ACTIVELY INFORMATIVE
PLANNING

By Simon Sanders

A sine qua non of sustained business success, which should be obvious but is not often clearly seen, is that for management to manage well, it must have a comprehensive understanding of how the business is functioning, performing, and developing. While it may be usual for management to have a good understanding of the markets, processes, and operations it is working with, it is not uncommon for its understanding of the company's resources--the way they are changed, developed, and utilized in the course of business activity (and what this means for the business)--to be extremely hazy.

Looking Backward

Conventional profit and loss, and balance sheet reporting does not provide the information management needs. A major shortcoming is the fact that historical accounts are inherently backward-looking and nonpredictive. They report what has happened but give very little indication of what is going to happen. They are also nonprescriptive, and although they can show the existence of problems, they do not provide much help in reaching solutions.

The use of budgeting is only a partial answer. There is no reason to suppose that estimates prepared months previously will accurately reflect the current outlook or that, when results diverge from budgets, the most appropriate course is to seek to return to it.

Greater effectiveness can usually be achieved by adding a third dimension-- activity-based planning--to the control process, supplementing reporting and budgeting. Activity-based planning is a method of short-term business planning that seeks to integrate, in as much detail as practical, the day-to-day activities of the business and the commercial and financial results. The objective is to produce short-term plans that identify, in detail, the actions that are needed within a business and the results that can be expected.

This approach requires that a flexible response to business conditions is genuinely acceptable to management. It cannot be effective in an organization whose plans are fixed and where the purpose of measurement is to identify deviations, and the objective of corrective action is to bring results back on to plan. It will be effective, however, where flexibility is allowed, and the adjustment process is not limited to corrective action but instead encourages the development and implementation of new plans within an overall general strategic framework.

Guesswork

Until recently, it was not really possible for companies--other than those with sophisticated information technology resources--to analyze complex data concerning the various tasks, actions, and transactions involved in day-to-day business activity when making plans and projections. Most companies tended to settle for plans and cash-flow projections based on simplified, generalized "guesstimates."

Now, however, fast desktop computers and user-friendly spreadsheet software make it relatively easy to develop comprehensive activity-based plans, replacing the broad-brush forecasts, and to do it cheaply. It is now possible, as demonstrated in the case of R-Con (not its real name) to calculate overall, short-term financial projections with a high degree of accuracy and to relate them directly to specific business activities. This enables management to take timely decisions with a reasonable certainty about the likely outcome.

The Case of R-Con

R-Con is a structural steel contractor. Although technically competent and experienced in contracting, the company consistently lost money over several years. The CEO, Philip Hugh (also not his real name), and his colleagues, attributed their problems mainly to a combination of the recession and the tactics of dissembling and dispute in order to avoid payment that have become rife in the construction industry. The manager at the company's bank felt that this was only a partial explanation, since he had a similar customer who was doing well despite industry problems.

The company did not prepare or work to budgets and simply compared its performance against prior year results. Philip Hugh found forecasting difficult and felt that, in the current business climate and with enormous variability in the size of contracts, he could not reasonably be expected to set targets or make predictions. When the bank asked for financial projections, however, he realized that the request was actually a non-negotiable condition for the continuance of his overdraft facility.

As is often seen in ailing companies, the information systems at R-Con were poor. The monthly reports package provided little information about progress or performance on the contracts that were the raison d'etre of the business, and the profit and loss and balance sheet summaries that formed the main part of the package were more in tune with the annual reporting requirements than management's needs. And, since it could take seven weeks or more to prepare them, the reports were hopelessly out of date by the time they were issued.

Unreliable Forecasts

In these circumstances, it is not surprising that the financial forecasts could not be depended on. Though there
was no evidence that trends were improving, the latest projection shown to the bank indicated that the company would overcome year-to-date losses and break even with only four months of the financial year yet to go. This was so plainly impossible that the bank became even less confident, and demanded an external review.

An initial survey highlighted these shortcomings in information and forecasting. It also showed that some of the company's policies were wrong and were based on an erroneous view of how business activities and financial results were interrelated. For example, it was believed that, because steel suppliers offered 60-day payment terms while R-Con's customers had terms ranging from 10 to 30 days and because it had succeeded in compressing its fabrication cycle-times by implementing just-in-time methods, the company effectively had no cash tied up in materials-in-progress.

Consequently, the CEO believed that the company was justified in pricing its proposals with no markup on cost of materials. "We see ourselves similar to labor-only subcontractors," Philip Hugh said. "We price to make a margin on labor and overhead costs and to break even on materials."

Misapprehensions of this sort are not uncommon, particularly in small- to medium-sized businesses where responsibilities may be sharply divided, with only limited coordination between operations, sales, and finance. Actually, the numbers behind the balance sheet showed that payments by customers were greatly extended beyond due dates and that the contracts were substantial absorbers of cash. Not only was R-Con underpricing its proposals, but the contracts it was winning tended to be those with high materials and low labor content--the exact opposite of what it needed to make a profit.

A Chance to Rebuild

While a history of losses, poor management information, and wrong policies may signal that a company is at imminent risk of failure, it can also highlight an opportunity to rebuild it into an effective, profitable business. The original requirement at R-Con was simply to review the outlook for cash flow and profit. As the work progressed, however, they were able to extend their results to provide the basis for a new activity-based planning and reporting system,
to bring activity, profit, and cash flow under control.

The management accounts showed that approximately 80% of R-Con's costs were directly attributable to individual contracts and at least half of the remainder was taken up by the relatively fixed costs of staff employees, rent, and utilities. Costs and revenues due to contracts already in hand were either already fixed or reliably estimated. So, notwithstanding Philip Hugh's views on forecasting, it appeared that there was sufficient and reasonably firm data to support a detailed projection of activities, performance, and cash flow up to at least three months and perhaps three months beyond that if they included estimates of early shipments of outstanding proposals that management was reasonably confident of winning. For R-Con, therefore, the core of its activity-based planning system was the contract data and control system.

Anticipating Problems

The first step was to organize information on contracts and proposals and to analyze purchases, labor, deliveries, and invoicing. They needed sufficient detail to facilitate useful control and forecasting, and fixed on 14 categories of purchases and five types of labor (eventually only three were used).

The process of delivery, invoicing, and securing payment in the contracting industry is complex, involving pro forma invoicing as a precursor to intermediate valuations by customers' surveyors. It is also inherently prone to disputes and delays. Responsibility for controlling invoicing and cash collection had fallen to the accounting department, and being outside the loop of operations management, it found itself having to tackle a daunting and growing overdue accounts receivable list.

One of the spin-offs from the exercise was that the accounting department was able to rationalize the rules for handling sales, cost of sales, inventories, and accounts receivable and bring the operations managers further into the commercial processes of invoicing and cash collection, where they were well placed to anticipate and tackle problems before they degenerated into intractability.

Phased Forecasting

As in a conventional contract control system, the data distinguished between amounts to date and forecast amounts. The innovation for R-Con was to phase the forecast amounts according to the expected timing of the associated activities and transactions--a new task
but not a difficult one and not even a time-consuming one, once a routine had been established.

One of the keys to effective activity-based planning is to choose a suitable time scale for the phased forecasts. We adopted a scale of four weeks to the "month," which provides the detail
and flexibility of weeks but is compatible with the fact that many costs, payments, revenues, and receipts are recorded monthly.

Contract-Control Sheets

The contract data were assembled in spreadsheet form using Microsoft Excel, in a standard format that we called contract- control sheets. The work was carried out in partnership with the contracts manager, who was subsequently to take on the task of maintaining the system. The format was designed so that all calculations were automated with integrity checks to spot inconsistencies before they got into the system. Integrity checking did not mean that the system was able to do the contracts manager's thinking for him or that he could afford to be careless, but it did help him to identify and resolve anomalies in the data.

The purpose of the contract-control sheets was not simply to provide forecasting data but also to provide continuous, up-to-date and comprehensive reporting on the state of individual contracts. They were therefore not limited to analysis of the basic data such as purchases, labor usage and costs, invoicing, and receipts. They also worked out the actual-to-date and projected figures for cost of sales, profit, work-in-progress, and retention balances, taking into account interim deliveries and valuations, as well as completed contracts. Much of this analysis could have been dug out of the job ledger but only with effort. The contract-control sheets provided the information directly, showed forecast as well as historical figures, and required much less effort to produce. It is planned to dispense with the job ledger analysis altogether and to rely on raw work-in-progress and receivable balances, backed by the contract-control sheet system.

Consolidation

Once the initial contract-control sheets were completed, it was a short step to bring all the data together in consolidated form using an Excel macro. The R-Con consolidation macro produced a complete phased picture of purchases of contract materials and services, workload and labor cost, and cost of sales, sales/deliveries, contract profit, cash receipts, work-in-progress, and retention.

Possibly, the most important of these factors was the projection for purchases of contract materials and services. By re-phasing the consolidated purchase figures in accordance with suppliers' payment terms, it was possible to calculate a forecast of payment amounts and due dates to a level of detail and precision that was limited only by the amount of detail chosen for the contract-control sheets. Modifying the payment assumptions allowed us to evaluate the effects of deferring payments to ease cash flow--a very useful capability for a company with cash problems. The four weeks per month time scale made it possible to identify the timing of peak cash demands to the nearest week, which is sufficiently fine pinpointing for most circumstances.

The factor next in importance was the aggregated estimate of workload. It showed overall loading according to the various types of effort required, and although R-Con had an effective scheduling system already in place, the overview provided by the consolidated contract-control sheets made it an easy task to spot bottlenecks and shortfalls.

Finally, we brought the consolidated projections together with estimates of overheads and other indirect costs and payments and with the current balance sheet to produce a set of profit and loss, balance sheet, and cash-flow projections. The contract-control sheet data accounted for far and away the bulk of the estimated data. For the rest, many major costs and payments such as rents, leases, and salaries were fixed or near-fixed in both amount and timing (or would require special cost-cutting action if they were to be changed significantly), and most of the remainder, such as utilities, could be estimated with a good degree of precision.

Highly Accurate

It was therefore possible to calculate the overall financial projections with high accuracy and repeatability and, most importantly, all the figures could be traced directly to R-Con's actual business activities. The result was an activity-based plan that management could understand, support, and work toward--quite a change from the rough forecasts based on broad assumptions that had proved to be so unsatisfactory in the past. It showed that the way ahead was not going to be easy, but that it was genuinely possible to turn the corner. Above all, it showed what needed to be done and what the results would be.

Now, R-Con management is using its activity-based plan as its main control document, with the contract-control sheets providing constantly up-to-date information covering the bulk of current activities. More needs to be done to improve the information systems, including upgrading the general standard of accounting and reporting. This will go hand-in-hand with careful monitoring of the activities and factors that determine performance against plan; reporting on a daily, weekly, or ad-hoc basis as appropriate.

Improved Profitability

Contract profitability has already improved, overheads are fully under control, and now that the commercial aspects of contracts are monitored with the same understanding and pursued with the same vigor as technical and operations issues, the company has found itself able to identify and deal with receivable problems earlier and more effectively. *

Simon Sanders is director of BALA/RS Consulting Ltd., which specializes in business turnarounds, and author of Faculty of Finance and Management's Good Practice Guideline on Business Recovery.

Reprinted with permission from Accountancy, February 1995.

Editor:
Michael Goldstein, CPA
The CPA Journal