Part 5 of the Financial Management series will show how a disciplined approach to financial management can save time and improve margins.What is a system?
A system contains the following four items:
- Monitoring reports
- Feedback loop
Each of the four components can work individually; however, it takes all four working in conjunction to make a system.
There is one overriding principal for making any system work: discipline. Without discipline, systems eventually crash.Creating a financial management system
A successful financial management system is broken into two parts:
- The accounting system. Without a strong accounting system, the information may not be timely or accurate. (see Financial Management — Part 1, Jan., '05)
- Internal and external benchmarks. Internal benchmarks include operating budget, days under construction, warranty ratios, job cost variances, etc. (see Financial Management Part — 3 and 4, April and May '05, respectively) External benchmarks are those found throughout the industry. External benchmarks can include, but are not limited to, targeted gross margins, expense percentages, average number of homes a superintendent can produce per year, etc. The combination of finely tuned internal and external benchmarks allows the maximum performance for parts three and four of the system: monitoring reports and the feedback loop.
There are several monitoring reports involved in financial management; however, the three most important are:
- Income statement
- Balance sheet
- Cash flow statement
This installment of the Financial Management series will deal primarily with the income statement as we analyze Smith Builder's performance to date.Drilling down
There is no mystery to becoming a good financial manager. All you need to do is put on your detective's hat and follow the clues. The good news is if your accounting system is set up properly, the clues are easy to see.
Start with the income statement and compare budget to actual results. Where is there a difference? When the difference is significant, follow the trail to the detail. Once in the detail, it's fairly easy to spot what went wrong.
The next step is to close the loop. Take the time to make a change to a procedure or policy. Explain what happened to the people involved and discuss how to avoid the problem in the future. Better yet, have them explain what happened and how they think it best to solve the problem.Case Study
Throughout the series, we've been following Chris Smith, a 45-year old builder who has been in business for six years. Chris has been chugging along for a few months now and a few things have gone right, a few have gone wrong. We'll use information from Chris's income statement (not shown) to explain problems he has had.
The first major problem Chris faced this year was the Elliott job. Several things went wrong with the job which caused a five week delay. First of all, total sales revenue was lower than the budget by $342,421. This had a major impact on the month and the year-to-date bottom line because Chris also missed out on $70,000 of gross profit associated with the Elliott job.
Another snag during the Elliott job had to do with custom ordered cabinets. The lead time was much longer than expected and caused the majority of the five week delay.
Chris, Anne, and Katherine (Chris's financial consultant) have been discussing if it will be possible to remain truly custom. The once-profitable custom jobs have become less profitable as volume has grown and the team has made more mistakes causing slippage. For Chris and his team, production type jobs, have become more profitable and easier to manage.
Another issue Anne and Chris had reviewed was slippage on the Stein job. Total job costs were supposed to be $235,000 but came in $2,650 higher. Anne and Chris reviewed the job cost details together and found that about $2,100 of the overrun could have been avoided.
Next, Katherine and Chris began a review of expenses. They started with the indirect costs, which were $2,926 over budget. As they started to review the detail of the indirect costs, they saw that two line items were the culprits: estimating salaries and warranty costs.
Chris had budgeted his estimator's salary would be about $55,000; however, to get the candidate he wanted, Chris had to pay $10,000 more in salary. It also took Chris a month longer to hire the estimator, so the budget he set for the entire year would only be off by about $5,000. The new estimator, Dan, was doing such a good job, Chris was confident that Dan would earn far more than his salary with better job costing.
Another issue arose regarding warranties. While Chris and his team were moving into their new office, a minor warranty request from a customer was missed. To appease an upset customer, Chris agreed to do some warranty work that cost him about $1,600. He probably wouldn't have had to do this work if they had not dropped the ball earlier.
The incident brought up a larger issue for Chris. He had noticed that it had become more difficult to manage warranty requests as they've grown. He decided to do some research into some new warranty software to help him manage the increased volume of homes and found it would cost him about $2,800 for an off the shelf warranty module. He and Katherine discussed the impact of such a purchase on the budget.Looking at the big picture
Chris and Katherine determined that the biggest problem so far was the slippage on the Elliott job. If that would have closed on time, the month and year-to-date picture would have been much better. Adding the Elliott job to the month would have brought expenses to less than 1 percent off budget and the net profit target would have been within $10,000.
Chris thought the review with Katherine was great. It really helped him understand what happened in the past and he felt like he was getting better at reacting to problems and working out solid solutions for improving them. Katherine told Chris that looking at the past is only half the job of a financial manager and that they needed to spend some time looking forward as well.
Chris would make sure no more homes slipped during production especially the home he planned to close in December.
Chris was being very careful to stick to the plans and specifications he made for the parade of homes even thought the temptation to add some nifty features to the home was great.
Obviously things don't always go as smoothly as they have been for Chris. In the next issue, we'll discuss how to handle some problems that can arise when things go really wrong. We'll also review some more advanced financial problems such as break even analysis and performance ratios.