Overhead… Who Cares?

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You probably couldn’t stop your accountants from allocating overhead to your operating profit centers, even if you tried. I’m not a business historian, but somewhere along the line, accountants everywhere became convinced that allocating overhead to operating unit P&Ls results in a better understanding of profitability. That may or may not be true, but let’s not use an accounting concept for making business decisions.

What is Overhead?

Overhead has a different meaning in every company, and its calculation varies widely. Generally speaking, though, it is considered to be the cost of running a head office, including centralized costs such as executive salaries, office rent, computer systems, etc. When the accountants allocate overhead, it is often in the form of a percentage of gross revenue. If a company has a division that contributes 10% profit, and another that contributes 8%, a 4% overhead allocation would reduce these results to 6% and 4%.

In this example, it would appear that the first division is 50% more profitable than the second, and management might be tempted to allocate resources accordingly. But its contribution margin is only 25% higher, so the result could be misleading.

If you can’t tell if your operations generate enough profit to cover overhead, you might consider looking for a different occupation. For the record, I’m sure many intelligent people disagree with me.

Don’t include Overhead in your business decisions

In my experience, many accountants don’t really appreciate that accounting conventions have no place in business decision-making, and operating executives often don’t feel confident enough to challenge the accountants on their own turf. Some things to remember:

Overhead is just an accounting concept
Overhead does not affect cash flow
Overhead allocations do not affect total company profitability
Overhead is calculated differently in every company

I have seen some dysfunctional results arise from trying to shoe-horn an accounting concept into business decisions.

A Retailer

A retailer had several stores that were not only losing money, but had a negative cash flow. That is, their operating loss was greater than their depreciation and amortization. The stores clearly needed to be closed to stop the damage.

The CEO, however, had done his math. If he closed the failing stores, the overhead allocated to those stores would have to be redistributed to the remaining stores, reducing their accounting profit after overhead. The CEO could not be persuaded that closing the losing stores would improve the company’s total profitability.

The failing stores continued to lose cash flow, and the overhead was allocated to all stores… until the CEO was replaced.

A Homebuilder

A homebuilder had a target IRR for new community construction projects. IRR is a measure of cash flow that calculates the return realized on a cash investment. The CFO, an accountant by training, insisted that all cash flow projections include a 3% charge for overhead, despite the fact that overhead has nothing to do with the incremental cash flow generated by a new construction project. He argued that when the project was under way, overhead would be allocated for accounting purposes, so the pro formas should reflect that. The pro formas then became just a forecast of the accounting records, and IRR, the real reason for making the investment, was calculated incorrectly.

At least the pro formas were conservative as a result of this allocation, but the company probably missed out on some good opportunities whose IRR projections fell below the hurdle rate. As it happened, the company’s actual overhead was not even 3% at all.

Another Retailer

Some retailers charge the cost of their distribution centers directly to expense, in the manner of unallocated overhead, while others include it in the cost of their merchandise, charging it directly to operations.

In a year when earnings were tight, I was encouraged as division CFO to find ways to increase reported profit, so I capitalized the distribution center costs. This resulted in a large transfer of costs from expense to inventory, substantially increasing reported earnings. The parent company paid senior management large bonuses that year, regardless of the fact that nearly all our profit came from an accounting change.

Although we reported more profit, the actual economic impact on the company was a negative cash flow in the amount of the bonuses that were paid. Was the accounting technically correct? Yes. Was it the most appropriate accounting under the circumstances? Maybe not. Would I do it again? … Well, I did like that bonus.

A Land Developer

When a land developer sold finished and partially finished lots to homebuilders, they did a land residual calculation to arrive at the asking price. That is, they estimated all the builder’s costs and revenues, and priced the lots so the builder could achieve a specified percentage profit margin. But one of the costs included in the analysis was 3% – again 3% – for overhead. If they didn’t include the overhead, they could have started with a higher asking price, and maybe sold the lots for a higher price.

Does your CFO take a practical view of Overhead?

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What (Not!) To Do In Troubled Times – Part 2

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Regrettably, I’ve seen my share of companies in troubled times. Some CEOs step up and take effective action, but others are less effective. Here are some unfortunately common behaviors that have led to failure. This group of behaviors falls under the category:

General Confusion

Change plans constantly, and don’t inform all of your mangers of the changes – There is always the fear that plans aren’t working, or aren’t working fast enough. Plans need to be carefully thought through and executed at all levels of the organization if they are going to succeed. A rapid succession of poorly conceived plans is worse than no plan at all.

Make radical decisions, then reverse them without explanation – Wild decisions such as cutting the price of your flagship product by 50% (it’s a fictitious example, but just barely) are not the only way to increase business. Everyone, including you, knows it’s not going to work, and abruptly changing your mind a few weeks later will only make you look more foolish.

Find reasons why managers who don’t always agree with you should be absent from meetings – It’s nice to hear from people who agree with you, but you need to hear every point of view, especially in troubled times.

Constantly reshuffle management responsibilities – Sure, you sometimes wish your managers had stronger or different capabilities. But you hired and promoted them for their expertise, experience and judgment in certain areas of the business, and they are the ones who are going to help you through the rough patches. Juggling responsibilities just causes confusion and resentment, and after a while, you’ll be the only one who knows what is going on… maybe.

Appoint capable managers to lead new initiatives, but don’t let them actually do anything – Is this really the time for bold new initiatives? Or are your senior managers more effectively used to improve the core business? Don’t waste your most valuable resources on projects that you will probably never green-light.

Think about it. Does any of this feel familiar? … Really think about it.

Valuing a Consulting Business

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There are probably hundreds of reasons why you might contemplate selling your consulting business. Among them would be retirement, changing markets, illness or just the urge to move on and do something new.

Who is the buyer?

The buyer will probably be another consultant – either a competitor or a firm with a desire to expand their offering to include your area of expertise. It is unlikely that there will be financiers, or others with no direct experience standing in line to buy your business. There is, however, a pretty good chance the buyer will be a partner or an employee, in which case you need to start talking to financial planners long before you expect to do the transaction.

What are they buying?

When you think of selling the business, you tend to think of it as just that… the business. When we start thinking about its value, though, it is a good idea to put ourselves in the buyer’s position. What specifically does the buyer hope to acquire?

–          Your client list / existing relationships.

–          Expertise in a new field, or the opportunity to serve a backlog of client demand.

–          Name and reputation.

–          An instant start in the business with a functioning team – it saves the time, energy and uncertainty of building the business from scratch… as long as the cost isn’t too high.

–          Ability to leverage your client base – the buyer can provide services from your business to his existing clients, or alternatively, sell new services to your current clients.

–          Owner to stay on through a transition period – to facilitate the smooth transfer of relationships, retention of staff, transfer of knowledge and expertise.

What is the price?

Consulting firms typically have relatively little in the way of assets, so one way or another, the selling price is likely to be a multiple of earnings or cash flow. EBITDA (earnings before interest, depreciation and amortization) is a traditional measurement of cash flow, but why not add back your salary and any special items such as health care and travel that could be considered personal, and would not be costs to the company after the sale? Also consider accounting, legal, insurance etc. costs that will go away after the acquisition.

The value of a single-person operation will probably be lower because of the impracticality of having the seller stay on through a transition period, and the higher risk of losing clients.

The purchase price will depend on the exact fit with the buyer’s business, and the time and cost of entering the field. Remember that if you ask too high a price, the buyer may decide to start the business from scratch, maybe even hiring your best employees away from you, and competing for your existing clients.

Rules of thumb – selling prices generally fall between 2.5 and 3.5 times earnings (high utilization rates and low costs will result in a higher value) OR .75 to 1.25 times gross revenue, which probably yields the same value, depending on your profit margins.

The purchase price will be higher if you stay on through a transition period. You would draw a salary, of course, and it doesn’t hurt to be there to keep an eye on your payout.

Payment Structure

You’ll get the highest price if it is paid out over time, say 2 – 3 years. An up-front payment in the range of 25% is common.

Remember that if a buyer pays 3 times earnings up front, he will get no return on his investment for 3 years, a situation that few investors can tolerate. Even if there are synergies that result in additional business, the buyer would probably have to lay out additional investment to realize them.

 

Do you know who to call if you need help selling your business?

 

ROI versus IRR … In a Nutshell

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Both the CEO and the CFO of a large company told me that ROI and IRR are the same thing.  They’re not. Interestingly, both executives’ annual bonus was determined by how their ROI compared with other companies in the industry.

I worked for a big company that required a 16% after-tax IRR on new investments. As it happened, the company’s ROI was typically in the 16% range. The Director of Financial Planning told the operating teams that achieving a 16% IRR automatically resulted in a 16% ROI… But he was wrong. It was just a coincidence.

Another company required an 18% pre-tax IRR on new investments, and for several years reported an ROI of about 18%. That was also a coincidence.

ROI and IRR are very different calculations, and are used for very different purposes.

Return on Investment (ROI)

ROI is a measure of how effectively a company is utilizing its capital investment.  It measures the company’s profit during a fixed period of time, usually one year, divided by its average assets.

Calculating ROI

Pretax Profit Before Interest  /  Average Total Assets, excluding Capitalized Interest  (-)  Average Non- Interest Bearing Liabilities

Taxes and interest are excluded from the calculation in order to compare the performance of different companies more effectively. A company with a low tax rate, or a highly leveraged company will have very different result from those of a company that has higher taxes or operates with low debt levels, so this calculation removes those variables. Other calculations, such as Return on Equity (ROE) evaluate performance on a more comprehensive basis.

Non-interest bearing liabilities include items like accounts payable and accrued liabilities, which are effectively free financing, so the corresponding assets aren’t really considered to be an investment.

How Useful is ROI?

ROI is a widely used calculation, but we must remember that it measures only one year’s performance, so it can swing widely from year to year if earnings are volatile. This may not be a bad thing in cyclical businesses, in which all companies experience the same environment.

In my opinion, ROI is most useful in established companies that are not growing or contracting at a rapid rate. The book value of a young company or a growing company’s assets is likely to be relatively high, as they invest in future earnings, and haven’t charged off extensive depreciation and amortization.

Conversely, there is an old joke that the best way to increase your ROI is to go out of business, because your investment is declining as you sell off assets, while you still report income from the sale of those assets.

Similar Calculations

There are plenty of slightly different calculations such as Return on Net Assets (RONA), Return on Capital (ROC) and Return on Invested Capital (ROIC) that can be argued to be more representative of a particular company’s performance, but they all have the same basic objective.

Internal Rate of Return (IRR)

IRR calculates the compound rate of interest earned over the life of a specific investment, using not only the dollar amounts, but also the timing of cash expenditures and cash receipts.  Because it uses the concept of the “time value of money,” IRR is used to compare investment opportunities that have very different cash flows.

Calculating IRR

IRR is based on the concept of Net Present Value (NPV). NPV says that one dollar today is worth exactly one dollar. A promise to receive one dollar a year from now, however, is worth less than a dollar, because you’ve missed the opportunity to earn income on that dollar for a year. If you could earn 10% (the Discount Rate) on your investment, next year’s dollar would be worth only 90.9 cents today ($1.00 divided by 110%).  On the bright side, a future expense is also worth less today.

IRR is the Discount Rate at which the NPV of a series of cash flows is zero. That is, the interest rate earned over the life of an investment after the initial investment has been repaid.

Typically, interest and taxes are also excluded from the IRR calculation for comparison purposes, but of course, you will want to see the net leveraged IRR too.

How Useful is IRR?

If you have $1 million cash to invest, should you invest in the project that requires the entire investment up front, then pays nothing for 3 years, when it returns $1.5 million? Or should you go for the one that requires a $500,000 investment in each of the first two years, and then pays $350,000 a year for the next 5 years? There are obviously a lot of other factors to consider, but IRR will tell you which one pays a higher return.

Similarities Between ROI and IRR

None… ROI and IRR are entirely different calculations.

Does your CFO explain and discuss financial metrics with your management team?

What (Not!) To Do In Troubled Times – Part 1

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Regrettably, I’ve seen my share of companies in troubled times. Some CEOs step up and take effective action, but others are less effective. Here are some unfortunately common behaviors that have led to failure. This group of behaviors falls under the category:

Personal Interaction

Cut off communication – When things start to go wrong, your best friends can be a source of support and morale. But they should not be your only points of contact. Resist the urge to see only friendly faces and hear only from people who agree with you. Don’t close your door and hire a bulldog assistant to keep people away. The more people you hear from, the more you’ll understand changing conditions, and the better equipped you’ll be to deal with them.

Stop making field visits – In stressful times, don’t look at your office as a sanctuary. You are unlikely to learn anything useful there. The people who make and sell your product are the ones who can really tell you what is happening, and often how to make things better. And your attention is reassuring and inspiring to them.

Take long trips away from the office – Yes, bad times are stressful, but you can’t hide from them. Taking more personal trips and long weekends will just put you out of touch, and will send a very wrong message to your management team.

Make it clear that you only want to hear good news – We all like good news, but if you won’t hear the bad news, or require that all bad news have a positive spin, you’re going to lose your grip on the business. And you’ll look foolish to your management team.

Hold more long meetings – Meetings are necessary for communication. More meetings, longer meetings and meetings with more attendees can be detrimental. You may feel comfort in surrounding yourself with subordinates, but the more time you spend talking to them, the less time they can spend identifying and solving problems.

Think about it. Does any of this feel familiar? … Really think about it.

Profit Improvement – Simple Communication

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Communication

Sometimes a simple conversation will solve your problems. This can be a natural process, or the result of an expensive and time-consuming structured organizational review. If you have a problem, talk about it.

A telephone call – The sales department of a homebuilder often selected lots for sale in such a manner that the engineering department had to return to the city with new plans for approval. This caused time delays for sales and frustration in the engineering department, and resulted in increased plan approval fees. A Six Sigma team approached the problem, creating wishbone charts, pareto charts and other analyses to identify the underlying problem, but could find no statistical pattern. Finally, the head of engineering telephoned the head of sales, and the problem was eliminated in five minutes.

A meeting – The buyers at a retail company weren’t getting all the information they needed from the accounting department, so they appointed a full-time administrator to track and report on outstanding orders and merchandise receipts. A meeting between the buyers and the accountants resulted in an automated report that solved all the buyers’ needs, and the administrative position was eliminated.

Bottlenecks – A land developer was experiencing chronic delays in processing grading permits. Business was booming, so every day represented delayed revenue and additional carrying costs on multi-million dollar developments. A Six Sigma team spent several weeks of process flow-charting and statistical analysis, only to learn that the manager in charge of grading applications was swamped, and had a long backlog. They added a part-time clerk, and the problem was solved. Asking a few simple questions much earlier would have been a lot easier.

Does your CFO encourage your operating team to communicate with each other?

What? … Manage Return on Equity?

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Return on Equity, or ROE, is a widely recognized measure of a company’s performance. Even though some senior executives’ compensation is based on ROE or a similar measure, many regard it as an academic, technical calculation, and wait until year-end for the accountants to give them the result.

ROE tells you how effectively you are using your company’s resources, and it CAN be managed. It is a tool that should be evaluated and refined constantly to ensure your business is headed in the right direction. It can be managed by breaking it down into its separate components:

The calculation of ROE is:

ROE = Profit Margin X Asset Turnover X Financial Leverage

Profit margin is your profit as a percentage of sales. No surprises here. You know your industry, and you know your company, and you know how to improve your margins.

Asset turnover is your sales divided by your total assets. Turnover drops when you carry more standing inventory than you need, or make capital investments before you really need them. Faster collection of accounts receivable will improve your asset turnover… And obviously, increasing sales will improve your turnover.

Financial leverage is your total assets divided by shareholders’ equity. Negotiating longer vendor payment terms can increase financial leverage. So can increasing debt, but that is a complex decision that should be discussed in depth with your CFO.

Does your CFO work with you and your operating teams to improve the components of ROE?