Understanding cost drivers

A few years back, I was brought in by the president of a small business which manufactured and installed custom storage systems for offices and restaurants.  His concern was that either his accounting system had a bug in it or that someone was stealing from him.

This came to light when he ran his most recent quarter profit and loss; it seems that for the first time in over 7 years, he lost money.  His shop has never been busier.  He is getting lots of highly profitable contracts so the quarterly results don’t make any sense.  I asked to see quarterly information and got to work.

The first report I reviewed was the profit and loss report.  Sure enough, there was a $53K unabsorbed overhead amount  This happens in one of two ways – quarterly overhead went through the roof or the driver, in this case direct labor hours, were substantially lower.  Sure enough, the direct labor hours were down about 10%, indicating that labor wasn’t recorded.  Which would be really strange as the controller had been doing this job for almost 5 years and consistently made the overhead allocation adjustment correctly.

overhead1

So I asked the president if there were any major changes.  His response was that he decided to outsource all of his installations.  As a test, he explained,  the company in the prior quarter elected to put the installation out to bid on one project and the price came in at about 60% of what his costs were.  So he decided that he was going to “sell” the installation department to his department supervisor who would then quote jobs as an independent contractor.

I explained to him that what he was seeing was a direct result of the decision to outsource without knowing all the available facts.

Fact: There were two different departments, each with its own overhead costs and driver

Fact: the Company was using a single driver addressing the total overhead

Conclusion: The same (essentially) overhead dollars were being allocated over fewer direct labor hours, leading to larger unabsorbed overhead since the rate was not adjusted to reflect that fewer hours were being “sold”.

I then showed him a spreadsheet of what this actually looked like:

overhead2.png

The company rate of $41 was correct, but only for its overall purpose, allocating company overhead to production costs.  In reality, very little of the overhead went to support the installation department.  As a matter of fact, when separated, it became obvious to him that the shop was being subsidized by the installation department.

When they bid a job and included the rate of $41 to the install hours, the company was in fact generating an additional $27 in revenue which went to the bottom line.  But this was hidden from the controller, the president and the estimating department.  Thus, the $100 per hour revenue rate appeared high when compared to the $75 rate that the subcontractor offered.

In truth, had the company been facing lost estimates, they could have reduced the hourly rate for installations from $100 to about $65 and still earned a decent profit.  But you have to look deeper into your company structure in order to understand that options like that are available to you.

When most of your costs are fixed, then basing make or buy decisions on your overhead absorption rate can be dangerous.  The key is understanding that allocating costs by way of hours turns that fixed cost into an illusory variable cost.  You begin to think that by eliminating the driver, the cost goes away as well.  It doesn’t work.

Once the president understood this, he was able to convince the installation team to rejoin the company, although he did have to make some concessions as to bonuses when it came to profit earned on installation jobs.  And with this information, the company went through the various areas of the business and examined how costs were incurred and allocated to projects to even more effectively estimate contracts and keep their bids competitive while improving their profitability.

 

Leading versus Lagging

Accounting is a universally accepted lagging indicator.  Profits are so last month, the balance sheet is yesterday’s news, and don’t get me started on net book value of equipment.  As strange as it sounds though, most people making decisions seem to be ok with all the things that happened yesterday and in some cases things that happened years ago.

One of my favorite lines in a presentation is, “Running your business by your accounting information is like driving with your windshield blacked out and being forced to steer by looking in the rearview mirror.”  It is dangerous and will ultimately run you off the road and yet many people find comfort in looking at past performance and remembering the good old days.  But you have to start looking at other things in order to make better decisions.

Let’s start with revenues.  Quick question, are you tracking your sales funnel?salesfunnelex

Looking at this, we can begin to make an educated guess at where sales are heading next month and perhaps beyond.  With $30K sales in final negotiations and $80K in the proposal stage, you know that with a closing ratio of about 45%, you are looking at close to $50K in revenues closing in the next month.  Meaningful?  Compared to saying that the company did $42K last month and $68K in the same month last year?

revenueproductsyr.png

While it might not seem like a leading indicator, this one could be if properly used.  This tracks the revenue by products, not based upon their model, but based upon the year that it was originally introduced.  If your company prides itself on bringing new products to market but you are unsure how new products fare, this could be an eye opener.  In this particular case, the bulk of the revenues is generated by legacy products, followed closely by near-legacy product sales.  Is this a problem?  Perhaps, especially if you find out that your advertising and promotional dollars are being spent to keep legacy products in front of customers, or that you are spending a ton of money on advertising the new hotness and it is not taking off.

This reminds me of a recent conversation I had with a client.  It seems that one of their major customers is going to merge and most likely will no longer buy products from them. The obvious question, how are you going to address the concern?

No problem he says.  They are going to lay off employees.  We have been spending almost $750K a year on R&D and we haven’t gotten anything out of it.

I was voting on cutting senior management compensation by 98% and moving them to some sort of incentives based on new products and new channel sales but I guess slowly going bankrupt by starving the company of new products is a much safer bet.  After all, every “VP” should be guaranteed a paycheck.

Find a creative way to look at your company’s data, especially sales.  If you are not tracking sales prospects, start now.  Your sales people will give you lots of reasons why it won’t help, but don’t take no for an answer.  If you have new products that are not selling, find out why.  My bet is that somewhere along the way there is a disincentive to either buy or sell.  Customers are getting a better deal on your old products or your sales peoples’ commissions are better on legacy products.  Or it is a dog and you need to dump it!

Don’t simply rely upon accounting reports when it comes to managing your business.  Get creative, tell your controller or CFO to get creative when it comes to predicting future sales and expenses.  Yesterday’s news is important to someone, but that someone doesn’t have to be you.

 

The Power of Illusion

ASC 606.  While I think it can be a very useful tool in some situations, like with condominium and homeowner associations, I am not convinced that it will help a reader, an investor, anywhere else.  That is because it is almost uniformly built on the concept of management choice – which sadly can lead to poor decisions that ultimately hurt investors.

In a perfect world, I think the concept of ASC 606 is inspiring.  Finally, a reader can see what has been committed to and what prices will end up being paid.  What a great way to predict a company’s ability to generate future cash flows.  But that isn’t what is going to happen. I have seen enough at my end of the spectrum to know that anytime subjective measures are involved, those impacted want the measures skewed in their direction.  And something like ASC 606, which almost completely makes determining revenues subjective, simply is going to take this to a new level.

This reminds me of an attest engagement on a contractor.  The contractor stated that they had a maintenance contract which runs for 12 months with options to extend an additional 12 months and 6 months.  No problem.  We though.  We asked for the contract, the controller hemmed and hawed.  Why?  She put the information into the disclosure so there must be a basis for its inclusion.

Apparently not.  It seems that the customer is not so thrilled and has expressed that they won’t extend the contract.  But there is a catch.

The customer is also the ultimate customer on several other contracts.  It seems that the customer accounts for about 60% of the revenues for this company and when this contract goes, there is about a 99.8% chance that the other contracts are not renewed and new contracts won’t be awarded.

This all came to a head when we questioned the fade, or loss of gross profit, over contracts.  Long-term contracts are handled on the guesstimate method.  We use the “objective” measure of actual cost incurred in relationship to the guess of total estimated costs.  The total estimated cost is management’s choice, its illusion, which drives not only gross profit recognized but also the percentage of completion.

We identified a problem.  The fade, or the loss of gross profit over time, on contracts was starting to become noticeable.  The graph shows what we noticed:

fade analysis

The gross profit percentage ends up remarkably lower over time.  There is really only one reason for this, the inability to estimate accurately.  Notice that all fade is in excess of 5 basis points, the smallest fade being 7 points on project ABC.  If this were a $10,000 project, that wouldn’t be a big issue but it is their second largest contract.  And worse, you can see that on one job they estimated an increase in gross profit in year two only to have it plunge to a net contract loss of 5%.

GP Fade

I know I know, the point.

The problem is that they estimated their new contract, the one likely not to get extended at 45% gross profit.  The trend though, is clear: Gross profit fades lower consistently over time.  The trend indicates to us that the project will end up at 30% overall.  The project AAA is recorded at 5% complete which means the company has recorded over $100K of gross profit.  The trend says that, at best, they have earned $67K.

But wait, there’s more.

Since the original estimated cost in year one is too low, this changes the percentage of completion.  Not a lot, but enough.  The true fade, after revising the percentage of completion is

true fade.png

Huge.  So huge, in fact, that it can’t be ignored.  It totals out to about $375K of gross profit incorrectly recognized in earlier years.

Of course, our concern is not really those older contracts, it is the new one, the one which is likely not to be extended.  It is our concern that current gross profit is overstated by about $50K AND it is likely that this contract won’t be reupped and that there will be no future contracts with this customer.

With the loss of this customer, revenues will drop 50%.  Given the fade problem from poor estimates, the company has not had the gross profit it envisioned on these projects which has forced it to borrow heavily to meet its operating needs during the end phase of these projects.  The borrowing, by the way, is from both the bank and the new projects with higher initial gross profit that will ultimately fade away.

Since we are independent CPA’s attesting to the financial statements, we are held to the standard that we think the company in question can continue as a going concern for at least one year from the date of our report.  We ran several different scenarios, none of which succeed in changing the trajectory.

I would like to say there was a happy ending.  I guess in a way there was.  Management, the sole owner, decided to terminate our engagement.  The next year, the owner filed for bankruptcy.  The bank never got is independent accountants’ report by the way.  They didn’t call the loan and ended up with over a $500K loss due to the reorganization.

It is tempting to believe that management wants accuracy and objectivity in its reports.  But as with estimated costs to complete, ASC 606 is open to management’s very subjective and capitalistic approach.  Management is responsible for

  • determining what makes up a contract with a customer
  • selecting at least one (and possibly only one) performance obligation
  • Allocating the contract price over the performance obligations
  • Determining when the performance obligation is complete so that the price can be recognized

These all have similar requirements – management’s ability to use good judgment.  And much like with contract estimates under old GAAP, it will be well-nigh impossible for an independent CPA to challenge management’s assertions, until it is too late.

 

Alignment

Growing a business can be challenging.  It doesn’t help that there are lots of books and internet articles explaining how so-and-so did it with no investment and no effort.  Those stories might be inspiring, but they don’t always tell you the whole story.  What those stories aren’t telling you might cause you to chase a plan for longer than you normally would.  No small part of that has to do with alignment.

Alignment in business is all about making sure your marketing, your message and ultimately your assets all support your core business.  A great example of this came from a company I was assisting as an outsourced controller.  At a strategic retreat, the leadership decided it wanted to start going after larger commercial construction projects.  This was a great idea but it meant more than just saying “here we are.”

First we had to deal with the fact that most manufacturers did not adequately plan for their liquids and gas piping.  And yet, in order to do the job well, the piping needed to be planned.  Client’s did not have specialists on staff to handle this nor did most architectural firms.  Don’t get me wrong, they had a good idea of how it needed to be, but some things are highly specialized.  To be successful the Company needed to invest in an engineering team.

The engineering team needed the right tools.  Auto-cad, plotter and a quiet place to do the design work.  Not to mention a large space where the team could meet with clients to review the plans and requirements.

The company then needed to get the message out to the construction community.  The company’s sales team needed to be armed with information to help clients in their selection process.  We had to successfully educate them that lowest bid is not always the most appropriate bid.

Finally, the company needed to address its pricing model.  There was an obvious disconnect that was hamstringing the growth and adoption of the new service.  The company was moving from a repair and maintenance service to a construction service

but management was still using their service rate to try and price the construction.

rate analysis

The company was pricing local jobs about 20% higher than out of town work.  This was driven by two issues – first daily mobilization from an office no nearer than 15 miles from the nearest likely construction site and second applying the service rate to the total time.  The service rate worked well for service – it required some technical skill to diagnose a problem with a gas distribution system and the client expected to pay for the “emergency” nature of the call-out which included travel time to get to the job.

This doesn’t always apply in construction.  And because of this, the company was not completely aligned.  Local jobs were being lost and the company had work coming out of its ears hundreds of miles away.  The crews were tired of being away all of the time and it was harder to manage if things went sideways at the jobsite.

So, the sales manager, the engineering manager and I sat down and figured out how to get aligned.  The estimate was redesigned to charge a lower rate for mobilization in town.  The engineer generated a bill of materials for every job – one problem was that local jobs were not getting the same supporting documents since it didn’t seem like a problem to run around town and pick up parts when the crew was local – all of which allowed the company to still make a substantial profit on jobs, since the company was now able to land local contracts which reduced wear and tear on vehicles and employees.

rate analysis rev 1

As your company leader, always make sure your entire business is aligned.  The greatest service in the world won’t make you a dime if customers don’t agree with the pricing.