In fact, we small business owners are so smart that we actually figure out other ways of tracking our businesses just so that we can make sense of our cash flows and survive an extremely competitive environment. We will micro manage by product, class of service, or sales category. We’ll track sales by week, month, or quarter; we’ll track cash flows, expenses and anything else that give us a clue as to the health of our companies; all without the aid of regular financial statements. So why, then, is the very tool that seems so universally sought as the standard benchmark by big business, stockholders, bankers, and all financial institutions so important to them and so totally useless to us?
It’s because they are made by accountants for accountants. It’s just like lawyers making our laws. It’s designed to keep them in business and keep us guessing! And it is all due to the format which was somehow deemed to adhere to a standard which they figured was great for quickly analyzing a business’s credit worthiness; the insidious generally accepted accounting principles (GAAP). Statements so formatted are typically for external use (read that for your bank or lending institution) and gives them some assurance that the reports have been prepared in accordance with a common set of ground rules. That’s fine for them but does nothing for me.
So why are they confusing, hard to read, or just not in sync with our needs? The answer is that they use absorption costing. Simply put, that means that some fixed overhead expenses are allocated directly to all products, both those that are sold and those still in inventory. The result is that an expense can be held as an asset until it is sold. You may have already paid that expense, but it won’t show up on your statements as an expense until the allocated inventory has been sold. By now you’re probably thinking “no wonder these reports were confusing, they’re nuts”!
Is there a solution? You bet there is! Keep in mind that accountants are all about compliance. They consider their work to be all about documenting a company’s financial records for external users such as banks, tax agencies, and the like. They often figure that by getting the tax filings done, statements prepared, and everything nicely balanced their job is done and all that is left is to bill the client. If that is true in your case, then you are letting them off the hook too easily. You should also be asking for some reports that would actually make sense in helping run your business. Those same statements your accountant has prepared can often be easily reformatted into something just a little more intuitive using the Contribution Approach. Simply stated, this avoids allocating fixed overheads to unsold inventories and actually deals with period costs as they occur. Chances are that your accountant already has the data needed to re-issue company financial statements using variable costing instead of absorption costing. For many companies all you need do is request those statements in addition to those already issued. Statements showing contribution margin and realizing fixed period costs as they occur not only make more intuitive sense, they actually give you information which you can use in the decision making process. Gee, what a concept; a financial statement that you can use!
At this point I’ll add the standard disclaimer that I’m not an accountant and I’m not attempting to give anyone financial advice. What I am doing, though, is urging you to speak with your accountant and ask them if they are capable of creating financial statements which are more suitable for your internal use. There are a number of different tools one can use to measure and improve one’s performance. Variable Costing, Cost Volume Profit (CVP) Analysis, Theory of Constraints (TOC), Lean Six Sigma, and other tools may or may not be appropriate depending on your particular circumstances. Being able to measure your business’s performance is one of the keys needed to unlock the doorway to improvement. Creating reliable metrics requires accurate data that is usable. Don’t settle for statements that you only pass along to placate others. Insist on statements you can use in your every day decisions!
Bob Banasik is a senior business advisor and an accredited associate of the Institute for Independent Business, and can be reached at bob@bestbusinessassociates.com .
© 2009 Best Business Associates LLC
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