In this day and age, most small and medium sized businesses (SMEs) use computerised accounting systems; and suppliers of accounting software, such as Sage, have made the bookkeeping process very straightforward, irrespective of whether your annual sales are £100k or £50m. As a result most SMEs now maintain a reasonable quality of bookkeeping that accurately records their financial transactions. However, many limit the regular use of their accounts systems to the processing and control of sales and purchase invoices, debtors & creditors, wages & salaries, the bank, VAT etc. And this means that they are missing out on one of the most important tools that is available to help them manage their businesses more effectively and more profitably. I’m talking about the production of monthly management accounts.
From the work that I do with SMEs, there seem to be two distinct issues. The first is businesses that don’t produce monthly management accounts at all. The second is businesses that do produce monthly management accounts but structure them in such a way that, at best, they are not particularly helpful and, at worst, are seriously misleading.
Let’s look, firstly, at those businesses that don’t produce monthly management accounts at all. Generally these are at the smaller end of the SME scale. They often don’t see management accounts as a priority; perhaps have some difficulty understanding and interpreting them; and may struggle to produce them. Realistically, if yours is a one person business with no employees and a very small number of transactions, monthly management accounts are probably not going to add much value because they won’t really tell you anything, you don’t already know or can’t work out in five minutes with a calculator or spreadsheet.
However, the business doesn’t have to grow too much, before the number of transactions increases to the point, where you lose track of them. At this point, many businesses then keep a close eye on the bank account and assume that, if there’s cash in it, they’re OK. And that’s the first big mistake because cash is not profit. A business can be making losses, whilst still having a healthy cash flow. It can also be making healthy profits, whilst having a cash flow problem (I’ve written another article about this, which you can access at Cash v Profit). You need a profit and loss account at the end of each month to tell you whether you’re making money or not and you need a balance sheet to show you whether you’re solvent and whether you have a liquidity problem or not.
Your management accounts should give you an accurate picture of where all your costs are and whether your margins are where they need to be. You can monitor where all your cash is tied up (stock, debtors etc.) and whether there is enough in the business to pay your wages and creditors. As the months go by, you begin to identify trends that may be developing; rising or falling costs; deteriorating or improving margins; increases or decreases in stocks, debtors and creditors; improving or deteriorating cash position etc. So you start to identify problems at an early stage and are able to take remedial action before those problems become acute. Similarly, you can see where you’re having increasing success; so you can then start developing strategies to build on that success. Finally, where you have a business plan with a detailed financial budget, you can compare your performance against the budget and take actions to get things back on track, when you’re falling behind plan; or build on your success, when you’re pulling ahead of plan.
Unless you have some form of accounting/bookkeeping experience, you may struggle to produce monthly management accounts yourself. Apart from ensuring that everything has been posted to the correct nominal account, a number of procedures such as stock adjustments, work in progress adjustments, dealing with prepayments and accruals are required. So you’re probably going to need someone to make all of these adjustments and to then produce the profit and loss account, balance sheet and any other reports that you may require. Obviously, some SMEs are big enough to employ a full time or part time bookkeeper and if so, the bookkeeper should be able to undertake all of these tasks. Some larger businesses will have accounts departments with a number of dedicated staff. These are likely to be producing monthly management accounts as a matter of routine. However, if your business is not producing management accounts each month, you’ll need to consider whether it’s possible to produce them, using existing resources or whether you need additional support. If you do need additional support, you may be able to employ a bookkeeper on a part time basis for a few hours a week; or there are many self-employed people and small companies offering bookkeeping services. Either way this doesn’t need to be a hugely expensive commitment and the benefits to your business are likely to be substantial.
The fact that you personally may struggle with accounts and may not have a very good understanding of them, doesn’t mean you shouldn’t have management accounts as part of your business processes. They’re just too important to ignore. In these circumstances, just be honest with yourself and your bookkeeper or prospective bookkeeper; admit it’s not your thing and ask your bookkeeper to go through the figures with you, line by line, explaining what each line is and what it’s telling you. You’ll need to invest some time in this; but, if you do, you’ll soon learn; and you’ll quickly discover it’s not rocket science.
I now want to move on to the second problem, I see all too frequently, and that is management accounts that are not appropriately structured and, as a result, don’t provide information that is helpful for the business.
Generally speaking, this problem comes about because the business owner/CEO doesn’t tell the person, responsible for producing the management accounts, what information is actually required. It’s just left to the accountant/bookkeeper, who may well understand the numbers but who, invariably, doesn’t understand the business.
The two most common problems are: –
1. A lack of sufficient breakdown between key business activities and/or product groups.
2. Classifying as overheads, entries that should be shown as direct costs.
Let’s look firstly at the breakdown between business activities or product groups.
If your business has more than one business activity, you need to understand the performance of each one. For example, let’s say you fabricate PVCu windows and doors; but you have two different market channels. The first is selling an installed service to homeowners; and the second is selling, on a supply only basis, to the trade.
Your production costs are likely to be more or less the same irrespective of the channel. However, the cost structures of the two channels are likely to be considerably different, as are the selling prices. Selling an installed service to homeowners is likely to involve sales commissions, advertising, survey costs, sub-contract installation costs, installation material costs and finance/credit card charges. Selling to a trade customer, is likely to involve different sales and advertising costs and may involve delivery or possibly trade counter costs; but it’s unlikely to involve survey and installation costs. Your management accounts need to pick all this up and provide a margin analysis for both market channels. If everything is lumped together, you just don’t know where you’re making money and where you’re not. So how do you know what strategies to apply to each channel? The answer is, “you don’t”!
A similar issue arises between different product groups. Let’s now say that you’re still a PVCu fabricator but all of your sales are based on selling an installed service to homeowners. However, this time you also sell conservatories. Your sales and advertising costs may be similar for both products; but conservatories require a roof, and also involve a significant amount of building works. So the cost structure of supplying and installing a conservatory is entirely different from that of windows and doors. Once again, if you lump these two product groups together, how do you know where you’re making money and where you’re not? And once again, you don’t.
Your accounts must be structured to provide a margin breakdown for all your key product groups and market channels so you have an accurate understanding of the true margin made by each one.
Moat accounting software can handle this type of analysis as a matter of routine; but it does have to be set up correctly to do so; and that’s where the main problem lies.
I’ll now move on to the second problem I encounter, which is all about whether costs are classified as direct costs or as overheads. Direct costs refer to materials, labour and expenses, related to the production or supply of a product or service. Other costs, such as depreciation or administrative expenses, are more difficult to assign to a specific product or service, and are, therefore, considered as overheads.
Many SMEs classify materials and direct labour as direct costs but almost everything else as overheads. And this can be very misleading. Let’s go back to the business selling windows and conservatories on a supply and install basis to the homeowner. Not only does this business have materials and direct labour as direct costs, but it has installation labour and materials, disposal of site debris, survey costs, sales commissions, lead generation/advertising, finance/credit card costs, warranty/guarantee insurance. All of these are directly related to the sale, production and supply of the product and its installation. So all should be classified as direct costs.
If you decide to classify only some of these costs as direct, you’ll end up exaggerating your gross profit, which is normally calculated by deducting your direct costs from your sales revenue. You’ll also overstate your overheads because some of your direct costs will be absorbed as overheads. The consequences of this could be quite profound.
Let’s say that the business is barely profitable and that you have to take action to improve profitability. One way of doing this would be to increase sales; you, therefore, put a sales plan together. You think you’re making some good margins so you decide to offer some additional discounts. You also need to spend some more money on advertising and, of course, extra sales mean extra commissions installation costs etc. Everything seems to hang together and off you go. You’re initially pleased with the increase in sales, but when you run your management accounts, the effect on the bottom line is shown to be marginal. You’ve added some volume but for little or no extra profit. So what’s happened?
The problem is that your accounts have mislead you about your margin. Because you’ve only included materials and direct labour as direct costs, you’ve been duped into believing that you’ve been making healthy margins. However, if you’d included all of the other direct costs as direct costs, you’d have found that your margins were in fact very poor; and, once you’d accounted for the additional discounts you offered, it would have been clear that there wasn’t much left.
If you’d known this at the outset, it would have been very apparent that additional volume wasn’t going to provide a solution. The only effective options open to you were (a) drive down your direct costs as a proportion of your sales, (b) increase your selling prices, or (c) a combination of both.
Let’s now look at another problem that can occur as a result of confusing direct costs and fixed costs. Many businesses seeking to improve their profitability, embark on a cost cutting exercise; but they cut the wrong costs.
If many of your direct costs are treated as overheads and you need to make cuts, staffing, process costs, administration, maintenance & renewals etc. are often the soft options that you go for rather than address the more challenging issue of high costs in sales and marketing, installation etc. However, the outcome of this can be catastrophic because, in reality, you still have a margin problem but you’ve cut the basic infrastructure that would have enabled you to address that margin problem by driving down your direct costs.
In the home improvement sector, which is where I focus most of my time, one of the most common problems I see is SMEs that under resource their processes, controls and administration and, as a result, suffer from direct costs that are out of control. Genuine overheads are relatively easy to control because you can make definitive decisions as to whether you proceed with something and spend the money or whether you don’t. Direct costs are much more difficult because they depend on operational efficiency, effective processes, quality control etc. In many SMEs, total direct costs are much higher than total overheads. So controlling direct costs provides far greater potential to improve the bottom line than controlling overheads. In fact, quite often, an increase in overheads is needed in order to provide the resources that are required to bring direct costs under effective control. In this situation, the bottom line may get worse, for a short time, before it starts to recover to the levels, at which it should be.
Once you have your accounts structured to give you really good information about your direct costs and overheads, you can start making these sorts of decisions with confidence.
Many owners and directors of SMEs find interpreting their management accounts quite challenging; so, if that describes you, don’t think that you’re on your own because you’re not. It’s, therefore, very important to have good accounting and bookkeeping support, the scale and structure of which will depend on the size and complexity of your business. It could range from a part-time bookkeeper or bookkeeping service to a significant sized accounts department. But wherever your business is on that scale, what you can’t do, is just let them get on with it, as they see fit, because they won’t understand your business as well as you do. You need to work with them to get the structure of your management accounts right and to ensure that it provides you with the right information in the right way at the right time. If you invest some time and effort in this, it will repay you handsomely.
If you’d like to discuss any of the issues raised in this article, in more detail, please feel free to contact me.