Saturday, December 17, 2011

The Problem With Profit!

Profit is everything right? Wrong!

I could have called this article "what small business owners can teach managers in large corporates", but:
a) that is a crap title for an article
b) does not do justice to the importance of understanding how simply looking at profit can be so dangerous.

Take this example. A stand alone business unit of a publicly listed company ran its own Profit and Loss (P&L) that was consolidated up to the parent company. On one particular month the business unit sold (I am going to make the numbers up for purposes of confidentiality) $4mil worth of product to various retailers. The Cost of Goods was around $2mil and the Expenses were around $1.5mil. So if you do the simple maths you can see the EBITDA (operational profit) was $500K or 12.5%. Good business right? Well not quite. You see the same month the business had forecast sales of $6mil, although because of lead times to manufacture the product the forecast was required by the Inventory Manager to purchase the stock 5 months before the stock was shipped to the retailers. Unfortunately the business had actually forecast $6mil for 3 months in a row but about 1 month out of the first of the $6mil months the retail market tanked and whilst the Sales team were trying to come up with initiatives to make up the shortfall, the reality was the retailers were reducing their spend. So the long and short of it was that the business was having to pay for stock that is was not selling. In essence we have here a negetive cash position i.e. more money is going out than is coming in. In fact the reality was that if this business unit had not been part of a much bigger company it would have been in serious financial trouble with an inability to pay creditors.

But wait a minute, the business made an operation profit of 12.5%. So to summarise - a profitable business in serious financial trouble.

Putting the market challenges aside one of the key contributors to such a problem is the lack of all round financial skills that managers learn in large corporations.

Whilst larger companies can teach some great business skills they often don't teach great all round financial skills. Small business owners come to know the saying "Cash is King" very early on. However in large companies Cash Management can be part of Accounts Receivable, Treasury and often the domain of the Chief Financial Officer. Hence many employees, even General Managers with P&L responsibility, don't learn great financial skills as Managing Cash flow may be outside their remit. What they learn is primarly centered around the Profit and Loss.

So the next time you see a profit number, ask the question, "How does the cash position relate to the profit number?". If you do, and are in a large corporate, you are already ahead of many of your peers (and in many cases those above you). If you are in a small business and have not asked the question, God help you because your Bank Manager won't.

-----------------------------------------------------------------------------

I appreciate there may be readers who are questioning the forecasting, inventory management, supply chain, sourcing process etc that should assist in helping to manage the stock risk. The purpose of this article is not to overlook the various stock control mechanisms but to illustrate the problem with only focusing on profit.

2 comments:

Post a Comment

Comments Policy