When a finance team doesn’t know what is really happening in a business, its reporting is as much fantasy as it is fact, posing an incalculable level of risk to the business, its owners, and investors. Mutual understanding and trust between the operations and finance teams is of fundamental importance, as the following two stories I hope will make clear.
The first story is about a client of mine with a business that runs some of the largest fresh-food supermarkets in the region. A second-generation entrepreneur who has returned from the US, she has big ambitions for the family business that she now runs. While scrutinising its financial reports, she found that one of the stores buys raw hog for promotional purposes.
The cost accounting method she had in mind to use for this was straightforward: record the procurement price as the cost – say, 15 yuan per 500 grams. As the pork is a promotional item, it would go on sale at 12 yuan per 500 grams, giving an expected margin of (12-15)/15 = -20%. However, when my client looked at the monthly margin analysis of fresh goods, she was surprised to discover that the business’s internal operations system generated a very different figure for expected margin.
All the client wanted was a true financial reflection of what was happening in the business
The pork wasn’t accounted for at a consistent price but varied according to cut (loin, ham, rib, etc) and a standard cost allocation rate automatically assigned – a parameter determined according to the split ratio of each part and the selling price ratio of different parts. Ignore the complex mathematical logic here, please, and just focus on the story.
In theory, this parameter should have been adjusted on the basis of carefully cutting and measuring the different proportions of the different parts of each pig procured. However, because of the complexity involved in these calculations, the store’s staff simply applied the same cost allocation rate universally. As some of the pork cuts cost less than this figure to procure, the overall cost was actually lower than the promotion price and therefore delivering a positive gross margin for the business. However, my client showed little appreciation for this upside – all she wanted was a true and fair reflection of what was happening in the financial results.
What can we learn from this story? That if a business deviates from the truth, management won’t have a clear picture of its financial future.
My second story concerns another of my clients, a business that was preparing for a Nasdaq listing. Although it is a manufacturing business, its cost accounting isn’t difficult as its manufacturing processes don’t involve much difficulty. This should have made it an ideal client, yet during the course of the three years the project ran, our firm lost virtually the entire team working on the account. Some key members left because they could no longer tolerate it, and each year we had to onboard newcomers and rapidly get them up to speed to keep the project going.
We had to act like Sherlock Holmes to deduce the plausibility of the numbers
The reason for our eye-watering staff churn was that the client’s staff – including the procurement managers, sales team and even the warehouse officers – were disorganised and irresponsible about daily record keeping. It led to serious mistrust, with finance and accounting staff repeatedly having to reject the operational data submitted. As the business’s financial adviser, we sometimes had to act like Sherlock Holmes to deduce how plausible the numbers being supplied were. The mistrust reached such a level that the finance and operational teams could not even communicate with each other directly.
This second story makes clear just how much of a blessing it is for a company to have a good and trusting relationship between its operational and finance teams.
The key three
What I want to express through these two stories is really very simple, and can be summed up in the following three points.
First, if the finance and operations teams of a company do not get along, then the quality of its financial data will suffer.
Second, the scenario described in the first point can be improved by the company’s finance leaders being more proactive and getting the operations team to make changes and act in the best interests of the company.
Third, if those responsible for the company’s supply chain, sales and inventory management systems are passive or deliberately malicious, then the action taken in the second point will be utterly in vain.