Unless you understand some accounting basics, you will struggle to manage cost!
Frequency – regular.
Participants – colleagues with cost accountability.
Leadership rating ***
Objective
In the end, whatever the size of the business you work for or lead, cash is king – as it is in your daily personal life. There is no avoiding the fact that ultimately businesses or individuals go bust when, over an extended period of time, cash out exceeds cash in, and the deficit cannot be supported by ever-increasing debt.
This is an important reminder: that just because an organisation’s money is not your own does not mean you should treat it differently. If however you are a spendthrift who brings a casual attitude to money to work, then this will in the long term do you and your business no favours at all.
Managing cash underpins everything a business does, even sales – because no sale is worth it if you don’t know what the cost of making the sale is; and no salespeople are sustainable if you don’t understand whether their cost is justified by the margin you are making from each sale.
This leads me to observe that as as you start talking about cash and margin you enter a world where a basic knowledge of accounting becomes a must. This is not because as a leader you need to be an accountant – you will in fact have plenty of those around you and/or who work for you. The terminology that comes with basic accounting knowledge gives you a set of tools which will facilitate decision-making and help you lay and build the foundations for a successful enterprise.
As a leader make sure you understand the basic tenets of accounting: you will be a better leader for it.
Context
To manage cost effectively, you certainly don’t need to be an accountant! However, it will help if you have a rudimentary understanding of the three key dynamics of financial accounting.
- The three pillars of your organisation’s accounts:
- profit and loss – the periodic reporting of your sales and costs, and whether you are generating a profit or loss;
- balance sheet – the statement of your assets (what you own) and liabilities (what you owe);
- cash flow – the simple measure of whether more money comes in or goes out.
- The three types of costs you may be responsible for:
- cost of sales (goods sold) – those costs directly attributable (often on a unit basis) to what you sell;
- overheads (expenses) – those costs related to running your operation that don’t vary directly with sales;
- capital expenditure – investment in a product, service or physical item with an ongoing (resaleable) value.
- The importance of cash – the lesson from small and start-up businesses, namely that in the end businesses survive or fail through their ability to maintain operations by having adequate cash in the bank.
The significance of this basic understanding is not to enable you to match the ability of your accountants (you won’t, and you shouldn’t try), but to understand the impact of your decision-making on financial performance.
Challenge
Managing cost in an organisation is rarely as simple as it sounds because in order to function, sell and market to and service customers so many activities are undertaken and have to be paid for. Even in a small and simple business these can very quickly become a large number of separate activities procured separately. Scrutinising them can become difficult; indeed time is often the enemy of effective cost management. Some very specific challenges include:
- knowing what costs you are incurring – having systems which accurately describe incurred costs;
- understanding what those different costs are – and knowing how they impact the business;
- knowing what suppliers are being used and on what terms – the more there are the harder it is to disentangle cost;
- responsibility for cost – the more people there are who are responsible for cost the harder it is to take a clear view of the overall cost profile;
- determination – being prepared to investigate and challenge cost requires relentless determination in the face of status-quo vested interests.
Above all else, understanding and therefore challenging cost requires a determination to challenge the ways things are done, since so often reducing cost will require changes to colleagues’ behaviour, partner relationships and culture – so cost reduction may well face the greatest resistance of anything you do.
Success
Over time, of course, success in understanding cost will be measured by improved margins. In the shorter-term there are a number of clear yardsticks which will show any leader that by understanding cost they are on the way to that margin improvement, notably:
- a clear understanding of basic accounting terminology;
- a firm grasp of the relationship between the profit and loss and the balance sheet;
- knowing what factors significantly affect a business’ cash position;
- being clear about the parameters of the business’ operating model that drive cash;
- an analysis of what specific categories of cost fall into each type of cost – costs of sale, overheads and capital;
- a preliminary knowledge of the range of suppliers the business uses and for which cost type and category;
- an analysis of who does purchasing and the extent to which it is coordinated across the total business;
- a review of the extent to which key supplier contracts have been negotiated by purchasing professionals and benchmarked against alternatives;
- a review of the opportunities for supplier rationalisation and consolidation;
- a review of cost authorisation controls and the extent to which they are enforced;
- an understanding of how the organisation’s structure is itself driving cost, e.g. whether overlap/duplication is generating additional cost.
If you can make a start on these fronts, you will be on your way!
Pitfalls
The two key obstacles to an effective understanding of cost both relate to people:
- You don’t learn enough – as a leader you must develop the grounding in understanding cost that I have described above. Some of it will come from experience, some perhaps from reading and perhaps some from specific courses (like ‘Finance for non-financial managers’). Don’t be afraid of your ignorance, and more importantly don’t be afraid to admit it and do something about it – any degree of financial illiteracy will substantially undermine your effectiveness.
- You don’t have the right teams working on cost – you must have finance teams with sufficient resources, and the right systems, to be able to monitor and report costs effectively. But you must also have the right people agreeing to the cost in the first place, and at some stage this will almost certainly mean that you need colleagues with professional purchasing experience. After all, technical knowledge about software doesn’t give you the negotiating skills to be the right person to buy it. So don’t allow specialisms to claim the right to purchasing in their areas!
Leaders’ checklist
- Admit what you don’t understand about cost!
- Develop mechanisms – whether formal or informal – to improve your knowledge of the dynamics of costs.
- Be sure to know the basic difference between the cost of sales, overheads and capital.
- Be sure to have the right people in your teams responsible for purchasing decisions.
- Don’t allow organisation structures to obscure cost.
- Be determined – this is an area where you will meet significant resistance.