Imagine you’re at a restaurant with friends. You order a small salad, while your companions choose the most expensive items. You would probably ask for separate checks, since splitting the bill evenly would be an inaccurate way to allocate expenses.
The same goes for your corporate accounting. You can’t simply allocate indirect and shared expenses evenly into costs across departments or product lines—like spreading butter across bread—and expect to get an accurate view of your company’s finances. You need to take a superior approach based on cause and effect relationships.
Luckily, there are easy ways to improve the accuracy of your cost breakdowns and future cost forecasts. Here are three steps to get you started.
When it comes time to put the budget you’ve forecast into action, efficiency is the name of the game. And activity-based costing (ABC) can help. Unlike traditional costing, which allocates costs to products based on an average overhead rate, ABC determines all work activities associated with production, assigns a cost to those activities, and then determines the true cost of each product and standard service line. ABC is like the individual checks in the restaurant. As a result, costly and redundant activities become more visible, financial leaders find better ways to apply or reduce overhead resource expenses, and pricing with profit margin decisions becomes more accurate.
Fortunately, modern planning software can help you create easy-to-use ABC models that can be used time and again. And the ABC models can also assign distribution, selling, marketing, and customer service expenses to report a P&L for each customer. Back when ABC was still in its early stages of adoption in the 1990s, accountants over-designed and over-built models that were too complicated and collapsed under their own weight. Many concluded that ABC does not work. But today’s rapid prototyping with iterative remodeling implementation methods using software technology and reasonable estimates can “right-size” the ABC model. This approach provides high-accuracy results relatively quickly—in weeks, not months. With ABC, it is basically full absorption costing, but done correctly.
As you try to determine which factors are driving profitability, look at the trends shaping your performance with a critical eye. If you have been spreading indirect expenses into costs evenly across your portfolio, you will have a skewed view of performance. Some products are being over-costed while the others must be under-costed because there is zero sum error for the total. That means the reported profit margins are flawed and misleading.
If you use ABC models to better understand your direct and indirect costs and the resulting profit margins, you will have stronger assumptions to base your forecasts on. You will have calibrated unit level cost consumption rates to calculate future profits and cash flow based on product volume and mix forecasts. And the right automation software can help model cause and effect relationships so you can quickly update financial projections as conditions change.
However, research shows CFOs have yet to invest in this tech. According to our CFO Indicator Report Q1 2017, when asked which technology solution CFOs didn’t have that would most contribute to increased agility in the finance organization, nearly half (49%) cited predictive analysis. They want valid what-if scenario analysis and driver-based rolling financial forecasts.
As more companies adopt analytical tools, those that wait will find themselves struggling to keep pace with the competition.
In the absence of facts, anyone’s opinion is a good one. But usually the highest-ranking voice dictates what decision is made.
Sadly, many executives still rely on their intuition when making decisions. They use what’s worked for them in the past. Of course, experience and intuition are valuable traits, but analytics offer real-world and fact-based data that can provide insights, inform smarter strategies, and enable better decisions. Analytics create needed conversations and generate questions. Analytics can also answer the questions.
And research shows that, increasingly, more CFOs are recognizing the power of data-driven decision-making. According to a recent EY report, 23% of CFOs said that improving big data and analytics capabilities to transform forecasting, risk management, and understanding of value and cost drivers is a priority for the future finance function.
“Data can be an extremely underutilized tool, and a company’s capability to access the right data at the right time and then look at it through the right lens, can make or break a bottom line,” says Dan DiFilippo, PwC’s former global and U.S. data and analytics leader, in a press release announcing the release of PwC’s Big Decisions Survey.
Investing in analytics software can help provide the data needed to make better business decisions.
Don’t feel like you have to shoot for perfection, though. Start small, think big. Crawl, walk, run, and then fly. Leverage technology for your planning and modeling—but don’t overcomplicate things. Remember: It’s better to be approximately correct than precisely inaccurate. In the land of the blind, the one-eyed man is king.
This article was written by Gary Cokins, an internationally recognized expert, speaker, and author in enterprise and corporate performance management (EPM/CPM) systems.