Misclassified expenses and un-segregated revenue streams result in poor financial reports that can halt a company’s progress in its tracks
It’s hard to make informed decisions about a company’s future based on poorly- structured financial reports. Yet many small to mid-sized companies rely on reports beset with serious problems. No wonder these firms aren’t growing.
One common problem with financial reports is that the reporting system is capturing a variety of product or service revenue streams in one account. Without those streams being segregated, the CEO doesn’t know what areas of the business are doing the best and worst jobs of generating critical revenues.
Another all-too-frequent issue is misclassification of expense categories into overhead, rather than cost of goods sold. As a result, companies get a read on gross profit and gross margin that is simply not accurate.
For example, if a company wants to launch a new marketing program, officers will attempt to determine how many additional sales the program will have to generate to justify its cost. If they don’t have an accurate read on gross margin, they will make a decision based on skewed sales numbers. That could result in the marketing program being over or under-funded.
These financial reporting issues are very prevalent, and are present in four out of every five companies I counsel. The problems exist for two reasons.
First, company officials don’t know how to distinguish between direct costs to produce sales and those line items that should go into the category called “overhead.” Second, despite their desire to place all transactions in the right categories, the companies do a poor job of coding, or classifying, transactions.
Unless the company addresses these reporting issues, the CEO will face the same problems month in and month out.
He or she must take a stance and rectify the reporting problems. If the CEO is smart, he’s going to say, “We have a direct cost of generating these sales dollars in overhead. They should be in cost of goods sold.”
The result of poor financial reporting is wasted time. The company wastes time pulling financial statements together, and again wastes time being forced to pull information out of the accounting system into a format that can be used. Precious hours and days that could be used to concentrate on building profitable sales growth go down the drain. In this case, wasted time truly is wasted money.
In the preceding paragraphs, I’ve discussed the surprising prevalence of poor financial reporting, and the negative outcomes that result. In my next blog, I will address steps chief executive officers can take to meet the problem head on.
Now is the time to get started on financial projections for the coming year, and these are the fail-safe steps that will help you do just that.
Remember the story I told in my last blog, the one about the CEO who doubled his sales as a result of projections? That CEO was focused on revenue streams. That’s where all projections have to start. You must determine what your revenue streams will be, either by service or product line.
Total revenue or total sales over the course of a year don’t just happen. Three ingredients go into generating those revenues. The first is the number of customers your company has. The second is the transaction frequency, or how often your company is expected to do business over the next year with each of those customers. And the third, of course, is the average transaction value. If you had a hundred customers and did business with each 10 times a year, with the average transaction $1,000, you’d have sales for the year of one million.
The other thing to focus upon is the velocity of these sales transactions. Velocity is likely to move up and down over the year, and you’ll have months or seasons where velocity is comparatively higher than at other times. Your company won’t record the same level of sales each month, so give thought to how that will vary.
The next step in the approach is to establish the gross margins of each revenue stream. The gross margin is a very, very important number in your financial statement, and a topic into which we’ll delve more deeply in a future newsletter.
In order to make informed future financial decisions, you must know the gross margin. That’s a combination of looking at the direct costs to produce each revenue stream, and adjusting your sales prices as needed to hit your targets.
Let’s define direct costs, as opposed to overhead costs. A direct cost is any expense related to generating that sale and delivering it to the customer, while overhead costs are not directly related to that sale.
The final step is studying overhead needed to generate revenue streams. Most businesses, I think, let overhead be where it is, realizing it will cost so much to generate those revenues. Some CEOs will take it a step further, saying, “No, let’s allocate a portion of overhead to each of those revenue streams.”
The result of projections is peace of mind for business owners, because they’ve laid out a plan. If you’d like a plan for the year ahead, get in touch with me.
I offer a 100 percent guarantee on my work. I take on only clients I can help. Call me and let’s talk about your business. My phone number is 630-269-7646.