidates … but that isn’t it. The AI still only does what it is told. What changed was that the resumes are no longer looked at by anyone that understands the subject matter. A bottleneck, a gatekeeper was created in the form of HR and like most gatekeepers, was comprised of individuals who should’ve only been doing data entry, not selecting the most important analytical positions in a company when they, themselves, had never done anything analytical in their lives.

If you walked into your HR department today and asked around, there will not be a single one that could tell you the difference between an income statement and a balance sheet. Hell, if you asked them where you might go to find labor statutes for your state not one could tell you where to go … (each state has a dept of labor, easily found through the sect of state website for most) … and this would technically be THEIR job. HR is also the only department that doesnt seem to have to meet its own requirements … perhaps one will have a degree in HR or some other business degree. That at least says something since these are the only ones that ever display any real competency.

Take some time to check out your department … (some examples)

— degree Communications; experience barista

— degree Social Work; experience nanny

— degree English; experience retail personal shopper

— AA degree Business; experience cashier

—but I especially like the ones who have only done HR to HR to HR … and yet still have no idea how to identify poignant answers that identify real understanding of the skillsets required.

Now, this isn’t to say that the standard entry of personnel data cant be done, but HR requires understanding of labor statutes, severance, lawsuits for harassments, and numerous legal issues. If you were hiring for HR for your company, this is who you would hire? None of them would make their own list if they went by their standards for “time of experience”. Oh the irony. Is it any wonder that a parallel industry rose up for hiring, not only for the executives but for every middle level position on up?

Another issue that must be brought up is how could you possibly have your greatest skilled positions, often highly technical, judged and filtered by individuals that do not and couldn’t even begin to understand the skills? Again, just ask the basics … Income Statement and Balance Sheet.

—(I have sat through numerous sessions with these individuals asking their list of questions and finding that if the answers are not in the simplest format possible they do not know what to write down. If you pay attention to the interviews, you realize very quickly they are nothing more than secretaries attempting dictation, feverishly attempting to match keywords with time of “experience”, having no understanding of how to judge the answers to actually assess skills)—

This is why, someone from the department was the actual individual or individuals that went through resumes passed along from personnel. Is it any wonder the rise of the recruiting industry? But, what started with the executives has now spread throughout the levels from middle management and skilled positions all the way to the top. Of course, this came about because of another strategic principle, if there is excess profit to be gained, competitors will continue to enter the market. If I was evaluating this scenario, I would say you are overpaying the outsourced firms that only offer the recruiting/search services since you are still ending up with the same result .. a filtering of candidates through the same low competency HR department only now you are paying double even triple…

You are missing out on your candidates because your are allowing those with no understanding of how to identify skills to evaluate and make decisions on a skilled individual. This means you waste time interviewing those identified as a potential candidate due to their “time” and “keywords” relationship without any consideration to the quality of that time. How does that make sense? You need real skills, and identifiable understanding of the required skills. This is what you aren’t getting. It’s obvious in the repeat postings as I mentioned above.

—(another crazy real life occurrence: the other day I heard an HR rep mention that during an interview she asked the question “Where do you see yourself in 5 years?”

The single dumbest, laziest, ridiculous question is still being asked after 30 years. This is your HR. By the way, if you ever had to do group projects, it was always the people who somehow ended up in HR that you NEVER wanted on your project because they were never going to contribute anything. )—

I don’t care if this hurts feelings. Business isn’t about feelings, its about being profitable so that you can stay in business. When feelings come in the way of being competitive, the feelings become secondary. Fact is, the entire system needs an overhaul, but there are some things to do now.

First, you need to evaluate your HR department and their tasks.

—Skillsets, knowledge basis, processes, actual responsibilities and delivery.

—Evaluate Cost-to-Benefit of delivery on responsibilities, treat it like marketing because you are marketing your company to potential candidates.

—What is done to attract potential recruits?

—What tools are used, platform, advertising, ease of application?

—What questions are asked? Ask your HR what might be considered a “good” answer

Second, determine what activities are already outsourced.

—Odds are good your payroll is primarily outsourced and all that your HR does is the data upload.

—Odds are good you outsource your benefits to the company selected and they handle the majority of the onboarding through a benefits admin or account manager.

—Odds are good you have to outsource your any legal to a legal council so any matters of severance or harassment are primarily handled externally, HR being the notetaker again.

—Odds are any analysis of headcount and compensation is actually passed onto finance because no one in HR can use a spreadsheet or formulas for anything but the most basic of data entry.

—Begin to ask yourself what exactly your HR department does.

Third, seek to find an outsourced HR firm that can handle HR activities externally.

—Price their services.

—Determine savings by gutting the HR department.

—Reconfigure the HR department back into a personnel department that primarily coordinates information and data (as they already do) only with fewer people.

Fourth, if you are using AI to filter resumes have a functional department expert and IT walk through the process and what is being evaluated.

—Get back to individuals that actually use and possess the skillsets evaluating the potential applicants.

—The evaluation will be more efficient, a better evaluation can take place, you will only interview those with real skills thus optimizing time usage, and with technology this can be done.

Your people are your most important commodity. But it is a competency outside teh core competencies of most corporations and definitely out side the competencies of your HR department. It is far too important to be left to a department that was forced into existence and filled with individuals with almost no competencies of their own.

I discuss starting from the ground up, understanding that costs are external such as supply, AP and outsourcing and internal primarily related to time and activity as variable costs and the rest fixed costs. If you build up from there you get a better idea of how to develop cost measures which are key to a cost management system

The ability to fail is a rare trait, one that requires not only the self-driven determination for success, but the willingness to push limits and crash to failure. Only then realizing what you are made of when you pick yourself up having to do it all over again. Society is primarily constructed of the lemming mentality, only willing to do something “new” after it has been proven and accepted. You don’t build great companies with the long-run process doers, you build them with those driven, competitive, willing to fail.

Human behaviors are by and large, for individuals, unchanged over the course of their life, only vast societal shifts (peer pressure) see substantial change. The reason for this is that any change takes, one, a recognition on the part of the individuals, two, a desire to change, and, three, the hard work and perseverance to change. None of these are easy or direct, else additions would be easy to overcome. This is one of the reasons that understanding human behavior has been a topic of study for Marketing and Propaganda (is there really a difference) over the past several decades. If one can cluster or group individuals by characteristics and associated behaviors then, given a stimuli, the reaction can generally be predicted.

There are many studies, fascinating, scary studies on these topics … give it a search.

This isn’t about a nature/nurture environmental discussion, but more about what I have noticed (anecdotal) and others have discussed with me, specifically from the setting of various workplaces. Afterall, what could be a better place to observe than an environment that is supposed to be differentiated on skillsets and leadership from individuals, strangers, brought together to attempt to achieve a goal. A goal that can either be a basic functional operation or a competitive optimization of efficiencies with the goal of being the best … or some gray in between, but I can say that there is rarely an in between.

Why?

An operation is generally associated with its team and while the tools make a difference in speed, the tools rarely make up for shortcomings in the knowledge or abilities of the team. An optimal operation would require a team that can achieve at a high level, coordinated and efficient, an elite team. Elite teams have knowledge and skillsets that are top of their class, the individuals are self-driven, self-tested, but able to coordinate within each other’s spaces and act as a unit. An elite team carries a connotation of excellence, absolutely, but deeper, one wrought with both success and failure. You don’t become great if you don’t have the ability to fail.

Now let’s discuss failure. Those who have trained for any competition know failure because almost no one wins all the time (there is the obvious exception for certain teams and individuals in competition). One hopes the failures are ground out during training, perfection attempted through repetition and continued crafting of repetition, but pushing and driving to be better continuously. It doesn’t matter if its Mathletes, performance, athletics or the crafting of statistical models. The push to be better comes with failure, the acceptance of failure, and the rising from the failure to pursue a goal all over again. Most importantly this is above all an individual trait and one that has to fight against society’s misconception about failure and inherent insecurities associated with failure.

In a business performance is measured, for a company, for a department, for an individual using a variety of metrics. How often do you find the internal drive in an individual to get better, do better, push themselves and those around them to become better? I would bet not often. These are the people that seek out to make a process better, a model better, a report better … But…

These people make waves, disrupt the easy, regularity of a system, whether optimal or not, and are generally forced out of a department or frowned upon for trying new methods and pushing the limits, looking to better themselves and their surroundings. And certainly, they fall short, unfortunately only to be pounced upon by those that all but cheer the failures that may change the comfortable processes. (More often than not due to resistance and the unwillingness of others to assist when needed … this is why change management is so crucial). What’s worse, if these people are the drivers of change, competent, confident, and knowledgeable, then you lose the best and brightest that can make real change for the better. This happens all too often.

These people are often stifled, left to be absorbed into the cogs of the machine of the social structure in the company only to leave as soon as they feel they have the 12, 18, 24 months to display an acceptable period of time in a position (another point of ridiculousness given the environs of many companies). We see mediocrity, relative and subjectively judged competence, safety in repetitive action and no interest to drive for better, either individually or in processes, nor a push to offer new creative ideas and methods. It should be fairly evident to any watching movies these days that we do not even see a push for better, different, new ideas or creativity in our creative arts any longer…

What is blatantly evident is that you rarely find those driven to be better and do more in long term roles unless those roles have nurtured the drive. These people move until they find their place because they will continue to strive to be better and continue to work to success where the environment allows for it. This then suggests that if you create that environment, then they will come. Most companies will claim they do foster this environment, but anyone who has the ability to fail and has been through a company will tell you that most do not.

I have found insecurities to be an interesting behavioral topic for much of my life. Perhaps it is because I had to make a conscious effort to overcome it so my naturally drive to be better could come out. Having been in the creative arts and seeing how sensitive people are to the judgements of others while also hearing the petty reasons for why someone dislikes another’s work or performance got me beyond my insecurities very quickly. This combined with the transference of my commitment and method for training for athletics into that of training for finance and modeling, both on a knowledge basis and application basis helped me settle into a confidence and comfort that puts on par with discussing these topics with any executive officers of any company.

But, I encountered these insecurities again later in life both personally and in stories from others that occurred in the workplace and during interviews suggesting that the environment “encouraging” those with the ability to fail and drive change are blocked by the very people that supposedly create the environment. If I told you how often people were denied entry past the gatekeepers for an interview because someone didnt like the color of their shirt, the person reminded them of a bad relationship or their laptop camera made them look ‘different’, you would probably be dismayed. However, what might be worse is the rejection of individuals that might have more knowledge, skillsets and drive than those doing the hiring.

A short tale involves a nurse working in a department and taking classes to finish a bachelors degree. One day when discussing coursework, her direct boss overhead that she was taking a certain operations course. A course that was nothing more than the next in line to complete the degree, but because it sounded like the work that her boss did, the boss spent the next few months doing everything she would to create a hellish work environment to force her out.

Another instance was near comical. A VP of Finance for a short term loan facility was conducting an interview and asked for questions. The interviewee began asking questions about annuity payment structures, only the VP didnt know what an annuity payment structure was and rushed the question and interview to an end right on the spot. I could also include discussions with finance and accounting management within the closely related context of IT, data and statistics and how the utterly confused look on their faces was just sad as their “years of experience” did not teach them anything new within the realm of competencies or knowledge and it would take a drive and willingness to try something new, probably fail and try again to gain that knowledge.

The fact is that we dont live in a world where continued development, internal drive, training, and the ability to fail is encouraged, which is the only real way to effect change and competitiveness in an organization. Our society, the companies, the departments, even the selection processes are tailored and are filled with those sufficed to ‘just get by’ and continue with the processes and procedures that ‘don’t rock the boat’. Those in positions for 4,5,…10 years don’t drive change, don’t bring results… they bring subjectively judged competence and will do anything to prevent their knowledge basis from being challenge due to their unwillingness to challenge themselves and drive themselves to be more.

I say this now, in this time, because this is coming to light more and more everyday with the necessary merging of skillsets within business... like those of finance and data science. It is becoming ever more evident that to drive change into a data-driven environment takes not only the knowledge, but those that have trained, and have failed. This doesn’t exist in years of processes or those content with the status quo and day to day activities that don’t rock the boat. In order for this to change and to get those that are the elite team that create and optimize around their environment because they themselves aren’t afraid to fail, you need to structure the entire environment with such people and be aware of those that do not challenge themselves or understand that success only comes with dealing with failure.

Those with the drive to compete and better themselves will seek to create better systems and processes. Those that have trained for success and failure can be taught to use new applications for it is one more area of training that can be mastered through continuous repetition. Those individuals that have the ability to fail contain within themselves unique qualities and traits that can not be expressed in time periods and are continually a threat to those that depend on time period as some kind of a lazy crutch, a measuring stick of competency that doesn’t exist.

Accrual Accounting and the Balance Sheet, Income Statement, and Statement of Cash Flows

A mental mapping of the Accounting Equation and the T-account, that I learned fifteen years ago when I began my foray into accounting, always helped me link the usage of the three statements together. At a high-level overview I present it below.

Economic activities of the company are recognized in the period they are incurred, generally marked by the month end, regardless of when cash exchange takes place. This implies that cash exchange can take place before, at, or after, an activity and this timing must be reflected in the accounting statements.

In order to track the economic activity accounting bookkeeping has developed the double-entry accounting method and the familiar T-accounts comprised of debits and credits; all economic activities that trigger a recording are listed in the accounting journal, a debit paired with a credit, a date and the respective ledger to which the debit and credit will be assigned and recorded. This implies that ledgers, generally, are a collection of either debits or credits that can be aggregated for a total of debits or credits in a ledger and this is exactly what happens.

We can use the accounting equation and its direct relation to the financial statements to further our understanding of the basics of accrual accounting. Recall the accounting equation of

Assets = Liabilities + Equities

and take note that this is the layout of the Balance Sheet, left side is the list of assets in the order of liquidity and the right side is the list of liabilities in order of maturity followed by the equity break out. Further note that the equation also follows the T-account order of debits and credits. The left side of the equation, Assets, are referred to as having a Debit balance, which means debits are additive to asset accounts (ledgers) and the Liabilities and Equity have credit balances, credits from the journal entries begin additive to these accounts (ledgers).

How are changes to the Balance Sheet from one period to the next quantified?

The Income Statement

The income statement tracks changes to the assets and liability accounts through revenue entries and expense entries. If we consider these entries from the simplest perspective, aggregate revenue entries minus all expense entries bring us to Net Income. Since the Net Income is a total of all the changes to the asset and liability accounts and because of the account equation, Assets = Liabilities + Equity, this Net Income will go to Equity to balance the equation. This is called Retained Earnings. Because of this we can expand the Accounting Equation to an incremental version.

Assets = Liabilities + (Revenues – Expenses)

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The full version being

Assets = Liabilities + [Paid-In Capital + (Revenues – Expenses)]

Due to any outside investment in the company.

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Since Equity is on the right side of the equation and is a Credit balance account and because Equity increases with positive Net Income, Revenues must be a Credit balance account and Expenses must be Debit.

Finally, we circle back to Accrual Accounting and the use of the Statement of Cash Flows. In the opening of this article, it was mentioned that economic activity must be recognized in the accounting period that it occurs. Typically, this is cut off at the month end close so that all economic activity is represented from one month to the next.

The difficulty most people have with accrual accounting is that there are accounting entries to revenues and expenses that do not represent a cash exchange, the entries represent cash due to be paid, cash due to be received, or they are used to represent value used up or created over the period. Because these entries are needed to recognize all economic activity in a period in a balanced fashion, remember the Accounting Equation, Assets = Liabilities + Equity, then a statement is needed to reflect only the actual cash exchanges. This statement is the Statement of Cash Flows.

The accrual concept should make sense if you stick to the Accounting Equation. If you receive an Asset increase but have not yet paid any cash, then there must be a balance in either an increase in the Liabilities or an increase in the Equity accounts. Some of the most common examples include insurance, payroll and depreciation. We will lay each one out at a high level.

Say you purchase an annual policy for general liability insurance for $12,000 (commonly used in examples because it is divisible by 12) and pay the entire premium upfront. In this transaction you have paid all the cash immediately, but you are owed twelve months of coverage, a benefit to your company. The initial journal entry requires you to deduct $12,000 in cash, a credit entry, but record the benefit so the financials reflect its value at cost. This is entered into what is called a prepaid asset for $12,000, a debit. When one month goes by, you have “used” one month of this asset and the prepaid asset account is reduced by $1000. This reduction is made using the Insurance Expense account. The entries are a $1000 credit entry to the prepaid asset account and a $1000 debit entry to the Insurance Expense account. The Insurance Expense would show up on the Income Statement because it is an economic activity, but it is not a cash activity.

Payroll for many companies is paid out every other Friday and therefore it is common to have a payroll period split from one month to the next month. For simplicity let’s say that a pay period will include the last week in January and the first week in February. We will assume that you pay $10,000 per week. At the end of January, you will owe your employees $10,000 for that final week, it is a liability, but you will not pay it until the end of the first week in February when you will pay the full $20,000. To represent this amount owed at the end of January you create an entry to reflect that you owe $10,000 for labor, an increase in liabilities. Typically, this involves using a Payroll Expense account, a debit entry of $10,000, and Accrual Wages Liability account, a credit entry of $10,000. Note how the expense would reduce Equity while the liability is increased, keeping the Accounting Equation balanced, and since no cash was exchanged the entry is simply marking cash that is due to be paid. When the cash is paid, the opposite entries are put in each account to reverse it.

Depreciation is a purely economic entry and is similar to our insurance example. When a company purchases computers, a large piece of equipment, a truck, a building or something depreciable it is classified as an asset, a fixed asset. The entries would account for the cash paid and the asset gained. For an example the company will purchase a piece of machinery for $120,000 and it will be paid in cash. There is a $120,000 credit entry to the Cash Account and a $120,000 debit entry to the Fixed Asset account. The total cost of these items is not generally allowed to be deducted from revenues in the entirety of the cost, although current legislation has changed this for many new fixed asset purchases. In cases that the entirety of the cost could not be 100% deducted from the revenues, the total cost is expensed over time, through monthly periodic expense entries. The length of time is determined by either a useful life measure or categorized by asset type and assigned a length of time by the IRS. If the length of time is 10 years, then each month would require an expense of $1,000. Similarly to the insurance example, the $1,000 expense represents an economic value used up and has nothing to do with any cash exchange. The recording entries would be a $1000 debit entry to Depreciation Expense and a $1000 credit entry to an account called Accumulated Depreciation.

The Accumulated Depreciation account does exactly what its name suggests, it accumulates all the depreciation expense for assets begin depreciated. This account is reported with the fixed assets on the balance sheet and acts as a contra account given that it holds credit entries but is listed on the asset side with the debit accounts. This accumulated depreciation account allows for a presentation of assets on the balance sheet showing both the fixed assets purchased at their original cost and the accumulated depreciation over time. But the point of this is that the depreciation expense is another example of a non-cash expense that is entered at the end of a period for that time period.

It the Balance Sheet represents the assets, liabilities and equity investment in the company at a point in time, and the Income Statement represents the period changes through revenue and expense entries until the end of the next period, then the Statement of Cash Flows translates the Net Income from the Income Statement into cash by adjusting for all those noncash revenue and expense entries that have been made over the period. It is useful to examine where the cash changes have occurred, and cash can be obscured by all the non-cash entries.

The Statement of Cash Flows has three sections that track cash inflows and outflows. There is the Operating, the Investing and the Financing sections. The Operating Section is used for the non-cash entries from the Income Statement that adjust the assets and liabilities over the period. The Investment Section is used for capital expenditures and investments in other company equities and debts or any loans that your company might make to another. The Financing Section is used for cash activities related to financing, debt or equity, including sale of your stock, proceeds from sale of your debt, and repayment of principal to lenders. The total change to the cash account would come from the sum of the cash used or generated from Operating, Investing, and Financing.

Accrual accounting, using noncash entries, necessitates the introduction of the Statement of Cash Flows to view how changes in the Cash Account occurred over the period. Over the years, I have found many people would look at the Net Income figure and their cash balance wondering why the two figures couldn’t be aligned. Hopefully, the relationship between the three reports and the simple entries provides a high-level understanding for what happens in the financials and a better foundation for further knowledge development.

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This PDF is an aggregation that I put together of the various methods for analysis and processes for a strategic management system. If you are familiar with strategy in business many of these concepts will be mentioned, but I always thought that there should be a mapping, a flow that compiled the various activities. Since I have yet to find a book that has a flow from Planning to Execution to Evaluation, I put something together.

The title, Outlines the cycle of Formulation, Execution, and Analysis of the strategic execution. The diamond at the focus of the cycle, is the Vision, the goal of what to be as a company. The path to this goal is structured through the internal and external analysis of the market and industry and tactically constructed through the goals and measurable objectives.

Formulation’s diamond represents the guiding factors for the planning and formulation of strategy. The organizational structure, portfolio of companies and industries, the competitiveness of those industries and the unique advantages of the companies all act as foundational elements when creating a strategic plan.

Execution’s diamond is impacted by Top Down Tones, Governance and Oversight, Leadership, Entrepreneurship (or Autonomy), and how effective the overall organization design is when carrying out operations.

Each page of charts and elements of strategy are set up in the same fashion, a visual that helps you walk through the elements and recall the relations and factor for each stage.

Cash flow valuations are used for estimation of the value of organizations, project selections, capital budgeting, lease vs buy decisions, growth initiatives and anything that will have an impact on cash flows over time. There are several valuation methods within a discounted cash flow (DCF) setup that result in an NPV, net present value framework, that is an initial investment offset by the present values of future generated cash flows. Even an enterprise valuation can be thought of in this manner given that the valuation of the cash flows will be used to establish an investment price. I think it can be beneficial to examine the cash flows and discount rates used, and the theory underlying some specific valuation methods. It can be beneficial to introduce other methods, but more than that, the levered vs unlevered cash flows, betas and discount rates that the methods use.

Cash flow valuations hinge on two parameters, future cash flows (which could also be cash savings when dealing with depreciable assets in a replacement setting or lease vs buy analysis) and a discount rate. Those in finance will be familiar with the concept of using an interest rate to discount an expected cash flow in some future period back to the current period, hence this interest rate being referred to as a discount rate. The cash flows are generally derived as the incremental, after-tax cash flows expected to occur; after-tax being income tax. Incremental, or the difference, is used both when comparing between two choices such as lease vs buy analysis and when one is a new choice compared with the ‘status quo’ which is just the current normal operations. Incremental is then covers any scenario, but it is also useful from its definition because these cash flows represent the incremental add on value of a decision.

In finance you will see these valuation models, in general, set up as an initial investment (a cash outflow), a series of cash flows over a selected number of years that is typically equivalent to the life of an asset or project, and then some ending cash flow. This setup is the very basic foundation of the model, but as with most basic frameworks the “devil is in the details” to determine these cash flows and the appropriate discount rate.

The initial cost of the asset incorporates all of the cash flows that you would use to get the asset ready for service such as payment for the asset, freight, fees, installation, testing and so on. If you want to pull in some accounting, this is the value of the asset at cost that would be recorded on the books as a capital investment. Further cash flows that are included in the initial investment are any required changes to add inventory, increase working capital or incremental payments that would not have occurred if the asset had not been purchased. While these further cash flows would not show up in the Investing section of the Statement of Cash Flows, they would show up as changes to the Operating section.

If we look at investments that are required to be recorded using the acquisition method and would not be recorded at cost, which would pertain to mergers, acquisitions, consolidations, joint ventures, the valuation method is slightly different in the details. First the model would attempt to value the target acquisition through a cash flow valuation as one of several methods to attempt get a ‘feeling’ for the value of the company and arrive at a price that would become the initial cash outflow in our valuation setup. The actual initial cash flow paid as the purchase price of the acquisition (may not even involve cash or perhaps only partially paid in cash) depends on several measurements such as comparable acquisitions within the same industry, precedent acquisitions in the market that influence whether its a buyers’ or sellers’ market, any premiums demanded by shareholders, and other factors determine the value. When incorporating this onto the accounting books, there is then a process of identifying and measuring the fair value of assets and liabilities that have been assumed in the acquisition and any goodwill that resulted from a purchase payment that exceeds the value of the company and consolidating these with your accounts, a consolidation. While conducting a cash flow valuation you may not venture into how it will look on the accounting books, but it is good to have an idea since any reporting will be through the accounting and probably not from a cash flow valuation.

The series of cash flows over the selected number of years of life of the project may be the simplest of the three sections of the initial cash out flow, cash flows over the lifetime of the project, and the final cash flow. Incremental cash flows that can be attributed to the asset or project, generally of the contribution margin format (revenues minus variable costs) are the starting point. The next consideration involves linked expenses that may not be included in the variable costs such as warranties, property tax, insurance and any expenses that may be reduced such as labor hours. Since the goal is incremental after-tax cash flows the model should also include the effects of tax credits, income taxes, and the depreciation tax shield.

Finally, we arrive at the ending cash flow. This cash flow represents any cash relevant activities that will occur at the end of the project or useful life of assets. Included in this period would be a return to normal inventory and working capital levels, payments that may be legally or regulatory compliant payments per statutes to return land to normal, perhaps the selling of the asset and any tax effects, and any payments that arise due to the ending of the project or discontinuance of asset usage. Of note for assets with a long life, such as in the purchase of a company, you are unable to create a model of cashflows for an indeterminate number of periods. In these cases, the model may stop at year 5 or year 10 and use a mathematical equation called a perpetuity to calculate an approximate value of the total cash flows in the years beyond. This value is often referred to as the horizon value. In general the cash flows beyond this point are accepted as constant or growing at a constant rate and the calculation is a horizon value cash flow divided by the discount rate or the horizon value divided by the difference of the discount rate minus the constant growth rate, respectively.

As you will see below, cash flows in discounting models are usually free cash flows (FCF), unlevered cash flows. That is, there is no consideration for the interest payment tax shield. The cash flows included all cash available for payout to shareholders and debt holders. The interest payment tax shield, since it isn’t included in the cash flows, is then included in the discount rate. The exception to this is if the model is the Flow to Equity (FTE) model. The FTE model uses cash flows available only to equity investors and therefore the interest payments are removed from the cash flows and the discount rate uses the cost of equity valued for the additional risk of using debt. The modeler should specify the model method used, more of this to come, and when the term after-tax cash flow is used, it refers to the income tax as was mentioned above.

Once again, the common colloquial term for these models is the DCF model or Discounted Cash Flow model due to the discounting of the cash flows to the present time period by a selected discount rate. Since the initial investment is a cash outflow, it is generally represented as a negative value and therefore the deduction of the initial investment from the present value of all cash flows over the life of the asset or project is called the NPV, net present value. Any DCF model is always deemed to be a bit of science, and a bit of art due to the combined skills of chosen methodology and the choice of inputs. You may have already realized this with the mention of levered and unlevered cash flows, but there is also the method for calculating levered and unlevered discount rates as will be mentioned.

Before delving further I will write a brief note on IRR, Internal Rate of Return, since it is so common to use as a measure for selection of capital investment and projects. The IRR is simply a specific case of an NPV model. The Internal Rate of Return is the discount rate that is the break even for the investment or the rate at which the NPV = 0. A couple of things to consider with the IRR, first is that to arrive at the rate, it is assumed that all cash flows from the investment can be reinvested at the IRR. Second, while it is easier to see and understand a percentage such as the IRR in terms of being greater than say the weighted average cost of capital (WACC), there is no addressing the size of the initial investment in terms of dollars from an IRR when having to ration out the limited available capital. Further, since the IRR is not a unique value to a set of cash flows over time, it is also crucial to consider the size and timing of the cash flows from which the IRR was derived since the further out in time the higher the variability of the estimate. Finally, it is important to remember what the IRR or discount rate represents, namely risk.

Why do discount rates represent risk?

The explanation for this is in the fact that discount rates are the reinvestment rates for the cash flows over the life of the asset, project or acquisition exactly as was mentioned for the IRR. The discount rate is an interest rate and interest rates represent the expected additional compensation for the investment of capital or loaning of money and return of the principal at some time in the future. If we think of this in terms of debt, whether through a bank term loan or corporate bond offering, the riskier the repayment the higher the coupon on bonds and the higher the APR on the bank loan. This interest rate is called the cost of debt. The same thing also goes for equity. When an equity is purchased, there is the expectation that there will be either capital gains, dividends or both after the purchase. Depending upon the industry, company, financial stability and other factors that one may use to determine the riskiness of the equity purchase and it additional compensation rate, the cost of equity.

When developing the discount rate for an asset, project, or acquisition remember that because interest rates relate to the riskiness of the investment and the anticipated cash flow generation, similar risky investments should have similar discount rates. Or to put this directly, ensure that the discount rate accurately reflects the risk of the investment. Another thing to remember is what type of financing is represented in the discount rate. As we will see there are different methods of cash flow valuation for different scenarios and investments. Many of the well-known methods have a discount rate selected relative to the cash flow calculation, meaning that there is a relationship between where the financing leverage is calculated, in the cash flows or in the discount rate.

As you may also note, many of the methods are used for company valuations, but it shouldn’t be too much of a leap to consider that capital investments of assets and projects are incremental changes to the cash flows of a company and therefore change valuations. This is, again, why it is best to understand the basis of the methods and the relation of cash flows and discount rates to risk and financing so that, if needed, a more detailed and granular model can be created.

Let’s get a bit further into levered vs unlevered terminology. These terms are used to describe and calculate cash flows, discount rates and risk measures (also called betas). Unlevered describes a scenario where debt is not used and therefore none of the issues that arise with debt are considered, in this scenario only the business risk and its ability to generate cash flows from its assets are considered. Therefore, there is no interest expense tax shield and there is no financing risk associated with the company, asset, or project. Levered then takes into consideration financing effects, a scenario where there is both business risk and financing risk. Remember that discount rates represent risk.

The levered and unlevered calculations are easier to understand when dealing with cash flows, however, it is less common to use levered cash flows. It is more common to use the concept of levered and unlevered discount rates and risk measures, as an example of the calculation of the cost of capital for a company. Unlevered is useful when considering a comparison between companies because it is only considering business risk and not the specific choices in how to finance operations. The skill involved is when to use unlevered and levered rates and how to go about de-levering and re-levering. There is, of course, equations to assist with these calculations.

Solving for the market value of equity, market value of debt and the cost of equity and cost of debt is a necessity to complete any calculated discount rate. The reason for this is the a company’s costs of capital is always going to be used as a basis of comparison for and discount rate that will be used. These figures will influence a company’s discount rate for everything from its own valuation to its discount rate on asset purchases and project investments. Getting to the ‘right’ figures for these calculations can be guided by best practices and methods, but again, it truly is a bit of art and knowledge as you will read.

The market value of the debt is generally not the book value of the debt, especially when using bonds, because interest rates are affected by total debt of a firm, newly acquired debt, collateralized debt vs uncollateralized debt, economic conditions, and other factors such as the price on 10-year US treasuries. These all can change over time so the market value of the debt and the associated cost of debt should attempt to reflect current conditions. If the company uses term loans, then the value of the debt could simply be the book value, but attention should be given the cost of debt for additional debt since the rate given may be higher than the loan on the books.

The market value of the equity, when a publicly traded company, is a straightforward calculation of shares outstanding multiplied by the share price. When the company is a private company, the valuation can be a bit more involved and the book value could be used, but since the assets are recorded at historic cost this can affect the equity book value. One could attempt to give the assets a more realistic fair market value and deduct the debt to arrive at a more current market value, approximation to the equity value. Something to keep in mind is that there are different approaches that people use to arrive at these figures. Another approach is attempting to use a sample set of similar publicly traded companies and the average levered beta. This beta is then unlevered with respect to the average debt to equity ratio of the sample set of companies and the firm’s tax rate using the Miller-Modigliani (or Hamada) approach that you will see below. The final step is to re-lever this beta with respect to the private company using its own debt to equity ratio and, again, its tax rate. The approaches all have something in common, the value is to be conservative, objective and a fair representation.

Let’s now look at unlevered cash flows, also called free cash flows (FCF) as it represents the cash that the company is free to pay toward debt, dividends or investments. These are cash flows that do not consider the effect of the interest expense tax shield and are treated as unlevered.

FCF = NOPAT + D&A – CAPEX – Change in Working Capital – Dividends + Change in Deferred Taxes

NOPAT = EBIT * ( 1- Marginal Tax Rate)

Where NOPAT is the net operating profit after tax (income tax), D&A is the Depreciation and Amortization, CAPEX is the capital expenditure and dividends are payments to the equity owners and changes in deferred taxes are noncash adjustments.

A couple of formulas used to arrive at levered equity rates and unlevered equity rates.

CAPM (Capital Asset Pricing Model) r_S = r_F + B_S *(r_M - r_F)

r_S = levered cost of equity

r_F = risk-free rate

r_M = return from the market portfolio (well-diversified set of investments)

B_S = levered equity beta of the company

It is common to use regression to solve the levered equity beta when a publicly traded company is involved. The regression is Y on X or the dependent variable on the independent variable in a single-regression equation, which is easiest to calculate from a tool that can handle arrays, but it could be done using matrix multiplication as well. The Beta is simply the slope of the best fit line, of minimization of the sum of squared differences of the observed returns and the best fit line. In this case, the dependent variable is the returns of the stock, and the independent variable is the market premium, or the return from the market portfolio minus the risk-free rate. Once the levered equity beta is known it is straight-forward to find the levered cost of equity.

Hamada Formula B_S = B_U * [1+ (w_D /w_S)(1-T)]

The Hamada can be used to work from a levered to unlevered beta and back to a levered beta. Since the CAPM uses a levered beta, when an approximation is needed for a company’s beta, perhaps because it is a private firm, then this equation can be used to find a close approximation from a comparable set of companies. The Hamada formula can also be used to estimate the company’s risk changes relative to a changing debt-to-equity ratio since you can begin with the unlevered Beta and measure different ratios impact.

Miller-Modigliani r_S = r_U + (w_D /w_S)(1-T)(r_U - r_d)

The Hamada formula was derived from the MM equation and you can see that the levered return is equal to the unlevered cost of equity and the influence of the capital structure.

WACC

weighted average cost of capital

If considering a company financed using only common equity and term debt

● WACC = w_Sr_S+ w_dr_d*(1-T_c)

s = market value of the common equity

d = market value of of the long-term debt

r_S = cost of equity, generally calculated from the levered beta using the CAPM

r_d = cost of debt

w_S = s/(s+d)

w_d = d/(s+d)

T_c = marginal corporate tax rate

By far the most common method is the WACC which simply uses the firms financing ratio as the basis for the rate. The WACC is the weighted average cost of capital using both equity and debt financing. It is calculated using the market values of debt, equity, after-tax cost of debt (r_d(1-T_c)) and cost of equity (r_s). The market values of debt and equity are used to arrive at the ratios of debt to total invested capital, giving the “weight” of debt (w_d), and of equity to total invested capital, giving the “weight” of equity (w_S).

The cash flows are the unlevered cash flows, meaning they are treated as entirely equity and, again, there is no consideration that is given to the interest expense tax shield provided by debt financing. This tax shield is already in the WACC, the discounting rate. The interest expense tax shield in the after-tax cost of debt.

It may be prudent to evaluate all commonly used financing options to arrive at the WACC. If the company uses preferred stocks and short-term financing options regularly for financing activities these may be two options that you want to add to the weighted calculation. The reason for this is that preferred stocks and short-term financing each have unique costs associated with their usage that will differ from common equity and long-term debt. Decisions such as these are where the art of modeling construction come into play.

Usage of the WACC is assuming that the asset, project, or target acquisition is of similar risk of generating expected returns relative to that of the company from which the WACC is begin derived. It is also assuming that after the purchase, the WACC will not change due to the purchase and that the capital structure of debt to equity will remain the same. These are all areas for which special attention may be needed.

FTE

flow to equity

● FTE = NPV_FCFE

● FCF_equity = FCF – Tax Shielded Interest and Debt Repayments + Net Borrowing

Or

FCF_equity = FCF + Changes in Debt

● r_S = r_U + (D/S)(1-T)(r_U - r_d) from Miller-Modigliani

● r_S = r_F + β_S *(r_M - r_F) from CAPM using market values of equities (levered)

r_U = unlevered cost of equity, also known as the all-equity discount rate

r_U < r_S due to the fact that incorporating debt increases risk

The FTE is a method most often used for company valuations and used when the debt-to-equity ratio of the company fluctuates. This method is also known as levered cash flows or residual cash flows. This method uses free cash flows to equity, those available to the equity owners of the company and therefore any interest payments that go to the debt holders have been removed.

The discount rate is the cost of levered equity. The CAPM (Capital Asset Pricing Model) model is often used to solve the levered equity using the equity beta for a company which can be found in a couple of ways. First, there is the formula above that was developed by Miller and Modigliani’s (and Hamada) research into corporate finance topics.

The usage of the FTE can simplify calculating the value of equity for companies is the capital structure is complex and market values for securities in the structure aren’t known. However, the cost of equity does not change regardless of debt to equity in this method. If the debt-to-equity ratio is not maintained then this becomes an involved method since debt levels would increase the required returns from equity, the cost of equity.

CCF

capital cash flow

● r_CCF = w_Sr_S+ w_dr_d

The CCF uses cash flows available to all investors inclusive of the interest tax shield, the NOPAT and any additional adjustments such as the D&A added back. Because the interest tax shield is incorporated into the cash flows, the cost of capital used for the discount rate does not use after-tax cost of debt but the cost of debt in the weighted cost of capital calculation. In other words, the cost of capital is calculated as the WACC but without the after-tax calculation of the debt.

Since the cash flows incorporate the changes in the tax structure, this method can be easier to calculate, but again one is looking at the assumption of a consistent debt to equity ratio.

APV

adjusted present value

● APV = PV_unlevered+ PV_ITS

● r_unlevered = w_Sr_S+ w_dr_d

The APV examines the value of cash flows in two parts, the unlevered value of cashflows plus the value of the tax effects from leverage giving a visualization of the effect of financing.

The PV of the interest tax shield is the marginal tax rate * interest payment discounted by the rate of the tax shield. The rate of the tax shield is more theoretical and can’t be lower than the growth rate of the FCF. Since this is the case there is a compressed version of the APV that uses the unlevered cost of equity as a substitute for the rate of the tax shield.

The APV can be easier to work with than the WACC if there isn’t a constant debt to equity ratio. This method also allows a proportional debt adjustment to the cash flows over time and a constant interest coverage ratio relative to the free cash flows.

mIRR

modified internal rate of return

This method attempts to remedy the shortcomings of the IRR, specifically the fact that it is calculated assuming that the cash flows generated are reinvested at the IRR.

For the mIRR, cash flows are ‘reinvested’ at the cost of capital before finding the IRR. This sounds confusing at first but what it entails is finding the future value of the cash flows at the final period in the model using the cost of capital as the investment rate. Once the future value is found, the only cash flows at in the initial period (the investment) and the final period. From these cash flows an IRR is found, recall that this is the breakeven where the NPV = 0.

Capital Budgeting

Capital budgeting and planning is a common area for which NPV, discounted cash flow models are used. I am sure that those who have had to evaluate projects and rank profitability measures to determine where to invest limited capital have used NPV dollar values, IRR percentage values, payback and profitability index figures, but in addition to these methods, I wanted to add on that I came across in researching capital budgeting. Another useful analysis is that of Constraint Analysis. Constraint analysis isn’t a cash flow but an analysis of your operational process to find the bottleneck and hence the throughput. The idea is to invest in expanding the capacity at the bottleneck since this is rate at which you could maximally offer products or services which, if at maximum production, would be the limit to your profits.

If you are familiar with step-up assets when budgeting and planning for future revenues, then the use of Constraint analysis makes perfect sense. Once a constraint analysis is completed, then the cash flow valuation of the investment into the bottleneck can be completed. I just wanted to include this since cash flow valuations are generally used for capital budgeting decisions.

Closing

There are numerous examples of uses of these methods, so this wasn’t my purpose. My purpose was to introduce the cool usage of leverage and the fact that there are ways to create models built on its usage rather than sticking with the general use case of the WACC for NPV valuations. Besides, in order to get good at using new concepts it takes practice.

For many, in the Finance and Accounting Departments of companies, Cash Management Models (CMM) are one of the more difficult models to grasp the dynamics and source drivers. The primary reason for this is that everyone immediately rushes to gather financial statement information either focusing on Working Capital or on the Statement of Cash Flows. However, this can be a costly error. A CMM is not based on accounting data, it is based on operations data.

Let’s look at the purpose of a CMM. The primary purpose of a CMM is to ensure the timing of cash coming into your bank account matches the required disbursements going out of your bank account. The key words here being CASH and TIMING. Why? First, because accounting for companies is based on the accrual methodology which consists of many non-cash transactions, second, recording of transactions only occur after an initiating event, and third, some cash activities do not have an initiating event to record an accounting transaction. This not only means that many of the entries have nothing to do with actual cash transference, but the timing of transactions that do have a cash account impact can take place well before or after any actual cash is deposited or disbursed from the bank account. You must set aside your financial mind for a moment and go back to a cash-based mentality to create a useful CMM.

Where do we start?

Find the primary driver for your cash deposits and subsequent disbursements and map the process to ensure you gather the best data for your CMM model and forecasting.

Obviously, the first thing that comes to mind when thinking of cash is sales. Sales beget revenue, which is almost cash depending on your business, and any sales require disbursements to workers, rents, insurance, suppliers and financiers that enable sales to take place. Sales would seem to be a good starting point for both deposits and disbursements given the requirements to conduct sales. We will see that this should be true as we walk through our cash inflows and cash outflows.

Let’s then begin with, cash inflows, the deposits into our operational cash account by considering the question:

‘How do sales trigger cash deposits, also referred to as payments? ‘

Well, this depends. Does your company offer credit terms to your customers? In other words, does your balance sheet have Accounts Receivable? If so, then sales is only part of the answer to payments. Your sales may be comprised of cash-on-demand payments, credit card payments and sales made on credit terms that will hopefully result in payments. One more additional variable has become a factor in timing and cash flows thanks to Fintech and that is the number of methods used to receive these payments. For cash account deposits each of these will have different timings as to when, how much, and sometimes if, there will be a deposit of cash into your bank account.

Cash Inflows

‘Cash is King’. These are the cash-on-demand transactions, or the cash paid at the time of the sale. Whether these sales are taking place at a brick-n-mortar location or being exchanged at a job site for a small business, this cash must still make its way to the bank by physically taking it to a bank location. For many businesses the transactions from a business day or every couple of business days are gathered and recorded for pickup by a security service that transports the cash to the bank. But no matter how it gets there, note the timing of the process.

Timing is THE key consideration for any CMM as even direct cash transactions will most likely not be available in your checking account for a day or two after a sale is completed. This timing will depend on your pickups, the time of the drop-off at the bank and the time for a teller to process the transactions. If you are a business that accepts personal or business checks, and these are included in the deposit, then these amounts may not be available for a few days as the checks clear. Since CMMs are most often set up as weekly forecasts (13-Week being most common), then those few days to clear will impact forecasts and real time availability of funds. The benefit of cash-on-demand is that there are seldom fees that go into the payment of cash and, therefore, what you charge for a service, or a product is what you will receive.

Next, we consider credit card payments. Credit card payments and processing systems have come a long way. Payment systems are big Fintech business as there is continued competition to get your payments into your bank account as quickly as possible and make transactions as convenient to customers as possible, and therefore to your business. That said, there are timing considerations to dive into for your specific company that will impact processing speed and final deposit.

From the high-level overview, the two main steps for a credit card sale are Authorization and Settlement. Authorization begins with the card swipe and continues with authentication and funds verification. Settlement involves the transference of funds from the purchaser’s bank to your bank. Authorization can be nearly instantaneous. Settlement can take time.

Settlement time will be determined by your Point-of-Sale (POS) system, payment gateway, and the transaction clearing time of the banking institutions to transfer the funds. Most credit card processors will take 1-3 days to complete payments, but it can take up to 7 business days. Why? Behind the scenes, payment prep is more extensive than the initial authorization of purchase. In a process called ‘batching’, authorizations are collected and submitted to the acquiring bank in a … batch. The bank then moves these along to the credit card network so it can receive funds for the purchases which will then be deposited into your bank account. Of course, convenience costs money and credit card transactions charge fees for the service.

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Before jumping into sales on credit terms, I would mention that there are of course many apps that allow payment directly from a checking account, ACH, wire transfers and so on and that cash or credit card payments may be used to pay invoices for sales sold on credit terms, but the point is to understand what your company uses, a distribution of the methods used by customers and the timing for the methods to arrive at reasonable amounts for deposits into your bank account.

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Our third category of inflows is from trade credit, the Accounts Receivable. Again, trade credit could be paid with cash, credit card, ACH, bank wire or paper check, but trade credit has its own category because it extends the time of any of these payment methods by the terms defined in the trade credit allowance. If you are familiar with terms like net 30 or net 60 then you have seen trade credit terms, payment within 30 or 60 days of receipt of invoice. What many people are unaware of is that many companies start the clock only once they have received the invoice and this often now means when you have ‘officially’ entered it into their payment portal system. While this typically occurs with much larger companies that can control a market, smaller firms still have to deal with these issues that add time and money to your company’s ability to collect cash.

Now we look at cash outflows, also called disbursements, and how sales require cash out flows.

Cash Outflows

Cash outflows work in a similar fashion. Cash, credit cards and trade credit categories, but for disbursements of cash for operational products or services required for sales activities. These methods of payment, however, should have controls placed upon them to determine when these payments are appropriate and the limit of each type of payment. As an example, cash is generally used for small items required immediately for office, floor or field use that may be considered an administrative tool like printers, paper, even laptops. These cash payments are funded through “petty cash”. This ‘petty cash’ fund is common in companies that have brink and mortar locations and may only get the opportunity to order restocking of products and supplies once or twice a week. The store employees may need to go to a local store to restock an item that was overlooked or simply ran out before the next restocking opportunity, paper towels as an example. This is the smallest, but still necessary, consideration of cash disbursement forecasting as these will be replenished to the approved amount as needed and this is a direct cash replenishment.

Credit cards are often for items that are recurring and necessarily trackable expenses such as the aptly named expense accounts for fuel, business travel, meals and other allowed expenses that require considerable cash to be carried or reimbursement by the employees. It is much simpler to track and control these disbursements through credit cards, especially with today’s technologies to track and control card purchases.

While credit cards will also be used for direct, immediate purchases, the bill comes at the end of the cycle. This is therefore a budgeted and ‘accrued’ expense, a tally of certain expenses that will need to be paid in the near future, usually 30 days on a credit card cycle. The benefit of these payments is that if the company is on a corporate credit card system, the payments should be entirely predictable based on the cycle schedule. The requirement for a CMM is to understand historic spending patterns and when activities such as conventions and marketing campaigns are scheduled so that the added costs that will come due are for the correct amounts and on the correct cycle with the inclusion of any interest due.

These two categories of ‘petty cash’ and credit cards should almost never be used to pay for items that are available from vendors from whom you have trade credit agreements to pay for their products or services. The reason for this is the same as it is to the companies you would offer trade credit for accounts receivable on your products and services, companies want to hold cash for as long as possible. The benefit of doing this with trade credit vs credit cards is that credit cards charge interest on the short-term loaning of funds for your purchase while trade credit is an interest free loan for the period until the invoice is due to be paid, determined by the credit terms. I will get into this a bit more shortly but the disbursement of Accounts Payable works the same way as your Accounts Receivable, you pay when the terms determine that an invoice is due.

Like Accounts Receivable, if you are a large company that has some power in the market then you may get better terms. You may be able to get longer terms such as net 60 or net 90 to pay on your outstanding credit, but if you are a smaller firm then you may not get any terms and be required to pay COD, cash-on-delivery, net 15, or perhaps net 30. The requirement for the CMM is to determine if there is a historic relationship between vendors and the products and/or services that you offer so that you can forecast your Accounts Payables, and any disbursements from petty cash or credit cards for that matter, from the single driver of sales. Since there is an even more granular level to the Accounts Payable that may help to predict cash outflows from vendor trade credit, we step one more level down to purchase orders.

For many companies you will be assessing requisitions and purchase orders that represent costs for required equipment and goods to fulfill a particular service or product order that you may not keep in inventory or need to replenish. If approved these purchase orders not only signal a job that will trigger revenue but also costs associated with the performance of the job that translate into Accounts Payable. If you can determine the timeline, you can then forecast the approximate day this invoice will come due. Further, breaking down the services and products that your company provides may help to pinpoint certain purchase orders or inventory that is consistently used to provide the services and products, leading to even more accurate disbursement forecasts.

After giving a very quick overview of cash inflows and outflows you can probably see that while there is a close relationship between working capital and cash, working capital uses accounting entries that are triggered by accounting events while cash may flow on a different timing schedule as it is determined by payment terms.

Let’s run through a flow chart for a common business-to-business transaction to see this visually for a service business. Now this should be familiar, albeit different account names may appear in your chart of accounts. The important thing is to note that cash movement has little to do with accounting entries. Accounting entries are to reflect timing of earnings and liabilities in the appropriate periods where, again, cash is paid upon demand whether now or at a future agreed date.

• Date: 03/02/26

Needy Co. places a Service Order, Scheduled for 03/04/26 and will be completed within this accounting period

Accounting: none

Cash Change: none

• Date: 03/02/26

You place a Purchase Order for materials from Got-It-All Co. from whom you have no credit terms and payment is due upon invoice

Accounting: none

Cash Change: none

• Date: 03/03/26

Purchase Order materials received from Got-It-All Co. but not yet billed (aka Goods Received But Not Invoiced) as Got-It-All Co. tends to send out invoices on the 15^th and the 30^th

Accounting: entry to PO Expense

entry for a PO Accrual to recognize the liability (AP)

Cash Change: none

• Date: 03/04/26

Your service tech completes Service Order towards end of the workday

Accounting: if there is a manual submission process for completed work orders, the accounting team will complete it upon receipt tomorrow

Cash Change: none

• Date: 03/05/26

Your accounting team records Revenue and Accounts Receivable

Your Accounts Receivable team notes Needy Co. has ‘net 30’ credit terms and schedules the invoicing date for 4/6/26

Accounting: entry to Revenue

entry to Accounts Receivable

Cash Change: none

• Date: 03/13/26

Pay Day for Periods 2/23 – 2/27 and 3/2 – 3/6, You will pay the service tech for the job completed 3/04

Accounting: Your company would have had an accrued payable for payroll due for the 2/23 – 2/27 period

Cash Change: CASH OUTFLOW for payroll activities

• Date: 03/15/26

Your Accounts Payable team receives the invoice for the Purchase Order from Got-It-All Co. to be paid upon receipt of invoice

Accounting: entries to recognize invoice/reverse PO Accrual

entries to inventory and AP

entries for inventory/COGS, AP/Cash

Cash Change: CASH OUTFLOW for AP payment

• Date: 04/06/26

You Accounts Receivable team sends out the invoice for services rendered to Needy Co. for payment

Accounting: entries to AR/Cash

Cash Change: CASH INFLOW for payment of services rendered upon receipt of invoice

Now that we have drawn attention to the types of cash inflows and outflows and the fact that accounting transactions are not the same as cash changes in your bank account, let’s look at how we might categorize cash changes to make a CMM more accurate.

Perhaps the first thing one notices in the flow chart is the amount of time between cash changes and the second that there are a couple of disbursements of cash before actually being paid. This is something that entrepreneurs often overlook, the fact that there needs to be capital invested prior to even generating revenues because situations just like this are the norm in operations.

But, after a look at the timing you may also be drawn to the payroll payment and thinking to yourself… hmmm… that is a regularly occurring payment. Payroll is not only regularly occurring, but it is also composed of a fixed cost for all of those that receive salary or work a set number of hours on an hourly wage. In fact there are many fixed charges for a business that are not only predictably scheduled, but also easily predicted amounts.

Payments for rent, insurances of all varieties, salaried payroll and benefits, interest and principal payments on debt, revolvers and leases and so on. You might think of your fixed costs as your operational leverage or even begin to consider contribution margins but the concepts for the CMM is the same, what are the consistent, fixed costs required to operate. This is the amount of cash that flows out of the bank account to continue operations.

Thankfully, you should have a complete list of all of these contractual items. You should have insurance coverage, premiums and due dates, and you should have debt contracts and rates (variable or fixed) and amortization schedules or payment schedules depending on the type of debt. You should also have all rental contracts, leases and payments due over a given term. You even will have a list of all salaried employees and a schedule of payroll so that you can get a headcount total and total cost of administrative and executive costs for your CMM. All of these items can be set up to reflect actual disbursements and certain payment outflows that will be due in the future that will take the guess work out of a substantial portion of the outflows.

We started with a basic understanding of where cash inflows come from, what payments might be used for cash outflows and a look at how accounting transactions might not necessarily reflect cash changes. We now also have covered that a good portion of cash disbursements are orderly and nearly fixed amounts. The final piece to our CMM is an analysis of the relationship between the Purchase Orders and Accounts Payable required to support Accounts Receivable of different service and product categories and customer terms. This is, obviously, the most difficult part, but it is also the only real forecasting given that if your relation of required materials for different services and products is accompanied by a regular cost variance analysis then your anticipated disbursements should relate directly to your forecast of the services provided and products sold.

This final piece can be a bit more granular than some financial analysts are used to but given that any customer can request any service or product and each customer will have specific credit terms, it is essential to get to a level that relates services and products to the credit terms so that the timing of the Accounts Receivable invoicing is accurate. Since you will probably have a standard list of suppliers for Purchase Orders and Accounts Payables, then you will order certain supplies and equipment from the same companies over and over. Because your credit terms with your suppliers are unlikely to change often, the relationship of Accounts Payable required for services and products, again, will be less of a forecast and more of a relationship of the timing of services provided and the due date for the invoicing of the materials ordered from the supplier.

The look at the different considerations I have presented for the construction of a cash management model might be different than those presented for companies suffering from an illiquid position and struggling with solvency. Because the traditional 13-week cash flow model stems from these situations, a great deal of attention is given to the unwinding of the working capital segments of Accounts Receivable and Accounts Payable. This is primarily due to the fact that situations of solvency rely heavily upon creditor confidence that they can be repaid, and continuing operations can support itself without additional debt or creditor allowances. The 13-Week Model is meant to model the unwinding of the AR and the paying of the AP while showing that continuing operations can finance itself through the regular sales process. Since the current portions of the balance sheet become the primary benchmark for operational solvency, the most liquid current assets and current liabilities are the focus. The process can involve a concentration on the AR specifically and a brief pause of the AP in order to get cash payments and collections back on track. This situation will be a bit different than for a regular company that desires to develop sound cash management practices, though the 13 week time frame is still commonly used.

A company that wants to monitor its cash flow, manage its treasury and ensure sound operational payment and collection activity before getting to a troublesome spot needs to take a more granular approach to the actual flows of cash into and out of the bank account on a near real time basis. This method will enable a company to develop investment strategies and plan for strategic development of operations, acquisitions and CAPEX. It will also draw attention to issues of liquidity well in advance of solvency troubles and when combined with other analytical and reporting tools the CMM will pinpoint which area of inflows or outflows need attention.

Cash Management Models are not easy. These models take some time to consider the process flow and to narrow down exactly what activities trigger cash changes to the bank account prior to creating a forecast and modeling of future activities. But if you create a process map and find your granular sources of inflows, outflows and track down your timing schedules then you will be off to a very well developed model that can be continuously updated for more and more accuracy.

Say the US demands, a certain number of units of shoes at the current prices. Let’s say 10,000 units of shoes and let’s say that there is a weighted average price of $60 for a pair of shoes. The concept of demand requires a consumer to be ‘willing and able’ even though there are probably others that would like shoes, only 10,000 units can be moved at an acceptable profit given this weighted average price.

Tariffs force the price of shoes to increase so that the weighted average price is now $65 for a pair of shoes. At this price, the ‘willing and able’ demand falls to 9,500 units. If tariff were actually being used as a protective and defensive posturing, this would require the US to be able to supply the 500 units at the weighted average price of $60 per pair, or at lease offer some units at a weighted average price between $60 and $65 per pair, otherwise the current level of consumption is impacted and the US consumer is impacted because they would be better off being able to have purchased shoes.

Given that a profit was being made at the $60 per pair, weighted price, and no US manufacturing competition was introduced, as one would expect, then we are implicitly lead to believe that US manufacturing could not be profitable at this weighted price. For this one could believe that the manufacturer would offer a distribution of products that would also offer a weighted price around $60. If not, you then have to ask, at what price would US manufacturing be profitable? But not just profitable as this isnt the only consideration for manufacturing. At what price could a US manufacturer be profitable AND off a return on investment inline with that of the importers else there would be no reason to invest in the US manufacturing because better returns for the same risk could be earned elsewhere.

The fact is that the low end of the demand is impacted, not the high end. The high end probably already has some competition. If no US manufacturing could compete at the low end, which is where the demand needs to be replaced due to the tariffs, then the tariffs probably aren’t helping the US consumer. In order to “bring back” manufacturing the tariffs would have to force the prices high enough to make US manufacturing feasible, meaning profitable and offering an acceptable return on investment of capital to initiate the manufacturing.

When discussing the return on investment, we then have to assess the IRR or NPV or some approximation of a cash flow model for the factory to compare to other investments of similar risk. But could you find similar risk? If the tariffs could be removed at any time, or almost assuredly within four years, and even the old factories could not be refurbished, reequipped (with imported equipment mind you) with reestablished supply chains (again probably from overseas) and ready to produce in less than 24 months … well … who would take that risk? what other risk would be similar? Who would invest capital on knee jerk reactions that could be removed on a whim?

Probably no one.

I have yet to see if tariffs impact only ‘finished goods’ or how ‘finished goods’ would be defined if this was the case. This is important because given today’s supply chains, numerous items are built or assembled across countries, sometimes several. An item like an alternator for a car is technically a finished good. You can purchase one and fixe your automobile. But, these are also ordered and essential for a factory assembling vehicles in the US, like a Toyota factory. Would all alternators be subject to tariffs including those used by the US manufacturing assembly plant or only those that you would purchase for your vehicle? What if no alternators are made in the US? Then you now are simply paying a higher price because you have no other option. These are the questions you NEED answers to before you either cheer tariffs or berate tariffs. I simply want to pose situations and stimulate questions.

On the television and from “brilliant” financial commenters there have been all kinds of comments both in favor of and against the tariffs. The commenters talk of “basic economics” or “laws of thermodynamics” on drunken podcasts to explain their beliefs on what will happen to the economy and prices, but I have only seen a couple of instances in which someone has tried to walk through the dynamics of what occurs. Of course, these instances are not mainstream and, while they may be “viral”, there are never enough viewers to make any difference to the overall belief systems of the two sides of those in favor and those against.

I will begin by saying that laws of basic economics are not laws. The only “law” that is close to what one would accept as a law is the law of demand. The “law” of supply doesn’t exist. I hear over and over about the supply being the force that drives economies but the fact is that if this was remotely true than if you could supply something, anything, and people would buy it. They don’t. Interestingly this supply take is almost always from uber wealthy individuals that work in finance and investment areas and not in real goods. If they had tried to create a supply of real goods and services they would realize that only those that fill a void and create value for the customer become successful. The irony in this begin that these real goods and services companies are typically the only ones the uber wealthy in finance and investing will look to for their investment portfolios.

A purchase of a good or service is defined by the need or a derived value of the good or service, not simply the supply or availability, no matter the price. Certainly this derived value could be a perception pushed through an amazing marketing endeavor … think pet rocks … but eventually a “normalization” of behavior wins out and even free items may be avoided if there is no value derived from the item. The only reason a supply driven economy can be considered a plausibility is due to this quirk of behavior in people that can be persuaded, for a time, to purchase something that has been supplied and may not have had any demand otherwise. Behavior is a peculiar thing.

The general counter to demand driven economies is that there would be no needy people, or poor people, again stated by uber wealthy, because their demand would drive supply. However, there is a key defining point that a demand can only be satisfied if those demanding something are willing and ABLE to purchase at the offered price. The dynamics of cost and price always play into a transaction. But if you were to look at supply driven vs demand driven ideologies I can guarantee this, if there is a demand for something then you have a ready market regardless of whether there is yet anyone supplying this demand and you can determine whether this demand is profitable. If, on the other hand, you supply something and have no demand, and can’t convince anyone that they should demand the good or service, you go broke guaranteed because you KNOW it isn’t profitable. And note that the supply driven idea has that extra step, and extra cost, of having to convince people to create demand.

How does this play into tariffs?

If you recall my shoe example tariffs increase prices, and this is a virtual guarantee in the short term. But as prices increase fewer people can afford to purchase the items as it would take up more and more of the disposable income they have available. This means that people who were able to purchase are no longer able to purchase. From the perspective of the supplier, demand is reduced. The only demand that is available to be satisfied is that demand that was removed when the prices increased. However, this demand is at a price too low for suppliers to produce a profit domestically and meet the required return on any investors capital for the given risk profile of the endeavor.

Let’s look a bit deeper now.

Since we are a consumer economy most of our products, that are sold by stores here in the US, are products that are made in other countries. These stores, owned by US citizens, will have to pay tariff fees on these goods whether or not there are similar products available within US domestic production. Not only will this increase prices on the products, but it will significantly reduce the margins of the small business owners. Once again, the small businesses will be targeted in much the same way as they were during the pandemic.

The foreign companies that need to pay the tariffs will, at first, need more dollars to pay the fees. This will most likely result in treasury purchases and the treasury rates declining initially. As fewer units are sold in the US due to rising prices that squeeze out the demand (as in the example), fewer units will be subsequently ordered to replenish the purchased goods. Not only does this mean reduced revenues in the US, but it also means that factories in foreign countries will be running at lower utilization rates unless they can find purchasers for the units that would normally be sold to the US. Two things would follow … first, less treasuries are needed to pay tariffs on a declining number of units being imported and second less treasuries are need as there would be less investment in the US by foreign companies because their investments will not turn out as high of profits.

Again… the argument is that foreign companies would “simply” build manufacturing here. Only that didnt happen the first four years and it wont happen this four year term. Why … as already stated … the price to make a profit for domestic manufacturing would need to be quite high comparatively to the imports. These high prices squeeze out demand since disposable income cant keep up with the prices AND the capital that would be needed to invest in developing manufacturing would not see the returns on investment that are currently seen in companies that utilize global chains.

The first four year term this was attempted… and if you were to look objectively at what happened, almost no companies brought back manufacturing even though it was continually proclaimed that they would do so.

The individuals that will suffer through this are, as usual, the middle and lower classes and the small business owners.

Contribution Margin = Revenues – Variable Costs

At this point the statement may not mean much, but at the very least, it should elicit the question, “What are Variable Costs?” and perhaps even the question “Why do they matter?” Perfect.

The understanding of cost behavioral patterns relative to productive output is the key to better decision-making and strategic planning. In a world of risks and the unknown, companies should strive to know the knowable. That is to say, understand the historic cost relationship to changing levels of revenues, or more accurately, the distribution of the product or service units sold that were responsible for the revenues since different product units would entail different processes.

Take a moment to consider a process required to complete a product or deliver a service. The process is comprised of certain resources and assets and then, over a period of time of activities, the product is completed or service delivered. The process isn’t likely to change much unless there is a direct and deliberate attempt to change it through process innovation, perhaps new material or technology. Since this is the case, the associated costs and time of activity due to the process aren’t likely to change. This gives an analyst and planner the benefit of knowing the costs and cash disbursements relative to an output of units. Perhaps you are already a step ahead and thinking of the costs of the equipment, the labor and the materials. Good for you!

Sure enough, some of these costs will be variable costs and some of these costs will be fixed costs. Before I get into these costs please note the close association of the data leading us to the contribution margin through an aggregation of processes and how it is tied with operations management and research. Let’s name some areas and some data points that would impact strategic planning and finance:

**Supply-Chain Management

Procurement Contracts, Accounts Payable Terms, Logistics Terms

**Process Management

Throughput, Cycle Time, Flow Time, Outsourcing, Leasing

**Inventory Management

Safety Stocks, Cost of Carry of Inventory, Economic Order Quantity, Warehousing

This is just one reason why I think it is valuable to conduct process mappings of activity within an organization, but that can be drawn out in another article. For now, back to the costs.

We should begin by thinking about how to classify costs as variable or fixed costs. I think the easiest way to classify variable and fixed costs is by using activity as your baseline. If a cost were recorded in the financial statements even if there was no production activity then these costs would be, in general, fixed costs. These costs include both cash and non-cash recordings, such as depreciation expense and cash recordings such as salaries in the financial statements. If a cost only occurs if there is production activity then these costs are, in general, variable costs. Now you are probably thinking that some costs might occur regardless of activity, such as some utilities, and then would increase once activity begins. Good thinking. These are semi-variable costs and have a fixed portion and a variable portion.

Now, Semi-variable costs are probably best handled using Regression Analysis, also known as Least Squares Regression, but you could also use the High-Low Method to approximate the variable and fixed portions. I will go through Regression Analysis in another article, but given how easy it is to use linear estimation in Excel or other statistical applications, these days, the break-out of the variable and fixed cost portions is just an equation away.

Quickly and shorthand, if you regress Y on X, the dependent variable on the independent variable, your equation would be y = m*x +b. The ‘b’, or intercept, would be the fixed portion and the ‘m*x’ would give you the approximate variable costs for a given output of units ‘x’. ‘m’ is the coefficient, or slope, of the line that you fit to minimize the total squared distance from the observations to said regression line by way of the least squares calculation. Of course, there is also consideration for how well the regression equation can estimate the costs measured by the ‘r-squared’ statistic. Again, I will write about regression analysis in another article, but it is a great method to assess semi-variable costs.

Displaying the contribution margin format of the income statement next to the traditional GAAP statement will now benefit our discussion of variable and fixed costs and how these are treated differently in the standard gross margin income statement vs the contribution margin income statement.

and the Contribution Margin Format

As you can see, GAAP requires an allocation of any costs that are related to the production of the product or service being sold, including overhead. This is referred to as absorption costing. Recalling that COGS, Cost of Goods Sold, would be drawn from the ‘Finished Goods’ inventory, or simply the inventory account, when sold we can understand why these are called inventoriable costs. For GAAP costs are primarily based on traceability to a product or service and not if the costs are variable costs or fixed costs. Direct costs, those of material and labor can be directly traceable to the product or service completed. Allocated costs are allocated to a product or service on a base rate from a pool of aggregated costs.

As an example of variable overhead, say the production equipment in a manufacturing setting, or even laptop computers in a service industry using billable hours, needs increased maintenance as the usage is increased. If we can’t directly trace any of these costs to a specific product or service but it is still related to the completion of the finished good or delivery of the service we must still allocated these costs to the product. The method to accumulate these allocatable costs varies but one method is cost pools based on the category of overhead.

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The pool of maintenance costs to be allocated is $50,000 and the base rate we will use is labor hours of production which totaled 10,000 hours. The $/labor hour would be $5/labor hour.

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The fixed overhead is similar to the variable overhead except that because this category is comprised of different types of fixed costs, such as salaries and depreciating assets, the pools are often allocated on a time-based rate and/or a square-footage-of-occupied-space derived rate.

No matter if the operation is a process, batch or job costing system for manufacturing, merchandising or service industries, there will be an accumulation of costs associated with the finished product that are assigned for inventorying purposes and GAAP financial statements. This may have seemed like too much information but understanding how the financials are used and what is aggregated on the financial statements is key to better financial analysis.

At this point, it is also important to note the methodology for recording these inventoriable costs may differ in your organization. Your organization may use a standard costing system or a normal costing system to record direct costs and overhead costs into inventory and then settle up differences at the end of a recording period. (Just for reference)

Standard Costing

Uses Historically Derived Estimates for Direct Materials, Direct Labor and Overhead allocations.

Normal Costing

Uses Actual Costs for Direct Materials and Direct Labor, but a predetermined Overhead Allocation Rate.

This is stretching the focus of the contribution margin topic but, since costs are a primary element of arriving at the contribution margin, I thought it was beneficial to quickly cover some costing methods and I really enjoy costing studies.

Back to the income statements.

Now that we have seen the GAAP, externally reported, gross margin method and the respective costs, let’s take a look at the Contribution Margin method. This method simply separates the costs into variable and fixed portions at every level of product costs and operational expenses. The point is to assess exactly what costs are only recorded during activity, the variable costs, and how these costs change with changing levels of production activity. Remember that the fixed costs would occur even if there were no production activity and this will help when separating and assigning the costs.

How is this useful? - you might ask.

One Element:

Cost – Volume – Profit (CVP) Analysis

Answering questions such as:

What sales volume is required to Break-Even?

What profit can be expected on a given sales volume?

How do changes in selling price, variable costs, fixed costs and output affect profit?

How does a change in the distribution of sales products affect the break-even and profit potential?

To answer these questions, we would begin by finding the per unit contribution margin and the contribution margin ratio. One nice thing about contribution margin is that it provides for some easy ‘napkin math’.

Break-Even in Units = Fixed Costs / Per Unit Contribution Margin

680 units = $17,000 / $25

Break-Even in Dollars = Fixed Costs / Contribution Margin Ratio

$27,200 = $17,000 / 0.625

Note that this information is also useful when planning a business. If you can tally up all your fixed costs and begin planning for the resources and labor for the business, then you will be able to figure out how many sales you will have to make to meet your bottom line. This is especially effective for restaurants and store fronts because you can realistically figure out if your location or other factors can adequately provide the required number of sales.

Uses of CVP continued:

If the Sales increased to $50,000, then the change in Net Income is quickly found by the dollar change in sales times the contribution margin ratio.

$6250 = $10,000 * 0.625

If using the change in units then we would use the per unit contribution margin. Say the units sold increased to a total of 2500 units, then the increase in Net Income would be as follows.

$37,500 = 1500 * $25

- Analyzing an Advertising Increase:

Say the Ad Budget is increased by $10,000 (a Fixed Cost) and believed to increase sales by $16,000. Would this be beneficial?

Contribution Margin would increase to $16,000 * 0.625 = $10,000

Since Fixed Costs also increased by $10,000, the change in Net Income would be 0 and there would be no benefit.

-To Stimulate Sales, Pricing Change Decrease by $3 and Advertising Increase (Fixed) of $1000

Current Contribution Margin and Units $25 * 1000 = 25,000

Changed Contribution Margin and Units $22 * 1350 = 29,700

The increase in Contribution Margin 4,700

Increase in Fixed Costs – Advertising 1,000

Increase in Net Income 3,700

Shown via the long method:

While these examples only display one product, a weighted average price for products can be used to represent the product distribution and sales mix to achieve the same ends.

-Capital Expenditures, A replacement machine and incremental change:

The current machine is 3 years old with a 5-year useful life for straight line depreciation and a book value of $17,500. The new model would save on variable operating costs and costs $50,000 also with a 5-year useful life for straight line depreciation. Both machines can achieve a normal sales volume of 20,000 units.

The purchased machine and its book value is a sunk cost and has no incremental relevance. Also since the insurance and other elements should be the same for both machines these will not play into the incremental change either.

Of course we would also need to dig into the ROI to determine whether the $5000 increase to Net Income justifies the expenditure.

-Adding or Dropping a Product Line, Department, or Segment:

Decision Support and the impact that variable costs and fixed costs have on the analysis since fixed costs do not change in the short to medium term.

By the looks of it Segment B may be on the chopping block, but how would an analysis using the variable costs and Segment B’s contribution to the total fixed costs impact the total company’s bottom line.

Let’s say if Segment B is eliminated then its building space would be divided 50/50 to Segments A and C. Utilities are currently allocated based on floor space (recall cost pool allocations from above). About 70% of the salaries from Segment B would be eliminated and the other 30% would be split between the costs for A and C.

The Total Net Income decreases from 8,900 to 5,380 due to the eliminated contribution margin from Segment B.

Because contribution margin analysis requires a separation of variable costs from fixed costs AND because these costs implicitly represent the activity costs and non-activity costs to provide a product or service, a more realistic picture of profitability and expenditures comes into view.

Takeaways from Research, Industry Papers and Financial/Operations Analytics:

•   Staffing on Pods.

“The time and the room used suggests two characteristics of the service and labor requirements.  As time increases, the service becomes more involved and it is more likely that a DVM would need to spend more time with the patient.  This would impact any other VT that has completed a basic service and may need a discharge sign-off.  The only ways to address this is to have a second DVM or needing another VT to free up some of the DVMs available time.  The second characteristic is rooms.  If there are only exam rooms or only an op room, then perhaps 1 DVM is fine.  As soon as there is an Op Room and an Exam Room then there would need to be 2 DVMs.” -WFB   

•   Using room availability and DVM time to determine staffing and maximize Throughput.

               1)  Exam Room Pods                                                  2) Operating Room Pods

              1:1 VT to Exam Room                                                 1:1 Op Team to Op Room             1:4 DVM to Exam Room Min                                  Op Team : 1 DVM, 1VT, 1 VA

•   Online Interactive Communication Between Exam Room and DVM (tablet)

•   Online Interconnectivity, files, records, paperwork accessible via cloud from desk to desk

•   Online and App scheduling, records, communication, payment

•   Waiting Room Kiosk Check-in, Phone App Check-in

•   Optimize Phone Tree

•   Separate Intake and Discharge Desks

“In order to maximize revenues, we desire throughput.  Our throughput will be patients per hour.  Ideally, we want to maximize throughput by the contribution margin derived from a service, further defined by total contribution margin per hour since labor hours is our constraint to providing services.  Contribution Margin is the Revenues – Variable Costs required to provide the services.  The remaining amount is the margin available to contribute to the paying of fixed costs and any net income.  Note that the contribution margin is different from the gross margin that many are used to seeing on the P&L statements.” -WFB

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If you have read any of my articles, you probably know that I lean towards the critical side of concepts that are presented for various aspects of business ‘practice’ and industry ‘solutions’.  Many people do not take well to criticisms, but the only way to improve something is to have it critiqued.  Not subjective mind you, insofar as colors or design as you can get 50 different design critiques asking 5 random people, but technically. 

The past few days the topic of Vet clinics and services has come up several times.  As I was looking into it, I thought that it would be a fun real-world example to cover for operations and finance.

Let us begin with process flows.  I always begin with Process Mappings.  I will explain, but I am just going to post a flowchart example from one of the available vet sites that I found. 

Source:

https://vetsource.com/blog/how-to-use-process-flowcharts-for-an-excellent-client-experience/

It looks like a nice example of a flow chart.  But it is neither organizing, nor offering any insight into optimization.  In fact, in the article on flow charts ‘improving’ client experience the only discussion is about different types of flowcharts and does not offer up the point of using a mapping.

Note:  Protocols are not flow charts, although a flow chart could be used to visualize procedure.

I would like to offer some insight into process mappings and why you use the mapping, in addition to other operational and cost considerations for modeling.

Flowcharts are, of course, used to map flows of a product or customer through operations but this is all this flowchart displays.  If this is the final version of an operational design, then your could stop here, but the entire idea of the article was how to use flowcharts to streamline your operations and it does not.  Even deeper dives into the activities on this simple flowchart, as the article suggests, will simply only outline what you are currently doing in your operational process.  Certainly, this layout may make you think of steps that are missed or you may be able to use it to create a SOP (standard operating procedure) for the activities on your flowchart.  These are useful.  However, again, you are making note of current operational procedures only, mapping current procedures will not optimize nor make operations run more smoothly.  Nearly all the articles that I saw on the topic of veterinary process flows only discussed mapping your current processes.  Some did mention topics to consider in your processes that would impact tasks, such as Forms, Legal, and even Finance, but there was no mention of how these would relate to your optimization. 

I would have to believe that if you were looking for information on processes, then you are actually desiring insight into optimization, and therefore cost minimization.

If you run a practice, you are aware that there are operations underway, that time passes with the activity and time is money, not only with costs from the activities in your operations, but also with future revenues that are related to client satisfaction.  You probably don’t need someone to tell you how to jot down the process.

What you are actually asking is …

“Is this the best process that I can put together and how do I measure it?”

What Makes the Process  - Operations Management

Constraints. 

If you are discussing operations and process mappings with someone and they do not mention constraints, bottlenecks or throughput, then you should consult with someone that does mention these focal points.  Why?  Because in any operations, you can either meet the demand or you can not meet the demand.  If you can not meet the demand then you must assess your process and find the bottleneck.  If you can meet the demand, you need to evaluate whether your utilization of resources is generating enough cash flow to support operations.   

The maximum number of clients that you can get through the system of processes is the maximum revenue that you would be able to achieve, bearing in mind a consistent sales mix.  This rate is the maximum throughput, which is probably greater than your average daily throughput rate because your maximum throughput may be calculated on ‘as-if’ everything was perfectly smooth.  This rate is impacted by the bottleneck in your process, no process has more than one bottleneck and no process can run at a faster rate than the maximum rate of the bottleneck.  No expenditures (investments) at any other place in the process will improve the maximum throughput rate, it can only be improved if you address the bottleneck.  This is a huge misconception in operations.  The only way to improve the rate at the bottleneck is to increase the available machines or people that comprise the bottleneck.   

What is the bottleneck in clinical operations … first,  the doctors.  The DVM is an absolute critical point in a process that nearly every patient must pass through prior to check-out.  With the exception of perhaps a dental visit or grooming, a DVM is highly likely to at least stop in and give a ‘once over’ to the patient and any note that the Vet Tech has made just to give the final approval for a discharge.

Perhaps there is one DVM and we will assume the exact same exam is performed the entire day for the example.  Since DVMs are the only ones allowed to Diagnose, form prognosis, prescribe and perform surgery your time is going to be required.  To put in some numbers:

Do you average 50 patients per 8hr day?   9.6 minutes / patient   aka   6.25 patients / hour

Do you average 100 patients per 8hr day?     4.8 minutes / patient   aka   12.5 patients / hour

Note that the only way to increase patients is to decrease time per patient in the instances in which the DVM is required.  The DVM dictates the flow.

If you add a DVM.  This directly addresses the flow rate at the bottleneck.  Assuming that both DVMs can see patients at the same rate, you now double your maximum throughput.  If your throughput at the DVM is now improved then your bottleneck has moved to another constraint in your process, most likely room availability.  Of course, your next questions should be, is added throughput from a second DVM necessary or do you opt for a Vet Tech and what is the cost to benefit of adding to the throughput?  How does room availability play into the overall considerations?

The point of constraints is the primary issue of the optimization of scheduling relative to services required which I will discuss further down, but in the veterinary setting this will always be shadowed by time.  Time dictates both our potential revenues from the maximum services that could be provided within a time frame and both the variable costs required for those revenues over that time period with added guaranteed fixed costs that will need to be covered regardless of whether any service is provided.  You should be considering a breakeven point right now for your clinic. 

As a DVM you only have the time in a day.  Perhaps this is a standard 8-hour day or a 10-hour day or 12-hour day, but the point is that as a DVM running a practice all items should be thought of in terms of time and arranging the schedule so that your time, and its revenue generating potential, is optimized.  Yes, this should be obvious, but the reason I am pointing this out is that scheduling and flow should be planned in reverse from the DVMs potential schedule and maximum capacity in various scenarios and not necessarily from the waiting room.

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The interesting thing is that in waiting room studies and queueing theory (primarily studied using human subjects), many of the activities, such as moving a patient from the check-in to a patient room, only to wait longer to see the doctor, are designed to create the feel that the process is in motion.  You could just as easily wait in the waiting room until the time that you would actually see the doctor.  Granted, we could discuss the grouping of patients in a single area to create the shortest distance between patients that the doctor must travel, but a good deal of waiting studies are done on the creating of an environment of motion to satisfy the need for humans to feel like they are making progress towards an end.  Perception is a critical component to customer satisfaction.  

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Time.

I do not want you to think that this process is taking away from the personalization of service or customer satisfaction.  The time we are discussing is made up of several components which is inclusive of the actual activity and an allotted time for customer service but an attempt to standardize time for each type of service is useful for scheduling and cost management.  Time is money, or a better saying, Time is Net Cash Flow.     

Costs.

“How do I measure cost, assign cost and, relative to the service level that I would like to provide, can I save on costs?” 

An important concept that is often missed from understanding costs for a practice, and is directly related to our consideration of time, is that of variable costs vs fixed costs and methods for allocating overhead costs to services provided.  This not only helps to assess costs, but also gives you a baseline from which you can understand how you might want to price your services. 

Variable Costs are those that are directly related to the service.  If you are carrying out more exams, costs required for those exams will increase.

Variable Costs consist of

               Direct Materials

                              Example: Exam Gloves, Specimen Containers

               Direct Labor

                              Example:  Vet Tech Hours dedicated to conducting Exams

               Variable Overhead

                              Example:  Sterilizer, Sanitizer, Cleaning Supplies

Fixed costs are those that do not change regardless of the number of exams or surgeries that you will perform.

Fixed Costs consist of

               Fixed Overhead

                              Example:  Depreciation, Insurance, Rent, DVM Salary   

Please note that although your hours may be fixed this may not be true for your vet tech or vet assistants if they are hourly, then their hours will vary with the number of patients.

A quick illustration:

               Cost for a ‘complete’ exam using a vet tech and a DVM collecting blood and urine and put in some numbers.

Total time dedicated begins immediately after the last task completed, respectively for each worker.  Most likely the DVM will come from another exam room or completing other tasks while the Vet Tech retrieved the patient and began with checking vitals etc..  The Vet Tech may leave when the DVM comes in to prep a second exam room patient and then the total time with the patient would be 40 minutes.

(time line – not chronological, but time after last task completed and total dedicated to exam)

There are a couple of methods to assign costs to a service.

               1)  Normal Costing

                              Using actual costs for direct materials and direct labor and a rate by some metric                                    such as labor hours to allocate overhead.

               2)  Standard Costing

                              Using a standard cost for direct material and direct labor and a rate by some metric

                              such as labor hours to allocate overhead.

One of the reasons I suggest a standard method is due to the fact that time by the DVM and Vet Tech is not generally trackable task to task.  In addition, it is difficult to track and cost a pair of exam gloves, bandages, or other material.  If you create a standard for each type of service offered, you would be able to standardize the total cost by service, at lease as a base rate.  You would create a list of standard materials used, standard labor time and post clean-up materials used for each type of service.  I believe that you would find that there is a substantial amount of consistency in materials used for a service provided.

Base Rate for Complete Exam  (some numbers for example)

               Direct Materials

                              List of materials standardized. Gloves, Specimen Containers, Syringe, etc..

                                             Cost:  $2

               Direct Labor

                              Vet Tech: 35 minutes

                                             Cost:  $11.67  at  $20/hr

               Variable Overhead

                              (as cleaning and sanitizing would be a considerable amount of variable overhead)

                              (do not forget to include comp and benefits in the variable overhead)

                              Rate based upon Labor Hours

                                             Cost:  $2.33  at  $4 / labor hour

               Fixed Overhead (multiple rate bases to allocate different overhead costs)

                              Rate based upon Labor Hours

                                             DVM: 10 minutes

                                             Cost:  $10  at  $60/hr

                              Rate base upon Room Used and estimated total number of Exams Annually

                                             Exam Room proportion of Depreciation, Rent, Insurance etc.

                                             Cost:  $11.32  at  $0.09/foot for a 10x12 Exam Room

               Total Cost: $35.32   (note that this is not pricing, this is supplies, labor, allocated overhead)

The Direct Material, Direct Labor and Variable Overhead should vary minimally with respect to time for a particular service offered as protocols for a service would dictate, what is done, how it is done and what items are used to accomplish it.  As long as all components with respect to time are accounted for in the costs, the only aspect that may change is the price paid for the items or price paid for labor. 

Any changes to these variable costs are most likely going to result from changes in prices of materials used, cleaning supplies and so on.  The fixed costs will be dependent on an accurate forecasting of services that will be offered, but this will be dependent on time and is the reason I brought up the categorization of services offered into time segments.

Fixed Cost Allocation Example

1000 total services performed annually

600 comprehensive exams at 40 minutes

200 surgeries at 3 hours

100 surgeries at 5 hours

100 dental cleanings at 25 minutes

.6*40 + .2*180 + .1*300 + .1*25 =

24 + 36 + 30 + 2.5 = 92.5 minutes weighted average

92500 minutes total = 1540.17 hours dedicated to actual services

If we approximate 2000 total hours for the DVM at $60/hr, then we will be allocating 92,400 to services and 27,600 expensed to admin work.

If we also know the exam room is 120 sqft and the operating room is 240 sqft.  We can allocated the fixed cost other than that of the DVM salary.  We will assume that the comprehensive exams and dental are completed in the exam room and both types of surgeries occur in the operating room.  If there is $15000 other overhead costs then we create a pool for the exam room of $5000 and for the operating room of $10000 based on square footage (although other measurements could be used).

The sub pools would then use the labor hours as the final allocation basis.  The exam room anticipates 441.67 hours which results in $5000/441.67 = $11.32/labor hour for services in the exam room.  The operating room anticipates 700 hours which results in $10000/700 = $14.29/labor hour.

Now that we have a brief mention of costs we will look again at the scheduling since an optimization of schedule is how you will maximize available revenue.

A possible method to approaching this scheduling and optimization of operations.

We will postulate a busy animal clinic and its capacity will be determined by the bottleneck in the process flow as demand will be assumed to meet the bottleneck to introduce the concept.

Begin by categorizing all activities according to the average time to complete and further segmented by room needs, an exam room or an operating room.  Below we categorize only by activity time, those of check-in or check-out are separate activities.  The time segments may not be as accurate as they could be, but due to the consistent protocols for requested services by patients we may see consistency in time to complete activities. 

The categories will be 25-minute, 45-minute, 65-minute that require an exam room and 65-minute, 120-minute services that require an operating room.  To assist with flow, there will be two pod teams.  An exam room pod team that will align with the DVM time and an operating room pod team. 

In order to maximize revenues, we desire throughput.  Our throughput will be patients per hour.  Ideally, we want to maximize throughput by the contribution margin derived from a service, further defined by total contribution margin per hour since labor hours is our constraint to providing services.  Contribution Margin is the Revenues – Variable Costs required to provide the services.  The remaining amount is the margin available to contribute to the paying of fixed costs and any net income.  Note that the contribution margin is different from the gross margin that many are used to seeing on the P&L statements.

The reason for the two teams is that if an exam runs into a requirement to hand off a complicate patient to the operating room, this will enable the exam room team to keep pace with demand and continue their pace of throughput.  The operating team provides two purposes. 

1)  It allows for a higher margin of services to be provided and if the demand for surgeries is available, the operating room team should be able to cover their costs.  They should have a daily schedule of scheduled surgeries, alternating with open periods to handle other aspects required in the hospital or allowing for time slots to take in emergency cases.

2)  It allows for the exam team to continue its throughput.  The op team allows for the exam team take coordinated lunch breaks without impacting the flow of patient demand and can take a patient hand off or an emergency case.

I will break out the teams and display Gantt visual scheduling later on, in addition to putting in some costs so that we can get an idea of supporting financials.

Now that the teams have been explained, back to the service time segments.

For the 65 min category, the idea is that there are services in that time frame that take place in one or the other of Exam Room or the Op Room and the 65 min activities in the Exam Room may be able to use a different personnel arrangement than the 65 min activities that must be done in the Op Room.   

There are 480 minutes in an 8-hour day.  Each room has 480 minutes available for scheduling, and we want to match our bottleneck.

The workings of a hospital or clinic are interesting.  Since the DVM will probably always need to complete a once over and sign off on the discharge of any patient that comes through the doors, even for ‘routine’ checks, the DVM becomes your critical point of contact.  This is why the veterinary’s time is generally the bottleneck in the flow and one reason I would suggest pods so that the DVM is free to run continual checks or hand off to the operating room DVM and keep the process flowing.  The other dynamic for this process is then available rooms.  It doesn’t do a hospital to have more rooms than a vet can handle or fewer rooms than a vet could handle.  This is where the time of the process could be aligned to the DVM’s time and a pod could be created.

A sample flow:

It is my belief that rather than attempting to match DVMs to a ratio of Vet Techs, you assign a pod of rooms relative to the anticipated throughput.  One VT to a Room and a DVM to a pod.

Below we have a Receptionist, a VA that is assisting with Retrieval of the Patient from the waiting room and assisting with cleaning.  In this way, the Vet Tech can dedicate more of their time directly to the patient and if a flow is moving well, the VT would have a high utilization rate on just revenue generating activities.  The DVM would be able to go from patient to patient to complete checks and again, focus all time on the critical point.  You want those whose time is required for revenue generation to maximize their time on those activities.

Let’s demonstrate

Of course, this is just the Exam Room Team.  Also, for a hospital that is offering 25-min, 45-min and 65-min categorized services, I would want to derive how many of each we may expect and also still suggest a pod of Four Rooms and Four Techs.  The higher potential would accommodate a change as we will see.  And again, I will display this and some revenue-cost numbers later on.

The Point and Some Considerations.

The time and the room used suggests two characteristics of the service and labor requirements.  As time increases, the service becomes more involved and it is more likely that a DVM would need to spend more time with the patient.  This would impact any other VT that has completed a basic service and may need a discharge sign-off.  The only ways to address this is to have a second DVM or needing another VT to free up some of the DVMs available time.  The second characteristic is rooms.  If there are only exam rooms or only an op room, then perhaps 1 DVM is fine.  As soon as there is an Op Room and an Exam Room then there would need to be 2 DVMs.   

I might then suggest that staffing is relevant to the time category of the service (and thus the involvement of the DVM is highly probable to be longer) and the type of rooms used, although there would also be the relationship that the longest services, ie: surgeries, would correlate to the room required.   In addition, to support the relationship of staffing/resources to time category, due to recovery post-surgery there is also the possible need for an additional room (recovery) and observation labor as the anesthesia wears off and the patient has final checks before discharge.  This would probably not be necessary for the 25-minute or 45-minute categories of service. 

The Pods.

My suggestion to create an optimized flow, match the time the DVM must spend with a patient relative to a service provided.  Below is the flow, a single exam room is used.  Check-In takes 5 minutes, Retrieval takes 3 minutes.  The service is 25 minutes and the DVM will need 7 minutes to complete a look at the patient records, review current notes and then approve a discharge that will take 5 minutes.  Check-In could handle 12 patients per hour at a 5 minute Check-In time.  Retrieval could handle 20 per hour.  The bottleneck for this layout is the exam.  Only 2.4 patients could be seen per hour.  We would hardly need a VT and a DVM with only one room in use, but a VT would still be on staff and this would not be cost efficient if demand was potentially higher.  Note the DVM at 7 minutes per patient could see 8.5 patients per hour if they weren’t tied up with other tasks.  I am also making a ‘behind the scenes’ assumption that an office manager would handle admin so that the DVM could be fully utilized.

Again, lets look at the 25-min layout but with slightly different Retrieval, DVM and Discharge times.

We would like to align our capacity to that of the DVM flow rate.

Using Two Exam Rooms, both providing 25-minute services, can provide 4.8 patients per hour.

Using Three Exam Rooms, 7.2 patients per hour.

Finally, using Four Exam Rooms, 9.6 patients per hour and we have aligned closer to the DVM.  The only way to increase the bottleneck at the DVM would be to increase the number of DVMs.

As noted earlier, we would improve DVM flowrate if we could reduce time per patient or add another DVM. If we also optimize our other process points, our flow is greatly increased.  If we ran with four Exam Rooms, still at the 25-min segment and the DVM at 7 min per patient, this process could nearly run at 8.5 patients per hour.  Due to dynamics involved in this process, the point isn’t the flowrate as a ‘hard’ number, but the bottlenecks, time and adjustments to change the flow.

A Four Exam Room Set Up, a Pod, 1 Vet Tech to each room and 1 DVM for the four rooms could handle 8.5 patients per hour with a receptionist at check-in and a vet assistant handling retrieval and other tasks.  Granted, this is only looking at one category of service delivery (25-minute segment) and there have not been any considerations for costs or pricing of services and it is assuming that you would require this capacity. 

We will run some other numbers now.  Let’s look at the other extreme, the 65-minute Exam Room segment of services.

Again, using only one exam room, and noting the other process times.  With a longer service, we would probably see longer times at each node in the process.

Two Exam Rooms

Three Exam Rooms

Four Exam Rooms

Even though we have more than doubled the time of the service provided we have only halved the flow rate for the DVM, but what is most important is that if the required time spent by the DVM with each of the patients relative to the 25-minute segment and the 65-minute segment is close, then four rooms aligns with the flow rate for both segments and would also implicitly work with the 45-minute segment.

The numbers may not be exactly representative of real services though I did have some references to timing of services, check-ins and check-outs from the journal study that researched an animal hospital complex.  The numbers are meant to give an idea of changes from a low end and a high end of timing of services, the number of rooms and the changes in throughput so that I could illustrate the controlled version.

This layout is a bit more realistic.  We will assume the check-in will be 5 minutes and handled by reception.  The Retrieval/Prep will vary from 3-10 minutes relative to the category of service as well as the DVM’s time with a patient, 7-15 minutes.  The last stage is the discharge which will range from 5-20 minutes.  As you can see, any exam room has three possible service time segments that could occur.  We want to know how many arrangements are possible with the highest probability and what kind of influx of patients this arrangement could handle.  We, therefore, need to assign some probabilities to the services categories to get an idea of scheduling  scenarios day-to-day, in addition to retrieval time and DVM time. 

I would use historic data to determine the percentage of each category serviced over the historic term.  I would also take note whether certain days see more of a type of service than other days.  For example, if you have, in the past, only had surgeries on one day, then this is going to skew data if not taken into account.  Or, perhaps, you see more emergencies on a Friday and more dental cleanings on a Monday, then you may want to assign probabilities and arrange planning by day of the week.

For these examples, I am simply going to treat everyday equally and assign 80% to the 25-minute, 17% to the 45-minute and 3% to the 65-minute segment.  The initial probabilities will allow me to calculate the expected values for Check-In, Reception, DVM, and Discharge process points.

I ran some simulations data using the parameters.  I put some skewness into the data for the potential longer times that would be reflected in the 3%, 65-minute segment, however this type of appointment would probably only occur once per week.

(time in minutes)

Given the above simulations and mean data, we could run about 6 patients per hour. 

1Reception

1 VA

4 VT

1 DVM

With an Ops team to run surgeries, hand offs and emergencies.  Say a surgery team could run one surgery per hour.  Scheduling 5 surgeries with 3 open periods would enable absorption from said handoffs and emergency cases.

A Gantt Schedule for a visual Below and derived from the Schedule Chart, however I used 25 minutes for the service segment on the charting.  No, people are not machines, but a flow chart, once established allows for adjustments and an understanding of how adjustments may affect the overall flow.

and in chart form:

No, nothing in life works out exactly as planned.  The purpose of working out models, is to establish relationships between variables and patterns.  Once you understand the relationships, it is easier to work out how adjustments to the plan will impact the flow. 

By freeing up the DVM to use as many of their hours as possible towards the critical point in the process of closing out the patient and moving them into the discharge phase, you are maximizing your throughput. 

Given an average time of 10 minutes per patient, this flow is optimized using four rooms and therefore four vet techs offering patient services of 25 minutes with a 10-minute discharge phase.

Please note that even if you have six vet techs, it is irrelevant, if you have fewer rooms.  If you only have four available rooms, only four vet techs could offer services at a time.  The ratio method of scheduling is flawed, unless you are pairing vet techs with vet assistants because the services offered require some helping hands.  You do not bring on more vet techs than rooms, except for breaks and you may have a mid-day vet tech that is the ‘break’ tech for the day.  You do not bring in more DVMs than the flow rate requires which would be dictated, again, by total possible services offered at a time and this is directly related to rooms available.

If your operations were running at a theoretical capacity, then you can begin to look at the approximate costs required and assigned to the different services. 

Analyzing the Current Scheduling in terms of Labor

Understanding how your costs are assigned, will also help to understand your utilization of labor.  Monitoring of your bookings and hours will help to arrive at costs designated directly to the appointment and costs that may be incurred due to idle time or other activity.

The Exam Team:

               DVM – The DVM is a salaried employee.  I would probably assign the DVM labor to that of direct when working with a patient, else it would be assigned to Overhead.  It is a cost that must be born out of revenues regardless and therefore it is another supporting reason to put the labor to its most productive use.

               VT – The VTs labor will be direct labor to patient or indirect labor (part of the variable overhead or VOH) when prepping a room for a patient.  If a VT has idle time, this too would be indirect labor since their labor is probably not salaried.  If the ratio of VOH costs is increasing, it probably indicates that there is too many VTs on staff for the demand.

               VA – The VA labor is similar to the VT except that their labor is probably indirect labor in relation to preparing a room or patient for their appointment or they will be assisting reception or conducting administrative work or seeing to other tasks.  If the tasks are more on the administrative side, I would assign these labor hours to a fixed overhead.  The general idea behind the fixed overhead is that the tasks would have to be done by someone and are not really relatable to any direct providing of a service to a patient or preparing to provide the services.

               Reception – The reception labor hours are either indirect labor and thus a part of the variable overhead, or the hours will be administratively focused and fixed overhead.

The chart above shows a rough designation of the labor costs for the staff over the day were a full day of appointments to be serviced.  Obviously, were the appointments to be less than anticipated the change in the cost ratios would reflect this event occurring by less of a portion assigned to direct labor.  Labor would be a dynamic component in a service industry and is always the most difficult of the costs to assign to a service.  Costs do not necessarily have to relate to your pricing for the service, but more labor than needed would impact margin and therefore, knowing how to match labor to demand is essential to optimize your business.  A way to monitor this is by tracking the cost per minute.

Now there is a chance that another VT or VA is necessary for surgeries.  This would raise the DL/min cost on surgeries.

Since labor is the primary cost, this is an good indication of what services cost in terms of time.  We would now have to include direct material costs that go into performing the service.  I would include items that are essential to the service such as exam gloves, masks, gowns, specimen containers, vaccines and so on.  Items that would be added to the variable overhead might be cleaning supplies, sterilizing agent, lab regents for testing and calibration and items that are associated with the service (like a clean and prepped exam room), but not the service itself.  And finally the other fixed overhead costs would be salaries for the clinic manager or other administrator staffing, rent for the facility, lease payments on equipment and so on.  How you would allocate these costs may vary but I would tend to create pools to allocate these costs.

Referencing the fixed overhead costs for the rent or perhaps depreciation expense if you own the facilities, you could allocate the expense based on room square footage and then to the minutes the room is used to perform services.

I know this is a longer topic, but I did want to try to display scheduling, utilizing of labor at critical points and a short piece on costs related to the services provided.  I hope that some of what was said in my paper is a catalyst for possible improvements to current operations.

Strategic considerations and its development has become fairly limited in business. While a full framework is presented from coursework so that a strategist might know what information is necessary for a full strategic evaluation, it is almost never used. I would venture that few have the full set of skills and experiences to present a valuation of possible implementations of a strategy and thus a cost-benefit for evaluation anyway. There was a time when understanding why certain tools for modeling were developed and knowing what the strengths and weaknesses for these financial modeling tools are in different circumstances.

Understanding the IRR assumes that any cashflows earned in a period must be reinvested at the IRR rate in order to maintain that return for the life of a project or investment, else your return decreases. Understanding that the NPV has more flexibility in the projection of cashflows, both positive and negative and that risk can be represented in either the discount rate or the cash flows. Understanding that there is a sound reasoning to using a DCF model due to the considerations of alternative investments, risk to return ratios for classes of investments and the Law of One Price in financial theory. We could go further into needing statistical distributions to work out expectations or even other performance metrics and how the wrong metrics influence poor decisions, but that is not the exact topic I want to cover here.

“Strategy” has become one-sided only concerned with the entity that is seeking a consultant, at best a stale plan to generate more sales or to implement a technology that will surely save on cost, and at worst, a way for the more prominent consultants to have another billing cycle at the expense of the company.

Strategy is not one sided, it is at the very least, considering two competing sides as a strategy must consist of, again, the very least an action and consideration of a reaction. If you are in a monopolistic market set up, then you don’t have a strategy, you are simply attempting to optimize and anyone with basic knowledge of operations and costs could understand this need without needing any knowledge of strategic planning.

Strategy is unavoidably influenced by the framework of both your internal and external factors that include your competitors’ reactions to your implementation of your strategy. You may not see this as clearly in the mega-conglomerates, but if you are a small business competing in a regional market, you deal with it daily.

Strategic Planning: The sequence of interrelated procedures for determining an entity’s long-term goals, aligning with the Mission Statement, and identifying the best approaches for achieving those goals.

Management strategies impact all areas of operations, directly or indirectly, and then through quantitative representation, make their mark on the financials, but any strategic development should begin with the same framework and hopefully support derived from data analytics.  As I like to say, you don’t need to reinvent the wheel, but you need the correct tire for the conditions. 

Let’s list some of the framework:

Close Up On PESTLE

The real differences in any strategy will rest with the depth of skillsets and abilities of the consultant and quite frankly most are lacking in the understanding of managerial accounting methods and corresponding financial valuation techniques that enable the creation of useful cost-benefit models for decision analysis. 

Since all strategy presented requires investment of capital and will impact the financial structure of the company, these investments must be evaluated by some capital investment hurdle rate and the metrics for success of the plan established.

Many strategies only provide guidelines for operating activities but do not determine the activities to be undertaken.  Those that do suggest activities are more often than not “technology” centered or “marketing” centered strategies.  I would like to remark on these strategies

I prefer to present reality for the range of possibilities that could be; as perceived, you may think of this as optimistic to pessimistic, but as a business stakeholder you should only think of the possibilities as scenarios. 

Your questions should always be :

“Can operations continue through the range of scenarios?”

“ What adjustments must be addressed to prepare for the range of scenarios given the probabilities assigned to the scenarios?”

Quick Take on Technology

It has been the belief for some time that tech, tech, tech will save the day.  I have seen the implementation or attempted implementation in every area of operations, Orders, AR, AP, Scheduling, Communications, Tasking, Reporting, etc etc…  I will simply say this piece …

If the technology does not reduce time on a task or process and therefore reduce costs, the technology SHOULD NOT be implemented.  I have seen too often the introduction of “technology” that either duplicates technology already available on another platform used by an organization or a technology that does not reduce time on a process, but in fact INCREASES the time on a task or process. 

It is common to have departments decide they want a unique application because they were used to its layout or various options offered, but even a basic business course on pricing and options will tell you that packaging together all necessary applications is more expensive that finding a single application that meets your needs, CRM, ERP, ERM, Accounting, HR, Payroll systems etc.  It seems to be the current trend to see “start-ups” in the tech industry only create applications that are essentially communications and video platforms.  It is as if these options are not already available on a myriad of platforms that are used by corporate entities, but it is these applications that are often the “tech” that is being introduced.  It is also common to see little to no evaluation on the cost-benefits ratios of any of these applications to justify the expense. 

The most financially irresponsible circumstance I have heard of to date is one that involved a “Big Four” firm (there is such a history of integrity within these firms) and a billing/collections system for government payments on services provided within the healthcare industry.  The system was supposed to increase efficiency and accuracy of collections, due primarily to the method of assigning services to each patient through coding used by government approval systems.  It was hoped that there would be fewer returns for inaccurate or wrongly coded services.  Mind you, there were only about 5% of total billings that were of issue and totaled under $1million annually.  

The system was pushed by the “Big Four” as they could install, train and then mentor for many months and millions of dollars in billing.  For some reason the CFO believed that the 5% of collections that were returned were going to be worth the $16million dollar price tag.  But that wasn’t all.  The staff that was running at 5% returned rate had to be increased by TWO AND A HALF TIMES to use the new “tech” system and still wasn’t able to get the improvement promised.  Hey… but the “Big Four” got their billing.  Needless to say, four years later, the entire department is now outsourced because the company couldn’t afford the fiasco that was put upon them and accepted with seemingly no cost-benefit analysis.   

The moral of the story … Value and Evaluate.                                                                                                                

Quick Take on Marketing

In the same vein, marketing strategy. 

I will pose a question to you.

When you search for the answer to a question on a search engine, how often do you go past the first page?

I would venture a guess that it may be 1% of the time.

I would pose another question. 

How many brands do you follow on various social media sties? 

Natural follow-ups.

How many are brands from which you have made purchases?

How often do you click on their posts?

How many brands do you follow only because they post entertaining vids and not for products?

Now consider, how many scrolling pages upon pages of posts are on your feed intermixed friends, family, celebrity, sport personalities, and then brands. 

Ponder these questions when someone starts talking to you about “SEO” and the thousands and thousands of competitor businesses that are all being told the same thing as a marketing “strategy.

Marketing is a multi-pronged strategy that should involve much, much more than social media or even the website, but this is where numerous businesses stop.

Marketing is what I call the “Rabbit Hole”.  You need to make potential customers aware of your existence, but the key is in finding WHO those customers are through data else you are dumping money into an effort that may yield little fruit. 

If you are asked WHO your target customers are, you should be able to lay out socioeconomic defining data and which data is most prevalent across all customers.  If you answer, ‘everyone’, then you are not getting the most out of your advertising spend.

That said, even in rough economic times, defining data could be a saving grace to a fully fleshed out marketing strategy involving marketing, media selection, promos and distribution channels.  The real questions are, what data to collect, how to collect it and how best to analyze the patterns within it.  To simply stop at ad data like clicks or views is not going to be beneficial without reference to closing.  

The only stories that I care to relate when it comes to marketing is that claimed ‘creatives’ are a dime a dozen.  You need a ‘creative’ that understands data and behavior and you may benefit from expanding your understanding of the general marketing medium as the way to market as commercials are less and less impactful no matter if they are on TV, radio, or a podcast.

Back to our Internal and External considerations for Strategy

Strategies presented without a full understanding of the internal and external factors relevant to a company, competitors, industry and economy is no strategy at all.  Certainly, you can make adjustments to operations and efficiencies, but what do you do when the rest of the competitors do the same?  A primary element of an industry analysis is that of competitor reaction.

Strategy is never singularly sided, otherwise, what would be the need for a strategy.  At the very least a developed strategy always involves an action and a reaction.  The best strategies plan out several actions, anticipating reactions, or even forcing reactions, think of games like Chess and Go or the study of game theory.

Too often have I seen strategies implemented from only an internal view that should have also taken a look at external factors in order to offer up a complete evaluation.  While it is difficult to anticipate all reactions from competitors, some should be obvious, and others can be tracked over time.  Most reactions will be directly related to available resources or the economic environment.  If you pay close attention, a competitor’s reaction may tell you a lot about their situation.

Track reactions to your Promos and Pricing and their Promos and Pricing.

Track the direction that competitors are taking product lines, options, designs.

Track joint ventures, it gives directional clues that they believe they can move product lines.

Track media channels they are tracking your media channels and perhaps your ads.

Pieced together you will be able to begin to formulate an outline of their strategy, markets they may enter, how they may attempt to take your market share and perhaps even further insight into how their operations are running and their capital position.  It may be worthwhile to keep track of your top three to five competitors.

Strategic Outlining and Development

You will find the intertwining of the Internal and External aspects of strategic planning are unavoidable from start-up to maturity.

Mission and Vision Statements layout your long-term framework and guide your short-term planning for your company. 

What is your company’s purpose?

How do you want your company to be viewed?

These statements will be heavily influenced by the industry and current competitors in the industry.

Where can you fit?

Where can you provide value for the customer?

The answer to this will be shaped through your 5 Forces analysis and Market Structure. 

How does the industry shape up for profitability?

What type of structure? A Monopolistic Competitive Market structure?

How easy is it to enter the market? Resources?

Are companies price takers or price setters?

What products are offered?

You will find your competitive edge to deliver your value proposition through your Core competencies, R&D, innovation, technology, supply chains, etc.  And discover how your competitor delivers through their core competencies.

At this stage a refining takes place as you will decide how to edge into the market utilizing your strengths and taking advantage of discovered opportunities.  To stay in the market and continue to improve, being aware of the needs for improvement, the weaknesses and the arising threats from external forces, the PESTLE analysis, will be necessary.

Can you pair your core competencies with the

Competing on Cost,

                              Quality,

                              Speed,

                              Flexibility.

               (Only the most generalized “strategies” are presented using the framework above)

o   Cost Leadership – Low Cost

o   Cost Leadership- Value

o   Differentiation

o   Focus – Low Cost

o   Focus – Value

                              Cost Leadership

                                             Low-cost provider for given level of volume

                                             Sell at industry average, but optimization allows higher profit

                                             Sell at below industry average and gain market share                                                                                                         Significant Capital to invest in production and logistics

                                             High Skill manufacturing

                                             High Skill R&D

                                             Effective, Efficient distribution channels

                              Differentiation

                                             Product or Service of unique features offering customers value

                                             Perception of value or difference amongst competitors

                                             Premium Price for value or uniqueness

                                             Features

                                             Functionality

                                             Durability

                                             Service Support

                                             High Skilled Marketing Research

                                             High Skilled Sales Personnel

                                             Brand Reputation

                              Focus

                                             Niche market segment

                                             Quick Response Approach

                                             First to Market Innovation

                                             Highly Skilled Market Research

                                             Tailored Product for Customer Value

                                             High degree Customer Satisfaction

Finally, your internal and external frameworks choices will determine your usage of resources (which may actually be one of your advantages) and bring you to the Value Drivers, metrics and the areas of management to conduct the operations from which you will deliver your value proposition. 

These frameworks truly shape your company, your products, the delivery and your investment in furthering your Mission.  The frameworks shape your strategy … or quite frankly, should shape your strategy.

Most strategies actually begin from the Value Drivers or areas of management, Operations, Marketing, Finance, Performance, without consideration of where these aspects had sprouted.  These strategies are short-sighted and attempt a quick fix to a driver to improve a metric.  While metrics derived from these areas offer an indicator, a need, for change and hence strategies, these metrics are actually sourced from the depth of the frameworks.

As an example … Pricing Strength. 

               What is the Market Structure?

               Where does the Industry sit for Buyer Power and Supplier Power?

               What are your Core Competencies?

               How do you define your product delivery, cost, quality, speed, flexibility?

               Your framework defines how much influence you have over drivers and what options you may have to improve drivers.  

It may be best to view the metrics from your drivers and aspects of operations as simply the quantitative representation of past strategies and decisions allowable within the framework of market, industry and company resources.  

The fact is that frameworks have brought the company to its current point and these frameworks, represented quantitatively by the value metrics, will be the key to develop strategies to improve your drivers and metrics.  Both the Internal and External influences must be considered.

Why is this important and how does it work for business?

Simply stated, this same concept works with investment decisions.  The return on invested dollar has to be equivalent for any investment of a similar risk profile.  If this was not the case, if you could get a higher return for the same risk profile, then you would move your money into that investment until so many people moved into that investment that the return offered would be lowered to that of investments of a similar risk profile.

Where does this arise for businesses?

In any investment there are two main elements for valuation and associated evaluation, net cash flows and risk to those cash flows.  It is no different for your business.  While a financial security that you purchase may hide the fact that there is business risk and operational risk that occurs while generating cash flows to meet the payment obligations, those risks exist.  The same type of risks that occur for your company only you deal with them directly in the hopes that you can generate cash flows to meet your obligations.   

Externally – Risk Views.

If you are a publicly traded company, then investors would evaluate your risk profile and anticipated capital gains that they could earn from purchasing your shares, an equity investment.  An investor would assess your financial ratios to discern were you are relative to other companies in your industry, since these companies are most likely to have similar risks, put a risk rating on your company.  If you have solid ratios, liquidity, profitability, acceptable leverages, then you may have an investible risk profile.  If you have enticed investment in your stock, it will show in the price rising or in price stabilization.  If, however, you have not, the price will drop as other investments will be selected based upon risk and cash flows.

Note if you are a private company, the same is true, only you are the primary investor evaluating your risk profile and acceptable investment prospects unless you have available capital from a banking institution.  (You will then have an interested external party that will view financials and probably establish covenants on your capital accounts.)  The capital you generate from operations could either be paid out and invested elsewhere by the owners in alternative investments or invested back into the company with the intent of generating a better return than what is available in alternative investments of similar risk.   

When you offer debt financing in the form of commercial paper, notes or bonds, there is once again an assessment of risk and ability to meet the payment obligations.  An investor is going to check out your financial ratios and financial statements to assess your risk profile, risk rating from a credit agency, and determine what compensation is needed for them to part with their money to make an investment in your debt offering.  You hope that the return or coupon rate you offer aligns closely with the investors’ determination so that the amount you raise closely aligns with expectations of capital raised, but the market will make the ending determination for the appropriate yield to maturity on your company’s debt.  This will fluctuate as operational risks change within your company and the ability to generate cash flows changes.

If you are discovering that the market is dissatisfied with your risk profile through the cost of equity rising (your stock price lowering) and cost of debt increasing (yields to maturity rising), this is signaling to management that the world is now seeing issues in your operations and strategy and this view of increasing riskiness is going to make financing continuing operations more difficult. 

By the time the world sees issues in your financials, as a publicly traded company, it is on the verge of being too late and you may require some equity backing by an investment firm to reestablish the operational footing else suffer insolvency.  It is important to tend to your operations for exactly this reason and understand how you can implement signals to draw attention to ratios as early as possible and strategize your improvement.

If you are a private company, again, a similar situation occurs although your signaling may be to suppliers as you stretch your payments later and later.  It may be to bankers as you understand, too late, that you are having capital issues. A banking firm will be reluctant to loan or offer additional capital without restrictive covenants or may not offer it at all.  Firms that do offer capital will now view your changed risk profile as very risky and only offer capital at extreme rates and only after they view their seniority in debt position.  If you have already broken restrictive covenants and can not pay off the obligation, the creditors may take hold of your company.

The point is that how your company is viewed from a risk perspective will impact any external costs for continuing operations or expanding operations.

Internally – Risk Views.

Your risk profile is used in determining your rate for financing various operational activities, internal financing through the generation of earnings, term loans, revolving loans, any credit offered with recourse or nonrecourse will have a cost associated with the riskiness of operations.  This cost will be associated with a higher equity cost, higher interest rate, discounted rate, compensation balance, or in the case of trade credit a complete elimination of any credit terms to make payment. 

At this point you may have worked out the synonymous terminologies, risk and cost.  Due to risks, any capital you have available to you comes at a cost, overall, the WACC – Weighted Average Cost of Capital from all sources.  If you can reduce risk, you can reduce costs.  If it can be reduced, it can be measured and the capital used evaluated for efficient, effective usage, the ROI – Return on Investment.

A Primary Factor in a Risk Profile

Generating positive net cash flows.  This is the root factor for all of your ratios that act as a basis for external evaluations of your risk profile and a measure for internal operations.   You must work to improve it, at first just relative to others in your company’s industry.  Due to the fact that net cash flows arise from the complete operations of your company, from product development, production, sales, capital structure, asset utilization, to customer service and warranties, there are numerous places to begin improvement.   

To start, ineffective and inefficient operations reduce the amount of cash flow that could be generated from current operations.  How you choose to finance operations, how you choose to organize production departments, technologies chosen, marketing channels, organizational structure, all these impact effectiveness and efficiency and thereby risk and costs. The interrelation of these decisions is quite remarkable and the dynamics are difficult to model, but there really is something to be said about the way the WACC encapsulates all the elements of risk, financing, operations and evaluation of investments.

It should be no surprise that certain industries are more risky than other.  Industries that have higher fixed costs and higher operating leverage are riskier than those with higher variables costs.  Industries with higher financial leverage are riskier that those with less financial leverage.  Industries that are reliant upon different types of suppliers, for example computer chips, may experience periods of higher risk.  Geographic location, changing consumer trends, and anything that may inhibit a company’s ability to generate earnings is going to be a risk.   

You generate cash flow from business operations.  How well you are able to convert your products into cash is a significant factor in determining the basis for you risk profile.  You need to generate enough cash inflow to support operations.  If you are a growing company, you will find that you may need more capital to expand to meet demand.  You may not be able to generate enough capital through operations alone due to capacity constraints.  However, you may have enough capital to use towards implementing some financial leverage in your operations and taking out a loan.  This loan will enable you to expand operations by making investment in plants, equipment, materials, labor and working capital accounts.  The catch is that by taking out a loan, you now have to make enough sales to cover that loan payment and have thus increased your risk profile.

It isnt’ quite a Catch 22, although it may seem like it.  There are plenty of models that can show you that once a certain growth rate in sales is reached you will have troubles continuing to fund your operations with internally generated cash flows alone.  At some point, using financial leverage will benefit several aspects of your financial statements, including reducing your tax liability.  While this is true, remember, too much financial leverage increases risk.  Like most things in life, a nice state of equilibrium is best.

Now using this loan as a very insulated example, given the complexity of operations and financing, consider how much it will cost you to pay back the loan, the effective rate, and this was the cost of this debt.  This effective rate is determined by your company’s risk profile and significantly so through your company’s ability to generate cash flow.  From your perspective, you hope that the investment you have made will now return to you cash inflows above and beyond the cost of borrowing those funds.  This ROI is how you might measure your internal firm investments in operations, a similar fashion to those weighing out investing in your company.  As long as you are able to generate more cash flow from your investment in operations than what it cost you to borrow the loan then you are making positive use of your funds.

You might further stretch your investment by optimizing your operations to run more efficiently.  Perhaps this includes a drive toward collecting receivables or better cash management practices or making changes to your data and internal reporting.  This would be reducing risk in your operations and reducing your overall risk profile.  As you ran more efficiently and reduced your risk, this would be reflected on your financial statements and you may see investors begin to purchase your stocks and your stock price rise.  Hopefully you are beginning to see the connection between risk, financing and operations and decisions.

As I hinted at, financing operations has some complexity, it is layered with expectation for gains to equity, operational risks and, further, different types and amounts of debt financing.  Your goal should be to find what your overall cost of capital is weighted by amounts of equity or debt financed, this is the WACC – weighted average cost of capital.  When gains to equity are not paid out to investors, you are, in fact, borrowing that money from them with the intent of creating gains to that borrowed equity, those expected gains are the cost of equity.  Each type of debt financing that you are using may have slightly different rates and different total amounts borrowed.  And, finally, your risk profile will be used to determine your current market cost of debt adjusted for the most current market view of your operations. 

Note:

The weighted cost of capital is often applied to Cash Flow models as a discounting rate.  These models are termed DCF (Discounted Cash Flow) models.  I realize that not everyone is a fan of the DCF model due to the discounting of the cashflows at rates that seem to be more guesswork than not since predicting the future is not possible, however there is significant precedence for this in investing and, as I have pointed out, any capital used by a company is an investment and the same rules for arbitrage apply.  Since this is true, the capital invested must be discounted, at least, by a rate consistent with investments of a similar risk profile and return, if not derived from the capital structure of the company.  A second point to make is that, when it comes to debt, the terms for debt securities held to maturity are guaranteed to payout at the yield to maturity on the date purchased or in the case of term loans, the cost is guaranteed for the term and supports the usage into the future.  And finally, a look at the Quality of Earnings and consistent reporting could be considered a solid foundation for continued earnings at least at the current level and therefore any cost of equity would be continued, at the very least, at the current, consistent level of operations.  

Quick Coverage of the Methods to Calculate WACC

Equity Calculation Methods

               Remember that companies of the same industry, operations, size, financial ratios, capital structure and other risk characteristics will have similar costs of equity.  If you do not have direct information available for your company (ie: private companies) then you can closely approximate it using a company with similar characteristics as described.  The one caveat is that a private company will also have a liquidity risk on any equity investment.  This means that once an investment is made, it is not easily sold to another as is the case for publicly traded stocks.  The lack of liquidity for trade requires adding percentage points to the cost of equity of an equivalent public company’s cost of equity.

Public companies:

               Dividend Paying Public Companies

                              Gordon Growth Model

                              Current Stock Price = $20

                              Most recent Dividend = $1

                              Dividend Growth Rate = 6%

                              Cost of Equity = (Next Period Dividend / Stock Price) + Growth Rate

                                             18.8% =  (($2*1.08) / $20) + 8%

                              If you can approximate the growth rate of dividends and know the most recent dividend payout then you can easily calculate the cost of equity for a stock.  Since dividend paying companies know how dividends and consistency is desired by the markets, these companies will probably be an easier calculation than those of the non-Dividend paying.

               Non-Dividend Paying Companies

                              To arrive at a cost of equity for a specific security we would probably use:

                              1)  CAPM ~ Capital Asset Pricing Model

                              Risk-free Rate =  6%

                              Beta Value  = 1.2

                              Market Rate  = 17%

                              Cost of Equity = RFR + Beta*(Market Rate – RFR)

                                              19.2% = 6% + 1.2*(17% - 6%)

The key to finding the cost of equity is to find the Beta.  This process gets a bit involved, but the idea is to find a representation of a “fully diversified” investment portfolio and track its changes in returns, daily or monthly.  This portfolio is often simply substituted for a stock index such as the returns of the Russell 2000 index.  The returns of the company are regressed onto the returns of the market index and the regression coefficient is the Beta.  This Beta represents the systematic risk of the stock, also called non-diversifiable risk and measures the changes in the stock’s returns relative to the changes in returns on the market.  This Beta is determined by the risk characteristics of the firm (ratios and capital structure). 

Once the Beta is known, the use of the risk-free rate and the market rate can be used to find the cost of equity.  If you don’t know how to calculate the beta, Yahoo Finance will have 5 year Betas for publicly traded companies.

I tend to prefer the Russell 2000 index for a representation of the market portfolio because it is comprised of small-cap companies and is a closer representation to companies in my workspace.  Since the market return will be dependent on the time period you choose, you will want to be aware of the time frame you choose.  Let’s say you get the average monthly return for the index for the past six months and annualize it and choose this as a good representation for your anticipated equities performance over your desired timeframe. 

I also tend to prefer a risk-free rate in the maturity range that aligns with my timeframe or to use a forward rate that is anticipated over my timeframe, but many people will simply use the rate on a 10-year Treasury Note.

                              2)  APT – Arbitrage Pricing Theory

                              Factor suggestions for regression (as opposed to a market index):

                                             Gold

                                             Inflation, PPI and CPI

                                             Commodity Futures

This method again uses regression to determine Betas, but as the plurality suggests, there are multiple factors used in the regression.  As multivariate regression involves both the finding of factors that may influence the returns of a company stock and the statistical evaluation for time-series data such as non-stationarity is more complex for added variables, I will just leave this as a note and option for further review if you want another option to research.

Debt Methods

When calculating the cost of debt, always remember that you will calculate the after-tax cost of debt as there is a tax shield provided by the interest expense, as mentioned earlier. 

Public Companies:

                              Tax Rate = 35%

                              Yield to Maturity = 9%

                              After-Tax Cost of Debt = 9%*(1-35%) = 5.85%

Because of the actively traded markets available to public companies any outstanding company bonds being traded will have current yield to maturities available for a current market value of the company’s cost of debt.  Do not use the coupon rate as that does not reflect the current market value of the company’s debt as perceived by investors.

As there are many different structures for debt, term, revolver, callable, putable, convertible, with and without warranties, recourse, nonrecourse, tranches in securities, leases and so on, debt definitely should have consideration for weights according to amount used of different types of debt.  For example, while short term financing is generally not included in measuring the cost of debt, in favor of using long term debt, if short term financing is a regular source of financing, it should be included in the cost of debt calculation.

Private Companies:

The creditor options for a private company will be similar to public companies with the general exception of having a market to sell corporate commercial paper or corporate bonds.  Since this doesn’t have an active market for trading these securities it is not typical for a private company to have this option, though it is not an impossibility.  Once again, because of the fact that there is not a market for a note or a bond for private companies, a bond sold would have to have a higher rate of return to compensate for illiquidity.

If you have looked over the variety of debt and considered equity financing, then you probably have realized that there might be a bit of skill to selecting and setting up financing benefits, optimizing your financing in addition to your operations, and yes… absolutely.  If using debt financing has both positive and negative aspects to it, then you will want to make the most of it in the least risky way possible.  Decisions such as leasing or buying equipment, making or buying elements for production, selecting short term or long-term financing options to working capital changes and so on to support operations.  Again the remarkable dynamics and integration of decisions.

Once operations are underway an assessment of what your capital costs you to utilize for investment is useful as a measure to value future strategies to determine whether they will add value to the company at the current cost of your capital.  Recall the DCF model above.  Recall that it is a discounted cash flow model that required a discount rate.  Well, given that the WACC represents both internal and external risks through the rates of equity and debt financing and any changes to operations and therefore risk would eventually flow back through to the rates of the WACC; it would be prudent to make use of the WACC as the base for the discount rate for certain financial modeling and capital planning projects or as a hurdle rate to determine whether cash flows from projects would be acceptable returns on an investment especially when comparisons are made to the IRR. 

The WACC itself is a measure of the success or opportunities in your strategies, operations and financing all rolled up into one number.

And a bit on Costing

Granularity.  We have come to a foundational data set category.  We have three, Direct Materials, Direct Labor and Manufacturing Overhead.  Direct Materials and Direct Labor will fluctuate, be variable, with production and production will be derived from projected revenues.  Overhead, as we will see, is a bit of both variable expenditures and fixed expenditures.  Overhead is a key factor in costing and will impact net income in ways you might not have anticipated due to production’s relationship to revenues and the treatment of allocated overhead.  We will get to that once we get to the Overhead Budget, but before returning to Direct Materials Budgeting directly I do want to mention some aspects of costing since this would be relevant to the proposition I made regarding the use of the budget, integrated, at a participative level for analysis and performance.

You may believe, as many do, that once you are at a certain level of granularity, the benefit no longer weighs out beneficially against the costs of analysis.  That this level won’t impact the budget and won’t benefit the time to complete it.  I would say that this depends on numerous factors, but I would also say that since a unit cost must be determined and overhead allocated anyway, due to reporting requirements; is the ability to create granular budgets already present in your company’s recording of financial data.  Furthermore, if your many of your products depend on a few key materials, then the material costs will definitely have an impact on your budget and should be included for, at least, sensitivity analytics.

Let’s get into some information on Costs and then get into the Direct Materials:

There are many groupings of costs.  You will note that there are some costs that can be included in different groupings.  It will take a bit of time before the designations become familiar, but because all transactions need to be recorded for accounting reporting there are definitions and acceptable methods that require definitions.  No worries, eventually you will familiarize yourself with these topics.  Always know, you will find that understanding costs will assist in the broad scope of GAAP financials and the gross margin method and, of course, the more useful method for planning and profitability analysis, the contribution margin method.   

I don’t think I could possible offer a comprehensive list of all possible combinations of costs and usage, but I will try to offer a good foundation.

Accounting References:  (Costs for Reporting, Internal and External)

Product Costs: 

Costs required for getting a product ready for sale.  These costs begin with the familiar Direct Material, Direct Labor costs that would go into a production process or costs that would go into getting a provided service ready for sale.  These costs are defined by business type and product.  Additionally, these costs should include the allocated the costs of manufacturing overhead of the process.  Think of the representative accounts COGS or COS, Cost of Goods Sold or Cost of Sales. 

Period Costs: 

Costs that will be expensed for the period and are not directly related to readying any specific salable product and therefore not allocated as overhead.  These costs will be the Selling, Marketing, Administrative and Corporate Operational costs that are there to support the entire operations of the company.  These accounting costs are interesting because you may find that period costs may have allocatable potions to products that were produced in a given period.   

You may be more familiar with these if we were to have an Income Statement as a reference.  Costs above the gross profit will be product costs.  Costs below the gross profit will be period costs.  How do you arrive at the product costs you may and should ask? 

Perhaps, you have also heard reference to inventoriable costs and inventory recording methods.  These are terms derived from the requirement to allocate the manufacturing overhead to the product to report final product costs according to accepted accounting principles and also how to assign direct material and direct labor costs in a world of continuous output when we attempt to value the process at a point in time for reporting purposes. 

Imagine just saying “stop the production” and “we need to examine all completed and partially completed products and come up with a total cost for all overhead, material and labor right now”.  That isn’t practical.  Not only is this not practical, prices of purchases and costs will not be exact between reports.  Accounting methods for inventory assists with this by tracking layers of purchases and using inventory accounting methods such as FIFO (First-In, First-Out), LIFO (Last-In, First-Out), weighted average, to derive a COGS or COS. 

I have been simply using weighted average for my calculations because it is straightforward and requires little explanation.  Essentially, without worrying about equivalent units, its total costs between reporting periods divided by total units produced between reporting periods.  Simple. 

However, many firms will take advantage of FIFO for internal tracking due to the fact that it can be readily converted into a Dollar Value LIFO for external reporting, gross margin and tax benefits respectively.  Choices in the methods of inventory recording and COGS calculations will give different benefits. In addition, certain methods may be needed due to unforeseen circumstances such as a fire destroying inventory and a valuation of the lost inventory for insurance purposes is desired. 

The methods are covered in depth for inventory accounting requirements in advanced accounting and while choices of method will be the final deciding factor of how COGS is valued, weighted average is a good place to begin for understanding.  The others can be a bit more involved, but numerous articles have been written with examples on these methods and reasons for using these methods if you are so inclined to learn.    

Let’s look at those Product Costs

In production process of products we have put the three categories of costs into overlapping sets.

                             Prime Costs                                     Conversion Costs

Prime Costs = Direct Materials and Direct Labor

               Direct, Traceable Costs to the production of a product.  The traceability may not be exact, but the usage of the material is easily determined.  If you manufacture aluminum cans, you know a direct material is Aluminum, but you may not know exactly how much per can since this is going to be within a tolerance and there may be excess material used over the course of a period of production due to some waste.  However, aluminum was used. 

               As a comparison, you may need machine molds that wear out over time.  The molds are used for thousands of cans, are not a material of the can and couldn’t be traced to just one since the mold is not a material of the can.  The molds would be an example of variable overhead.  The point being that, if necessary, you could pick one unit and derive the materials and costs of the materials used for that one unit.

               The Prime Costs are the variable costs of production.  These costs will fluctuate with the level of activity of the production process, the more units produced, the higher these costs.

Conversion Costs = Direct Labor and Manufacturing Overhead

               Costs required to convert materials into a finished product.  These costs could be assembly, machine operation, or a craftsman and the use of hand tools.   

               It is important to point out that there are Direct Labor Costs and Indirect Labor Costs.  Again, think Direct and Traceable as a helper.  Labor that goes into the production of the unit is direct.  Go back to our Aluminum cans.  The individual working one of the machines, perhaps laying out the sheets of aluminum for a pressing, is direct labor.  The individual that may maintain the machine is an indirect laborer and is in the Overhead category.  This brings us to the Overhead.

               I like to think of Manufacturing Overhead as a compartmentalization.  If you operate a factory, any costs that are not selling, marketing, corporate administration, direct costs or direct labor are going to probably be designated manufacturing overhead.  So, all costs within the walls of the factory and the cost of the walls and the taxes for having those walls on a plot of land are all costs to categorize.  I draw up the image in my mind of a box and plopping it onto a square and everything associated with it needs to be accounted for in the products by way of Direct Materials, Direct Labor and Manufacturing Overhead since without this box and operations, there would be no product. 

Now that we have a fair notion of the defining characteristics of the elements that make up the product costs, there is one more point to solidify.  It was mentioned that Prime Costs, the Direct Materials and Direct Labor costs, will vary with the level of production.  These can be referred to as Variable Costs.  Knowing which costs are the variable costs will be useful for determining budgets predictive of actuals, and create accurate, measurable variance for changing levels of production. 

If your production varies, these variable costs will also vary.  The Prime Costs should display a linearity with production.    But we still have those other variable costs that come from some of the accounts in the Manufacturing Overhead.  Manufacturing Overhead can then be separated into Variable Manufacturing Overhead and Fixed Manufacturing Overhead.  The process for separation may involve some Regression Analysis or some High-Low Activity calculations, but many of the accounts that will be classified as Manufacturing Overhead will have a portion of fixed cost and variable costs that will be incurred beyond a certain level of production. 

A relatable example is electricity.  You probably pay a base rate for electricity every month.  If you were to us your A/C consistently for a summer month, then you would expect a bill above your base rate.  It is similar to the factory overhead.  The production process too pays for electricity on a base rate and the costs above this rate will depend on how long the machines are running during operations.  If production runs longer, the electricity cost will be more than if production ran short shifts the entire month.  Simply, the base rate is the fixed and consistent rate that you expect to pay regardless of operations.  What you need is the approximation of the cost above the base rate in a relationship to the production runs.  This is the variable rate.  The costs that have part fixed and part variable are just called mixed.   

Again, the benefit of being able to group all variable costs is that we can more closely approximate costs to activity of production and therefore to the degree we can include the Variable Manufacturing Overhead we will add accuracy to costs relative to production.    

Can you visualize how a categorization of variable relationships could be used for more accurate budgets AND be used as a sensitivity analysis factor for changing levels of production?

Note that this is not done in a standard Financial Reporting on the Income Statement. 

Let’s Add Some Operating Considerations

Operations, Productions and Cost System

You may produce numerous units, similar in assembly, in batches and make use of a Process Costing system to record the cost of inventory and product.  You may also produce more unique, customizable orders that can easily be assigned respective costs and, therefore, make use of a Job Costing system to record the costs of inventory and product.  Your operations and these systems will further define how costs are assigned in the best method for your business, how you will budget for costs, your further operational considerations, and the method to measure efficiencies.

Broad Based Breakdown on Operational Relationship to Cost Method for Inventory, Product

1)  Process Costing

               Think of a manufacturer that produces on an assembly line, our Aluminum cans.  You produce many similar products continuously on the same equipment, through the same departments.  You may have designated batches, but the products are very similar.  Perhaps you are printing Aluminum cans for different sodas.  Each type of soda is a batch, but the process is very similar.

Again, it may be difficult to assign exactly how much direct material and direct labor due to some waste of aluminum in the pattern cutouts or perhaps some idle time between batch setups.  However, you do know how many cans were in each batch, how much aluminum was used and the times it took to complete the batches.  You can get direct material used per can and direct labor used per can with a little division.   

Our overhead will need to be assigned (allocated), but we should attempt to separate our overhead to arrive at the most accurate assigned costs possible.  As was mentioned, we can begin this by separating overhead into variable and fixed portions of overhead.  Further the, while the variable overhead should be fairly easy to allocate to units produced in the period (often based upon direct labor hours or machine hours) for which there was variable overhead, the fixed overhead will be allocated per unit based on another historic data point, normal activity. 

Once again, using historic data, the normal activity of production is the practical number of units produced over the period.  The practical number of units would allow for the inclusion of planned maintenance, normal operating activities and normal material waste.  Once we arrive at a normal unit production, this number will be the basis (the denominator) for which we allocate fixed costs.  The numerator being total BUDGETED fixed overhead costs.

Example as a Measure for Planning and Budget:

          Direct Material (basic example – no beginning  WIP inventory, all material used)

You may know you used 1000 lbs of material and the material was purchased for $4/lb and 500 units were produced.  Assume all material purchase was used up.  The approximate calculation is 2lb material per unit at a cost of $8 per unit or $4000 of material. 

               Is this good or bad?

               We will find out using Standard Cost for measurement.

Process Costing Lends itself nicely to  :  Standard Costs for budgeting and performance     measures and inventory value ( FIFO, LIFO, Weighted Average – There are several aspects to costing to value units).

               Standard Cost is the use of standardized measures for production budgeting based upon historic data. The standardized measures will include a predetermined dollar cost for materials per unit, dollar cost for labor per unit, a measured (ie: lbs) amount of material per unit, a measured (ie: hours) amount of labor per unit and an amount of overhead that should be applied to each unit which is based on normal production activity, as mentioned above.

               For our example say we created Standard Costs of $4.25/lb for material purchases and 1.5 lbs/unit.  We now have costs to compare against the actual costs.

               We have two different variables to consider for the Direct Materials, but the Direct Labor will be similar conceptually.  We have Material Usage and Material Cost.

Actual Cost = Purchase Cost Material ($4/lb) * Material Usage (2lb/unit) = $8/unit

----

               Purchase Price Variance =

[Std Cost Materials ($4.25/lb) – Purchase Cost Material ($4/lb)]  * Material Used(2lb/unit)

               = $0.50/unit  Favorable  @ 500 units

               $250 Favorable

               Std = Standardized Cost

----

               Quantity Variance =

[Std Material Usage (1.5lb/unit) – Material Used (2lb/unit)] * Std Cost Material ($4.25/lb)

               = $2.13/unit  Unfavorable  @ 500 units

               $1,062.50 Unfavorable

----

               If we were to look at total variance relative to materials, caused by usage and labor, we would calculate that the total variance is $1,062.50 – 250  =  $812.50 Unfavorable, driven by usage.  This could be due to the cheapest materials, purchased due to rising costs of prices for production.  You will see this from time to time, but more importantly you will have to determine if this variance is within a tolerable scope. 

Note:  for variable costs, if the standard (budgeted) is exceeded by the actual, it is unfavorable, we do not need to use negative signs in the calculations.

----         

Through the usage of standard cost for comparison we can assess our performance relative to production and not have to rely on a “run rate” that doesn’t offer us this dynamic insight for units produced.  I will demonstrate, below, how one product can impact overall costs … as I have been doing throughout this series on budgeting and why a more detailed budget is beneficial and factually less costly overall.

It is highly probably that material inventories used in a process costing system will be tracked using a periodic inventory tracking method, as opposed to a perpetual inventory method.  While the perpetual method can be used with identifiable inventory, such as items with barcodes in retail or automobiles on a car lot, the periodic method will use purchases over a period of time to make adjustments to inventory carried and conduct physical audits at the end of the period to evaluate actual levels.

(other means of tracking can also be used for physical tracking but the basic implication,  it is difficult and costly to maintain continued inventory tracking and adjustments)  

Since the GAAP periodic inventory method will also use purchases for recording and tracking and the calculation of COGS, this data will align with the overall consideration of detailed budgeting and measurement without significant extra effort.

2)  Job Costing

The second broad category of costing for production activity, inventory and product is that of Job Costing.

Think of a product that may be unique or customized, perhaps construction of a home, prefab homes, boutique clothing designer or services offered to a customer such as that of auto mechanics, plumbers, electricians, consultants and so on.  You might offer a quote based on historic values like we used in a Standard Cost system, but you probably bill based on actual costs of material and labor because these items can be tracked to a single customer or a single product. 

While we nearly always reference historic values as a comparison for performance, the term historic may have a different time period value that is acceptable or useful for a given comparison.

Now, I tend to lean towards Normal Costing for operations that could be classified as Job Cost operations.  Of course, this is dependent upon the number of jobs and whether a substantial amount of inventory is carried for job operations, modular homes as an example.  This type of industry may actually have a hybrid of Job and Process and would have to assess how to value inventory.

I believe Job Costing Lends itself nicely to  :  Normal Cost for budgeting and performance     measurement and inventory.

               Normal Cost is the use of actual costs for material and direct labor with, again, the addition of the allocated portion of overhead.  With this method you will still have the ability to set standards for the labor time to complete jobs and amount of material needed to complete jobs but you will assess labor time against actual rates and material used against actual costs.     

For smaller operations, I like the ability to model sensitivities to changing prices using the Normal Cost method.  To the degree that this is manageable, actual costs will reflect liquidity in real time relative to current prices which can be crucial for job-based operations and assessing financing needs.  Job-based operations will probably have more variability in both jobs and financing relative to process operations which tend to be larger firms with more consistency in operations and cash flows.     

Costing can seem to be a mix and match.  You could have a process costing with a normal cost method for recording inventory costs. You could have a job costing with a standard cost method for recording inventory costs.  And, as suggested, there are hybrid operations.  Finding the best method will be determined by, not only, operations, but you capacity to collect and organize your operational and financial data.

Before I close this article, I will display the continuing modeling and budget variance for the simple models that I had constructed in the previous articles.

If you recall, I had broken the products into Price Tiers and Margins and have worked a deeper, more granular look at revenues, production and now materials required for production.  Also recall that I was examining the impact of the changes of just one of six price tiers, with three product lines and only 5% of total units sold, on total revenues so that I could support the suggestion that a more granular approach to budgeting would be more than beneficial for an organization.

It is a very simple materials example, but I think it is useful for an illustration.  Below is the Standard Costs and Standard Measures for materials for Product 1, 2 and 3 of Price Tier I and the actuals for the anticipated level of production.

As I mentioned, I am choosing to use a weighted average costing for products and inventory valuation for the production period.

Below is the roll-up for the quarterly.  The only variances in production will be in the Price-Tier I segment for illustration as we will assume all other tiers we exactly planned.

The reason we are assessing the variance costs as favorable/unfavorable is due to the fact that we only made what we would sell and require for ending inventory.  Therefore, there were ten fewer units produced.  We would like to know if we were still maintaining our standard of price and material relative to this change in units produced.  If we simply set a top-down budget we would not be able to see the direct impact of these ten units and the labor, material portions of the units. 

You may wonder why we would still make 94 units to hold in ending inventory.  Ending inventory is set up for the NEXT periods sales to maintain a smooth and continuous sales out without worrying about stockouts.  Since we are still anticipating our budget for the next quarter, we are also still working with the anticipated sales flow out and therefore want 94 units in inventory for this purpose. 

In reality we would have probably made the 10 units that did not sell and have ended up with an end inventory of 104 units.  This then reflects that need to have a dynamic budget that could adjust to these units in the future periods. 

Do we continue with the planned production and, in the event of a downturn in the economy, have a surplus of inventory?

Do we try to create a granular and participative, dynamic budget that can adjust (Continuous or Rolling Type) to actual sales?

As we continue below, We simply get to our granular look for actuals and standard costs for our budget and measurement for the Three products of the Price-Tier I segement.  A reflects the

Material Usage and Variance and B reflects the purchase price variance from standard.

A) Material

If you take note of the Unfavorable marks and recall the Actuals and Costs Chart repeated here:

Lets take a quick look at the calculations and labels.  You will note that the broad labels of material are simply divided into lbs ~ pounds and sqft ~ square feet.  There is no distinction between type of material or if there is a difference in material between the products … this is just how we purchase and therefore measure usage of the product.  Since this is the case, the Segment total calculations will be based on a weighted average of sqft and lbs.

The budget was for 3146 sqft and actual was 3250 sqft.  In order to calculate the material usage variance we use the standard cost (budgeted) times (budgeted material – actual material). 

(3146 – 3250) * $216.67 = $22,533 U

and recall that for costs, the actual is greater than the standard and so it is unfavorable, we do not need to use the negative sign in the calculation.

As we move into the unique products, we no longer need to use the weighted average and can use the actual and standard costs from the table to calculate our variances.  This is another way to look at how the weighted average works into calculations.

Overall:

Even though we made fewer units, we were not as efficient as we anticipated and it cost us in the production of Product 1 and Product 2.  If we deemed this to be a variance that is uncharacteristic of our historic data then we may want to look into our production and materials for products 1 and 2.

Below we continue to our purchase price for our materials so we can assess the current market for our materials that we use in the production process.  If we note that there is a significant difference in the pricing …

Were there stock outs of our materials and rush orders needed to continue operations?

Was there a disruption in the supply of a material and a price increase due to temporary issues?

Was there a permanent price increase and we need to adjust our standard costs for        material?

B) Purchase Price

In closing I do want to mention that while I did mention various costs, these charts in the example were for material only and the next article will discuss the direct labor budgeting.  If you recall this is the second Prime Cost that goes into the production process and the second part of the costs of our units – #1 Direct Material, #2  Direct Labor, #3  Allocated Overhead.

As you should be able to see from the example charts, the tracking of costs that go into material purchases and usage can also have a substantial impact on the accuracy of a budget and is another reason that a more integrated and granular approach could be more useful than is generally considered.  This Tier is only 5% of anticipated revenues.  If there were trend fluctuations in this Tier due to a change in the economic environment, extrapolate out the impact.  Without a more dynamic and granular approach to the planning process, issue would arise quickly.  This is what I had suggested since the first article.  Granted, this premise is brought about by the ‘unique’ situation that we say during lockdowns, but it isn’t the first time economic markets have seen major changes in consumer behavior. 

In addition, the data that I have presented for variance calculations is probably available from the Operations Director for the product lines.  Most of the data I am using is probably available to a particular segment, but may not be known to or available to the finance and accounting department that is often saddled with the budgeting and planning process.  Since this the data is often already available it could be used, would provide accuracy, and be used for performance and dynamics.  This again, I believe,  supports the integrated approach to the budget that is inclusive of operations and will increase their understanding of how their data will fit into the overall budget process; hopefully initiating a budget process that shifts some of the work away from the finance and accounting department. 

Final note : 

The understanding of actual cash, liquidity and working capital is also an associated area of concern when conducting planning of operations.  Since this area of the budget involves the purchasing of materials, this is a good time to use this budget to complete a:

Schedule of Purchasing Disbursements

First, I will open up with pricing.  Generally speaking, pricing is a function of marketing and a part of overall marketing strategy.  The four P’s for those familiar.  However, what is often overlooked, and is definitely the overarching influential factor, is the competitive economic market structure.  I won’t go deeply into the theories or concepts such as economic income vs accounting income and marginal revenue vs marginal cost but understand there is much more to this topic.  My paraphrasing is brief, but this brief intro will be useful for understanding pricing next time you are in your shop determining prices or out at the market wondering how a price is determined. 

A quick look at 1) Economic Market Structure and 2) For P’s of Marketing Strategy:

1) Economic Market Structures

               Defined by:

• How many firms are competing?

• How easy is it for a firm to enter into this competitive market against these firms?

• Product offered and how differentiable is it to other products?

• Is the product easily substituted for other products without customer loss of value?

                              Suggested Further Research:

                                           Porter 5 Forces Model

                                             Product Life Cycle

               The theory is all markets will work toward equilibrium.  This means if profit is to be made, firms will enter until the market share is claimed and all profit is taken by some company.  Firms that can’t compete for the profit share will exit the market through bankruptcy.

Barriers might be financially based, such as an investment in equipment, resources based, such as a key mineral for production, operationally based, such as unique supply chain

Developments, or other advantages or barriers that make start-up difficult.

               A)  Perfect Competition

• Many Competing Companies

• Ease of entry into market for New Firms – Minimal barriers

• Products of Minimal product differentiation

• Price is necessarily competitive (low) due to the numerous options available.

                              -ecommerce (think of text books or eBay), farmers markets

               B)  Monopolistic Competition

• Many Competing Companies

• Ease of entry into market for New Firms – Minimal barriers

• Products of Low – Medium product differentiation

• Prices are competitive, but added value found in different characteristics

                              -most of our familiarity with markets and prices are based on                             -retail, restaurant, salons, clothing, grocery stores, hotels

               C)  Oligopoly

• A Few Companies Controlling Market

• Ease of entry into market for New Firms – Substantial Barriers

• Products of Low - Medium product differentiation                            

• Prices generally controlled by the firms, but influenced by market demand

                              -some grocery store chains (region), tires, oil, railroads, automotive

               D)  Monopoly

• One Company Controlling Market

• Ease of entry into market for New Firms – Highest level of barriers

• Products of Highest Differentiation

• Prices could be highest as no competitors, but this is one area often regulated

                              -utility companies, control market, but often government regulations

                              -regulations due to need (water, electricity) and price control

2) Four P’s Marketing Strategy

Product

               What is begin sold?  Yes, this is narrowed by industry, product-line and usage, but further by specific characteristics and perceived VALUE that a consumer believes will benefit them after purchase.  The benefits could be in the promotion, ie: customer service, warranty, which is why this is a four P’s evaluation, but it is also ease of use, materials, BRAND reputation, design, desired characteristics, perhaps longevity and so on. 

The primary point is the environment of competition in which the product will compete.  While many products will be similar and substitutable for your particular product, are their characteristics that will separate your product from the field and are these of value that can be reflected in the price.  People may pay more for an ergonometric design, or for a supplement that is proven free of heavy metals. 

In economic terms most products will by within a monopolistic competition.     

Position

               This is ‘placing’ a product into the market amongst its direct competition.  Most often, one would think of this as following the consumer perceptions of the brand that is introducing the product.  Is the brand known for luxury items, high-quality industrial goods, low-cost/low-quality items and so on.  This positioning of a product and its relationship to the brand is why companies often have tiers of brand names so that product lines can be introduced to the market and associated with the brand tier.  Obviously, the brand can substantially influence how a product will be priced.

Cars are a perfect example.  Jaguar – Ford, Lexus – Toyota … and so on.  It is difficult to be a new company without a reputation and enter into a market known for a specific product or specific expectations on characteristics.  

               Further, this ‘placing’ also involves the distribution of the product.  Do you have your own retail outlets?  Do you use other retail outlets?  Do you only offer products online?  If you use other retail outlets, which outlets do you want to display your products?  How much influence do these retail outlets hold over your product, your pricing and your promotion?

Walmart is a perfect example.  Walmart holds considerable sway over products’ pricings, placement in their stores and promotions.  But, if your brand is considered high-end, luxury champagne, you wouldn’t place it in Walmart.

Promotion

Marketing study and even focus groups help round out research into how the product and brand is viewed by the targeted consumer in the space of competition amongst similar products and what value can be placed on different features, relative to competitors, so that the price can be determined.  But these studies also go further to determine other aspects that accompany the product that may be a contributing factor toward a purchase.

Manufacturer financing, warranties, coupons, product displays, advertising, advertising method, advertising frequency and numerous other considerations go into promotions.  These offers aren’t just to entice a customer to purchase, these offers may also be with a retail chain to entice the chain to carry the product.  A marketing professional would be able to add to this, but I believe the general idea is presented.

Price

Ah. Here we are.  The Price.  Numerous factors go into price as the aforementioned implies, but there is more to pricing.  Price is both offensive and defensive.  It may be used against competitors to defend market share, or it may be used to seek out new markets or increase market share.  Price is as much a tool as it is used to increase operating income.  Pricing is really fascinating.

While price will be influenced by the economic market structures, the product itself, and the desired positioning, we can now add a bit more detail regarding the actual customer demand that allows price to be used as a tool and how understanding customer demand is, in my opinion, the foundational block from which the rest of strategy should be built.

Understanding customer demand, requires understanding customer behavior, often defined by key socio-economic traits.  Once again, since this is a social behavior that will impact usage of a limited resource (customer income), there are economic theories that help to understand how your pricing can be used to study and predict your customers’ behaviors.

You might wonder why products are often so similar and it is because there is already a known and established customer base for the product.  If you know there are potential buyers, a considerable amount of risk is eliminated since you may not sell the quantity that you plan to sell, but you will probably still sell close to your planned quantity. 

A brand-new product, think Apple’s Vision Pro Goggles, will require you to make educated guesses as to quantity to produce against quantity sold at a desired price and then hope that the consumer is happy with the item and not returning them for failing to meet expectations.  Within the realm of technology and gaming, this strategic risk is one of the reasons pre-sales and reservations were introduced in the early 2000’s. 

However, the technology industry also has a customer base that is described as the Early-Adopters.  Once again, using Apple as an example, it is well known that a new product release will garner a predictable level of interest and lines of customers desiring to be the first to purchase and use the latest and greatest in technology offerings.  These Early-Adopters will pay top-dollar, allowing for a quick recouping of research & development costs, just to be the first to review and gain status associated with the brand and the technology.  If these Early-Adopters are satisfied, they will provide for a direct line of word-of-mouth advertising that will further drive sales.  Granted, this is a combination of the cultivated branding by Apple and the behavioral traits of the technology consumers, but it does illustrate an understanding of the customer and usage of price as a tool in the real world.

So … some economic theories and representative models of customer demand and prices.

Theory of Demand

Note:  there is no Theory of Supply … a Supply curve is simply used as a representation of how changes in regulatory edicts or market environment will influence a company’s willingness to produce a certain quantity of a product.

Basic Point : In a free market, over a range of possible prices for a product, as the price increases there will be a decrease in the quantity demanded.

This should be easy to understand.  You would probably be willing to pay a range of prices for a certain product, but only to a certain maximum price.  Anything higher than this price … nope… it isn’t worth it to YOU.  This is the limit of the price paid for the value you get from the product.

This limit may be different based on YOUR INCOME and YOUR VALUE perspective of the product.

The graph of this concept

The value perspective can be defined by need, ie:  water, utilities, or it might be defined by usage, ie: equipment and tools, or it might be defined by association, ie: brands and labels.  If you want to look further into economic views of products and values, you can check out Luxury Goods, Normal Goods, Inferior Goods and how purchase will change based upon our next factor, Income.

Income Shift

Basic Point:  Your income will dictate the quantity of a product you are willing to purchase at a given price and from which category of products (Luxury, Normal, Inferior) you will make your purchase. 

It should not be a surprise that with more income you would purchase more goods that you may consider a luxury item and fewer that you would consider inferior.  Think of purchasing Mac’n’Cheese vs Steak.  It should also not be a surprise that you may be willing to purchase goods at a slightly higher price because you now have more income.

Price Elasticity of Demand

In order to measure the change in demand relative to a change in the price and thereby determine, using the various theories, how your customers’ view your product and even how your customers’ are doing financially in the current economic environment we can benefit by using the price elasticity of demand.

These two variables work in opposite directions for the general economic market structure.  The increase in price will decrease the quantity demand.  The percent change is useful because if a 1% change in price will cause a 5% decrease in the quantity demanded then you know your product is highly sensitive to price (highly elastic) and customers are not willing to pay a higher price or customers have many options for products very similar to your product.  If the percent change in demand is less than the percent change in price than the product is inelastic and very well may be a necessity.

Of course, within your company someone will have to collect sales data, change prices, evaluate promotions and price specials and create an analytical environment to make use of the economic tools listed above.  However, knowing at what price your customers will purchase your product, how they will react to price changes, and how they perceive the value of your product is only half the equation of pricing.  We also need to understand pricing methods relative to cost of production and desired returns on investment in production.  After all, your company needs to be competitive on price in order to sell your products, but if you don’t maintain a positive operating income, you won’t be solvent for very long.

Pricing Methods (in brief)

A) Cost-Plus

               This method is exactly as it sounds.  Determine the cost and add a margin.  The cost aspect can be a littler more complex than one might assume initially.  Will you use variable cost or will you use absorption cost?  How will you allocate overhead?  Are you using process costing or job costing, standard costing or normal costing?

               When determining the margin, what will you use as the required rate of return? IRR, ROI, WACC or some flat percentage.

B)  Target (Market) Pricing

               This method is in-line with the positioning of the product that is mentioned in the Four P’s of Marketing Strategy.  Your product is going to be placed in the competitive market and, if this market is established, you are going to have a ready list of competitors’ products and respective prices.  Once known, you need to back out your margin from your respective cost to produce the product. 

               Since the competitive price range is established in the market, this pricing method is often used in concert with Value Engineering.  That is, going through your entire value chain used in the production of the product, from design to service, and evaluating the chain for the areas that add value to the product and those areas that could be eliminated to save costs.  Through this assessment of value and cost optimization, a greater margin can be worked out for the product.

Pricing is an involved activity.  A good bit of analytics and a good bit of understanding of economics is useful, if not required, to create a competent and competitive pricing mechanism for a company’s products.  That said, I want to add one more dynamic to this article on pricing strategy, the target customer.

Target Customer

Understanding your target customer will assist your company in planning your marketing strategy, advertising channels, product distribution channels, future product-lines and revenue forecasts.  In other words, getting the most bang for your buck on all necessary cash outflows associated with selling your product and an accurate projection on future cash inflows.

It is for this reason that companies try to gather data representing their customer base.  If you recall, I did hint that customer demand relative to product would reveal common socio-economic details about the general customer purchasing a product. 

One of the most common errors that a company makes is believing that their product appeals to everyone.  This is simply not true.  If you were able to acquire socio-economic data on all of your customers, inclusive of their interests from age, income, profession, education, and home zip-code to hobbies then you would find curious commonalities for the majority of your customers. 

Further, if you were able to find four or five primary characteristics then you would be able to plan out commercials, the medium to use to run commercials and perhaps even the time to run the commercials.  You would discover what appeals to your customer base and be able to optimize any investments that are necessary to continue your operations.  You would find benefit understanding your customers and you would find it in the data.  I believe that the analytical approach to discover your target customer would be extremely useful for any company.   

Companies and even customers can benefit from this data collection and analysis.  Now, you do not need to invade privacy to learn about your customers and you probably already have substantial data on your customers.  But if you find that you do not, ad hoc analysis can be used to draw conclusions about your customers or potential customers.

Useful Sites include (some free, some pay):

Federal Reserve Data Tracking

Bureau of Labor Statistics

Centers for Disease Control

State Employment Statistic Tracking

Real Estate Companies

Social Media Sites

University Sites

One might be surprised at the amount of data that is out there and available.

Privacy is still a primary issue when it comes to data even though we give up so much to various social media platforms.  First, always respect your customers’ data.  Second, that aggregate mess of data could be made useful with a few techniques such as Clustering Analysis.  But that is a topic for another time..

#3 The Production Budget - Service Capacity Budget

The balancing act of demand, carrying costs and financing considerations

If the Sales Budget is the hinge, the production budget is the door.  It is the bulk of operations and the focus of nearly all short-term and long-term strategic decisions. 

               Is the current product offering in demand?

               Do we want to enter a new industry or product line?

               Do we have the current equipment to produce the product?

               Do we consider an acquisition?

               If our current product is in demand, do we have the best current technology?

               Will an equipment upgrade save money?

Do we have the capacity to meet current demand?

               Can our throughput meet demand in a timely manner?

               Is our operation streamlined to optimize performance?

               Do we have the ability to finance current operations internally?

               Is our ending inventory planning adequate to meet continual demand?

               Is our material buffer adequate to support continual demand?

               Is our lead time on material orders adequate?

               Is our storage capacity for inventory adequate?

               Is our labor force adequate and competent to meet specifications and throughput?

If any area could make use of the coordinated activities with FP&A and bottom-up budgeting, it is the production budget.  There are numerous complex decisions to be made that determine how to keep operations flowing smoothly, effectively, and efficiently and all of them involve operational understanding integrated with financial knowledge.  If you recall any studies or experience in a manufacturing setting, for example, then you may recall throughput, bottlenecks, buffers, process arrangement, specifications, scraps, reworks, WIP inventory and, of course, overhead allocation.  All of these operational activities and metrics will initiate and translate to a financial transaction or aggregated financial transactions.  Why not the integrated, participative budget and the further benefits of communication and cooperation?    

This production budget can be referred to/planned for in a couple of ways in my opinion depending on your business model and from which additional pieces of the budget it will be fed data.  Expanding on this, production is initiated to meet demand for a product, and, in that relationship, is similar to service capacity availability to meet demand for a service.  In both instances a company may want to have available product, as product inventory, or service capacity, as labor inventory, to avoid stock-outs and missed sales or to offer a buffer to mitigate the possibility of supply chain issues which would prolong production times. 

[While many will easily draw the association with materials and inventory, some will have trouble with the labor concept.  Labor is not generally thought of in the same way as materials.  However, from a transactional perspective, the labor directly associated with the product or service is a product or service cost in the same way there is a direct material cost.    Whether you have enough labor to meet demand is just as much of an issue as to whether you have enough material.  We experienced this first-hand during the pandemic.  And in the same way material costs rose, labor costs rose.  In short, you are paying for and inventorying labor in the same way you do so for material, even in a service department.  The issue that arises in labor in regard to time and the ability for dynamic changes in labor is also not that different from material.  A change in customer demand may mean you have too much material inventory, it may spoil, it may suffer obsolescence, it may not meet upgraded technology specifications.  This is actually why I believe the ability to contract and part-time working is beneficial to a company, however government often complicates the ability to react and is, often, the source of resource waste.]       

It is obvious that you don’t want to have too much capacity or too much inventory, as you will suffer under-utilization and obsolescence that translates into lost money, but it is not ideal to want for capacity or inventory since you will also suffer losses of revenues through stock-outs, customer dissatisfaction, customer switching to substitutes and competitors, loss of sales and long-term loyalty, and a hit to brand reputation.  The degree to which customers will put up with inventory issues varies amongst industries.  In some cases, the lack of capacity becomes so synonymous with a particular industry that it becomes a part of folk culture … what thoughts do you immediately associate with cable TV?  That said, once investment is put into capacity or production of inventory you have also lost liquidity until such a time that you can collect on those investments. 

The need for accurate and complete budgeting that offers for dynamic planning and measurement would seem to be critical and quite bluntly can only be achieved and evaluated at the activity sources of the cost drivers in relationship to the top-line revenue drivers.  Again, this is bottom-up and integrated budgeting, but if we were to put a more familiar label to this, it is the contribution margin that would offer the CVP (Cost-Volume-Profit) analysis and perhaps most accurate performance measurements and data for decisions. 

Certainly, there are some notable assumptions associated with the contribution method, but I believe that given this is an internal tool, there are some steps that can be taken to remedy the issues with assumptions and facilitate the end goals of a useful, measurable model. 

               Assumptions/Issues

                              Sales mix is constant

                              Inventory levels remain stable

                              Inventory Costing  (Absorption vs Variable)

                              Contribution Margin is not used for financial reporting

              Allowances

           Sales mix is generally presented as constant for any budget, just as any relationship in costs of production or OPEX to the revenues is also generally considered constant. Sales Budget may present options. One of the options is the categorization of the various products by price and margin (eventually contribution margin as opposed to the more readily available gross margin). The separation into price and margin should be roughly the grouping of cost-based priced goods, value priced goods and even luxury goods. If the groupings have common cost basis and common customers trends, a sales-volume sensitivity can be done amongst the groups and should still give a heads up on changing market dynamics and trends and the impact on revenues.

                              Inventory is generally a strategic planning unto itself. End Inventory Budget. Given that inventory is usually set against future demand and ordered to minimize order costs and carry costs, it is not too far of a stretch to lean on the assumption of a minimally changing inventory. If a deep reduction occurs, such as a change to a Just-in-Time styled inventory system, this project would have its own budgeting to enact. Once in place, again, inventory levels would return to relatively constant levels.

                              Absorption Costing allocates overhead to units produced.  Fixed Overhead Budget. The gross margin method allocates fixed overhead to units produced, and fixed over head becomes an inventoriable cost (product cost). The Variable Costing method treats fixed overhead as a period cost and expenses the cost in the period incurred. In order to have the most versatile budget and make use of the information provided in a contribution margin, it is best to create a fixed overhead budget and have the ability to restructure the contribution margin method into the gross margin method for reporting and external stakeholder usage.

                              Contribution Margin and Gross Margin methods are related by Overhead. As previously read, there is a relationship between the two methods and their net incomes will varying dependent upon units production vs sales. If unit production is greater than sales and finished goods end up being added to ending inventory, the gross margin method will have the higher net income. It unit production is less than sales and finished goods must draw units out of inventory, the contribution margin method will have a higher net income.

There are always assumptions in a model.  It is the model that provides the most versatility and usefulness relative to cost that should be pursued.  What I continue to hope is that a look at how activity drivers and complexities within operations can influence top margin and bottom margin will inspire an interest in an integrated and coordinated budget for better planning and more accurate profitability analysis.

Looking at the complexities that lay with operations and the respective decisions that will be represented in the financials, there is a need, even at the highest levels to have some understanding of the cost drivers and how top-level financials will be impacted by changes in these drivers.  One may be surprised at the impacts, which I will show through some production budget examples below.  This can be accomplished through a more integrated budgeting process that will offer better measurement analysis over the course of the year.   

               -added complexities will depend on the classification of responsibility center

This method obviously isn’t for every managerial decision-maker, and many will scoff at the persistent belief that time isn’t an issue.  This impulse is, again, derived without consideration of the negative impacts of a top-down view of a company.  However, decisions are influenced from beliefs, and I have seen peculiar circumstances where executive management has only been concerned with two or three data points due to their belief or philosophy and the actual activity cost drivers were completely overlooked as in the Working Example.

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Working example:

I will say that sometimes, activity level drivers and all the data in the world will not change the executive decisions.

In one case, the executive decision maker’s philosophy was “you can’t sell it if you don’t have it.”

Through this philosophy the driving data point was TOTAL unit inventory.  It wasn’t based on category.  It wasn’t based on analysis of customer preference by location.  It was total inventory by location.  And with this there was a drive to purchase and INCREASE inventory at a time demand was slowly trending down and interest rates were ticking up. 

In my capacity I tried to offer the perspective that “it only sells if it is demanded by a consumer”.

This attempt, on my part, to offer an accompanying strategy to align with the general, albeit naïve, approach by the executive decision maker was in vain though I had conducted considerable analysis in an attempt to optimize this goal.

There was no consideration to distribute the category and product models so that variety met the desire of the customer for options … nope.  There was no consideration that this inventory was draining an already tightening liquidity and would impact loan covenants.  There was no consideration for the rising interest rates and the dependence on varying rate revolvers for financing of inventory. 

Sometimes, details will not be considered regardless of the power of the data for decisions.

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Corporate leadership strategic peculiarities aside, I will mention some of the impactful production considerations that link finance, operations, budgeting and planning during the assimilation of data for the Production Budget.

Constraint considerations

• Capacity    

• Production Throughput and associated Bottleneck

• Inventory Storage

                         Storage of Finished Goods

                              Storage of Raw Materials

• Supply

• Distributions/Logistics

Financial considerations

• Carry Costs

• Order Costs

• Leases – Space, Equipment

• Labor Changes

• Material Changes

Any constraints will obviously relate to how your business generates revenues, but all processes have a bottleneck impacting throughput and all operations have constraints that will impact utilization.  Note, that just because you project revenues for a budget and can plug in production to support these revenues in a model, reality may not agree with the model.   

In a manufacturing company, unit production occurs, units produced per unit of time, but

• is material available to keep operations running,

• is storage available to stock finished goods,

• is labor and equipment maintained to keep operations running,

• is overproduction occurring,

• are carry costs rising,

• and so on.

In a retail environment, inventory needs to be maintained to avoid stock-outs, but

• is the storage space available,

• is the space in close proximity or are there added logistical issues to take into account,

• is there a significant behavioral trend to the purchasing of an item that will change purchases,

• is there a change in the anticipated obsolescence of a product,

• and so on. 

In a service company, an evaluation of how many resources will be needed could be taken into account,

• is the labor available with the necessary skillsets to meet the specific needs of a client,

• is the equipment available to meet the needs of the laborer,

• is there an optimization of the operational expenses (direct costs) of the service or is a plan development in progress that would lower cost,

• and so on. 

Regardless of the industry, understanding the impacts of even the basic considerations of constraints and associated financials can offer both accuracy and planning triggers for strategic short-term and long-term decisions.  Note, that many of these considerations mentioned were either variably associated with production or a mixture of variable and fixed costs that would be associated with production.  Quite frankly, any assets or expenses that are associated with production should be known, as well as, the degree of influence, to make fully informed decisions.  Again, this would be found in an integrated, bottom-up budget that coordinates input from many departments throughout the company.

Let’s take a look at the planned Production Budget associated with the Sales Budget from #2 Master Budget – Sales Budget.

The production of the units needed for sales is going to be closely associated to inventory levels of both finished goods and materials.  As was done in the Sales Budget, the Price Tier I category is the only variance from budget when the actuals are used.  Since production can only be accomplished using materials, the attributable direct material costs are listed with the budgeted material costs.  We will get a better look at the reasons for the variance in the Purchase Budget.

The Production Budget is divided into quarters, B-Q1 (Budget – Quarter 1), with the anticipated material costs and the A-Q1 (Actuals – Quarter 1) production and material costs for comparison.  This Production Budget is going to be tied to several other budgets, through the material, the labor and the overhead, the physical activity and the costs for each.  For now, I included material costs, but this will be broken out further in the Purchase Budget and note that we still only display the changes for the Price Tier I products.  These three products alone can have a significant impact on the budget.

The ‘devil is in the details’ is so true for the tracking and calculating of the units and the costs of Finished Goods inventory.  Inventory is easily the best example to view the blending of operational data and financial data due to this fact that we have both physical units and the accounting representation of the dollar value of these units.  This is further complicated by materials and material inventory needed to create the finished goods and the added accounting method chosen to value inventory, LIFO (Last-In, First-Out), FIFO (First-In, First-Out), Weighted Average, DV LIFO (Dollar-Value LIFO). 

I am using a weighted-average approach.  It is easy to calculate averaging units in beginning inventory with the units produced during the period.  Since this is only an example, I will use this straight-forward method, but your inventory method may differ and adjustments would need to be made to give a better apples-to-apples comparison.     

When looking into the future and attempting to project production, we are concerned with the beginning Finished Goods inventory and the required ending Finished Goods inventory.  If we already have inventory available, we only want to produce the number desired, however, we also may want some units held in inventory so that we can continue operations and sales into the next quarter without worry of stock-outs or stoppages of operations.  Some companies can have drastic negative consequences if production does cease.  But, once again, holding too much inventory costs money as well as not holding enough inventory so a cost-benefit assessment must be done to determine your company’s various inventory levels for finished goods and materials.

Below is the planning for the aforementioned, Price Tier I and the three products within this segment that feeds into the total roll-up for the Production Budget.  The ‘Plugs’ section is the determined percentage of ending inventory that we would like to have on-hand relative to the projected sales for the next quarter.

As you may have noticed, the orange and green boxes are the same.  We, as people, tend to think of time frames linearly and segmented by period, a day, a week, a quarter, a year.  Of course, operations continue regardless and there should be a circularity to the planning process period over period.  This is what the orange and green boxes suggest.  If it is determined that the orange boxes were adequate for the sales that occurred in Q1, then the percent change anticipated for the next year’s Q1 sales should simply require a percentage adjustment to the beginning inventory in the orange box for the next years budget.  This is another instance that supports why I believe the budget should be allocated across departments for coordination and integrated into operations so that it is able to be used for performance measurement, variance analysis, and completed more quickly as time goes on.  

[consider… FP&A is being used to create budgets, the drivers of which are at the operational level and consist of understanding the activities (the variable costs) to provide the service or product, how can an individual that has minimal understanding of operations provide technically sound and reasonably accurate budgets? 

Over the past ten to twenty years, the financial system has allowed companies a considerable amount of slack (errors) in planning and strategy.   With the very brief exception of the few months the Fed Funds Rate was ~4%, this time period offered cheap debt funding and significant financial leverage opportunity.  This implies that any errors were effectively cheaper than they should have been historically.  As debt is no longer cheap, companies that can’t plan will suffer the consequences that come with debt now holding the strategies accountable.]

Hinge of the Budget Process

The development of the sales budget is by far the most challenging and most crucial step in the master budget.  Most of the components of every other segment of the master budget can be based upon the necessary supporting expenditures to meet the delivery of the revenue projections.  More than being the basis, however, is the understanding of assumptions that impact the sales budgets to a degree that is often overlooked.

Assumptions. 

I have often found some amusement over the course of interviews when an anticipated question comes up and I am asked about different models that I have constructed and assumptions that were used.  While I understand the point of the question, the fact is that the question is worded in such a way, that implies the interviewer doesn’t understand what is asked.  This is not uncommon.  It is well-studied through surveys and assessments that even within finance departments, a majority of finance managers score at an average level of financial acumen and have even less knowledge of modeling and statistics.  Unfortunately, there is so much knowledge required for proper financial reporting and accounting compliance that there isn’t always time to become adept at model development and statistics.  Of course, the reason why it is an amusing question is because all models are comprised entirely of assumptions.

One is assuming the same economic environment will continue or that the cycle will change when anticipated.  One is assuming that the industry environment will continue as planned without the obstruction of new regulations, political risk or consumer demands.  One is assuming that the historic data recorded and the relationships between the various accounts, ie: revenues, COGS, and OPEX, will continue.  One is assuming that the product selling mix and related margins for each product will continue.  One is assuming that financing costs will still be manageable and be maintained at historic costs and levels.  Point is, everything is an assumption because one can’t predict the future and, what’s more, is that these assumptions are still within the realm of relatively normal operations.  We haven’t even addressed other risk factors that would begin to really offer up risk and impact the business.  This is why:

    “All models are wrong, but some are useful.”      -George Box, British Statistician    

I have always thought this is a wonderful quote.  If you have ever created a model that is useful and reasonably accurate then I believe you may enjoy it as well as you are also probably well-versed in recognizing models that are not useful; but as for that interviewing question, there is simply no understanding, no smile, no reaction when trying to explain all models are built entirely on assumptions.  There is just a blank expression.  Let that state what it will.

As for the sales budget, I would like to draw attention and expound briefly upon the one critical assumption that I believe is overlooked most, the sales volume mix.  I bring this up because the top-down budgeting approach will often end up projecting the weighted average price per unit for total revenues.  If you are lucky, perhaps you get a few high-level product segment revenues that are aggregated into the total revenues, however, again, if the product segments are comprised of a selection of products, then each of these segments will still be reflecting a weighted average per unit revenue.  If your product lines consist of significantly different prices and margins, as is seen in most companies, then the influence of the high price, high margin products can really move the needle if there is a change in consumer behavior.  I witnessed this first-hand as a high price, high margin item began to dominate unit sales over a two-year period.  The product ran in the high twenty-thousand-dollar range with nearly 30% gross margins and began to account for 15-20% of total revenues.  It was easy to come to an objective conclusion that this could not continue for long as the industry environment was changing rapidly back to historic norms for this product.  However, there are times when great numbers cloud executive judgement and these dominating revenues, responsible for much higher weighted average per unit revenues, were forced onto budget projections.  What would follow is a quick three- month transition to 10% lower revenues as the sales units of this product predictably dropped off.  This impacted loan covenants and operations were cut back.  Even good, reasonably accurate and useful models can be ignored.

It should be no surprise that if you understand that weighted average calculations can obfuscate unit sales until it is too late, then you will understand why I always advocate for a bit deeper look into operational leverage (  ) and an examination into the  as a sensitivity of units and price with consideration on contribution margin.  If you can’t be certain that your sales volume mix will continue into the future, check its impact.  To give a quick illustration, I put together some budget numbers and examples for each segment of the master budget.

I broke up the product segments into

Price-Tier I | High-Margin,

Price-Tier II | Low-Margin,

Price-Tier III | High-Margin,

Price-Tier IV | Low-Margin,

Price-Tier V | High-Margin,

Price-Tier VI | Low-Margin.

While weighted-average unit price representation can be misleading due to the underlying product units driving the revenue, there are companies that have product lists of product thousand long and may have difficulty or wouldn’t find benefit in analyzing individual products.  In these cases, you can approach budgeting in a few different ways.

Group by Price Tier and Margin (as above and I will show this further below)

Group by Manufacturing Facility and then Sub divide into Price Tier and Margin

• This approach allows for a common grouping of materials for budgeting

Group by Pareto – 80/20.  Group Top 20% of products that contribute 80% of the Revenues

Group by Selection – Top 20 products that drive revenues

Group Quartiles – Quartiles by Price, Margin, Units or a selection representative and useful

This list is just an idea that many have used for performance measurement and budgeting and is in no way exhaustive.  Find a method that works and allows for a recognition of the price, margin and unit volume that will move revenues.

Example:

I have offered a few additional categories below in examples A, B, C, so a user might get an idea of the categories used and how many products are in each category.  For now, Margin is Gross Margin (absorption costing) since this is how most companies will have their data available for initial categorization of product lines.  The gross margin has its own issues with misleading information about the profitability of a product due to the allocation of the fixed-overhead to each product and the inventoriable fixed-overhead assigned to each product in the Ending Inventory.  If your company does not have COGS preconfigured, perhaps you will want to look at the contribution margin (variable costing).  However, for now it is simpler to just look at a gross margin.

In A, the %-Units Sold is the same as the %-Products Offered for simplicity.  The %-Units Sold will change in B.  The %-Products Offered will not enter into the calculation, it is only there to give an indication of how many products are within the category. 

Because each category has several products, a median price is given.  I chose a median price rather than a mean price to account for (at least initially) any skewness in the prices of underlying products for a quick look at the distribution.  The sigma is given to offer an understanding of the variability of the prices within the category.   

The %-Units Sold * Gross Profit will give you (Weighted) Wtd-Unit Profit. 

Adding these together will give you the per unit profit that you would see on the rolled-up income statement.

The %-Units Sold * Margin will give you the (Weighted) Wtd-Unit Margin.

Adding these will give you the per unit %-Gross Profit that you would see on the rolled-up income statement.

A)

As you can see, we begin with this hypothetical historic distribution of unit volume, and pricing data.  I have highlighted the extremes since these are the two components that we will change.  Price-Tier I makes up 5% of total units sold.  Price-Tier VI consists of 30% of total units sold. 

B)

Assume there is an income shift, people suddenly have more money available.  We saw this during the pandemic and there was correspondingly, an increase in unit purchases of higher valued items.  A minor 5% shift in unit purchases increases margin 3% and per unit profit nearly $500.  What would happen at a top-down budgeting as this relationship is carried forward?  If you recall my story above, this run-rate was believed to continue and all financial decisions were made up it.

C)

Now let us take a look at an income shift in the other direction, a lower purchasing power.  Comparing A and C, a 3% shift in units purchased results in a 2% decline in margin per unit and a decline of $286 per unit. 

While a simple illustration, I believe you can see the importance of looking into the elasticity of sales mix to margin, which will of course work its way down to the bottom line and impact net profit.  I now want to draw attention to the Price-Tier I segment and how you might choose to separate your products into categories.  You could consider (to the degree the cost-benefit is acceptable) a tiering of products such that a % change in unit sales volume mix has an acceptable impact upon weighted unit price.  As you may know, I would still suggest as detailed a modeling of products and pricing as possible.

Below is the categorically, rolled-up revenue budget with six price tiers for products.  Take note that it is a simple quarterly budget projection for units and revenues alone and actually offers more information than a number of composites for companies with top-down budgeting methods.  The exception being, of course, entities that plan for budgets at brick-and-mortar levels or with manufacturing segments.    

As we continue the scroll down, keep in mind the issues that arose using weighted average at a higher level and how deviations from budget would require data dives to assess the cause and reports would still have to be built to track performance drivers.  

Below is a product list for the Price-Tier I segment.  It is three products, and comprises 5% of the products offered by the firm using the price tier and margin method.  Adding product level detail, I have also added the budgeted anticipated price per unit.  But let’s now add a quarter of actual units and revenues, A-Q1.

Note, I did not complete a Sub-Segment for each tier.  I did one tier for an illustration of impacts at the product level as actuals roll in and for a look at variance and causes.  This Sub-Segment, the Price-Tier I,  will be used for each of the pieces of the master budget  as I progress and it will be used for a look at variance.  Perhaps it will display the usefulness of a bottom-up budgeting approach and spawn some ideas for tracking and performance.

The next charts below include the actuals for the first quarter.  The only price segment that deviates from plan is, as mentioned, the Price-Tier I, so that information can be more easily gleaned.

If you are familiar with managerial accounting, you will recall flex budgeting as a useful method for measuring variance when product activity levels, whether sold or produced vary from budget.  It is not enough to know you sold 26,990 units vs the planned 27,000 units and $71,608,375 in sales vs the planned $71,950,000.  You should be asking was that good relative to the number of units and the resources required to produce the units and what were the causes. 

While the variance analysis is usually used to measure rate variances and usage efficiencies of direct costs and variable overhead, it can also be used to look at income variances against the actuals, budgeted and flex budgets so that you can narrow down the sources of variances.

At first glance this may not be intuitive, but it isn’t much different that reading percentage variations, row-across, it simply has a bit more information in the same space.  

Look at the rolled-up revenue.  Budget = $71,950,000 vs Actual = $71,608,375 for a difference of $341,625.  But what does this mean aside from the fact it is lower than budgeted.  For this, we look to the variances.  We can see that $323,880 is from the variance of prices and $26,650 is from the variance in units sold.  We can see that both are U, unfavorable variances, as prices and volume was lower than budgeted. 

But what do the numbers below signify?  Again recall that there are weighted averages at work when items are rolled-up and aggregated.  We can see that the Price-Tier 1 experienced the same overall revenue difference as it is the only source of the difference, however, its contribution to the total revenues and total units is only a fraction of the total and all other Price-Tiers were predicted exactly correct.  The fact that all other Price-Tiers are correct, smooths out impact and narrows it down to the major attributing factor, the price. 

At the Price-Tier level, we see that the difference is attributed, primarily to a price variance.  It is $228, 662 unfavorable, while the unit variance is $112,963.   However, since the unit variance is only 10 units, you can surmise that overall in aggregate, the unit variance would have a much smaller factor in variance since 26990 are sold.  So let’s drill down into the products of Price-Tier I.  

Using the same process, we can see how the products performed and the source of the differences to budget.  I have included the budgeted prices and actual prices for illustration, but once one is used to reading variances and with the more detailed budget, it is quick to drill into sources of variance.  This will become more evident as we progress.

Looking at Product 3, we see the source of our variance.  Product 3 is showing a $570,000 variance from budget.  Of this difference, $120,000 is due to the price, but $450,000 is due to the unit volume.  Now consider, the $1000 lower price and even with the better unit sales of Product 1 and Product 2, Product 3’s 30 less units dominated the revenues for the entire aggregated revenues. 

This might be an issue.  If we were to just get the budget and actuals at the highest, top-down view we may simply view units and revenues as a dip.  After all, it is 10 units.  But the source might suggest a shift in customer preferences, it might suggest a pricing issue or a competitor entering the market. 

The benefit of a more detailed budget is that actuals can be queried and calculated and mapped directly into the budget, or vice-versa, and the budget can then be used for direct comparison as the actuals are rolling in.  Using budgeted pricing and costs allows for immediate comparisons of prices, costs and units to their actuals and offers immediate reasons for the variance.  This saves time and narrows down the search for data for the analysis.  For many companies, using a higher-level, top-down budgeting method, this variance may have been overlooked, or if it was looked into, it would still require the data dive and the implementation of reporting at that level.  The reporting may or, more likely, may not include the direct comparison to the budget and the assumptions of price and units.  There is time spent that is directly associated to budget, its lack of detail, and its usefulness even if time is saved from a top-down approach using run-rates.  Very few decisions only carry the immediate and easily visualized trade-offs like time.  Most decisions have impactful trade offs two and three steps into the future, and when it comes to time, this is the rule.  Set you budget and performance as an integrated process with actual operational results.    

After our quick look into the actual to budget variances and the portions contributed to the factors of price or units, I will continue looking at forecasting of revenues and methods.  As a reminder, the variance analysis will come up again as the other pieces of the budget that comprise the expenditures to either produce units directly or cover OPEX and will be displayed in subsequent articles.

The variance analysis is useful but does require a bit of knowledge in managerial accounting techniques and cost accounting to carry out the analysis but once explained it is very straight forward and over time becomes second nature.

Methods for forecasting the sales numbers

Statistical

                  1) Time Series

Time series models study residuals of regression models.  It uses the stationarity of residuals, which means there is a nicely behaved variance, to enable future predictions.  Below are some methods, increasingly more involved, that can be used for modeling.   There are Numerous Choices:

• AR – Auto-Regressive

• MA – Moving-Average

• ARMA – Auto-Regressive, Moving-Average

• ARIMA – Auto-Regressive, Integrated, Moving-Average

• (S)ARIMA Models – (Seasonal) Auto-Regressive, Integrated, Moving-Average

These models are probably most common in stock market predictions, but with a few years of monthly data of sales units these can also be used to predict unit sales volume.

If we were to breakout the components in simple terms, Auto-regressive models attempt to use the previous one or two months as a basis for predicting sales in the next month.  Perhaps we find a pattern in the data that suggests half of two-months prior unit’s plus twenty percent of the prior month’s units plus some fixed number is a close approximation to units sold in the following month.  This method is able to still give a bit of volatility in the units sold.  This is simplified as it is a regression equation of a series of data one month regressed, two months regressed and so on to test the predictability of the model, but it gives an idea.

The Moving-Average is a smoothing technique.  Again, we look at past units, but now we are using an average to predict the future.  Perhaps we use a prior three-month rolling average to predict the next month.  As you may guess this smooths out the peaks and valleys.  Used alone, this is more a warning mechanism for sales dipping or rising compared to an average.

The ARMA model takes some pieces from each.  ARMA models use auto-regressed averages with respective residuals and a fixed value to predict future values.

The next two offer adjustments to the ARMA model.  An ARIMA model has the “I”, integrated, is a differencing adjustment to create stationarity. The (S), seasonality, is an adjustment for the number of months between seasonality in the data.  

Time Series is a bit involved, but if you have worked with regressions, it can be understood and very useful.

                   2) Simulation

                                             Monte Carlo Models

I tend to think the Monte-Carlo simulations work well for new business models with little to no history.  If you study comparative firm data or conduct reconnaissance on units sold of competitors over a time-frame then you can conduct a simulation of the units sold parameter and a variance for each month.  This method will give you a basis to build a budget and some numbers for comparison with consultants.   

Delphi

                   Top-Down, Expert Opinion

I have always liked that this method was called Delphi, as in ‘Oracle at Delphi’, but the method often rests somewhere between ‘gut-feeling’ and historically supported data with a percentage bump to meet with expectations of external analysts.  That said, these are the numbers that would be most likely to have full support from management.

Participative

                   Bottom-Up, Operational Management, Marketing, Sales

This method would probably provide the most motivation and accountability amongst the various departments and management if several departments were involved.  There is a chance for an attempt to lower projections if there is belief that those slightly lower targets would be easier to hit and significant performance benefits rest on those projections.  It is generally thought that performance measures should be based on accuracy of budgets and drivers to alleviate this potential.  

If one would like to use run rates, then perhaps it would be prudent to still sit down with marketing and get a schedule of the yearly strategy.  If a company normally uses a fixed advertising budget, but twice a year pushes a large and targeted promo and revenues noticeably spike, this would be useful information for the model.  If that promo is going to be reduced to one, or increased to three times per year, the revenues will need to be adjusted accordingly.  While most other drivers of revenues could be run-forward, a noticeably successful marketing strategy and its timing, and coverage should be taken into consideration.  

Additional considerations for forecasting:

Forecasting Noncontrollable Considerations

               Seasonality

               Cyclical

                              Economic Cycle

                              Industry Cycle

                              Regional Cycle

Forecasting Controllable Considerations

               Marketing Strategies    

Sales Mix

Sales Pricing

Sales Discounts

Promo Timings

Trade Credit

Product Life Cycle

New Products

Number of Products

Product Cost

Cost Methods

Product Margins

Trade Credit and Collections Development

The annual budget. 

I hear the groans and see the underpinnings of dread from those experienced with the process at the mere mention of it.  In many companies the process takes long hours to complete, especially when finalizing the process that may ‘work’ for the company.  For these companies, planning software or not, the budget may not be as accurate as it could be, may not be as motivational as it could be, may not be as useful as a planning tool as it could be and, quite bluntly, it may be only minimally useful to the extent that it reflects run-rates for the next twelve months which has all kinds of issues in the assumptions, but there may be a better way to go about it.

Let’s begin with the first issue that is often overlooked.  A budget is nearly always prepared as forecasted GAAP-influenced, gross-margin formatted accounting statements.  This stems from the fact that the budget ends up being, primarily, an accounting exercise and, correspondingly, this format is by far the most easily recognized by those with and without accounting familiarity.  The gross-margin format comes with the added benefits that the US-GAAP format is required for external reporting, as a tax-basis and these pro-forma statements may also be available for covenant analysis and further debt financing analysis by banking institutions.  These are all beneficial for external users, but since the budget is representative of management expectations and planning in the short-term, it’s usage for internal processes should, in my opinion, be the priority.  After all, its effective and efficient internal operations that provide for the earnings potential that concern the external users.  

If we were to plan the generalized, complete budget, it would comprise of an operational piece and a financial piece.  The operational piece consists of segments that feed into each other as supporting activities and transactions and, when complete, will feed into the financial piece to complete the master budget.  This budget is often called a static budget due to its construction, fixed time frame and static assumptions.  The typical build has several disadvantages and shortcomings.  It is often built from the top-down using aggregated financials, is set for a specific operating cycle, is usually set with specific activity levels, not to mention numerous other assumptions, and is usually leaving users wanting for diagnostic and predictive analysis at the detailed level for which there was no consideration.  This build is used due to its ‘advantages’.  The top-down, high-level aggregated financials are supposed to save time and as mentioned, the financials are used as a ‘run-rate’ or carry forward of relationships of the accounting statements.  Since this format is used for financial reporting and tax purposes and is familiar to most users of financial statements, this offers additional reasons to continue this methodology for the build.  However, numerous problems exist with this budget build, and I would venture that not nearly as much time is saved as believed with this method as it isn’t the time for the build alone that should be considered.

The generally accepted characteristics of a good budget suggest that there should be more to it than a financial pro-forma practice, offering more by way of useful dynamic planning and performance analysis.  While, certainly, the budget should reflect organizational goals in action, it needs to also be motivational for segments, a control tool for measurable performance of these segments, offer these segments a dynamic planning environment and the budget should encourage departments to coordinate and communicate to create a synchronized system akin to the goals of ERP (Enterprise Resource Planning) systems.  But, Perhaps the most important characteristic of the budget is that is should be technically correct and reasonably accurate.  If one was to objectively evaluate these characteristics and assess the method by which these could be achieved, the method would not be top-down and wouldn’t rely solely with the gross-margin format. 

The fact is that a top-down budget has far too many assumptions taken for-granted in its completion and not enough attention is paid to the drivers at the level of activities.  What’s more, the usefulness as a comparison tool is limited since the drivers and needs for comparison imply dynamics and a top-down budget is, for nearly all its intents and assumptions, static with minimal capability to analyze sensitivity.  Further, any time ‘saved’ in completing the budget from the top-down is surely used in the time needed to data dive for an examination into actual dynamics because, as the time issue arise out of the budget falling solely onto the finance team, the deep dive analysis necessary post-development will also fall on the finance team.  Wouldn’t it be better to create a process and mapping that, once structured, could meet most every requirement of a good budget.

Again, the top-down, gross-margin format is pursued due to the belief that it saves time and while it may in its set-up, it almost certainly does not post-development, as the needs for performance, dynamic planning, variance analysis and any diagnostic analysis requires substantial drill-down into details and expanded internal reporting constructs to meet needs of internal users and with this, any time ‘saved’ during the budget build process comes back in post analytics. 

So … what’s my point? What’s my proposal?

I believe that many companies experience the aforementioned issues and these issues are why most companies face difficulties with budgets and the reason employees groan when it comes time to attempt a budget for the next period.  Again, I don’t think it needs to be this way.  I think that budgets, like all models, can be tailored to be useful and reasonably accurate and set up to meet all the requirements that a budget is intended to satisfy.  I believe that a more participative budget can be completed to relieve some of the time strain that has often been placed on the accounting and finance department.  I also believe that by doing so, it can do as intended, it can increase the awareness of strategic endeavors by operations, the awareness of the issues that operations face by senior management, and the financial acumen of everyone in the company; and the budget can still be put together for the external users. 

We can build fully participative, modular budgets that can be rolled-up into either variable cost, contribution-margin formatted or absorption cost, gross-margin formatted budgets.

This process does take some time, but once it is set up and certain portions of it are allocated to designated segments, it would save time, allow for performance measurement, dynamic planning and the mere constructing of it would begin coordinating and communication activities.

With the technology available today, from analytical tools such as Python, R, and Excel to Business Intelligence tools such as Power BI, and the ability to integrate them all with common databases, any size business can develop a modular budget.  With certain techniques, even companies with hundreds of products can use a more granular structure to take advantage of more accurate costing analysis, pricing analysis, efficiencies and significantly better budgets and planning.

I will offer up some examples and comments for each stage of the process that I suggest through spreadsheet examples.  One thing that is great about spreadsheets is that you can create an intricate, layered model with multiple stages and parameters.  I think there is far too much reliance on ‘planning’ tools that are generally inflexible and are set up to create top-down models.  Spreadsheets are very powerful tools and, as a consideration, the more integration that your ERP system has with spreadsheets and other tools such as Python, the better.  The ability to layer and flow results into high layers of a model is a great way to achieve a measurable impact from the activity layers in the model when conducting dynamic analysis.  For those that believe your chart of accounts is too lengthy for a spreadsheet, I have built models using spreadsheets from a chart of accounts with two thousand accounts for a very detailed accounting of expenditures and inventory.  It was well organized and very useful for financial analysis.    

The primary hinderance to a complete bottom-up budget that could incorporate much more robust cost and profitability analysis while also allowing for activity level analysis of planning changes is the ERP systems.  My experience using a notable ERP and FP&A planning system… 

Many of the large ERP systems do not do well with layers of detailed accounting.  These systems are designed for the top-down approach or a single level approach, for example, consolidated financials or a manufacturing facility.  These systems lack the dynamics, flexibility and flow that the spreadsheets offer.  If you doubt this, when you are required to analyze a variance and impacts of changes…what tool do you turn to?  I would bet you say…spreadsheets. 

Well, we tried to implement our two-thousand accounts and asked for a drill down capability for analysis during our ‘training’ segments with our consultant.  Try as our consultant might, this dynamic functionality was not available for our desired purposes.  The consultant continually tried to get us to roll-up our accounts into the financial reporting categories due to the limitations of the system.  We would end up conducting a bottom-up analysis in a spreadsheet and then uploading it to the platform.  This seemed to be an inefficiency and a waste of resources.  We were better off using the integration of the database, spreadsheets, and BI platforms for our purposes.  Technology for technology’s sake is not always a wise decision.  Always weigh out costs and benefits to any decision.  

 My thoughts on the organizational process for budgeting, planning and performance measurement: 

Note:  Any budget process must have Sr Management Support and Departmental Accountability.

               Perhaps this seems to be a given, but if implementing a bottom-up approach, the departments must be made aware of their involvement in the process.  I have seen departments simply ignore the process as though it was high-school and it was homework that could be skipped.  Having to pull in senior management to ensure participation would seem to be juvenile, but it is not as uncommon as one might believe.

#1  Begin with a complete Mapping of processes of recorded transactions within the Company.

               This has the added benefit of being an information tool for new analysts

- The primary consideration should be the triggering of transactions

- If your design looks like a schematic, you are on the right track

- Map departments to departments first

- Map within departments to drill down into activities

- The design for the mapping should be well thought out:

• Central Focus on Production Departments

• Central Focus on Inventory

#2  Audit your Database for financial, marketing and operational transactions that are currently stored to ensure alignment with mapping transactions.

               Drivers should align with objectives and strategy, ensure drivers have the data

- You cant analyze or use data that doesn’t exist

- Establish what you want to measure

- Ensure that data is available, if it is not:

• Establish how to measure it

• Establish how to record it

• Store it

• Use it

#3  Record the list of Department Contacts that will participate in the Budget Process

               ie:  during the sales budget projections, a marketing representative, sales representative and perhaps an operations representative may all be needed.  Marketing, sales and operations should be able to give details into the marketplace, promo and advertising timing and strategies and relevant impactful information for anticipated sales over the year that may not be known to FP&A.

A quick outline is put together in the last section at the bottom of this article.

#4  Begin outlining your segments

Operational Budget Segments

-          Sales/Revenue

• Inclusive of Schedule of Cash Receipts

-          Production

-          Purchases

• Inclusive of Schedule of Cash Disbursements

• Direct Materials

• Direct Labor

-          Overhead

-          Ending Inventory

-          Selling and Marketing

-          Admin

Financial Budget Segments

-          Pro-Forma Balance Sheet

-          Pro-Forma Income Statement

• Contribution Margin Format

• Gross Margin Format

-          Capital Budget

• Current Outlays

• Future Outlays

-          Pro-Forma Statement of Cash-Flow

-          Cash Management

End Note:

As you may have guessed, I am an advocate for a contribution-margin approach as a basis for budgets.  While this approach is less familiar than the gross-margin method, there are numerous benefits to this method that don’t exist with the gross-margin method.  Since the contribution margin method separates variable costs that are directly traceable to the production process from the fixed costs that occur regardless of production it sets up your master budget for all kinds of internal performance measures, better costing analysis, better profitability analysis, a more participative budgeting process, and a better understanding of pricing of products.  In addition, formatting the contribution-margin format into the gross-margin format for reporting and tax purposes is a straightforward process.

The Modular Structure

The goal of a modular structure is to not only initiate a participative approach to budgeting but to also utilize these budgets as a basis for performance evaluation, variance analysis, planning and facilitation of coordination and communication as a budget is intended. 

The time spent in the coordinated effort of a bottom-up approach should:

-          Increase overall corporate financial knowledge

-          Promote awareness of issues in departments and levels that may be unknown

-          Distribute the budget tasks to take some of the time pressure off of finance and accounting

-          Enable ready to go drill-down analysis to save time on diagnostic analytics in the long run

-          Encourage department to department accountability through open communication

Being headed by an FP&A representative, the goal is to alleviate the pressures put upon the accounting team for completion of the entire budgeting process and still maintain the capabilities for data analysis, modeling and forecasting.  Since a good budget should incorporate operations and finance data, a fair amount of the weight of the budget should be put upon the shoulders of the operations segments with the aid and questioning of the FP&A representative driving the model construction, parameters and any necessary data or understanding of the drivers that may not be well known to the FP&A department.

The FP&A representative should be able to lead the analytics and buildout of the models of the budget for each of the segments that will assist in the development of the respective sub-budget.  The segment representatives should be able to supply the necessary information required for the model.

               1.  Organizational Process Mapping

               2.  Budget Committee Representative of the Departmental Segments, without forgetting Support

• FP&A

– senior buy-in, lead by FP&A representative

• Sales

– regional managers or business development

• AR/AP

– manager (trade credit, supplier credit, payment, float)

• Marketing

– marketing manager (promo, pricing, placement strategies)

• Operations

- could include several sub-sectors, divisions, brick & mortar

• Procurement

– purchasing manager, pricing, order timing, EoQ

• IT

– support activities tracking

• Maintenance

– support activities tracking

• Human Resources

– support activities tracking

Revenue / Sales Budget

                Schedule of Cash Receipts

                Team Representatives:  FP&A, Sales, Marketing

Production Budget

               Team Representatives:  FP&A, Operations, Procurement

Purchases Budget                              

Schedule of Cash Disbursements

   Team Representatives:  FP&A, Operations, Procurement, Accounts Payable

Labor Budget

Team Representatives:  FP&A, Operations, Human Resources

Production Overhead Budget

                Team Representatives:  FP&A, Operations, Procurement, Maintenance

Ending Inventory Budget

                Team Representatives:  FP&A, Operations, Logistics

Selling and Administration Budget

                Team Representatives: FP&A, IT, Maintenance, Human Resources