Billing Best Practices (#73)

In this podcast episode, we discuss the various best practices that can be applied to the billing process to make it more effective. Key points made are noted below.

The subject, specifically, is how to create and issue a customer invoice.  Now, this seems pretty simple.  Your accounting software has a standard invoice template, so you call up the pre-defined customer billing information, enter the various line items you’re billing, and put the invoice in the mail.

How to Find Invoicing Problems

You may have noticed during collection calls that customers are not always paying late because they don’t have the money, but instead because of something wrong with the way you created or delivered the invoice.  In other words, collection calls are a really good way to figure out where your billing process is broken.  So let’s go through some of those collection problems and see how we can fix the billing process so that the collection issues go away.

Issue Single-Line Invoices

One of the problems is that a customer won’t pay because it’s protesting one line item on the invoice.  If there are lots of line items, that means all of the other items are being held up too.  If there’s a history of this, and if the other line items are for really large amounts, it might make sense to split up a large invoice into several smaller ones.  In particular, if you think there might be some debate over a particular line item, then put it in a separate invoice.  Obviously this can be outrageously laborious if you deal with all kinds of line items, so reserve it just for the really large-dollar invoices.

Proof Large-Dollar Invoices

And speaking of large-dollar invoices, if there’s a risk that a customer won’t pay a really big invoice because of a typo, then by all means – hand over the larger invoices to a second person, along with all of the supporting documents, and have them proofread the invoice.  Sure, it might delay invoice delivery by a day, but so what?  Proofreading could keep a payment from being delayed a really long time.  Of course, this won’t work if you have thousands of small invoices, but if a really big one comes along, just be extra careful.

Clearly Present the Invoice Number

Another problem you find is that the customer keeps mixing up invoices.  This happens when you don’t clearly state an invoice number, or you don’t show any invoice number at all. The customer expects an invoice number, and he’s looking for one, so clearly position it in one corner of the invoice, put a box around it, and print it in large font and bold.  This sounds stupid, but I think some companies make a game out of how far inside an invoice they can bury the invoice number.  So… take one of your invoices out, and stare at it from the perspective of the customer.  If they have to dig around for key information, then you need to remodel the invoice.  This is your problem, not theirs.

Clearly Present Contact Information

So what if, despite your best efforts at creating a clear invoice, the customer still has a question.  Does the invoice clearly show a contact phone number?  And does someone actually answer that phone number?  This cannot go into the department voice mail.  Nobody checks that voice mail.  You have to make sure that the contact number goes to a real live person.  If not, then the customer will just say “screw it,” stick the invoice in their IN box, and wait until the invoice is past due, so that someone in your collections department calls them.  This is not the customer’s fault, it’s your fault.  You are not giving them a clear way to communicate with you.

Identify the Recipient

Another problem is the invoices that never find their way to the right person.  Invoices have a way of vanishing inside customer organizations, and you never know until they go unpaid, and your collections person finds out that no one ever received it.  There are a couple of ways around this.  First, if you have a sales staff that keeps in close touch with customers, then periodically run your active customer list past the salespeople to see if any contacts have changed. Also, the collections staff should have a pretty good idea if someone has left a customer’s accounting department, so run the list past them, too.

Another option is to mark all envelopes with an “Address Correction Requested” stamp, so that the Post Office notifies you whenever a customer changes its location.

Accelerate the Issuance of Invoices

So what about the timing of sending an invoice.  The standard view, of course, is to mail it as soon as possible after you’ve delivered the goods or service.  I certainly agree with that.  But – if you know in advance exactly how much to bill, you can run the invoices early and mail them early.  As long as you also set the invoice date to the correct date that coincides with delivery, there’s really no accounting problem. By issuing invoices early, you’re giving customers more time to process them for payment, so you should get paid a little sooner.  This doesn’t work for every kind of sale, but keep it in mind.

Consider the Invoice Delivery Method

So what about invoice delivery.  The traditional method, of course, is mailing every invoice.  But there are better ways.  Some companies have set up on-line billing sites on the Internet, and ask you to re-enter invoices into those sites.  If so, by all means take them up on it!  Sure, it’s painfully slow and requires extra staff time.  But on the other hand, you’ll know for a fact that the invoice is in the customer’s accounting system, because that Internet site usually has an automated feed that goes directly into the customer’s accounting system.  And sometimes, you can even use the site to track payment progress.  So, what’s not to like?

Now, what about e-mailing an invoice?  I think it’s one of the best collection techniques once something is overdue.  But as the way to initially send an invoice, I’ve had an amazing amount of trouble with it.  Customers usually want you to send invoices to a generic e-mail address, and then they don’t check the mailbox.  And also, you never know when the customer’s spam filter is blocking your e-mail.  In short, it seems like a good idea, but e-mail is just not a good way to initially deliver an invoice.

And then there’s the wave approach to invoicing, which means that you hit them with multiple copies of the same invoice from all possible directions, like the mail, and fax, and e-mail, and an overnight delivery service.  This really pisses off customers, but if you have someone who finds any possible excuse not to pay, then this takes away an excuse – because there’s no way they didn’t receive the invoice.  I don’t use it much; this is really just for the most annoying customers.

Related Courses

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Office Work Flow (#72)

In this podcast episode, we talk about ways in which the flow of work within an accounting department can be improved. Key points made are noted below.

The accounting department handles a lot of transactions, and that means there’s a lot of paper flow, and also a lot of physical movement within the department.  The trick is to handle those transactions as efficiently as possible, and a good way to look at it is office work flow.

Remove Obstacles

The first step is to take out of the department anything that gets in the way.  This means removing excess chairs, desks, and filing cabinets, as well as unused computers, printers, fax machines, and so on.  Once those items are gone, make a layout chart for the entire department.  On the chart, list all furniture, offices, and cubicles, and then add to it the flow of travel that everyone takes over the course of the day.

Minimize Travel

What you’ll usually see is that there’s a lot of unnecessary travel.  For example, a manager buys a really large copier with all kinds of functions, and puts it in a special copy room way down at the end of the hall.  If you have that situation, then there’ll be plenty of wasted travel down the hall.

Same thing goes for mail.  If a billings clerk is creating customer invoices off and on through the day, she might wander down the hall seven or eight times to drop off envelopes at the front desk.  You get the idea.

The solutions are pretty obvious.  Instead of a central printer or copier, buy a bunch of small ones, so that people just turn around in their work areas, and there it is.  No need to travel anywhere.  This is really a good way to go with printers, because a decent laser printer just doesn’t cost that much anymore.  As for fax machines, I’m not entirely sure they’re even needed, since you can easily give everyone a decent high-speed scanner, and have them scan documents and then e-mail them.

As for travel to the mailbox, just create a mail drop in the accounting department, and have someone collect it once at the end of the day.

Enhance Storage Systems

A special issue is the filing cabinet.  Because of all the paperwork they contain, they’re basically immovable, or at least can’t be moved without a great deal of effort.  So, everyone has to walk to the filing cabinet.

The work flows related to filing cabinets are so repetitive that you may even notice that the carpet is worn out on the travel paths between certain clerks and their favorite cabinets.  So what do you do?

The trick is to have clerks move all the files they need from a filing cabinet into a wheeled bin, and bring the bin back to their work areas.  The intent is to have a whole day’s work sitting next to them, so they only take one trip to the cabinet in the morning, and then one more trip to put it all back in the evening.  That’s not always possible, but it might apply to a few situations.

Enhance the Cubicle Layout

And then we have the issue of cubicles.  They’re pretty fixed objects.  But the work flow of the accounting department can vary quite a bit over time, so you have to work around the cubicles. One option is to take them out entirely, and replace them with desks.  The nice thing about a desk is that it can be moved pretty easily.  You can create small work groups by assembling clusters of desks.  For example, it might make sense to put the cash applications person right next to the collections person, who’s also next to the invoicing person.  That way, all three people involved with customer payments can interact.  This is easy with desks, a lot tougher with cubicles.

Especially cubicles with high walls, which completely eliminate communications.  If you’ve got to have cubicles, then at least have ones with low walls.  That way people can look across at each other much more easily.

Enhance the Cubicle Work Flow

Now there’s also work flow within a single person’s work area.  In case you hadn’t noticed, there are basically two types of people – those with one piece of paper on their desks, and those who are comfortable living in a dumpster.  That second group claims they’re still efficient, but I don’t buy it.

This is a really difficult area to correct.  Someone who’s comfortable with clutter just doesn’t see the point in cleaning up their work areas.  But if you can get through the interpersonal issues, then here’s what to do next.  Empty out the work area.  Completely.  That means the computer, the cables, the files – everything.  Dust it down.  Make it quite clear that you’re taking it right down to the bare walls.  Then very selectively put back only those items that are really needed.  Take everything else, and put it in a holding area for a week or so, in case something else is needed.  After that, stick all the residuals back in the supplies closet, or wherever it belongs.

Now, I’m not talking about just clearing out some excess files.  I mean that you question why someone has an extra pen.  Why they keep an extra Post-it pad.  And etcetera.  The reason is that clutter is incremental, and will start building again as soon as you finish this exercise.  So by taking things right down to the bare minimum, there’s a larger amount of reclutterization needed to return to the bad old days.

And, by the way, this complete overhaul is not something you do just once.  Certainly, try it once a year, and some companies go in for it a lot more frequently.

Now, work flow can also be impeded when you have too much material – of all kinds – hiding inside drawers, and cabinets, and behind doors.  The problem is that low-usage items get parked in these places, and everyone forgets about them, and then you have a lengthy search on your hands when you finally DO need them.  Instead, take doors off of cabinets and remove drawers.  Better yet, eliminate entire cabinets and don’t have drawers.  This forces you to keep everything out in the open, which makes you more likely to file it away where it should have been filed in the first place.

Clarify Office Supply Storage

And finally, we have office supplies.  This impedes work flow when people have to search high and low for supplies.  Obviously, don’t let anyone squirrel away supplies, so that no one else has any.  The objection is that the supplies area is always short of supplies, so people have to keep a private stash.  To get around that objection, assign supplies replenishment to one person, and make sure there’s a review checklist that they go through every single day.  If you do that, supplies shouldn’t run short.

This doesn’t necessarily mean that you keep printer cartridges in a central area.  If there are lots of printers, then keep a few spares next to every printer, or at least in a nearby depot, so that people can swap them out on the spot.

Parting Thoughts

In short, accounting is a busy hive of – inefficiency.  People move around far too much for all kinds of reasons.  But if you remove impediments and cluster the right people together, the resulting efficiency improvements can be amazing.

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Budget Model Improvements (#71)

In this podcast episode, we discuss a number of ways to improve the budget model. Key points made are noted below.

I’ve seen a number of companies churn out some amazingly unrealistic budgets; or to put it another way, I’ve hardly ever seen anyone put out an achievable budget. A big part of the problem is that the mechanics of their budget models are just wrong.  Here are some things to look out for.

Include Capacity Planning in the Budget

First up is a large issue – which is capacity planning.  How many times have you seen a senior-level manager decide that his company can achieve far more sales in the next year, but he doesn’t work through the mechanics of how the company is going to pull in those sales.  Don’t forget – a company’s future results will probably match its historical results unless it takes some significant action to change the situation.

One of the best examples of capacity planning is salesperson productivity.  A manager decides that sales will double, but he gives no thought to the sales staff that has to produce the increase.  If the current sales productivity is $1 million dollars per year per person, then you can’t realistically expect the exact same sales staff to somehow generate twice as much sales volume the next year.  Instead, there needs to be adequate staffing to match historical productivity levels.

And don’t go thinking that you can drop a bunch of raw new recruits into a company and expect them to be just as productive as the old timers.  Instead, and to keep using the same example, the sales staff may need months – or a year – before they can even begin to match the historical sales level of the existing staff.  Which brings me to another budget point, which is – timing.

Incorporate Ramp-Up Time into the Budget

Again, let’s say that management wants to double sales, and you’ve even convinced them to acquire enough staff to do so.  But, how long does it take to ramp up?  OK, we just talked about the sales staff requiring a lengthy training period, but that’s not remotely all of it.  In addition, what is the sales cycle for the customers who are supposed to provide the extra revenue?  If more equipment is needed to produce for those new incoming orders, what’s the lead time to buy, and install, and test it?  And what about adding other overhead staff, such as customer support or engineering?

The ramp up interval for all of these activities can be enormous – what if you discover that it takes a half a year before you can even begin to expect additional sales?  Hmm.. Sounds like you won’t meet the target.

Incorporate Staff Turnover into the Budget

And another budgeting issue is the turnover of new staff.  Let’s face it, you can’t hire perfect people based on a couple of interviews.  Sometimes, you’ve got to let them go, or they look elsewhere.  Depending on the industry and position, the turnover among new recruits could be really high.  If so, this slows down your timing even more, so those budgeted revenue increases are beginning to look mighty far down the road.

Incorporate Step Costing into the Budget

Now, I’d like to circle back around to another part of capacity planning, which is step costing.  This is when you reach a certain activity level, and you just have to incur a really large new expense in order to manufacture one more unit of production.  The new expense could be anything – a new factory, a production cell, a major new hire.

For example, a manager decides to double revenues, but the factory foreman tells him that this will require 100% utilization of the factory.  The manager tells the foreman to do it, but doesn’t realize that this is a mathematical impossibility, because some downtime is always needed for ongoing maintenance.  And, the cost of that maintenance keeps going up as you get closer to 100% utilization.  The result is no authorization to increase capacity, and instead the company does not meet its budget – since it can’t – and it incurs massive expenses in order to operate too close to the 100% utilization level.

Instead, the budget analyst needs to know the earliest and most likely points at which the really big new step costs must be incurred, and make sure that everyone else knows about it, too.

Incorporate Cash Needs into the Budget

Another major problem with budgets is going into financing fantasy land.  For some reason, managers don’t seem to realize that a massive ramp up in operations requires a lot of new working capital – their budget models may not even contain this information, so they just follow the budget, find themselves running short on cash very suddenly, and then have to scramble to fund money at the last minute.  A much better alternative is to have a working capital calculation within the budget, and keep referring to it as you go through the various budget model iterations.

If anything, keep it on the front page of the budget, where no one can miss it.  That way, you can easily see what each new budget iteration does to your cash needs.

Reduce the Number of Accounts

There’re also a lot of low-level efficiency improvements you can make to a budget model.  For example, reduce the number of accounts that you budget for, since each one requires some time to maintain.  If a line item is too small to bother with, then merge it into some larger account.  Also, if you have some hard numbers that just aren’t going to change, like scheduled rent payments, then lock them down, or at least change the cell color to something glaring – like red.  That way, no one will touch those cells.

Set Variable Costs to Vary with Activity Levels

Another issue is variable expenses.  This isn’t just the cost of goods sold, but also things like training, or telephones.  These expenses change as a cost driver changes, so set up the cost driver in the model, and have those expenses vary automatically with the drivers.  For example, if a company usually pays out $500 per year in training expenses for each employee, then just create a formula that automatically plugs in an expense based on the head count.  By setting up some of the expenses under a formula, you don’t have to worry about making changes to those expenses as you go through multiple budget iterations – they take care of themselves.

Centralize the Variables

And yet another issue is where you put all of your variables.  If you sprinkle them all over the model, it can be really difficult to find them all, let alone update them.  So instead, put all of them in one place.

Additional Enhancements

Now, what about having managers create an entirely new budget for themselves every year?  That can be a laugh.  Since they’re not trained in creating budgets, they have a terrible time creating anything that reflects reality.  Instead, if the budget analyst knows what the general strategic direction is, then have that person go ahead and plug in the bulk of the budget line items, which are mostly based on historical information anyways.  Then she makes notes on the key items that the manager has to decide on, and goes over just those items with the manager.  The result is a budget that probably has the right amounts in the right months, and also wastes the least possible amount of manager time.

And finally, the budget will be viewed as nothing more than an annual annoyance unless you integrate it into two key systems.  The first one is purchasing. If the budgeted expenses are loaded into the purchasing system, it can issue a warning when expenditures exceed budgeted amounts.  This tends to keep managers extremely aware of their budget commitments.  The second item is the performance pay system.  Bonuses should be paid based on what managers committed to in the budget.  If they don’t make plan, they don’t get a bonus.  It seems simple, but most companies don’t link the budget to pay, so the budget is ignored.

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Breakeven Analysis and the Margin of Safety (#70)

In this podcast episode, we discuss breakeven analysis and the margin of safety; how they are calculated and when they should be used. Key points made are noted below.

What is Breakeven?

Breakeven is the revenue level at which you earn exactly no profit.  The calculation is to add up all of your fixed expenses, and divide by the gross margin.  So for example, if you have $10,000 of fixed expenses and your gross margin is 40%, then you need to sell $25,000 in order to break even. The breakeven point will go up if the amount of fixed expenses goes up, or if the gross margin goes down.  Conversely, the breakeven point goes down if the amount of fixed expenses goes down or if the gross margin goes up.

How Breakeven is Used

So why do we use it?  It’s good for two kinds of financial analysis.  The first is when you’re looking at a business unit for the first time, usually as an outsider, like a consultant or bank analyst, and you want to find out how much money it can potentially make – or not make.  For example, if a factory can potentially produce $1 million of revenue, and the breakeven point is at $200,000, then there’s lots of upward potential for profits.  But where you really see the usefulness of breakeven is in the reverse, where the breakeven point is so high that the company literally can never earn any money.  The breakeven point is higher than its ability to produce.

I’ve seen this last one a surprising number of times.  It’s amazing how many business owners have no clue that their cost structures don’t allow them to ever earn any money.

The second type of breakeven analysis is for incremental management decisions.  Usually, this involves one of two sub-levels of analysis.  The first is what happens to the breakeven point if a company accepts a large order that has a relatively small gross margin – if the new gross margin is really small, then breakeven analysis shows that the order may clog up the factory’s entire capacity.

This also brings up a good point with breakeven analysis, which is that a company may have to accept price drops in order to find enough orders to max out its factory capacity.  The result is that, sometimes, the highest profit level is somewhere below a facility’s maximum capacity.

The second analysis, and the one I get involved with the most, is whether purchasing new equipment is worthwhile.

I’ve seen a couple of cases where adding a complex new piece of equipment increases the fixed cost base so much that there’s no way the company can break even, or only do so if nearly its entire capacity is used.  I don’t want to duplicate what I’ve said before about capital budgeting, so go back to Episode 45 to learn more about that.  For the purposes of this discussion, just keep in mind that you can really attract management’s attention when they realize that a large asset purchase can render an entire factory completely uneconomical.

Also, please note that the point when a company usually makes the most profit is at the point just before a company invests in new equipment.  Once it makes that new investment – usually to increase capacity – costs go up, there’s not enough product demand to use the new capacity, and therefore profits drop.

What is the Margin of Safety?

A variation on breakeven analysis is called the margin of safety.  This is the percentage by which a company’s sales can drop before it reaches its breakeven point.  It’s a really useful concept when a company thinks that some of its sales might be at risk of going away, such as when a single customer has a large proportion of its sales.  By calculating the margin of safety, a company will know how much revenue it can lose before it’ll begin losing cash.

The calculation for the margin of safety is to subtract the current revenue breakeven level from the current sales level, and dividing by the current sales level.  For example, if the current sales level is $1 million and the breakeven point is $600,000, then sales can drop 40% before reaching the breakeven point.

Breakeven and the margin of safety are useful for analyzing management decisions, because they’re so incredibly simple.  Managers understand them right away, so you can easily create a before-and-after PowerPoint slide for a pricing or purchase decision, and they can see the relevant outcome.

Problems with Breakeven Analysis

The real problem with breakeven analysis is that people don’t know when to stop using it.  The tendency is for someone to first use it for a company-wide or factory-level analysis, and then keep drilling down, to the point where they do a detailed breakeven analysis for a single product.  The result is a report that shows a whole range of breakeven points for a company’s products, and which might even lead to some of them being discontinued. I’m sure the person who creates this level of detail thinks he’s doing a good deed, but all he’s really doing is working up the management team over what is actually a large pile of false information.

When you run a breakeven analysis on a single product, you’re probably allocating expenses to the product from a variety of work centers; and you’re also probably including direct labor when you calculate the gross margin.  But that’s flawed reasoning, because if management drops a product because of a high breakeven point, it’s just voluntarily dropped a bunch of revenue, while the factory as a whole still has all of the same fixed cost structure.

In short, you can get way too granular with breakeven analysis.  It’s best to stop using it at the product line level, because that’s the point at which you can usually assign specific people and equipment to a group of products.  And if it’s too difficult to break out costs at the product line level, then don’t use breakeven there, either.  Instead, confine the analysis to the factory level.

When to Use Breakeven Analysis

This means that you don’t need to use breakeven all that frequently.  A company may have thousands of products, but perhaps only a dozen or so product lines, and quite possibly just a few factories – and only at the higher levels is breakeven appropriate.

Another issue is how frequently you should run a breakeven analysis.  The answer is – not frequently at all.  Most fixed expenses and gross margins don’t alter very fast, so if you run the calculation once a month, any breakeven changes will be so insignificant from the previous month that everyone will ignore it.  So if you calculate it once a year, that’s fine.

Now, these frequency recommendations are based on a steady-state environment, where there aren’t many changes.  However, you should run a breakeven and margin of safety for any major changes, like a new price point, or if some new equipment is purchased.  So in total, depending on the size and number of changes within a company, you might only dust off a breakeven calculation a half-dozen times a year.

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Listing on a Stock Exchange (#69)

This podcast episode covers the essentials of what it takes to be listed on a stock exchange, including the application process and listing fees. Key points made are noted below.

The Need to Trade on an Exchange

If a company wants to be publicly held, there’s not much point in doing so unless it involves trading on an exchange.  Without being on an exchange, a company has all kinds of costs associated with being public, but there’s not much of a market for its stock.  Instead, it’ll probably trade on the over the counter bulletin board market, and not many people trade there.

The reason it’s so hard to trade over the counter shares is that institutions, like pension funds, don’t trade there.  Their investment rules very specifically state that their investment managers can only buy or sell the stocks or bonds of businesses that are on an exchange.  In a lot of cases, the rules are way more restrictive than that, so a company has to be trading on a specific exchange, or be listed within a certain index on an exchange.

Which Exchange to Pick

So, in short, you have to be on an exchange in order to experience any significant trading volume.  The next question is, which exchange?  There are many exchanges all over the world, but in most cases, a company likes to stay close to home and use an exchange right in its home country.  It’s just easier from a regulatory perspective.

In this case, since I’m in the United States, I’ll focus on the key exchanges there, which are the American Stock Exchange, the NASDAQ, and the New York Stock Exchange.  The American Stock Exchange is called the AmEx for short.

The Listing Application

To be listed on one of these exchanges, you have to go through a listing application, which takes anywhere from three to six months to complete.  I generally see the process taking closer to six months than three months.  The exchange sends you a boilerplate set of questions, which cover things like the total number of shares outstanding, the number of shares held by insiders, the number of independent directors on the audit committee, and whether there’s any fund raising activity going on.  The questions aren’t especially difficult, but it’s only the first round of questions.

Once the exchange receives your answers, it assigns a listing analyst to the application.  That person is overworked, and might not even open up the file for a month.  Eventually, he’ll review it, and dig through all of your latest public filings, and then send back more questions that are a lot pickier.  Expect at least three rounds of these questions.  Then the listing analyst sends the application to a supervisor, who does another review.  This one tends to be shorter, but by this time, three months have very likely already gone by.

Targets to Pass

Now the exchange will look at some hard quantitative targets.  You’ve got to pass each one of these, or you will not be listed.  The first one is the total number of round lot shareholders.  A round lot shareholder is anyone owning at least 100 shares of your stock.  The American and New York Exchanges require at least 400 of them, and the NASDAQ requires 300.  The reason for this rule is that the exchanges want the shares to be owned by quite a few investors, so there’s a better chance of trading occurring.  If there were just one shareholder, it’s possible that nobody would buy or sell it.  So this is a volume trading requirement.

Another requirement is the market valuation of the company.  The exchanges don’t want tiny little companies trading on them, so they have some hard requirements to keep out the small guys.  This is called a market capitalization test.  Market cap is the total number of shares outstanding times the current stock price.  The market valuation test varies quite a bit by exchange, so under one very specific scenario, you can get away with just a $50 million market cap on the AmEx, whereas the New York Stock Exchange can require a market cap of as much as $375 million.

And then we come to a very troublesome requirement, which is proving that the company is profitable.  Each exchange has a several different set of standards that you can try to qualify under.  So for example, the AmEx will let you in if you’ve had $750,000 of pretax income and stockholder’s equity of $4 million, and will even waive the market capitalization requirement if you have that.  On the other hand, one of the standards imposed by the NASDAQ requires aggregate pre-tax earnings of $11 million in the past three years.

And then there’s the stock price.  The larger exchanges don’t like low stock prices, so they impose minimum limits for listing applicants.  You generally need at least a $2 stock price on the American, and $4 or $5 on the NASDAQ.  Some companies will try a reverse stock split in order to increase their share price, but that’s usually a bad idea.  A reverse split attracts short sellers, so a company may find that its stock price did not double as a result of the split, and in fact it may be close to what it was before the split.

By the way, if you can get your stock price up to the minimum requirement for just one day, that’s not good enough.  The listing analyst will review a short-term history of the stock price to see if it appears to be sustainable at the minimum level.  If there are a few dips below the minimum, that’s OK – but there can’t be a trend where the price appears to be permanently heading below the minimum level.

This may sound like a lot of requirements, but I’m actually painting a simplified picture.  Each of the exchanges use multiple listing standards that you can qualify under, so for example, if you’re not profitable, then maybe you can qualify under another standard that has more onerous requirements for market capitalization or retained earnings.

Generally speaking, a smaller company wants to start on the American Stock Exchange, because its listing requirements are easier.  It can also choose to list on the NASDAQ Capital Market, which has roughly the same standards, but a higher stock price standard.  If it’s bigger or more profitable, then it can try the NASDAQ Global Market, which has tougher standards.  The largest companies will want to list on the New York Stock Exchange, which has the hardest of all the listing requirements.

Staying on an Exchange

Now what about staying on an exchange?  Each exchange has continuing listing standards which are easier than the initial entry requirements.  The main sticking point is the stock price.  Basically, if it drops under $1, the exchange drops you.  This is not the case for the American Stock Exchange, which doesn’t have a minimum standard – but they will delist you if you get into financial difficulties.

The Cost of Being Listed

And finally, what does all of this cost?  The AmEx and NASDAQ Capital Market both charge about the same initial listing fees, which are $45,000 to $75,000.  The NASDAQ Global Market’s listing fee is in the range of $100,000 to $150,000, and the New York Stock Exchange will usually charge somewhere between $150,000 and $250,000.

But of course, they’ll also impose an ongoing annual fee for you to remain on the exchange.  The current maximum annual fee for the AmEx is $34,000, the NASDAQ Capital Market charges about $28,000, and the NASDAQ Global Market charges $95,000.  The New York Stock Exchange has a much broader fee structure, but basically caps its annual fee at a half a million, though it’s possible to pay under $100,000.

Parting Thoughts

This has been an extremely condensed view of the listing process. A really complete treatment would need a podcast about 20 times longer, but the basic premise is that if you’re fairly small and not very profitable, you start out on an exchange that’s designed for your needs, like the AmEx or NASDAQ Capital Market.  You won’t have access to all possible investors, but they at least give you the opportunity for a fairly active trading environment.

As you get bigger, and you want access to more investors, switch upmarket to the NASDAQ Global Market or the New York Stock Exchange.  It’ll cost you more, but there’s likely to be significantly more trading in your stock.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Tax Technology (#68)

This podcast episode covers how you can apply the most current tax technology to the filing needs of a business. Key points made are:

• Tax technology is based on compliance, filling out tax forms; regulatory complexity drives the output of these systems.

• Tax technology tends to be 5-10 years behind other business systems.

• It is relatively common for tax software to be tied into a corporate ERP system.

• Tax laws are so specialized now that few people are authorities on all tax areas of a business.

• An overriding goal for a public company is to make sure that there are no tax surprises, since the CEO and CFO are certifying that the financial statements are accurate. This means that incorrect tax filing calculations must be eliminated.

• The Big Four audit firms are taking the best tax talent away from corporations, so the corporate level of expertise is falling.

• A tax department needs good policies and procedures, as well as data collection systems for both structured and unstructured data. It must have a high level of real-time access, combined with excellent data security. All tax filings should be based on a single database.

• Best to use software as a service, in order to have a central database that is readily accessible from anywhere.

• Tax software should include modules for data collection, project management, resource management, audit management, and tax filings.

• Tax professionals will still use electronic spreadsheets, but should exercise tight control over them.

Related Courses

Lean Accounting Guidebook

Small Business Tax Guide

Value Stream Mapping (#67)

In this podcast episode, we discuss value stream mapping, especially in regard to how it can be used to improve accounting operations. Key points made are noted below.

The Value Stream Mapping Chart

This episode is about value stream mapping, or VSM.  What it does is show you where there’s waste in a process.  It doesn’t show you how to eliminate it, but it does point out where you can find it. All of the VSM information you collect goes into a VSM chart.  The chart identifies all steps in a process, and key information about each item.  The “key information” can vary quite a bit by process, but it’s common to find things like total work time required, cycle time to complete a transaction, and error rates.

The chart also identifies the amount of time spent between steps, where the information from the last step is batched together, and consumes transit time to get somewhere else, and then parks in an inbound queue in front of the next process step.  It’s really common for the time between steps to be longer than the time during steps.

The Need for a Consultant

To create a VSM chart, you really need to bring in a consultant.  It takes a fair amount of time to collect information, and you probably don’t have enough staff available on-site to do the work.  Also, it isn’t something that you do just once.  Instead, you do an initial measurement, act on the information, then measure again to see what happened, and then keep measuring as long as you keep taking action steps.  In addition, it makes sense to re-measure the process at longer intervals to see if it’s backsliding.  Because of all this work, it really makes sense to hire a specialist who comes in at prearranged intervals, does the work, and gets out.

A consultant is also useful, because the people being measured don’t like being measured, and they have less chance of pressuring a consultant into fudging the numbers than they would with a fellow employee.

Using the industrial Engineering Staff

If you just can’t afford a consultant, then another good source is the industrial engineering staff.  They do this kind of analysis all the time, and they might do some kind of internal billing arrangement in exchange for helping out.  You could also try the internal auditing department, but VSM data collection is so repetitive that they might not want to help – and besides, they’re looking for control problems, and a VSM chart does not highlight control issues.

Information Structuring

So how do you structure this information in a VSM chart?  It’s not difficult at all.  First, create a series of blocks across a spreadsheet, with each one being a separate step in a process.  Then fill in identifying information about each step within each block, in sequence.  So for example, if you’re documenting a procurement cycle, the first block might be to submit a requisition, the next block is for processing a purchase order, and the third block is to receive goods at the warehouse – and so on.

Beneath each block, jot down the information you want to collect.  For example, there might be an error percentage field, and another field for the number of full-time equivalent staff used for the task – whatever it might be, the information goes directly under the block that you’re measuring.

Also make note of the processing time required under each block, and then also note the time required between steps.  With all of this information, you can quickly glance at an entire process, and decide where to direct your attention to improve it.

What you do with a VSM chart depends on what you’re trying to improve.  For example, if overtime is too high an expense, then you can track overtime for each step, see where the most overtime is located, and concentrate on overtime reduction in that area.  A more common issue is document error rates.  In this case, you may need to do two VSM charts.  The first one reveals which process contains the most errors.  Then you run the VSM again, but now as a drilldown for just that one process.  It’s quite likely that a single machine, or work practice, or employee is responsible for the bulk of the errors.

If process time reduction is the issue, then chances are good that you need to focus on the time between process steps, with the greatest emphasis – obviously – on whatever gap requires the most time.

All of these examples bring up an interesting point, which is that you can run multiple VSM charts on the same process, in order to fix different things.  On the first pass, the goal may be process time reduction, so that’s what you measure, and that’s what you reduce.

The next time around, you focus on errors only, and you reduce those.  But at some point, these different goals will probably interfere with each other.  So for example, let’s say that you’ve just shrunk a process way down, but you did so by cutting out some controls that resulted in more errors.

At some point, you’ll need to come to terms with which goal is more important, and back off a bit with the other conflicting goals.

Where to Use Value Stream Mapping

So where does VSM work best?  Definitely in high-volume processes, because this is where it makes the most sense to try to wring even a few extra seconds out of a repetitive process.  Conversely, don’t even bother if there’s really low volume, or where people constantly switch around among different jobs during the day.  If there’s no volume, then measurement results aren’t very reliable, and there’s not much payback from making an improvement.

Given these restrictions, there’re really only a few places in an accounting organization where value stream mapping can help – and those places are pretty obvious.  You should be looking at customer billings, cash receipts, and payables, in particular.

If you liked hearing about value stream mapping, then you might also like to listen to a discussion of accounting run charts, which show you how to track process performance over time. That discussion was back in Episode 32.  There are also articles about value stream mapping and accounting run charts on accountingtools.com.  To access them, just go to the website and enter a few key words in the search bar at the top of any page.

Related Courses

Accounting Information Systems

Lean Accounting Guidebook

Obsolete Inventory (#66)

In this podcast episode, we discuss how to identify potentially obsolete inventory, who should examine it, and how to get rid of it. Key points made are noted below.

If you have inventory, then some of it is obsolete. Period. If you don’t think so, then you’re not investigating it very well.  The trick is to form a group who’s responsible for obsolescence, then creating a system for finding it, and then figuring out how to dispose of it.

The Materials Review Board

The group you need is called the materials review board, or MRB.  This group has members from every department that has something to do with inventory, which means someone from accounting, engineering, logistics, and production.  For an example of why you need so many people, the engineering staff may want to keep some parts that they’re incorporating into a new product design.  Or, the logistics department knows that it’s impossible to obtain a particular part, so they’d rather hang onto it for service parts use.

This group is responsible for periodically reviewing the inventory, to see what goes and what stays.  To do this, they need information about which items are obsolete.  There are several ways to get it.

The Where Used Report

The best way is what’s called a “where used” report, which is really common in material requirements planning systems.  It’s a report that lists all of the bills of material in which a part is used.  If there’s no “where used” bill for an inventory item, then it’s not being used anywhere.  Kind of good key indicator of obsolescence.  To make it work better, make sure you deactivate any bills of materials for products that are no longer being manufactured.

The Last Date Used Report

Another option is the “last date used” report.  It’s not a common report in most manufacturing software packages, but it’s easy enough to create with a report writer.  All you want is the product name and number, the quantity on hand, and the last time the item was used.  Then sort the report so that the oldest items go first.

Now, this report will tell you if something hasn’t been used for a long time, but it doesn’t tell you if it will never be used again, since it might be a critical part of a product that’s coming up for a new production run in the future.  So use it with care.

Use Old Count Tags

But what if you don’t have an inventory tracking system, or you don’t think you can rely on it?  Well, if you do a year-end physical inventory count, then just leave the count tags on the inventory items.  If items get used later in the year, then the tags will be thrown away.  But if they aren’t used, then you can tour the warehouse a few months later, and just see which items still have tags on them.

This is an imperfect method, since lots of tags will be ripped off by mistake – after all, the warehouse is a high traffic area.  Also, if a whole box of parts has a single count tag on it, then the warehouse staff can easily work around the tag and still remove parts from the box.  So, be careful in using this technique.

Examine Engineering Change Orders

One last possibility is to look at the engineering change order records in the engineering department, or ECO.  The ECO describes what new part is replacing an old part on a product, because the engineering staff redesigned the product.  So, comb through the records and figure out which items have been replaced.

What to Do Next

So – we have several methods for locating obsolete inventory.  What do we do with it?  The next step is to summarize it for the materials review board.  To do so, list in a single report the name of each item, with the warehouse location, quantity on hand, the last year’s usage total, the planned usage total, and the extended cost of what’s on hand right now.

The MRB really wants to know about that last item, the extended cost.  This is the company’s investment in the inventory, and the MRB should really focus on the big dollar items.  Incidentally, if the warehouse is packed with inventory, the MRB may actually be more interested in the cubic volume of storage space taken up by the obsolete inventory – so the report could contain that information, as well.

The MRB then decides on whether to dispose of the obsolete inventory, when to do so, and also how much of it to get rid of.  In many cases, the logistics department still wants to retain some, because of service parts needs.  So, the MRB has to create an authorization memo that states all of this information.  Once it’s complete, the logistics department has to dispose of it.  And the sooner the better, since inventory drops in value over time.

Disposing of Obsolete Inventory

And how do we dispose of it?  One of the best ways is to have the service department call customers and see if they’d like to buy it as service parts, which means you can sell it at a good price.  It may also be possible to return the parts to the supplier, though there’s always a restocking fee, usually in the range of 15 to 20 percent.  Sometimes the supplier only issues a credit for them, so you’re still stuck with buying something else from the supplier with the credit.

Of course, there is always ebay.com, or any other on-line auction service.  This works pretty well for consumer goods, not so well for anything else.  Another option is to bring in a salvage contractor, though they only pay a fraction of the total value of the inventory.  If you use one, make them buy in bulk, and not pick over the inventory for the real values.  That way, you can dump more inventory on them.

And finally, you can also donate the inventory to a non-profit, and take a tax deduction.  It can take some time to find a good recipient, so this is a labor-intensive option that many companies just don’t bother with.

And finally, it’s actually better to throw obsolete inventory into the dumpster than it is to keep it in the warehouse.  That way, you free up shelf space for other inventory, and you no longer have to insure it.

Preventive Measures

Now, what about preventive measures, so that inventory never becomes obsolete?  A good one is to have the logistics department review any upcoming engineering change orders in advance.  That way, they can draw down existing stocks with a final production run, and then implement the change order.

Another option is to require the engineering staff to only design from an approved parts list, so fewer parts get used on many products.  And finally, you’ve got to keep the purchasing staff from buying in bulk.  Even if it’s a great deal on something, you just don’t want a two-year supply of a part sitting on the shelf.  The longer something is in the warehouse, the better the chance that it’ll become obsolete.

Related Courses

Accounting for Inventory

Inventory Management

Responsibility Accounting (#65)

In this podcast episode, we discuss the nature of responsibility accounting, and how such a system can be operated. Key points made are noted below.

How Responsibility Accounting is Used

Under responsibility accounting, the basic point is that every cost incurred must be the responsibility of someone, somewhere in the company.  That’s it.  Doesn’t sound too complicated, but it means that the accountant should create a whole subset of reports below the company-wide financial statements, and distribute them to every responsible party.

These reports come in three flavors.  The first is a profit center, where the recipient is usually in charge of an entire facility, and wants to see everything, including revenues, expenses, and profits.  There’re usually not a whole lot of profit centers in a company.

The second flavor is a cost center.  This is where there are no revenues directly associated with an activity.  It could be an accounting department, or perhaps a production cell on the factory floor.  This tends to have a pretty small number of expense line items, but they many involve hundreds of managers.  So you could issue hundreds of cost center reports.

And there are also revenue centers.  Kind of obviously, they only report on revenue results.  This type of report goes to the sales staff and product managers, though product managers can also receive full profit center reports.  These reports can itemize sales right down to individual stock keeping units, and so they can be fairly hefty.

Now if you’ve never issued responsibility reports, you may ask why you should start.  Well, consider the distribution of the normal set of financial statements.  It goes to the senior management team, perhaps some subsidiary managers, and that’s about it.  No one else knows what’s going on, until they get called into a senior manager’s office near the end of the year, and get blasted for having cost overruns or profit shortfalls that they knew nothing about.

But if you have responsibility-level reports, practically every manager gets something.  It may be a really short report, with one line item on it.  But if that’s what they’re responsible for, then that’s a good report.

How Overhead is Allocated

So, what about allocated overhead?  Lots of companies like to allocate overhead to individual subsidiaries, or to departments within those subsidiaries.  It can be things like corporate overhead, or the cost of janitorial services.  Allocating overhead is a really bad idea.  The main point of responsibility accounting is that you only see in a financial report those items for which you are responsible.  That’s it.  Nothing else is included.  Therefore, take out overhead allocations.

But this doesn’t mean that overhead is never reported anywhere.  After all, this can be a really large number.  What you do is only report it to the person who is – what a surprise – responsible for it.  So, you should report corporate expenses to someone like the chief operating officer.  Or, if you have janitorial expenses for an entire facility, you can report those expenses to the maintenance manager, and to the manager of that entire facility – but don’t report it to the department managers within that facility.  They can’t do anything about it, so don’t bother them with it.

Contents of a Responsibility Report

So… what exactly goes into a responsibility report?  You can certainly send out just the last month’s results.  But that doesn’t give the reader anything to compare it to.  To fix this, the most obvious option is a budget versus actual report, both for the current month and for the year-to-date. The trouble is, some of the most enjoyable science fiction I’ve ever read involves budgets.  In a lot of cases, they don’t even bear a slight resemblance to reality.  And strangely enough, the budgeted results are always better than the actuals.

A better alternative is to run a rolling 12-month report, which shows actual results for each of the last 12 months.  This has nothing but actuals in it – no budget allowed.  This gives readers a really good idea where everything is trending, which I find is much better information than a budget to actual comparison.

A variation on the rolling 12-month report is to do it as percentages, so that revenues appear as 100%, and the various expense line items are fractions of that 100%.  I think it has some value, but most users prefer seeing the underlying numbers.

How to Roll Out Responsibility Reports

Now, any controller who wants to just close the books each month and get on with life is shaking his head and wondering where to find the time to issue this massive number of additional reports.  Well, there are a couple of solutions.  First, see if your accounting package automatically prints and e-mails reports.  If it does, then set up all the responsibility reports in one massive batch, and run the batch right after the books are closed.

Second, you can push responsibility reporting down into the organization in stages.  The traditional financials are for the top level of managers.  Then go down one level, and you’ll probably find that you need about three times as many customized reports for this group.  Then push down another level, and you’ll triple the number of reports again, and so on.

The number of new reports needed at each level is directly associated with the span of control at each level of management.  If the span of control is five direct reports for each manager, then you can expect to create five times as many reports when you go down one additional level in the organization.

In essence, address one management level at a time, and stop issuing more reports when you can longer support the extra workload.

So far, we’ve talked about creating reports for all kinds of responsible parties.  But – what if no one seems to be responsible for something?  There are situations where an expense is incurred, but no one is authorizing the expense – it just happens.  This is usually minor stuff, like office supplies, and it isn’t an overwhelming concern.  But on the other hand, if you find a stray item, then bring it to the controller’s or CFO’s attention.  They should park it under someone’s jurisdiction, and should make sure that the newly responsible person knows about all it.

Related Courses

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SFAS 141R, Business Combinations (#64)

In this podcast episode, we discuss the new requirements of SFAS 141R, Business Combinations. Key points made are:

• Most assets and liabilities associated with an acquisition transaction should be recorded on the acquirer’s balance sheet at fair value.

• Any noncontrolling interest in the acquiree is valued at its fair value.

• The acquisition method is now used, instead of the purchase method.

• Everything should be valued as of the acquisition date.

• The cost of the acquisition is charged to expense as it is incurred, because these expenditures do not meet the definition of an asset.

• In-process research is recognized as an asset; it is amortized or written off later.

• Contingent consideration (an earnout) is to be recognized up front, at its expected fair value.

Related Courses

Business Combinations and Consolidations

Mergers and Acquisitions

Investor Relations: Guidance (#63)

In this podcast episode, we discuss the need for issuing earnings guidance to the investment community, including tips regarding the nature of that guidance. Key points made are noted below.

The Need for Guidance

Without guidance, investors have no idea how a company will perform in the future, and so they have to make their own guesses.  Since no one is basing their guesses on any real information, you’re going to see a broad range of estimates.  And that translates into a great deal of stock price volatility, because everyone assumes that the company’s stock should be at a different price point.

Now, stock price volatility is not good.  First, it attracts short sellers, who make money from rapid changes in the stock price.  It also drives away institutional investors, who prefer stocks whose prices move within a narrow range.  Since institutional investors are driven away, there’s less demand for a company’s stock, and so its price declines.  This results in a higher cost of capital for the company, because it has to issue more shares in order to raise money.  So, there’re some major consequences to not providing guidance.

Also, let’s say that a company has no analyst following, which is normal for smaller public companies.  If so, there is no one who can independently provide earnings predictions, which leaves the marketplace completely devoid of information.  So, the absence of any analyst following makes it even more useful to provide guidance.

When Not to Issue Guidance

But there is one case where it still makes sense to avoid issuing guidance – That’s when management doesn’t have a clear picture of future results.  This is most likely when a company is buying a lot of companies, or it’s entering new markets.  If so, its results may vary so much that it really isn’t helping to issue guidance that’s quite possibly wrong.  Under this scenario, it’s better to state the situation, and promise to provide guidance at some point in the future, once results become more predictable.

It’s also possible that a company’s forecasting systems are so crappy that it’s routinely issuing poor guidance.  In this case, the investment community will assume that the management team doesn’t know what it’s doing.  If so, it’s better to stop issuing guidance until it has better forecasting systems.

So, let’s say that you consider those issues, and decide to provide guidance – which is usually a good decision.  If so, the next question is – what kind of guidance.

The Type of Guidance to Issue

The usual type of guidance is for a range of possible results, and includes all the major factors that would be of interest to an investor, such as revenue, gross margins, net income, and earnings per share.  The range of projected results should be fairly broad the further into the future you go, since that’s the most uncertain.  Short-term results should fall within a tight range.

Here’s an example.  We’re raising our guidance for the fiscal year ended December 31.  We now expect the year’s sales to range between $120 and $135 million, resulting in net profits of between $14 and $17 million, and diluted earnings per share of between $1.43 and $1.49.  For the following year, we’re expecting sales in the range of $130 to $160 million, resulting in net profits of between $16 and $21 million, and diluted earnings per share of between $1.48 and $1.60.

An alternative is to provide guidance using percentages.  By doing so, an analyst can construct his own models of a company’s performance, and plug in the latest guidance to arrive at his own conclusions about the company’s likely performance.  For example:

Our projected revenue growth is 7-10 percent.  Based on our estimated increase of five percent in the cost of goods sold, we’re projecting gross margins in the range of 50 percent to 55 percent, with the low end of the range based on seven percent revenue growth and the high end based on 10 percent revenue growth.

If a company isn’t willing to provide this level of guidance, then a lesser alternative is to discuss the general financial situation, or the long-term strategy.  For example, you could say:

Our long-term strategy is to expand our franchising model throughout the North American region, with a target store opening rate of 150 per year.

A different method is to release a broad range of non-material information.  Analysts then use it to create their own models of a company’s operations and its likely operating results.

This is called the “mosaic” approach, because they have to piece together lots of  information into a composite picture of the company.  It’s for a company, because it avoids any specific guidance, but it’s a royal pain for an analyst, who has to work much harder to create an earnings model.

Now, once you decide to release information to the marketplace, be prepared to continue issuing it for a long time.  Otherwise, the market can react quite negatively when information is discontinued, since they assume that the company is hiding information.  So, if you think that information that was included in guidance is now irrelevant, then be sure to explain the reason for the discontinuance in some detail.  Otherwise, you might be looking at a decline in your stock price.

When to Update Guidance

If you give guidance, then update it on a regular schedule.  This usually means issuing quarterly guidance, right after the quarterly 10-Q report is released. Analysts depend on quarterly guidance, so they can revise their own estimates of company performance.  If a company elects to forego quarterly guidance in favor of some longer period, it’s possible that some analysts will find it too difficult to provide estimates regarding company performance, and they’ll drop their coverage.  If this happens, stock price volatility may increase, because there’s uncertainty about how the company is doing.  So, provide frequent guidance updates to avoid excessive movement in the stock price.

There are some cases where it’s reasonable to issue guidance even more frequently than on a quarterly basis.  For example, if a company has an analyst following and a number of them are projecting really high or low results, consider giving immediate guidance to put them back on track.  By doing so, analysts can alter their projections at once, thereby keeping the company’s stock price from tracking in accordance with those incorrect estimates.

Also, if a company doesn’t revise its guidance, then the investment community assumes that the information in the last guidance is still current.  So, if circumstances have changed, and made the current guidance misleading, then issue new guidance in advance of the normal guidance release schedule.  But only do this if the level of change is very substantial.

Whether to Issue Aggressive Guidance

Under no circumstances should you ever issue aggressive guidance, where it’ll be difficult for the company to achieve the forecast. What happens then is a short-term ramp up in the stock price, followed by a price crash when the company can’t achieve its own guidance.  If a company repeatedly issues aggressive guidance, then you end up with very high price volatility, which drives away long-term investors.

A much better alternative is to always provide guidance that’s within the management team’s comfort zone.  If everyone in a company knows they can attain the guidance levels, then they’ll be less fixated on reaching the target, which reduces the risk of fraudulent reporting.  Also, by providing reasonably conservative guidance, analysts will find a company to be more trustworthy and reliable, and so they’ll be more likely to provide coverage.

But, this doesn’t mean that you should always issue excessively low guidance.  If a company routinely exceeds its guidance by a large margin, then analysts will expect the same thing in the future.  So, if a company were to only meet its own guidance, analysts might treat this as poor performance.  Therefore, the best level of guidance is to issue slightly conservative numbers.

In short, use guidance whenever you can forecast results with some reasonable degree of accuracy.  Where guidance causes problems is when it’s too aggressive, so be consistently just a bit conservative.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Accounting Standards Codification (#62)

In this podcast episode, we discuss the structure of the accounting standards codification that has been produced for all GAAP accounting standards. Key points made are noted below.

The Need for a Codification

The Financial Accounting Standards Board is combining all accounting standards into a single database that’s indexed with a standard coding structure.  This means you no longer have to look up a Statement of Position, or an Emerging Issues Task Force consensus, or a Statement of Accounting Standards.  Instead, it’s all in one place.

Now keep in mind that this doesn’t change GAAP at all – but it does reorganize a couple of gazillion GAAP pronouncements into about 90 topics.  This means you’ll spend less time researching accounting problems.  And on top of that, every time they issue a new standard, they’ll drop the new text directly into the new coding structure.

Exceptions to the Codification

There are two exceptions to what you’ll find listed in the codification.  One is guidance issued by the Securities and Exchange Commission, though even in that case, some of their content will be included.  And the other exception is governmental accounting standards, which aren’t included at all.

The Verification Phase

This codification project is now in a one-year verification phase, while users check it out and make comments.  After verification is completed at the end of 2008, this will supersede all other accounting standards. While the verification phase is going on, you can sign up for it for free and browse through it all you want.  To do that, go to asc.fasb.org.  You have to register to use the site, but that only takes a minute.  I strongly suggest that you try it, because it’s really well done. If you look at the main FASB web site, which is fasb.org, you’ll notice that it’s functional, but they could use a professional web designer to clean it up.  But the codification site is an entirely different story, because it’s an exceptionally fine piece of work.

The Codification Layout

Here’s how the layout works.  Down the left side of the page, they itemize the top levels of the codification, so you’ll see just major categories, like assets, liabilities, equity, revenue, and expenses.  And – the part I like – they have a category at the bottom for industry-specific GAAP.

My personal favorite is steamship company GAAP, which is parked way down at the bottom of the list.  Not sure that applies to anyone anymore.

The top level also contains two other categories.  One is called Presentation, and obviously it covers how to present information, so it has subcategories for things like the balance sheet and income statement, but also more specialized topics, like earnings per share and interim reporting.

The other category is their catchall, which is called Broad Transactions.  It contains topics like business combinations, derivatives, and leases.

If you click on any of these categories, you can drill down through their menu system for as many as four levels.  So for example, if you start at the Expenses level and then select the Compensation sub-level, that takes you to Retirement Plans, and from there, you can go to Defined Benefit Plans.  But that’s pretty deep.  In most cases, the menu structure stops at three levels.

So let’s say that you drill down all the way to the underlying text.  If you do, you’ll have a selection of categories of information to choose from, like an overview, scope exceptions, the glossary, and of course the main discussion.  But rather than clicking on each item in turn, your better option is to click on a button called “Join all Sections,” which merges all of this information into a single web page.  I find that this makes it easier to read.  Now once you get to this page, you’ll find that it also has lots of hyperlinks to cross-references.

Other Codification Features

The site has some other nifty features, too.  If you go back to the home page, it has a tab on the right side that directs you to tutorials for how to use the site.  And for all of us old-timers, there’s an awesome cross-referencing tool, where you can plug in the name of the original GAAP source, and it returns a list of where the same information is now listed under the new coding structure.

So for example, if you want to cross-reference an AICPA statement of position, you access the SOP category, the system comes back with a drop-down menu containing all of the current SOPs, then you select one, and click on the Generate Report button.  Then it returns a complete list of where every single paragraph in the SOP can be found in the codification – with a hyperlink, of course.

So, what about the codification system itself?  Well, it uses four levels, with a three-digit topic going first, then a three-digit subtopic, then a three-digit section, and then a paragraph.  This is going to take some getting used to, especially when everyone has memorized their favorite accounting standards, and now has to convert this over to a new number.  For example, many of us know what FAS 123R is, because it deals with stock-based compensation, and that’s been a hot topic for years.  Well, now we have to remember that it’s subtopic number 718.

Yes, the new coding structure will take a fair amount of time to get used to, but on the other hand, this means we finally have a simplified way to research accounting topics.  And that beats the old system, which was pretty arcane.  Sure, we could navigate through it, but any newcomer to the field must have been wondering why they had to memorize all of those reference acronyms and numbers, like SOP 97-2 for software revenue recognition, or FAS 133 for derivatives.

Oh, and by the way, once you’ve memorized the new codes, there’s a search feature on the home page, so just plug in the code and it takes you straight to what you need.

So, how good is the new codification system?  Well, because of the excellence of the web site, I have to rate this an A+ effort.  To everyone involved in the project, which has been about 200 people for the past four years, you did a nice job.

Related Courses

GAAP Guidebook

Business Valuation (#61)

In this podcast episode, we discuss FASB’s statement number 141R, as well as the need for business valuation services when engaging in acquisitions. Key points made are:

• The original Statement 141 addressed the use of fair value when recording a business acquisition.

• The revised Statement 141R included a number of changes, including the following:

  • Changed the definition of a business.

  • Equity securities issued as part of an acquisition are valued on the closing date.

  • Includes an estimated fair value for any earnout provisions.

  • Acquisition costs are charged off separately.

  • In-process R&D is valued and carried on the balance sheet.

  • The allocation of the purchase price is about the same as before; includes fair values for tangible assets and intangible assets.

• When deriving a valuation for acquiree assets, can use a valuation firm to develop a valuation report. This report is more defensible, since these firms have a lot of expertise. A valuation project typically takes 4-6 weeks, and costs $15,000-$30,000.

Related Courses

Accounting for Intangible Assets

Business Combinations and Consolidations

Business Valuation

Mergers and Acquisitions

Profit Recovery: Vendor Relationship Management (#60)

In this podcast episode, we discuss how an examination of the relations between a company and its vendors can uncover profit recovery opportunities. Key points made are:

• Conflicts of interest between a company and its vendors can cause major expense increases.

• Companies tend to look for fraud internally first, which means that vendor investigations are delayed or never happen at all.

• A common profit recovery scenario is when a company makes duplicate payments to a vendor, which has not sent them back. This could be a vendor error, or it could be fraud.

• It is difficult to spotlight cozy relations between company staff and vendors, but you can use the Internet to uncover some of these relationships.

• Need strong procurement practices to examine vendor relationships on an ongoing basis.

• A conflict of interest may be OK, as long as the company is getting a good deal; verify whether this is the case with benchmarking, or use a full audit to search for anomalies.

Related Courses

Cost Management

Purchasing Guidebook

Lean Accounting (#59)

In this podcast episode, we discuss how lean accounting works, and the circumstances under which it works best. Key points made are:

• Lean accounting is a management system designed to operate in conjunction with lean production techniques.

• Lean accounting is oriented toward making internal corporate improvements.

• It issues reports much more frequently than the monthly reporting used by a financial reporting system.

• The focus is on the cost of goods produced, as well as on processes.

• Lean accounting tends to result in reduced inventory levels, which can negatively impact profits in the short term.

• Lean accounting tends to reduce assets and headcount.

• Lean accounting is most useful where lean production is used; works in manufacturing and service environments.

• Lean accounting makes it easier to identify opportunities for revenue increases and cost reductions.

• With lean accounting, you may not need to track as many individual transactions.

• Lean accounting requires a significant new project installation, possibly on a pilot basis, with a full roll-out at a later date.

Related Courses

Lean Accounting Guidebook

Investor Relations: Forward-Looking Statements (#58)

In this podcast episode, we discuss the background for investor lawsuits against companies, and how the use of forward-looking statements and cautionary statements are designed to avoid those lawsuits. Key points made in the episode are noted below.

The Reason Why Public Companies Did Not Forecast Results

Public companies used to have a major problem with telling investors anything at all about their forecasted results.  Until 1995, investors could sue a company to recover damages from a perceived securities fraud.  What usually triggered such lawsuits was pretty much whenever the stock price dropped.  As a basis for these lawsuits, investors used section 10b of the Securities Exchange Act of 1934. That section basically says that it’s unlawful to make an untrue statement of a material fact or omit to state one.  So… if a company said anything at all about its future plans and then those plans didn’t come to pass – then you had a lawsuit on your hands.

If someone did file suit, the usual process was that the company then filed a motion to dismiss, on the grounds that the alleged facts were not sufficient to create a liability under Section 10b.  This motion to dismiss was absolutely critical, because if the court allowed the case to proceed, then the investor could bury the company with demands for information, which is called the discovery process.  Which could cost millions.  At that point, the company usually settled out of court in order to avoid the cost of providing information.

Now if the company elected to take its chances in court, the investor could seek a class certification, which turned the case into a class action lawsuit.  So, if the company lost the case in court, the verdict would apply to all of its stockholders.  And then it would be really expensive.

You can see that investors could essentially point a double barreled shotgun at a company, and say “pay me now, out of court,” or “pay me a whole lot more in court.”  So because of the way the system worked, there were lots of lawsuits, and companies usually paid up.  Even if they hadn’t done anything wrong.

This was a bad state of affairs, because a key part of investor relations is to give the investment community some idea of what you intend to do in the future.  But because of the risk of lawsuits, no one dared to say anything.

The Private Securities Litigation Reform Act

Luckily, Congress fixed the problem in 1995 with the Private Securities Litigation Reform Act.  In brief, the Act forces a plaintiff to present a stronger case up-front.  This makes it easier for a company to have a case dismissed.

But in addition to that, the new Act includes a nifty section called Safe Harbor for Forward Looking Statements, which is Section 102.  As the name implies, it provides companies with a safe harbor from liability for forward-looking statements – but only if you identify them as forward-looking, and you add what the Act calls meaningful cautionary statements.  These statements need to specify the most important factors that can cause actual results to differ from what you’re saying in the forward-looking statement.

This doesn’t mean that you can keep using the same boilerplate cautionary statements, because the company’s risk profile might change over time.  Instead, you can refer to a complete set of identified risks, such as you’d find in a company’s annual 10K report.

This is obviously an important protection for a forward-looking statement, but that then brings up the question of what is a forward-looking statement?  Well, according to the Act, it covers a half-dozen areas.  The following four are the most important:

Projections of revenue, income, earnings per share, capital expenditures, dividends, or other financial items.

A statement of plans or objectives.

A statement of future economic performance.

Any statement about the underlying assumptions for those first three items.

You also need to know what is not covered by the Act.  Not covered items include discussions about roll-up transactions, going-private transactions, tender offers, and initial public offerings.

The Nature of a Cautionary Statement

So, what does a cautionary statement look like?  Well, let’s say you’re issuing a press release.  After the main contents of the release, you should add text that is something like this:

“In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the company notes that some statements in this press release look forward in time, and involve risks and uncertainties that may affect the company’s actual results of operations.  The following important factors, among others that are discussed in company filings with the SEC, could cause actual results to differ materially from those set forth in the forward-looking statements.”

And at this point, you can add some company-specific factors, such as “we may be unable to hire a sufficient number of qualified technical personnel,” or “competing offers may cause us to lose projects that are competitively bid.”

Let’s face it, this is a great deal of butt-covering, but if it can prevent even a single lawsuit, then I’m all in favor.

Any by the way, you’ll find that the cautionary statement may quite possibly be as large as all of the other text in your press release, combined.  So expect the cost of your press releases to go up.

And one last point about the Act.  You’re under no obligation to keep updating forward-looking statements, even if the information in the last one has become obsolete.  The Act specifically says, and I quote: “nothing in this section shall impose upon any person a duty to update a forward-looking statement.”  Of course, if you want to build a decent long-term relationship with the investment community, you’d bloody well better keep updating your projections, but you don’t have to.

When preparing any kind of forward-looking statement, it really helps if you first clear it with the company’s attorneys.  They’ll want to make dead certain that it complies with the Safe Harbor provisions of the Act.  So don’t just copy forward the language you used in the last press release or speech, because it may need some updating.  Don’t forget, the attorneys are there to keep you out of trouble, so use them.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Target Costing (#57)

In this podcast episode, we discuss the nature of target costing and how the process functions. Key points made are noted below.

The Uselessness of Cost Variances

Remember in your accounting classes in college, where the professor droned on about price variances, and volume variances, and efficiency variances?  Well, all of those variances involve the cost of a product after its already been designed.  The trouble is that most of the cost structure of a product was built into it.  And that means that all of those variances that you learned -- and may have been calculating since then -- don’t really help the product margin very much.  Instead, variance analysis only helps you understand if extra costs are being incurred over and above the baseline cost of the product.

The Nature of Target Costing

But they don’t give you any insight into how to reduce the baseline cost.  And that’s where target costing comes in.  In brief, target costing is about figuring out in advance what price the market will bear, and then designing a product that has a predetermined margin, based on that price.  If the design team can’t create a product with the right margin, then it stops the project.

That sounds pretty simple, but there’s a fair amount of iterative work involved.  First of all, the marketing department needs to research what other products are in the market already, and the types of products that competitors sat they’re going to introduce.  This also involves some estimates of the total market size, and the market share that the company thinks it can obtain.  The end result should be some decent estimates of the price point and features that a new design should have before management allows it to be introduced into the market.

Now the cost accounting people get heavily involved in this work.  They have to determine cost of all the key components, based on the estimated number of units to be produced.  When they subtract these expenses from the per-unit price point, the result needs to be at least in the general range of the target gross margin.

At this point, the product project will very likely have too low a margin, because the design team has not yet put any effort into cutting costs out of the design.  But that’s all right, because all we’re trying to do at this stage is to determine if it’s worth the effort to proceed.

So, let’s assume that management decides to continue with the project.  If so, the company assembles a design team that includes marketing, engineering, and accounting staff.  Under the target costing concept, the basic strategy of this group is to gradually reduce the designed-in cost of the product until it reaches the target margin.  The marketing staff helps by figuring out which product features are the most important and valuable to customers.  And the cost accounting staff continually re-runs cost estimates as the designers change the design.

And there is a lot of design work to be done.  The engineers can interact with the marketing people to see if it’s acceptable to design the product with a reduced level of durability or reliability – and that’s because some products are seriously overbuilt.  And for other products, customers don’t keep them long enough for there to be any concerns about durability.

But keep in mind that this is not just a design effort that reduces the cost of materials.  You can also add industrial engineers to the group, to see if there’s a less expensive way to manufacture the product.

Also, you can add purchasing staff to the team, because they can figure out how to most cost-effectively source materials, or maybe it makes more sense to outsource some or all of the production.  And they will certainly want to look at using substitute parts that are less expensive – but which may require some design changes so that they’ll work.

And it might also make sense to figure out a different distribution channel, such as Internet only, or through a distributor network.

Because of all these extra factors, the cost accountant might be running multiple costing scenarios at once, depending upon how the product is design, and sourced, and built, and sold.

To do all this, the cost accountant needs to compile a lot of costing information.  This can include the cost of purchased parts and of entire subsystems of parts at different volume levels.  This is really useful not only for more easily calculating the latest iteration of a design, but also for sensitivity analysis.  For example, if the product sells a lot less than expected, the supplier price points for some materials might jump a lot, which triggers a massive profit drop.

The cost accountant should also quite definitely do an analysis of how much time the product will require through the company’s bottleneck operation – whatever that may be – to see how badly it might clog up the bottleneck.  For more information about this topic, go back to my episodes 43 through 47, which are on throughput accounting.

So, getting back to the general process, during the early stages of the project, you can expect to have a swarm of costing models running concurrently, while the team works its way through a bunch of scenarios to see which one optimizes total profits.

But over time, all of these models need to be whittled down into a smaller cluster of options.  The way the team manager does this is to set up a series of milestone reviews, perhaps once a month.  At each review, the team has to be a little closer to the target margin.  So for example, at the start, the target margin may be 40%, but the initial margin estimate is only 10%.  So at the first milestone review, the team has to bring its margin estimate up to 15%, and to 20% at the next review, or else the project is scrapped.

By taking this forced improvement approach, design teams have to very quickly arrive at a competitive and profitable design within a fixed period of time – or else the project is cancelled.

Now, if a project is cancelled, this doesn’t in any way mean that the project team has a beer bash and a ritual burning in the parking lot of all its design paperwork.  No, that would be bad.  Instead, the team carefully assembles its files and stores them.  The reason is that the market’s price point may change, and material costs may change.

And for that matter, the company may alter its target margin.  So if these variables shift around enough, it’s possible that the project may become viable again.  If so, you reassemble the team, pull their research materials out of the archives, and get them going again – but this time they have a head start, because they kept their original materials.

The Result of Target Costing

So what is the end result of target costing?  It can lead to a massive improvement in profits, because companies don’t waste enormous amounts of time tinkering with products that realistically have no chance of becoming profitable.

And it certainly avoids the old technique of cost-plus pricing, where a company just builds what it thinks the market wants, tacks on a standard margin, and hopes the price point will be acceptable in the market.  That approach almost always leads to excessively high prices, which usually results in poor market share numbers.

The Downside of Target Costing

But what is the downside of target costing?  It requires the cooperation of a lot of departments on the same team – and that’s not easy to manage.  And another problem is that the target costing process can winnow out products even if the company needs them for strategic purposes.

For example, a car company may feel that it needs a top of the line luxury car, which sometimes yields a trickle-down quality image on the entire product line.  The target costing analysis on that particular car may result in a rejection of the product, because the margin is too low.  But if you look at its impact on the entire product line, it may still make sense.

So, use target costing selectively, keeping in mind the company’s overall goals in the marketplace.

Related Courses

Activity-Based Costing

Cost Accounting Fundamentals

Inventory Record Accuracy (#56)

In this podcast episode, we discuss the actions you need to take in order to achieve a high level of inventory record accuracy. Key points made are noted below.

Requirements for Excellent Inventory Record Accuracy

For lots of accountants, it’s pretty difficult to close the books when you’re not sure at all about inventory record accuracy.  In some cases, I’ve seen controllers insist on a complete manual count of the entire inventory every single month – because they just don’t trust the system. So, let’s create a system that works.  To do this, you need to address four main areas which are: the software, the rack layout, initial counts, and ongoing counts.

Inventory Tracking Software

For the first area, you need inventory tracking software that tracks inventory by bin location, and preferably for multiple bin locations.  Also, it must update records immediately, not in a batch.  If it’s in batch mode, then records will be inaccurate until you run a batch update, and that’s not acceptable.  If you don’t have software with these two features, then stop everything and buy some that does.

And by the way, there are software packages with many more features than that, going up to ultra-complex warehouse management systems.  But if you don’t have those two features, then you’re basically doomed.

The Inventory Rack Layout

Now let’s go to the second area, which is the rack layout. The first step here is to fix the physical layout of the storage racks.  There’re lots of issues to consider, like leaving aisle room for forklifts, and clustering racks for small parts in one place, and storing slow-moving items in the back.  This is a surprisingly technical area, so you might want to consider hiring a consultant who can design it for you.

Once the rack layout is set up, you need to create rack locations. 

Location codes are usually in at least three parts, with a letter for the first part that designates the aisle, then a two-digit number for the rack within the aisle, and then a letter for the level within each rack on each aisle.

That sounds complicated, but it’s not.  For example, C-17-B means that you’re in aisle C, rack 17, level B.

Now, as you walk down an aisle, the rack numbers should offset each other on each side of the aisle.  For example, you start off with rack 1 on the left side of the aisle, then rack 2 on the right side, and then rack 3 on the left side.  By numbering racks like this, inventory pickers can pick from both sides of the aisle as they walk down it.

Once you have the racks labeled, go back and create permanent labels with a bar code and the alphanumeric code side-by-side on the same label.  Make you print out the bar code format that’s used by your bar code scanners.  Then, put a clear plastic laminate over the labels, so there’s less chance they’ll be damaged.  And by the way, forklifts damage these labels all the time, so have a weekly procedure to replace whichever ones are no longer readable.

The Initial Inventory Counts

OK, let’s move to the third major area, which is initial inventory counts.  The goal here is to put the inventory into a fairly well organized system, so that you can then launch the ongoing counts in a reasonably efficient manner.

The first step for initial counts is to keep the inventory from being screwed up any further, and that means locking down the warehouse.  Yes, people do come in and take items of the shelf, and they don’t record the deductions.  They also take items from one shelf and then put them back somewhere else, which also does not help the record accuracy.  So, you need to lock them out completely, with a fence and a lock on the gate.  If this seems like overkill, please keep in mind that I’ve taken four inventory systems up to at least 98% accuracy, and each one of them had no chance until we installed the fence.

Now that things are safely locked up, you need to consolidate the same parts into one place.  This makes it much easier to count them later.  You will not complete this in one shot, because the same inventory item might be stored in a dozen places, and you won’t find them all on the first try.

Next up, have some experienced people who know the parts assign part numbers to everything.  Absolutely never use an inexperienced person to assign part numbers, because they will screw it up.  It might even make sense to use teams of two, so they can cross-check each other.

After that, have the same experienced people verify the units of measure on the parts.  Put the correct unit of measure on the same inventory tag that contains the part number, so it’s all in one place.

Then you have to pack the parts.  This means putting them in containers, then sealing the containers, and then labeling them with the part number, unit of measure, and number of units that are stored inside.  Also, leave a few loose parts for immediate use.  By doing this, it’s vastly easier for the warehouse staff to count parts later on.

After that, conduct an initial count, and drop all of this information into the inventory database.  Once again, only allow experienced people to do this count.  Any manager who allows the front office staff to count inventory should be shot.  An inventory count is more difficult than you think, so keep non-warehouse people off the premises.

That completes the third phase, which gives us the tools for an accurate inventory – but it isn’t accurate yet.  To do that, we need ongoing inventory counts, which are known as cycle counts.  And that is the final phase.

Ongoing Inventory Counts

To do ongoing counts, first train the warehouse staff in how to cycle count.  This means that they need to know how to run reports, do counts from the reports, and investigate variances.  And in case I haven’t said it before, cycle counting should only be done by experienced warehouse personnel.

Once everyone is trained, start cycle counting.  In brief, this means you print out a portion of the inventory list, sorted by location, and then match the report to the actual inventory.  To do so, the counter should review a complete block of inventory, such as a couple of side-by-side racks.  When doing the count, the employee matches the information on the report to what he sees on the shelf.  In addition, he matches what he sees on the shelf to what is on the report.

Please note: These are two separate activities.

Everyone counts from the report to the shelf, but by also tracing from the shelf to the report, you spot inventory that’s not recorded in the inventory database at all.  Managers like this extra count, since it increases inventory, and therefore reduces the cost of goods sold.

The frequency of cycle counting varies by company.  For a high-volume warehouse, you might need to cycle through the entire thing once a month.  Or, if some of it is slow-moving, once a year might be enough.  Or, keep recounting items that are always running out, or that are the most expensive.

Now, here’s the key part.  Whenever a cycle counter finds a mistake – and he’ll find lots of them at first – he doesn’t just go to the inventory database and update the record with the correct number.  The real trick is to have them investigate why the error occurred, and make sure that it doesn’t happen again.  To get to this level of investigation, the warehouse manager really needs to buy into the whole inventory accuracy concept, because this will chew up lots of cycle counter time, especially during the first few months.

The Need for Inventory Auditing

At this point, the system is in place, but I’ll guarantee you that it will not work as well as you’d like.  The reason is that the warehouse staff does not yet understand the importance of cycle counting, so they tend to let it slide.  Here’s what I do.  I have someone audit a small part of the warehouse once a week, and post the results on a white board in the warehouse.  We also assign specific aisles to cycle counters, so that we can post accuracy information by employee.  If any counters are having really good accuracy results, then we hand out a small bonus on the spot.

That’s the carrot part of the equation.  The stick part is that the warehouse manager’s performance is partially based on the overall accuracy of the inventory – so he may not do too well if he doesn’t meet his accuracy targets.

That covers the process. However, if you think this’ll give you a fabulously accurate inventory in a few weeks – think again.  There are likely to be a couple of dozen procedural problems that are causing inaccurate inventory, so until the cycle counters discover and correct each one of them, the accuracy will not be good enough.  So, based on my own experience, I can safely say that you need to budget a minimum of six months to achieve really high-grade inventory accuracy, which I consider to be 98%.

Related Courses

Accounting for Inventory

How to Audit Inventory

Inventory Management

Targeted Collections (#55)

In this podcast episode, we discuss several methods for concentrating your collection efforts in order to maximize the amount of cash collected. Key points made are noted below.

Collections Strategy

The strategy with collections is to pull in the largest amount of money for the minimum amount of effort – and in the shortest possible amount of time.  But, keep in mind that you can’t achieve all three parts of the strategy at the same time – at most only two out of three.  You’ll see this as we go along.

Focus on the Largest-Dollar Items

First, consider that first guideline of collecting the largest possible amount of money.  This means that you don’t waste time collecting small dollar items, or that you only use low-cost collection techniques for those items.  For example, the most expensive type of collection activity is using a collection specialist.  These people have to spend time collecting information about an overdue account, reviewing past collection records, and then contacting the customer.  This takes a lot of time.  In fact, the cost of just one call may be higher than the amount of the invoice.  So, what do you do?  After all, it seems crazy to not even try to collect a small dollar invoice.

Dealing With Small-Dollar Invoices

You have two choices.  First, use the accounting system’s automated dunning letter feature, and crank out a nice, inexpensive letter or e-mail reminder every few weeks.  Second, if the collection staff has completed collection calls to larger-dollar customers, then have them call about the small-dollar items.

After all, many collection employees are salaried, so despite what I said earlier, there’s not really any incremental cost to having them contact small-dollar accounts.  It’s just more effective for them to contact larger accounts first.

If neither approach works, then don’t waste any further effort.  Dump these small accounts onto a collection agency, and write them off.

So in this first scenario of collecting low-dollar amounts, we’ve achieved only one of the three parts of the strategy, which is to expend minimal collection effort.  But this is OK, because the dollar amounts are also minimal.

Collect Large Amounts Fast

Now let’s go back to the collection strategy.  We’ve addressed small overdue items, so how about large ones?  This is where we focus our collection resources.  But now we have a trade-off of wanting to use the minimum amount of effort, but also of collecting large amounts of cash within the shortest possible period of time.

In this case, we’ll forget about minimizing collection efforts, and instead focus everyone’s attention almost entirely on bringing in the cash as rapidly as possible.  There are lots of ways to do this, but keep in mind that you only use this level of activity for the really large outstanding receivables.  What I’m going to describe next requires a lot of effort, and it’s just not cost-effective for smaller collections.

First of all, contact the customer before the invoice is even due for payment, to make sure that the payment is scheduled.  If not, there’s probably a hang up somewhere in the customer’s payment process.  This calls for repeated communications right away to correct the issue.  Feel free to involve your salespeople.  They have different contacts in the customer’s organization than your collections people have, so use those contacts.

And speaking of the salespeople, e-mail them a receivables aging report once a week, preferably for only those accounts for which they’re responsible.  If they’re staying in close touch with their customers, they might spot problem invoices really early, and let you know.

If the customer happens to be a new one, you can also use this early contact period to go over your preferred payment procedure, so they know exactly where you want to have payments sent.  And you can follow that up with a letter that outlines the procedure in more detail.

Now, along the same lines, the collection manager should review the customer complaints database every day.  This is a really good way to spot upcoming collection problems, because the customer service department usually hears about problems well before the accounting department does. 

And the same logic applies to the deductions database, if you have one.  This is where you can find the types and amounts of deductions that customers have taken in the past, and the reasons for those deductions.  If a customer has a history of subtracting large deductions from their payments, this is a good place to find out why.

So far, we haven’t even reached the payment due date, but we should have a pretty good idea of any potential problems.

The next step is to do whatever it takes to accelerate the receipt of payment from the customer once the due date arrives.  For example, you can volunteer to have a salesperson or a courier pick up the check, or have them send it to a lockbox.  Or you can authorize the customer to use your corporate FedEx or UPS number to send the payment by overnight mail.  Or they can pay by credit card.  Or, of course, try to get them to send you an electronic payment, or to authorize you to debit their bank account with an ACH transaction.  In short, do everything possible to bring in the cash exactly on time.

But even if the cash comes in, it doesn’t help your collections staff unless they see the receipt in your accounting system.  Logging in cash receipts can be a bottleneck area, so make sure that all receipts are logged in the minute they arrive.  This keeps collections people from wasting time calling customers about invoices they’ve already paid.

Now at this point, the due date should only be a couple of days in the past, but you should already have a good idea regarding which invoices won’t be paid on time – and more importantly, why they aren’t being paid.  If the issue is that the customer has no money, then the collections staff can go through the usual process of setting up a payment schedule, using financing, getting the goods back, and so on.

For this type of routine collections work, you definitely want to assign your best collections people to the largest dollar accounts.  Some people just have a flair for working with customers and getting cash in the door faster.  If you have people like this, then by all means target them where they have the greatest impact.

Unfortunately, the real problem is when the customer won’t pay because some other department of the company itself is causing the problem.  For example, the deliverable was flawed or incomplete, or improperly engineered.  There are lots of reasons.

And this is where a lot of collection departments don’t know what to do, because the collection manager doesn’t want to bug some potentially powerful department managers who very likely outrank him.

The solution is not to shift the problem up to the controller, even though he may have more power to deal with the problem.  If you do this, the controller just gets buried with the details of following up on an unending stream of internally-generated collection problems.

The much better method is to set up a standard process that all of the department managers agree to in advance, where the collections staff shares problems directly to their counterparts in the other departments.  If an issue isn’t resolved fast, then the process automatically escalates the problem to higher and higher levels of management.  Also, the performance reviews of these managers should be partially based on their ability to resolve the underlying problems that cause collections to occur.

If you use this method, then the entire company gets behind the collection effort, rather than letting a group of perpetually understaffed and overworked accounting people try to fix everything.

And this brings us back to the collection strategy.  Again, for large-dollar collection issues, you want to bring the full attention of the collections staff to bear on it, and this extends to the other departments.  But it does not mean that you involve other departments in the collection of small dollar items, because that is not cost effective.  So, if you set up an in-house process for having other departments assist in collections, only use it for the largest collection problems.  Don’t abuse the system with small stuff.

Also, keep in mind that some collection techniques are not effective for collecting these larger-dollar invoices.  For example, don’t bother with a dunning letter or an automated faxing system.  Those solutions are designed for small-dollar collections, not large ones.  Instead, use the personalized approach that I’ve described above.

When to Use Collection Agencies

Finally, what about collection agencies?  Normally, you only bring them in after some time has gone by, because you want to try every other technique in order to avoid paying their collection fee.  However, let’s get back to the collection strategy.  A key target is to bring in cash in the shortest possible amount of time.

So, if you have a large overdue account, you’ve tried all normal in-house collection techniques, and nothing works, then don’t waste time.

It makes no sense at all to wait six months and then shift the receivable to a collection agency.  Instead, make the decision as soon as possible, and put the receivable into the hands of someone who can possibly make a difference.

Parting Thoughts

To summarize the targeted collection strategy, picture yourself using a broadside from a battleship to collect the largest overdue amounts, and only the most minimal efforts for small accounts.  Broadsides tend to win battles fast, but they also need a lot of gunpowder, so they can only be used sparingly.  The same principle works for collections.  Focused activity works much better than spreading your efforts too thin over too many invoices.

Related Courses

Credit and Collection Guidebook

Effective Collections

Payroll Cycles (#54)

In this podcast episode, we talk about optimizing the use of payroll cycles, and point out a legal issue that can interfere with one of the more common payroll cycles. Key points are noted below.

The Nature of a Payroll Cycle

A payroll cycle is the length of time between payrolls.  If you pay people once a week, then you have 52 payroll cycles per year.  Usually, it takes about the same amount of time to complete a one-week payroll cycle as it does for any longer period of time.  So, for example, if you pay people once a month, you only have 12 payroll cycles per year, which means that you expend about ¼ of the annual effort that you would if you had weekly payroll cycles.

Payroll Cycle Choices

Obviously, it makes a great of sense to have longer payroll cycles than once a week.  You could go with the example I just gave and pay employees once a month, but that can be really difficult for anyone living from paycheck to paycheck. So, that pretty much leaves you with two alternatives, which is either every two weeks or semi-monthly.  Semi-monthly means that you pay on the 15th and last days of the month.

If you use a two-week cycle, then there are 26 cycles per year, versus 24 cycles if you use a semi-monthly cycle.  If you select a two-week cycle over a semi-monthly cycle, that requires about 8% more effort.  If that were the only criterion, then most people would pick a semi-monthly payroll cycle.

But not so fast.  There are two more issues to consider.  Once is, that if you use a two-week cycle, employees get used to the idea of generally receiving two paychecks per month – so when they get an extra paycheck two times per year, they really like that.  It’s a subtle point, but employees generally prefer a two-week cycle to a semi-monthly cycle.

Illegal Payment Intervals

Let’s say that you’re using a semi-monthly payroll, so your last payroll of the month falls on the 30th day.  This day happens to fall on a Wednesday – so you’re paying employees on that Wednesday.  Your payroll service provider needs to process payroll three days in advance, so you have to submit the payroll the previous Friday. 

However, most timekeeping systems are based on weekly time reporting, so your payroll administrator logically enforces a cutoff as of the preceding weekend.  After that weekend, any hours worked will fall into the next payroll cycle.  What this means is that there’ll be a gap of eight pay days before employees are paid.

Guess what.  In seven states, it’s illegal to wait that long.  You cannot make employees wait more than 5 days in Arizona, or 6 days in Massachusetts and Vermont, or 7 days in Delaware, Hawaii, New York, and Washington.

If you’re an international listener, then check your local government rules.  There might be a similar restriction.

This is a real problem if you have a semi-monthly cycle.  Even if you live in one of the other states that allows a longer delay, you might someday have employees in one of those states, possibly through an acquisition.  Also, if your company has a union, check the union contract – it might have the same kind of restriction.

Parting Thoughts

So where does this leave us?  If you look at all of the issues impacting a payroll cycle, the two week cycle is the best combination of efficiency and ability to meet the labor laws.

And in case you think I follow my own advice, I impose a semi-monthly cycle on every company we acquire.  I just keep a close eye on how long it takes to issue a payroll after timekeeping periods have closed.

Related Courses

How to Audit Payroll

Optimal Accounting for Payroll

Payroll Management