UK: Where Has All The Profit Gone?

One of the problems our small businesses face is that their own Agenda for success – making as much Profit, (rather than just income), as they can from their limited resources - is not the same as that of either the Government, which simply wants ‘Business’ to help them, (and gratuitously), to achieve whatever social policies the presently ruling party has, Companies House, which likes neat paperwork, regardless of whether or not it reveals anything helpful, or the Inland Revenue which, apart from conning us into doing much of their work for them, needs to extract as much cash from our businesses as it can.

If the Government, Companies House or the Inland Revenue push so hard that achieving our own Agenda becomes impossible, who cares? They certainly don’t, but we just might. The resources available to them to enforce the extraction of as much as possible are, unlike ours, unlimited and unaccountable by the standards our businesses must meet.

Faced with such an array of hostile forces, is it actually possible for a small business to succeed? What does it have to do to defeat the powers of darkness? ‘Shed a little light’, I hear you say.

Most Businesses are unaware of the cost of meeting any contract they have, and therefore play Russian roulette with their profits. Many depend upon their Statutory Accounts, or whatever statement their Accountant produces annually and in retrospect to satisfy the Inland Revenue, to tell them whether they were profitable in any particular year. But that measure of profitability can hide the performance of a company that is about to die. In fact, more Companies fail through Cash Flow problems than through a lack of, (apparent), profit.

The fact is that the normal methods for reporting financial performance have been designed with ‘their’ interests in mind, and not ours. They are intended to aid regulation and public disclosure, rather than to improve business performance.

What tells a business how it is doing is regular financial management reporting – based on Management, rather than Statutory, Accounting principles – of what is happening now, rather than what is thought to have happened in the last full year, (which might have ended up to a year ago). And the more topical and timely Management Reporting is the more likely it is to show the present (profit), performance of the business and to highlight, or give warning about, problems which have to be faced.

But even then, and given an accurate report of more or less current performance, the interpretation of a Management Report requires a bit of basic information about Cost Accounting – the determination of the costs of particular parts of the company, including its infrastructure, the mechanisms it uses to develop itself and the processes whereby it plans, delivers and monitors its delivery of a service or controls its production.

Some essential activities, such as IT, the maintenance of records and the manager’s salary are simply costs that have to be borne – and they are grouped, by department or section, into what are known as Cost Centres.

Other activities, which might comprise making a widget from a piece of metal costing 10p and selling it for £1, are known as Profit Centres because what they do has added value and created a profit. A business might contain 10 Cost Centres, (of which Accounts will itself be one), but will generally contain a smaller number – sometimes only 1 – Profit Centre.

However many Profit Centres, or Cost Centres, there are, the Profit Centres must add value and produce work which can be sold at such a price as will produce a margin sufficient to pay for all the Cost Centres and still leave Profit.

There is a technique, variously known as Full or Absorption Costing, or Activity Based Costing, (ABC, in the jargon), which, for any product or service, works out what proportion of the costs of each Cost Centre supports the individual units of work of each Profit Centre, and then adds that to the cost of the materials and labour used to reveal the true profitability of each Profit Centre.

Typically, a business might make something, install and then maintain it at a Client’s site, and offer to supply spares or special consumables as required by the use of the product. That could be 3, 4 or 5 Profit Centres, depending on whether of not installation and maintenance are equally profitable and whether or not selling spares is more profitable than, or as profitable as, selling consumables.

So, it is very important to know the profitability of the several Profit Centres, not only so that management can avoid having one which subsidises another but so that it can see what changes in its business, or marketplace, it would need to make to, firstly, optimise and then, secondly, maximise its profit. Which is where this article started.

Understanding these Cost Accounting and Management Reporting techniques requires intelligent effort, rather than a degree in mathematical logic from Cambridge. This is much more applied common sense than accounting wizardry.

Typical cases within the writer’s personal experience, where this kind of thinking turned a little into a lot include:

1. A company which made £250,000 a year on a secondary activity selling spares, but an equivalent loss on its main activity of designing, installing and maintaining oil pipeline flow monitoring equipment. It had 4 Profit Centres, only one of which worked properly. Prices of spares were increased and cost measurement and control measures introduced to every other part of the company through a simple form of ABC.
2. A company with two unrelated activities, and only 2 Profit Centres, which made £350,000 on one activity and lost £400,000 on the other. Once it knew that it could make an easy, and informed, decision to have a Profit of £350,000 a year, instead of a loss of £50,000, for roughly half the effort, it was transformed. The unprofitable activity was sold off to a Company that needed the extra volume to spread the cost of its already existing cost base.

You might think that such a logical and, as it happens, relatively simple technique should be freely available to anybody who wants it. But it isn’t. There are no good books or courses. It is still the topic of many an MBA dissertation, and perhaps on that account alone jealously guarded, and something much studied by undergraduates around the world, as the Henley Business Partnership’s own e-mail postbag shows.

Perhaps its protection as an activity requiring high intellect is an aspect of the now familiar culture from which spring brilliant solutions to problems we don’t have and, because none of them ever thinks to ask, which leaves the real problems of business, which are inherently simpler, disregarded. No knighthoods or political advantage to be gained by solving those.

As in so many other fields there is much airy talk about cost analysis and cost control, but little action. Perhaps that is because putting the technique to practical use requires an understanding of the fundamentals of business, rather more than formal accountancy training, plenty of commonsense, access to Excel and an ease with simple maths at about GCSE grade C. Are these rare skills? If they are then I am more out of touch than I thought I was. I wouldn’t give you tuppence for one of those MBA dissertations. They must be worth just about as much as a degree in knitting.