Failure to understand what lies beneath the towering ice mountain in front of us can have disastrous consequences. On the other hand the benefits of insight are far greater than one might imagine.
Standard Financial Statements are the bit visible above the surface.
It is knowing what lies beneath that allows you to decide on the best course of action. (An aside - you need this information in time to react. It doesn’t do much good to find out there is an iceberg in your path just before you hit it!)
In the case of an iceberg, basic physics tells us how much is below the surface (the relative densities of ice and sea water). Likewise the results shown in Financial Statements are the consequence of various interrelated business processes. By understanding these, you are in a position to make a step change to the performance of your business - benefits that go far beyond a better understanding of the numbers.
A "real life" example
The following is an amalgam of real life situations encountered working with various leading brands in the fashion industry.
The iceberg shown in the Financial Statements was worsening margin. The trend, if it continued unchecked, threatened the survival of the company. In the absence of any tools to understand the real causes of this, there were many conflicting theories as to the reasons why. Morale suffered as each department blamed the others. As they say success has many fathers and failure is an orphan.
We developed an understanding of the business processes affecting margin to create a common understanding of drivers, influence, expectations and accountability. So the first step is to understand the processes:
Product Marketing is responsible for creating the ranges of products to be sold. They develop the product stories, decide on the colours & fabrics to be used, technologies, price points (recommended retail price), phasing (launch dates) etc. After agreeing the shape of the range, they brief designers who design the individual articles (SKUs) that made up the range.
The Sourcing team allocates articles to manufacturers to develop (working out best way to make them) and provide estimated cost based on forecast volumes. Product Marketing then works through these costs and modifies the range, design or retail price as needed.
The Sales team presents the finalised range to customers (retailers) who then place orders for delivery of the articles for several months into the future based on their estimates of what they can sell. The Sales team determines the level of discount each customer will get and other conditions of sale such as delivery, cancellation rights, additional financial support etc.
The customer orders are consolidated to get the total order by article. Product Marketing then recommends the actual quantity of each article to buy. Sometimes customer feedback will prompt changes in the design of certain articles. These decisions will typically affect the actual cost to manufacture.
So it is quite easy to see that with so many decisions and so many different parties involved it was not easy to find out the causes of falling margin or who is responsible. The challenge was to find a way to disentangle this various decisions and to create a common language for discussing the problem.
- Introduce the concept Standard or Reference Cost – the cost agreed by both Sourcing and Product Marketing in step 2. This creates a clear handover between the two functions.
- Introduce the concept of a Retail Mark Up (Retail Price relative to Standard Cost). Product Marketing now controls both elements of Mark Up (which can now be used as a kpi for the team) - targets can be set and actual achievement measured. Any differences can be easily identified, reasons understood and appropriate action taken.
- Set up the reporting system so that Retail Price is captured. Retail Price is the handover point from Product Marketing to Sales. It is now possible to have full visibility of what Sales controls - the difference between Retail Price and Net Sales.
- Report on variances between actual cost and Standard or Reference cost. There are many good reasons why differences may exist such as actual order quantity differing from estimates but more often than not they are “non quality costs” - the result of poor processes and mistakes.
- Finally make sure that data is captured at a level of detail that allows users to “drill down” into it to understand where the issues are… is it restricted to a group of customers? a product range? a manufacturer?
The approach is summarised in the schematic below.
Now that there is a common language for understanding the drivers of margin, we can look at trends identifying where things are not working and who is ultimately responsible.
The benefits go well beyond just reporting. By building this business process approach into both the planning processes and reporting we have something that is more intuitive and more meaningful to the individual departments. Planning processes reflect the way that people see and understand the business. Cross functional dialogue is encouraged because each party is able to see the consequences of their actions on the end result. Finally, and most importantly, there is now a way of identifying issues and opportunities at an early stage - whilst there is still time to do something about it.
Standard Financial Reports tell only part of the story, often when it is too late to do much more than damage limitation (repairing the hull).
By understanding the underlying processes and drivers, then designing a planning and reporting structure that reflects these, it is possible to create a step change in business performance.
- Plans become meaningful because they are based on business reality and prompt people to think in the right way
- Issues and opportunities can be spotted early, the reasons understood and the appropriate action taken in time to mitigate risks and take advantage of new opportunities. Unpleasant surprises are reduced.
- It helps to break down silos as different departments need to work together in the planning process.
- It encourages greater ownership and accountability.
- Decision quality improves as people gain a greater understanding of the consequences of their decisions.