Rooting Out the Foundation of the Wrong Management System

n my article last week discussing the need for each company to have its own Business System built around the unique, significant drivers of success, I pointed out the weakness of using the monthly Profit & Loss statement (also referred to as the Income Statement or the Operating Statement) as the critical measure of success.? In both the comments on the article and in a few direct messages I have been asked to elaborate on that – to explain just what goes wrong in using the Income Statement to drive management’s assessment of the performance of the company.?

From the start I need to acknowledge that there is no way to do justice to the topic in an article.? Accounting is complicated and laden with regulations.? If someone really wants to affect the outcome of a business, they need to go through the excruciating effort to really learn it.? At best I can point out some of the big issues, but the fact is that the business exists to make money, and no one can succeed in any aspect of a business unless they understand just how finance and accounting work.? You need to take a course in Intermediate Accounting, or at least agonize through the textbook if you want to make a serious contribution to business.? You’ll find the real reasons initiatives such as Lean or Total Quality generally fail, and then you can work to overcome the gritty obstacles, rather than just write the failure off to ‘poor leadership’.?

A very simplified view of the P&L looks something like this:?

There are apt to be a few more lines of detail around these major categories, but this is the essence of it.? It is important to know that the Direct Material, Direct Labor and Overhead are not the actual amounts spent on those things during the month.? Rather, they are the amounts spent on the things that were sold whenever they were made – could be last month … could be last year.? This is called the ’Matching Principle’; matching expenses with the revenues they were expended to produce.? It is also important to know that, while Direct Materials and Direct Labor are fairly straightforward, the Overhead line is an absolute can of worms.? Probably more accurate to describe it as Pandora’s Box.?

Problem #1 is timing.? The company is an ongoing operation and slicing this continuum into an arbitrary calendar month skews everything.? If you negotiate a price decrease with a supplier, and the supplier has a one month lead time, and you have a month’s worth of inventory of the item, that price change will not be felt for two months; and then it will impact production that goes into finished goods inventory to come out whenever the goods are actually sold (as described previously).? Same with changes in labor efficiency; and same with supplier price increases.? So what you are seeing in the monthly P&L is actually a mishmash of ups and downs in costs from previous months (or years) and has little or nothing to do with improvements or problems in the month being ‘measured’ in the P&L.?

Further, much of what is being done in the administrative areas – Sales Department, Engineering, IT, etc. Is project based and is not going to impact the business until some time in the future – but you are seeing the results of projects completed some unknown time in the past.? Likewise, in many of the production overheads, machine improvements and maintenance, training the purchasing people or holding kaizen events with production folks is going to have an impact in future months.? Finally, the Sales line is not necessarily what was sold this month – it is what was shipped this month.?

Bottom line – when you look at a monthly P&L it really has very little to do with the month in question.? Thinking that it is a valid measure of how the company did in the month is a grave mistake.?

Problem #2 is that the overhead line is a collection of fixed and variable expenses.? For that matter, Direct Labor is more fixed than variable most of the time. In reality, just about everything except the material expenses are fixed over the course of the next few weeks; and just about everything is variable over the course of the next few years.? As factories become more and more efficient and more automated, overhead dwarfs direct labor.? In the example overhead is 400% of labor, but in many companies, it is 600% or even 800%.? So, the biggest driver is not labor efficiency, it is this dumping ground of everything from the salary of the production manager to rags used in the shop to clean machines and everything in between.? It kind of moves up or down with volume, but mostly doesn’t.? The margin at the core of the P&L is mostly a function of sales volumes.? And as previously discussed, it is not reflective of the spending in the month anyway.? It is the spending on all of this in whatever months the goods sold were produced.?

It is little wonder that, with this collection of fixed and variable, significant and insignificant expenses from some collection of prior time periods staring at them in the overhead line, management tends to gloss over it and focus on the direct labor line.? As one executive told me, “We do that because direct labor is a lot easier to count.”?

Problem #3 is the concept of Over and Under Absorption of Overheads.? This is the single biggest obstacle to ideas such as Lean or the Theory of Constraints.? It is what causes reducing inventory to reflect negatively on profits and increasing inventory to reflect positively.? When a company uses standard costing (as most that are not purely custom builders do), the overhead rate is calculated annually as a percentage of direct labor – in my example, 400%.? When goods are produced, the expenses to make them go into inventory – even if they are shipped right away; they pass into and out of inventory and hit the P&L when shipped.? The expense that goes into inventory is the direct labor, plus the set overhead percentage, rather than the actual relationship of overhead to labor.? Got it?? Read it again if not because it is critical.?

To fully understand this critical issue, it is important to know that the P&L and the Balance Sheet are two separate but interconnected financial statements.? The P&L is a statement of how profitable (or not0 the company is.? The Balance Sheet is a statement of the assets and debts of the business, along with how much equity the owners have.? Inventory is on the balance sheet.? When goods are produced, they are in inventory, and do not move onto the Profit and Loss statement until they are sold.? There is no profit or loss impact from making things until someone buys them.?

So, if the factory produces more – by becoming more efficient, working overtime, adding direct labor people and so forth – but the fixed portion of the overhead does not increase linearly – the amount of overhead moved from expenses into inventory is greater than the amount actually spent on overheads.? This is called ‘Over Absorption’.? The company has ‘absorbed’ more overhead expenses into inventory than it actually spent on overhead expenses.? This appears on the P&L, usually buried in the overhead figure, as an offset to the overhead expenses described previously.? When a company steadily increases inventory it just about always appears to be more profitable than it really is.? But when the time comes to reduce inventory – either because the company is running out of cash to pay for the inventory, or because some bright person is extolling the virtues of operating like Toyota’ the opposite takes place.? production drops in order to sell off the excess inventory, and the overhead rate applied to direct labor does not cover the actual overhead expenses, so overhead it ‘under absorbed’, causing an add on to the overhead expenses in the P&L.? The company appears to be less profitable than it actually is.?

The gist of the over and under absorption issue is that, when the company goes on a course of manufactured inventory (WIP or finished goods) reduction, it will be less profitable until inventory reaches the lower level. This is artificial, to be sure, but it is how the P&L will reflect things. Of course, the reason the company will be artificially less profitable is because it was artificially more profitable while the inventory was being increased. Basically, when you reduce inventory the pigeons from the past will be coming home to roost. But this is real, and explaining the lack of profitability to stockholders and bankers can be difficult, if for no other erason that having to explain why management didn’t tell them about the profits from previous years not really being as good as the P&L indicated.?

In closing, it should be clearly understood that these problems with attempting to use the monthly P&L as the focal point of management performance are not there because the accounting folks are unaware of them. They exist because they are the law. These financial statements are the way they are – warts and all - because they comply with Generally Accepted Accounting Principles (GAAP), established by the Financial Accounting Standards Board. Following these principles is required by the IRS and the SEC, and most banks demand them as well. All of this convolution is not optional. What is optional, however, is using the P&L to measure and manage the business. GAAP was created to make things clear and consistent for investors and regulators, but nowhere does it say that management must use them to run the business. A critical element of creating a company’s business system is to create it own financial metrics and reports that accurately track and measure the things truly driving the business. Those reports must bridge to GAAP in some back-room accounting exercise, but they must be uniquely tailored to provide focus on what matters.?