Are your financial statements telling you what you need to know?

Throughout my carrier I have come across various business owners who are successful in growing their business but do not fully understand what drives their company’s profitability.  This problem can occur if a company prepares only consolidated financial statements and does not prepare financial statements for each of its business units.  There may be patterns or other information that are obvious from a business unit standpoint but masked when the company’s financial results are only reviewed on an aggregated basis.

Even if separate statements are prepared, in some companies expenses and sometimes even revenues are not accurately attributed to the correct business unit.  Additionally, many times companywide costs are not absorbed by the individual profit centers, thereby overstating and distorting the business unit’s profitability.  The “trick” is arriving at a balance of reviewing your company’s results at the best level of operational detail enabling sound business decisions to be made without being flooded with non relevant information.

Of course in order to review your financial data by profit center, you have to have an accounting software package that has the necessary functionality to capture income and expenses at this level of detail.  Basic software packages like QuickBooks use “Classes” to track individual business unit financial results.  Using filters, the software can report financial statements by profit center or on a consolidated basis.  QuickBooks also has a customer “Name” field that can be used to further report on departments within a Class or location (expenses only).

Let’s use a multi location retail company to illustrate the various decisions that need to be made to accurately report operating results on an individual location basis.  The good news is the vast majority of transactions are location specific and therefore easy to assign to the correct location.  For some expenses it is less obvious.  Decisions need to be made as to which locations should be charged and if the expense benefits multiple locations, what allocation method should be used to charge a given location.

Sales, returns, cost of goods, and inventory shrinkage, are generally generated from a location’s point of sale (POS) terminals and therefore are location specific. Decisions on how to value inventory need to be made that result in an accurate SKU valuation while at the same time does not require a complicated inventory costing system that adds little operational value.  Below are examples of the types of questions that need to be asked and addressed regarding components of cost of goods and inventory valuation.

-If vendors do not give full credit for customer returns, will the individual stores absorb the charge for the write-off of unsellable inventory?

-Will there be an asset recovery effort to dispose of goods that cannot be sold as new but still retain some value?  How will asset recovery income be allocated back to the stores?

-If inventory is shipped from a central warehouse, how will warehouse costs be allocated?

-Will warehouse inventory shortages be charged to stores fulfilled by the distribution facility?

-The costs of shipping merchandise from a vendor or a centralized warehouse should be included as a component of inventory.  However for some companies, valuing inventory to include these costs maybe administratively burdensome.  Expensing these costs (especially if they immaterial) as incurred with a year-end adjustment may be a reasonable alternative.  If shipping and other merchandise costs are material, not allocating these costs on the SKU level will distort gross profit that may lead to erroneous operational decisions.

Most operating expenses can be directly assigned to an individual location.   Payroll, rent, repair and maintenance, and office supplies are examples of expenses that are straight forward and can easily be assigned to a specific location.  Below are examples of questions that need to be addressed for those expenses whose location assignment or allocation is not obvious.

-Does advertising and marketing expenses benefit all or a group of stores?  If so, how should these costs be allocated?

-Does advertising benefit the current period or multiple periods (as in the case of a catalog)?  If so, how do you determine what percent of the advertising costs are expensed in a particular period?

– On bank statements, are credit card charges detailed by location so costs can be charged to specific stores?

-Are current workers compensation rates maintained by payroll class and allocated to the appropriate stores and administrative departments?  How are stores with good or bad accident experience rewarded or punished?

-How are insurance cost including general liability, property, and crime insurance allocated?

-Is there a plan to allocate corporate overhead to the various profit centers?

-Does the total of the operating results of the individual business units equal consolidated operating results?

Making the decisions on how to allocate the above expenses is not overly complicated but it does require the input of a person who understands the business.  Settling up and maintaining the allocations require a knowledgeable financial professional who understand correct financial reporting.  A balance of using the appropriate amount of automation without creating an “accounting system” that is difficult and costly to maintain is the key to accomplishing the task of efficient cost allocations.

The bottom line is preparing financial statements by business unit and performing expense allocations is the key to analyzing and understanding your business.  Maintaining financial statements by business unit gives you financial benchmarks enabling locations to be compared and outlying trends to be identified.  When these financial basics are not followed, even a business owner who lives and breathes his business may miss positive or negative trends and may not be optimizing the profitability of his company.

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