Real Numbers

by Orest J Fiume

  In the past, a Lantech accountant then dutifully entered this in the general ledger. She began on day two of the closing window and took about a day to complete her work, once numbers were reconfigured (allocating pay between two departments, etc). Jean investigated and asked: why not enter the summaries into the general ledger as soon as the information became available? That would remove payroll from the closing window altogether. Later, a team discovered that the payroll service could give Lantech an electronic version of the summaries, eliminating the need for re-entry. Now they get electronic files each week. A manual step in the process has been eliminated, and a task is removed from the closing window, bringing Lantech closer to real-time information.

  Receiving and applying information weekly would have been such a huge task in a manual process that Jean would never have committed the time. But with all the waste eliminated in a hands-off process, she can get information that is basically free of effort —which is very lean. Accountants can now see payroll throughout the month, and are alerted to any problems or trends that can be addressed as they happen. It is much easier to diagnose problems as they happen rather than waiting until the end of a period where you wade through a sea of transactions, looking for an answer.

  How about more complex issues? Warranty Reserves, for instance, is one of those tricky accounts that can consume vast amounts of time and add very little in terms of increased understanding of the company and product performance. Why is it so different than any other cost? It seems simple at first blush. There is a customer who has a product that breaks. The customer knows the product has, say, a one-year parts warranty. So, he contacts the manufacturer, who agrees to replace or repair the item. The maker spends some money doing this, of course. Why would the tracking of these numbers become so difficult?

  A number of other areas share these complexities. There is not one solution to reducing the time and effort it takes to deal with the more complex accounts. The following describes a wide array of issues we discovered when dealing with warranties and the approaches we used to become lean. Eventually, after trying various techniques, we realized that the reserve —like other complex issues —is really just a guess of a good estimate.

  Let’s go back to the principle of Matching, which says that any significant cost must be included as an expense as soon as the cost is realized. So when a product covered by warranty is shipped and you know, based on prior experience, this product or a similar type of product has a measurable failure rate, then you must show the projected warranty expense for that item when it is shipped. Just by shipping it, you have accepted a reasonable expectation that warranty costs will be incurred in future. The tricky part is figuring out how much to expense.

  The solution to booking warranty can vary depending on how large (or material) the warranty cost. Lantech was originally spending a lot of time trying to estimate this number and it was still just a guess because nobody knows which product will break, or what it will cost to fix the problem, until it actually happens.

  Here are a couple of methods to try as you come to grips with warranty. By product line, define the actual warranty costs as a percentage of current sales. Perhaps look at your last year’s historical results, but do not include your accrued costs, only the real costs. Let’s call this the Warranty Percentage. Then, to calculate a simple accrual for the expected costs related to the products you ship this month, multiply that percentage by the current month’s actual sales. This can be done inside the closing window. Or, to get it out of the closing window, take the total sales until the next-to-last day of the month and add in an estimate for the last day’s sales; multiply that times the Warranty Percentage. Or if your information system allows for automated allocations, put the Warranty Percentage in and then let the warranty accrual be calculated automatically as part of the closing.

  Over time, the percentage might change. Check it each quarter for fluctuations. If it does, try changing the percentage more or less frequently. Lantech found the percentage changed very slowly with a three-year warranty, so now they check every six months but only change it once a year.

  Or perhaps sales are growing very fast and there is a worry that the historical relationship of warranty cost to current sales is inadequate. Then a different kind of relationship might be better. If the key message you hear is that figuring out which type of relationship to use is too complex, let the final application of that method be simple. Perhaps you have 100 products. You might do some complex analysis to discover the good rates to estimate cost. In the end, however, you might find there are only two levels of cost: high warranty costs that affect 10 products, and the lower warranties that the other 90 products fall into. In this case, we only need to use two simple rates to book the cost and we can do these calculations outside of the closing window.

  Another alternative, if this cost is very significant for a company (remember materiality), might be to use a simple method for the first two months of a quarter and then get more precise after the third month. Try to find a simple method to make this guess, while ensuring that everyone is comfortable with the accuracy, conservatism and matching. If an acceptable reserve can be established using simplified methods, accountants can devote their time to something that adds value, like participating on a cross-functional team to determine the root causes of warranty claims in order to eliminate them. By reducing warranty claims to the point where they are immaterial, the discussion of warranty reserves is moot.

  This example should give you an idea of how you might deal with other complex issues, such as depletion, software development capitalization, goodwill amortization and credit reserves.

  On the path to a more lean accounting, we know that the time just after closing is a great opportunity to pull a team together and take a hard look at transactions. This is a time to reiterate the vision that everyone is pulling toward, to talk about what changes have been made, how those changes fit into the big picture and how important it is to have information quickly. This is not, of course, the time to use scare tactics or imply that people can be let go. Instead, highlight the carrot: point out the more interesting projects that can be accomplished by accountants who are no longer chasing transactions.

  Identify one person to pull together information each month, including a list of all the entries made after the end of the month. List the source of the entry, either a person or a system, a short description of the entry, and the dollar amount. Leave a big space for notes after each entry. The designated person should count the number of items and keep a trend chart, updated each month with the number of entries. Be careful not to immediately label activities on this chart as value-added or non-value-added. It can be demeaning to a team member to hear an entry is non-value added. Instead, let the person who made the entry be the one to identify its value. Show that the target is to reduce the number of entries and the number of days it takes to close the books.

  Now ask each team member to look over the list. Set parameters for what should be considered important, and then ask each person to target one error item, find out why it happened and how it can be corrected. To avoid conflict, team members should chose errors that spring from their own processes. Then each person can take an entry in her own sphere of responsibility and see if the process can be reduced by one day. Target the entries completed on the last day of close and try to reduce those by at least one day.

  For even more excitement, try a breakthrough improvement. Here, we set aside time to focus on reducing the days it takes to do the job by half or more. For instance, Lantech found that one of the longest items was inventory obsolescence. Before becoming lean, inventory obsolescence was a significant expense and accounting calculated each element in the obsolescence reserve. In Lantech’s case, the major elements were shipments by product line, write-offs from the obsolescence reserve, and the current level of inventory. For each item, a team looked to see when the data was available. For the longest item, they asked why it was so late and so on,
until the team truly understood why it took so long to calculate the obsolescence reserve. Managers decided that the activity was not needed every month and could simply be checked twice a year because it changed in very small amounts. Next, a team found that the obsolescence expenses kept changing, largely because there were so many corrections for prior-month errors. Those errors were not recorded as obsolescence, but obviously should have been. At the same time, the team noticed that the correcting entries were very small and did not affect the total very much —at least not as a percentage of the total expenses. Also, the inventory number was not final until the fourth day.

  The real breakthrough happened when the team realized they were trying to be precise in calculating a number that was completely unknown. An obsolescence reserve is just a guess at the dollar expense that will be incurred in future for inventory that is held today. This was the key to unlocking the mystery. Once the guesswork realization hit, Jean and her team decided to use the initial inventory number to calculate what the reserve should be in the future and use the amount of expenses from the general ledger to update the calculation. This turned out to be nearly the same number as it would have been, had they spent the time to book all the corrections and do the fine-tuning. Now, they use the same percentage each month to book the accrual and, at the end of the quarter, they review the reserve to see if it looks reasonable and check the percentage more formally. As Lantech became even leaner, producing only what the customers wanted, when it was wanted, obsolescence became a non-issue.

  A company once asked Jean to look at the efforts they were making using kaizen techniques to reduce the complexity of the accounting activity. It was a complex operation because they not only did accounting for their organization but also for some of their distributors. There was lots of opportunity for improvement.

  Leaders organized a kaizen and had team members map their current process. In looking over the process flow charts, Jean noticed that it took three days to calculate the bad debt reserve. The bad debt reserve has many of the same characteristics as the warranty reserve —it is a cost known only in the future, but must be recorded as an expense when the product is shipped out the door. Jean’s antennae went up when she saw that it took three days to calculate a guess.

  Jean discovered that it had not previously taken three days; in fact, it used to be very quick. But when auditors had reviewed the books, they suggested that the reserves were too low for the actual amount of bad debt activity. In accounting terms, it was not conservative enough. Still, the calculation took three days, which seemed excessive. To solve the problem of low reserves, the company had added some calculations to increase the reserve level —which, in their view, added sophistication to the calculation. In reality, they really just added complexity. The auditors did not say the reserve calculation was too simple, they just said the reserve wasn’t enough. To illustrate this point, two mathematical calculations:

  3 x 4 = 12

  (3 x 10 x 2) / 5 = 12

  The second calculation is more complex but yields the same result. Three multiplied by four is 12. This calculation is no more complex but adds more quantity. Same thing as the bad debt experience. This company confused complexity for conservatism.

  So here we are. You have eliminated most of the month-end transactions. Your systems are integrated; you can close books on a dime. The next big question is, do you need to close the books at all? This is not a question that can be answered glibly. But the question requires serious thought because it targets more closely the value of creating financial reports at all.

  There are some very good reasons to close the books. Monthly financial statements help you keep tabs on whether plans are being met and allow you to monitor for any new information about where the business is moving. There may even be enough feedback for a celebration. Whatever the answer, it needs to fit your business. If you find the value of closing the books is small, perhaps running a daily financial is close enough. Maybe it only makes sense to close the books every quarter. The goal is to set aside the rules and traditions that no longer make sense and find what is right for your business.

  8

  Budgeting and Capital Planning

  In many companies, budget season begins months in advance of the fiscal year’s end and has all the trappings of a Senate confirmation. Executives use the process to jockey for position, to gauge status in the company and, in some cases, to actually get projects funded.

  Meanwhile, the CFO dons the robes of a frantic St. Peter, seeming to judge the worthiness of all who pass before her even while scrambling to gather all possibly useful financial information and make it balanced and coherent. Capital requests fly in from all corners, each request padded against the arbitrary percentage cuts that people expect from accounting and upper management. A CFO can make enemies without even trying in budget season.

  We could discuss budget reform here, but it is more useful to stop for a moment and ask, do we really need a budget at all?

  The question may seem like heresy to those who know that the budget, along with the year-end closing of the books, is one of the major deliverables required of the accounting department each year. But if we are to get to the root of the accounting function, we must question our traditions and assumptions.

  For some companies, the budget process provides structure to decision-making and an in-depth annual review. The trap that many companies fall into, however, is creating a single budget process that is followed year after year, whether each step is necessary for the current business objectives or not.

  A few reasons —not all good —to create a budget:

  1. To create common operating and financial assumptions for the coming year and to track results, allowing leaders to quickly respond and re-plan if the results veer off track

  2. To provide a forum for selecting high-impact projects, and deselecting those which are not

  3. To give management a benchmark in compensation issues

  4. To meet possible lender requirement, and can ensure the business remains within the bank’s covenants

  5. To provide a shorthand method for communicating what decisions have been made: where new people will be added, how much advertising to do, pricing for a new product, etc.

  6. To allow management to assess whether a growth plan outstrips the organization’s ability to generate cash, particularly in low-profit margin businesses

  7. To focus the organization on specific objectives, such as increasing the profit margin or increasing revenue growth, or improving customer communication

  At its best and most useful, a budget is a common illustration of the business —its goals, realities and landmarks —that everyone can refer to during the year, to check the status of individual units against overall assumptions and targets. A budget can be especially important in organizations that are large and far-flung, where leaders don’t check in with each other consistently. As the year goes on, individuals within any organization confront unique problems and make decisions independent of the group. A budget can offer those managers a landmark on the horizon to ensure they remain on the same path as the rest of the company. A budget can also offer a quick big picture. Once all the columns are in place, it’s usually easy to see if all those start-up projects will make the company cash poor by the second quarter.

  Bad reasons to keep a budget include tradition —otherwise known as a being in a rut —and creating something only to report against in the financial statements. Executives who create budgets solely to satisfy a top-down budget mandate eventually find themselves confronting numbers without reason. Those companies that tie personal compensation of executives to the budget set up a sometimes-destructive tension, where managers make decisions based on personal instead of business motivations.

  “I don’t think budgets are worth a hill of beans, personally,” says Cold Spring Granite’s CFO, Greg Flint. “They’re based on guesswork and politics. Every year, you see financial guys negotiating for a tough budge
t and operations guys negotiating for an easy budget so they can look good. In the end, the financial guys own the budget. Operations can say, ‘It’s not my fault. You gave me a bad budget.’ So, we got rid of budgets.

  “What we do now is benchmark against this month last year and tell every department they must improve. If sales brought in $1 million last July with five people on staff, for instance, we might expect them to bring in $1.1 million this year with the same five people. Their goals are purely based on improvement, and we do not insist on arbitrary percentages for improvement.”

  When evaluating if and what type of budget an organization might need, one of the most useful tools for executives is the Five Whys. The name is partly intuitive, but the Five Whys does not stop with the fifth iteration of why? Instead, the Five Whys indicate a team’s continued search for hidden facts and the true answer. As the team drills down into the true purpose of the budget —for that organization, for that year —new answers will become clear.

  If the real reason for a budget is to get everyone on the same page, then the budget process needs to include plenty of time for team meetings and consensus building. If the budget is for the bank alone, on the other hand, there is little reason to spend significant time and resources creating the document. A smart CFO probably begins this process by asking bank officers what key elements they need from a budget —cash flow for example —and then focuses on obtaining this information.