Understanding Overhead

When I first start evaluating a financial statement, I try to group costs together logically.  It is far too typical for most businesses to rely upon the canned reports and these are almost always prepared in GL Number order.  But a clearer picture can be developed by grouping the costs of revenues separate from the overhead and the overhead into 4 main groups.

The overhead groups I prefer follow the Throughput model:

  • Labor Overhead
  • Marketing Overhead
  • Facilities Overhead
  • General

A little bit about the groupings:  Labor overhead includes not only those who are on payroll but also consultants and outsourced staffing.  So, for instance, if your company outsources janitorial services, this expense is reported in labor, not facilities.  My approach is to put all labor into labor overhead, including production labor, unless it is truly variable – which most is not these days.

General is the catch-all classification.  There are two services I typically would group into general – legal and auditing.  While both are still people performing services, these are services which your business typically cannot provide internally.  Otherwise, if it cannot clearly fit into one of the other three groups, put it in general for now.

Let’s say your business does $1.0 Million in sales monthly.  Your direct material costs are $350K and you have depreciation on equipment which manufactures the products you sell of $50K.  Throughput, which is the measure of how much money you generate to cover overhead and profit, is $600K.

Continuing our analysis:

  • Labor Overhead runs $400K  or 66.7% of throughput
  • Marketing Overhead is $50K  or 8.3% of throughput
  • Facilities Overhead is $50K or 8.3% of throughput
  • General Overhead is $30K or 5.0% of throughput

In total you are spending $530K to generate $600K of throughput.  88.3% of every dollar you bring in is consumed by your overhead, of which most is tied up in labor costs.  You see, when you separate out your labor into different categories, such as production labor, sales commissions, accounting and office staff, you can lose sight of the total amount you are spending to generate throughput.  It isn’t that these separate amounts are not important, but when you are looking at leveraging your business, having expenses scattered everywhere can lead to a misunderstanding.

Properly grouped, we can start analyzing.  There would be two points of reference to the analysis, average and best case.  Both of which can be found in the prior year’s records.  For the average, I would recommend taking the last 5-7 years of information and reformatting to match the groupings above.  You are looking for a trend and what you will likely find is that throughput has remained fairly steady but labor overhead has crept up.  It isn’t necessarily bad, but it does indicate that more money is being paid out for peoples time but the company is not getting much in return.

The comparison to best case can be a real eye opener though.  Here you find the year where there was the most profit and then compare where you are today with the overhead structure in place when the company made vast profits.  In almost all cases, you will find that the company increased spending across the board relative to that maximum profit year.

So, instead of giving a bonus to the employees and management, the company raised base compensation.  The company went from a 50,000 sf facility to 100,000.  When you study this great year you start realizing that perhaps it was luck and you were betting it would continue – only to find out it didn’t.

GAAP statements have their purpose.  But managing to GAAP can be dangerous to the bottom-line.  It is all too easy to want to capitalize everything into your inventory but that means that today’s costs are probably being buried and will be recovered in a later year.  But in the meantime, your costs are possibly growing out of control which is impacting your current cash flow picture and may even hurt you in the future if you have to reduce prices to be competitive.

Consider using the Throughput model for evaluating your internal financial statements.  I think you will be surprised at how much information it can provide you to help you make better business decisions.

If you would like more information or would like to discuss how effective analysis can help you understand your operations and profitability, feel free to contact mecontact me anytime.  I am here to help.

 

Financial Audit or Control Audit

We are often asked by boards if we believe that the management company’s processes are effective.  The answer is, we have no way of knowing as we are conducting an audit of the financial statements, not an audit of the managers’ internal control system.  To which the response is typically a look of bewilderment as most board members don’t understand the difference.

An audit of the financial statement does require the auditor to understand the internal control structure put in place by management so we can plan and perform the audit.  But what typically happens is that the auditor says, “That’s great, but we are going to assume management doesn’t follow it and plan our audit as though the system doesn’t work.”

Given the size and simplicity of the transactions in the typical association, it is faster and more effective to avoid testing the internal control system to ensure it works.  Take accounts payable; walking a single transaction through the entire control system and documenting the steps would take about an hour.  In order to rely upon the system to ensure it leads to the correct recording and reporting of the transaction we would have to test several dozen.  But, since this is a financial audit and we are concerned with ensuring that vendor invoices are reported to the correct period, we can simply review the individually significant invoices reported in the subsequent period to determine the period in which it was incurred and recorded.  We can go through the 4 or 5 invoices in about 10 minutes.

Since we didn’t rely upon the control system to ensure the invoice was recorded correctly, we completed the procedure faster and determined the results just as effectively as though we had relied upon it.  If we find invoices in the subsequent period (typically January) that should have been recorded in the prior period, we propose a journal entry.  The internal control system might have worked but we can’t say that, even if we didn’t find an invoice posted to the wrong period.

We understand that boards are concerned with the effectiveness of the internal control system and agree that it is important.  But the individual board does not want to engage an auditor to test the management company’s system.  Boards should require their management company to have a SOC audit.

A SOC, or Service Organization Control, audit is performed by an auditor on the service provider: In this case the management company.  The SOC audit ensures the appropriate controls are in place and function as required.  While there are different levels of SOC audit, the end result is the same – reporting on the effectiveness of the providers internal control system.

Frankly, state law should require a management company to have a SOC audit in addition to requiring the association to have a financial audit.  Associations which outsource the receipt and payment of funds need to know that the company they use has the right systems in place and those systems work.  The annual financial audit is not designed to offer an assurance that this is the case.

We realize that a SOC audit could be expensive.  To be honest, it might not even substantially reduce the cost of the association’s financial audit; although I think there would be some cost savings.   If a manager could produce a SOC audit which stated that the controls were in place and effective, we could probably drop our audit charge by 10-20 percent.  But beyond the potential savings you would have a strong marketing tool.

The feedback we have received is that an association board would rather have a report which says that the internal control system is in place and works.  We would like to offer this to a board but this type of report is not cost effective at the association level. But it could be at the management company level.  And it is quite possible that having a SOC audit report can help you land new clients – since everything else being equal, having a documented and tested internal control system is much more important to boards than knowing their financial statements are prepared according to GAAP.

Something to think about.

Improving the odds

Some days, it is challenging to write on topic.  For instance, today for this blog, I am on topic number 4.  And frankly, number 4 is just wing it.  So many things to discuss and I am not quite certain how to frame the issues or put them in context.

We had several meetings last week, not the least of which was the meeting to discuss a private placement strategic plan.  That did not go quite as well as I would hope.  The concern is valid – I mean, the plan calls for changing how certain software is licensed.  It models out but we all know models only go so far.  To change direction will cost a ton in marketing dollars and face resistance from the current marketplace who do not want a shift in power.

The shift will happen; it is whether this group wants to be the driver.  Actually, that isn’t it, they want to be, but the hard reality is that it takes a lot of resources to upset the current way of doing business.  With no guarantee of success.

Not that there is any guarantee of success by following the same model as the other developers in the marketplace.  But that channel is well known and understood.  The licensors will likely be open to incremental change which means that the cost to land a subscriber will be substantially lower than trying to go directly to the consumer.

Sorry, I know this seems somewhat vague but I am working under an NDA so have to be extremely generic.  But the strategic business problem is not unique – it is one faced by every business that decides to sell.

Who is the customer?  And how do you improve your odds of success within a sales and distribution channel?

If you are a handyman service one way to go about this would be to get door hangers and go to a mature neighborhood and hang them.  If you do up 2,000 you will likely end up with 40 new customers.  It won’t happen immediately but that 2% is pretty much cast in stone.  You will spend a bit on advertising but it will likely pay off rather quickly.

But, what if you wanted 10% new customers?

One way to attract more customers would be to offer free yard debris removal, for example.  People love a free deal and chances are, many more would look at your service offering after having a positive experience with you.  You will spend more money than on just advertising alone but, it might pay off.  Again, no guarantee that you will substantially increase above the 2% but there is lots of evidence to support the conclusion you will get above 2% new customers.  Your costs will most certain go up though.

Freebies, giveaways, basic services with the opportunity to license premium services.  These are ways to build trust with your product and service but they are not free to you and oftentimes are quite expensive.  Are they still worth doing?

Perhaps.  And that is what I am facing this week.  Do we redesign the offering to make it compelling to the existing channel?  It is going to be expensive either way – either by spending a ton of money on marketing and advertising to go around the existing purchasing channel or on giving away revenues while we work to entice users through free use.

Part of me, of course, loves the idea of challenging the status quo.  It would be awesome to completely upset the applecart and win this my way.  But, the reality is, it is probably more risky to take that approach than it is to work within the existing channel – even if the existing channel is ripe for challenge.

More on this another day.  Have a great Monday.  If you are ever in the market for a thinking accountant who loves marketing and sales, feel free to contact me for a free consultation.  I am here to be of service to you.

 

GAAP and Projections

I have a new project which I started at the end of last week and which must be ready for discussion by Friday.  I need to pull together a projection for a start-up company, determine its capital requirements, figure out how it should be structured by debt and equity class and then make sure that, given a certain range of possibilities, what the ROI is going to be.

Did I mention this has to be done by Friday?

It is interesting and I have a great model I have developed over the years (in my humble opinion) that helps me focus on the big picture while also making sure I cover the necessary ingredients.  One area I have spent a lot of time updating is the revenue projection side.  First, I am trying to design a revenue model which takes certain assumptions, like lead generation rates through sales close rates and figure out how many sales will happen.  And then from there how many sales support people are needed.  And then…

Sorry, I was going to slide right in and describe why I like modeling this so much but really, today I am writing to discuss how Generally Accepted Accounting Principles (GAAP) are causing a serious headache for me in this projection.

Naturally, my first irritation is the requirement of recognizing stock awards as compensation expense, although I know intuitively that it is something the employees earn.  It is still a challenge because the only “cash” part of this is the amount paid in taxes to gross up the award.  Why am I worried about it?  Because I am thorough and don’t want anyone to say they were “Unaware” that earnings were going to be lower than projected because GAAP treats stock compensation differently than cash models.

The bigger concern is the new GAAP on revenue recognition.  You remember, the one I have blogged about here recognizing that this particular headache was coming.  Well, this projection is impacted by it because, naturally, it is a software company that licenses its program on an annual subscription and offers free, unlimited tech support.  Love it.  Revenue recognition side?  Not so much.

I spent about 6 hours last night after the game (nice to see the Saint’s work hard to try and lose but they managed to survive until next week – not much hope there) updating my assumptions page and working through the model to address control and amortization of revenue.  No, I am still not done but I am getting closer.  What I can tell you is, I don’t like the results.

On a cash basis, this particular start-up should get to positive operating cash flow in about 14 months; right now it takes about 52 months to get to profitability under GAAP.  I am also seeing about $8,000,000 in deferred revenues.  That is, by the way, cash collected from customers that the company cannot claim as revenue.  Yes, it is software and there is no right to refund but still, under the control principles in new GAAP, the revenue is unearned.

How I get there is to make certain assumptions about purchasing patterns and I am making a rather aggressive assumption that most purchases will happen in the first part of the year.  It is more intuition at this stage but my research indicates that this is the likely time when this sort of software is installed – something about New Year resolutions.  So, this is only a few months of overall deferred revenues but it is enough to throw off accounting ROI.

Don’t get me wrong, I think the most important information comes from cash flow.  How quickly cash is burned through, minimum cash levels, marketing expenditures are absolutely essential to figuring out minimum equity positions, acceptable leverage, target interest rates; all that delightful CFO stuff that can make or break a project.   But still, I think that potential investors have a right to know everything about the project they are taking under consideration and GAAP is one of those things – because at the end of the day, if the goal is to go public, then GAAP is the beast to tame.

Like I said, I try to be thorough.

I will keep you updated, probably at the end of the week when I meet with the ownership to review what I have and start changing assumptions and figure out what to add.  They want to start pitching by the end of the month so I have my work cut out for me – because I am doing this on top of everything else I do!

If you are looking for an accountant who might be able to help you get to that next level, either by acting as your controller or CFO (or combination) feel free to contact me and lets schedule a time to talk.  I enjoy being of service to growing entities and risk-takers.ready for discussion

Have a great day.