Most CEOs want CFOs to be business partners. What does being a business partner mean in practice? Let’s get back to basics. One of the main things CEOs want is profit growth and they want CFOs to show them how to achieve it. “Easy,” I hear the CFO say, “profit is just revenue less costs, increase the former and reduce the latter.” Ignoring the few companies who have large revenue growth, the problem is that few executives genuinely understand the causes of cost in a business, less still which costs help to produce which revenues and how to remove those that don’t produce revenue at all. A consequence is often cyclical “slash and burn” cost reduction exercises which damage profitability rather than improving it.
Let me explain some of the issues by taking a couple of examples from a typical fast moving consumer goods (FMCG) profit and loss account.
Enterprise resource planning (ERP) systems are designed to produce gross profit by customer and product: sales invoicing is for a specific customer for specific products and ERP typically calculates product cost using standard costing methodology which allows precise costing of product costs by customer. Scratch the surface, however, and you will find standard costs are nearly always “false precision” hiding a multitude of inefficiencies from decision makers. A couple of examples:
- Manufacturing is increasingly automated with high cost equipment whose costs do not vary with production volume: depreciation, space, and planned maintenance costs probably do vary with the lifetime production quantities but unplanned maintenance, power and labour costs are often caused by batch set up, product change overs, etc. I can remember costing a food sauces manufacturer and the first thing the chap in charge of mixing said was that “cleaning the mixing drum took 30 minutes between most products, but 4 hours if a particular product was made first”. In effect the order of batches made a big difference to batch set up time, but nobody took account of this when planning batches.
- Many factory expenses are included in the standard cost as “factory overhead” including space costs (e.g. rent, business rates, heating), quality control, maintenance, even power. These costs are added to all material and labour costs in arbitrary ways such as machine hours. An analysis will quickly prove that different products and/or production processes consume different proportions of these “overheads” and that the standard cost does not represent the cost of producing a unit of each product at all.
Warehousing and distribution (W&D).
These costs are related to handling products and delivering them to customers of course, so fundamental to understanding “cost to serve,” and yet very few companies have the ability to analyse customer/product profit contribution after W&D costs. There are often hidden costs, for example: a high cost “screamer” process to pick and deliver urgent orders; or standard lower cost delivery charges to clients making small orders needing to be delivered to high cost remote locations. We recently helped a petroleum products company to allocate W&D costs based on the costs caused by each product and customer. Costs varied significantly even for the same product depending on the form of transportation used (e.g. barges, pipeline or road tankers) and this was often driven by the urgency and/or volume of the order. In parallel with a robust “cause and effect” methodology for W&D cost allocation, the account managers’ commission basis was changed from gross margin to customer/product contribution after W&D costs. The company experienced a 200% increase in profits over an 18 month period because the sales team were now motivated to sell to make a real contribution after W&D product/customer driven costs.
A model which shows how costs are “caused” and the “effect” of transaction volumes is vital
I could go on with examples from Advertising, Promotion, Selling costs and even many Finance department costs which are directly caused by product and/or customer related activity, and which should logically be charged against customer/product revenue to arrive at a real product/customer profit contribution. Let me “cut to the chase” instead.
Companies need to:
- Understand the value provided by their business to the customer. Do this by defining the high level processes (e.g. Invest, sell, buy, make, deliver) focusing on the value to the customer. We can call this the Value Chain, subtly different to that described by Porter .
- Establish the key business decisions required for each process in the Value Chain, their time horizons, the management information (MI) required and the “gap” between required and current MI.
- Agree 5-10 sub processes maximum for each process, focusing on the main causes of the process (drivers) and significant process failures or causes of waste.
- Define a few KPIs, say a maximum of 10, that truly cause (drive) profit, known as “lead” indicators and base variable pay rewards on these.
- Build a “cause and effect” model around the Value Chain and the KPIs. This model should be forward looking with best estimates of future driver volumes and costs. A good manager knows what has happened (what it cost) because they approved the expenditure in the first place; what they really need to know is the impact on future profitability.
It is important that this model helps distinguish the “wood from the trees”. In my opinion models should have a maximum of 50 processes, say 10 KPIs, be forward-looking and be structured to support key executive decision. Page after page of cost centre variance analysis doesn’t help these decisions at all.
So what does a CEO really need from the CFO?
A good cause & effect model will support what the CEO needs:
- Pertinent, forward-looking management information which shows which products and customers will make profit contribution and which won’t
- KPIs linked to strategic goals which give an indication of future profitability
- Timely driver-based rolling forecasts
- The capability to run scenarios quickly using new estimates and information
- A reward system linked to the strategic KPIs above and focused on real profit contribution rather than revenues or gross margin
What next? Identify profitability improvements in about 20 days
Here is the premise: business partnership by CFOs is fulfilled largely by demonstrating how profit growth can be achieved. Here is my challenge to CFOs: with an investment of about 20 days in expert profitability analysis we will define the high level processes, up to 50 sub processes, the MI gap, and build a “cause & effect” model as a proof of concept. We are confident that we will identify significant profit contribution improvement opportunities and that you will buy into the MI improvements required to help realise the improvements.
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Steve Benham, Profitability and Cost Management lead at itelligence, has 20 years’ experience implementing profitability and cost management solutions with ALG Software, Business Objects and SAP before becoming a founder of Vantage Performance Solutions, acquired by PwC in 2013, where he was a Director in Consumer & Industrial Products with responsibility for Performance Management.
 Competitive Advantage: Creating and Sustaining Superior Performance (Porter, 1985)
Acknowledgements – my thanks for contributions from:
Lars Herman Lokkeberg, Finance Manager, Orkla Foods Norway