Accounting, Financial, Taxation

Operating ratios may be even more useful than financial ratios because of the timely nature of their calculation and the decision specific nature of their use. While these ratios are in keeping with the thinking of most engineers and managers of sales, service and manufacturing can also use the principles of operating ratios effectively. But what is operating ratio? Let’s talk about the ratio.

Comparison of Financial and Operating Ratios Similarities

(1). Both financial and operating ratios are most useful when the information generated by the ratio is timely. Ratios are like other tools; they are beneficial only if you have them when you need them.

(2). As with financial ratios, operating ratios can be generated for any two numbers, for example: the number of salespeople and the dollars of sales per month. These two numbers will generate an average sales per salesperson, against which there may be a relative performance index. Also like financial ratios, unless there is a relationship, the resulting ratio is meaningless.

(3). Like financial ratios, operating ratios should not be accepted at face value. For the sales per person ratio, assume we find the average to be 17 sales per salesperson per day in an automobile dealership. Two of the salespeople make 43 and 53 sales per day, respectively, and the remaining five salespeople make 3 sales, 6 sales, 5 sales, 5 sales, and 4 sales, respectively. It would appear that you could replace the five salespersons with one aggressive person and be better off. However, additional information may reveal that the low-volume employees are automobile showroom salespeople and the other two are in the parts department. The parts room accounts for only 17 percent of the revenues but has 28.6 percent of the sales force. Several more ratios can be generated that would help in determining whether the sales force is well managed, efficient, and economical. Standing alone, no one ratio is as useful as a series of related ratios.

(4). Ratios for operations, like financial ratios, can be more effective if they are “trended“. Taking the salesroom salespeople’s past 12 months average ratio of sales per day, we observe these data:

Jan. 3.6 | July 4.9
Feb. 4.2 | Aug. 2.1
Mar. 5.4 | Sept. 4.7
Apr. 6.1 | Oct. 7.0
May 7.7 | Nov. 6.3
June 6.3 | Dec. 4.1

From this we see a two-peak cycle of automobile sales. The dealership can plan when it should order more cars to increase the inventory in anticipation of seasonal sales. It also may help plan for sales incentives, promotional advertising, vacation schedules, and other operational elements.

(5). The cost of generating the data necessary for any ratio should not exceed the benefit derived from the information produced from the data. As with any tool, a ratio should itself have a favorable cost-benefit relationship. In other words, the benefits should outweigh the costs.

(6). Ratios are useless if they do not meet a need. Looking back, the ratio of average sales per salesperson per period was designed to measure the relative performance of sales personnel. It did not do that adequately. It failed to inform management what the meaningful performance was for automobiles versus parts sales personnel.

(7). Properly structured, an operating ratio or series of ratios can be used for planning and control. As an example, some of the financial ratios mentioned can be used to evaluate credit policy. The same is true for operating ratios. If we monitor how well auto sales personnel are doing individually, compared to the monthly historical figures, we have a quantitative measure of individual performance. If we look at the aggregate sales figures of average sales per person per day against the historical average, we have a measure of how well the business is doing compared with past performance.

Dissimilarities of Financial and Operating Ratios

(1). Financial ratios relate to numbers from the balance sheet and income statement, whereas operational ratios are oriented more toward production, service, and sales—figures that may not be accumulated in the accounting system. Because of this, standard financial ratios are more likely to be routinely prepared, whereas operating ratios are more often tailored to meet particular needs. There is a greater tendency to compare financial ratios among businesses almost indiscriminately—resulting in bad comparisons among dissimilar businesses. Because operating ratios may be tailored, there is less of a tendency for misapplication and greater reliance on historical trends.

(2). Operating ratios often can be calculated very quickly from obvious data. For the example: of average sales per salesperson, management can have an accurate number for the previous day’s sales for each member of the sales force at the start of each workday. It is often more difficult to compile and verify the financial data.

The Use of Operating Ratios

Operating ratios can be used to evaluate any function. There may be a very large number of data-gathering efforts necessary to compile the needed input for ratio generation. Data gathering is costly and time consuming. It represents an investment that should have an expectation of a return to justify the expenditure. Therefore, you should first implement the use of ratios that have the greatest return or control. The ability to improve control through ratio generation and evaluation should be directed at critical steps in the process.

Breakdowns at critical steps may halt all production. For example: in a law firm specializing in appeals, time constraints are externally generated by rules of court with limited opportunities for extensions of time or deviations. Operationally, research is accomplished using sophisticated terminals connected to national data banks. Writing and editing is done on word processing software. All work flows through personnel highly skilled in the use of word processors. A breakdown in the word processing function could be very serious for the meeting of critical deadlines. Often the speed of input into the word processor is slower than dictation. Therefore, the ratio of skilled typists to writers may be critical. Ratio analysis can play a key role in determining a proper relationship.

There is a general five-step process for designing and implementing a control system based on ratio analysis. The number of steps may vary based on system complexity. The five steps are:

1. Analyze the process or system: Write a step-by-step description of the process.
2. Look for and identify critical steps: Is there any one step through which most or all work flows?
3. Analyze the critical step: Is it a potential bottleneck or constriction? Why is it a bottleneck?
4. Set a target performance ratio: Determine from past historical data how well you have done and ask, “How much better can we do?”
5. Evaluate performance and feedback: How well are you now doing? How do you improve the system? What is the justification?

Applications Of Operating Ratio [A Case Example]

Operating ratios can be applied to any business. The next case study applies a ratio analysis to a service company (an accounting firm). Other suggestions will be given for a retail store and a manufacturing enterprise.

The firm of Lie Dharma Putra and Associate is a South-Pacific accounting firm composed of 6 partners and 11 associate accountant and tax accountant. They represent three large automobile insurance companies and tens of retail stores and manufacturing enterprises in various tax litigations.

The firm’s business is basically steady, with two small seasonal variations. The firm has a sophisticated word processing system with satellite terminals; one draft, high-speed printer; one letter-quality printer; and a laser printer.

The firm has two senior secretaries, two junior secretaries, and one clerk-typist/receptionist. As the caseload has grown, one senior secretary spends almost all her time setting up new case files. The firm noticed that the secretaries were putting in more overtime, and the senior partner was concerned that things were getting done only just in time. Ratio analysis was undertaken by an associate who had an undergraduate degree in business.

She analyzed the flow of paper from the receipt of a complaint through the final order of the trial court.

She prepared a flowchart of what work was done, when, and by whom. She discovered two critical steps:

1. All work products passed through the two junior secretaries and one senior secretary as they input, edited, and printed out lawyers’ work products.
2. The reproduction and mailing of letters, pleadings, and briefs.

The technical word processing function was on the verge of becoming a bottleneck. The work just seemed to take too long to process.

The reproduction facility was a disaster. The equipment was always breaking down; when it worked, people were constantly walking back to work without copies because “the line was too long” or “a long critical job was on the machine.”

After studying the number of words processed by each of the three secretaries, she found an average of 52 words per minute. Not to be fooled by averages, she looked at the distribution. The two junior secretaries typed at 38 and 42 words per minute each and the senior secretary typed at 75. The other senior secretary, who only set up files, could type at 81 words per minute. The associate, told that this secretary had been hired because of her typing speed, calculated that if the senior secretary switched roles with the junior secretary, the firm could target word input at 67 words per minute, average, without changing personnel (a 29 percent increase). The junior secretary and the receptionist would be able to prepare all the files as they came in. The associate found that the senior secretary had started or updated 61 files per day. She set a target of 45 files for the junior secretary and 20 for the receptionist (because of her other duties).

She ran a study of the copier by asking each user to log in the number of copies made of each original and the number of originals. From this, she learned several things. There were only two basic types of copying requirements: (1) long runs (many copies of large jobs with many originals) and (2) short runs (few originals, few copies). The long runs, on average, consumed 6 hours a day total time and the short runs 1.5 hours. The average short run took less than 30 seconds, but the average long run took 17 minutes. Twenty-one long runs and about 200 short runs were run each day. With the machine breakdowns considered, the copier (owned by the firm) worked properly on average 8.2 hours each 9-hour day. Often copies were run through lunch hour on a staggered secretarial shift.

From these ratios, the associate made these recommendations: Buy a highly reliable small copier and dedicate it to short runs. Hire a clerk to do the copying. As justification, she made these findings based on ratio analysis:

1. On average, each secretary saved up five small runs or one long run before going to the machine.
2. On average, the machine was tied up doing long runs or broken down 6.8 hours out of every 9 hours, roughly 75 percent of the time. On three out of every four trips to the machine, a secretary found it occupied by a long run. Because the secretaries made 40 successful trips to the copier per day (200 short runs/5 runs per trip), they were making approximately 120 unsuccessful trips to the machine. If they waited for a long run to finish rather than returning to their desk, they waited 81?2 minutes (17/2).
3. By assigning a clerk to copying, all unsuccessful trips were eliminated. Even though an unsuccessful trip to the copier took only 45 seconds, 1.5 hours of secretarial time was saved (120 trips × 45 seconds).
4. By reducing the demand on the copier, the breakdown rate was expected to improve.
5. The biggest bonus to the firm was the actual freeing up of 7.5 hours of secretarial time. Simply to do the copying, a secretary stood at the machine for 6 hours a day for long runs and 1.5 hours per day for short runs. This, coupled with the 1.5 hours of time saved on unsuccessful trips, amounted to enough savings in dollars of overtime to pay for the small-run copier in nine months and still pay the salary and benefits of the clerk.

Ratio analysis improved the operation of the firm, gave it quantifiable measures of performance, and got some control over the operation.

This post offers an essential checklist for accountants in fulfilling their functions for managers. Accountants are saddled with the several functions listed below, and under the pressures of time they may end up giving short shrift to their duties to managers — which is understandable. However, the very continuance of the business depends on accountants providing managers information they need to know for making decisions and maintaining control. If managers don’t get what they need from their accountants, the business could fail or spin out of control. In this sense, management accounting functions are the most central — if the business fails, the other accounting functions are beside the point.

In a business, accounting has several functions. The responsibilities of the chief accountant and the accounting department include the following:

1. Complying with the manifold requirements of income taxes, sales taxes, property taxes, and payroll taxes.
2. Designing and operating a system to capture, record, process, and store all relevant documents and information about the financial activities of the business.
3. Ensuring the integrity and reliability of the information system, and preventing fraud from inside and outside the business (the latter being directed at the business).
4. Preparing financial statements that are reported outside the business to its lenders and shareowners (If the business is a public company, the accountants are also responsible for preparing filings with the Security and Exchange Commission).
5. Preparing financial statements and accounting reports for distribution to the business’s managers for their planning, control, and decision-making needs.

The last functions listed below are referred to as “management OR managerial accounting“. It concerns accounting’s role in helping business managers carry out their functions.

Designing Internal Accounting Reports

In designing internal accounting reports for managers, the accountant should ask, “Who’s entitled to know what?” Generally speaking, the board of directors, the chief executive officer, the president, and the chief operating officer are entitled to know anything and everything. This sweeping comment is subject to exceptions in business organizations that tightly control the flow of financial information. By virtue of their positions, the financial vice president and the controller have access to all financial information about the business.

Other managers in a business have a limited scope of responsibility and authority. The accountant should report to them the information they need to know, but no more. For example: the vice-president of production receives a wide range of manufacturing information but doesn’t receive sales and marketing information. The accountant should identify a particular manager’s specific area of authority and responsibility in deciding the information content of accounting reports to that manager. The reporting of information to individual managers should follow the organizational structure of the business; this practice is called “responsibility accounting”.

From the accounting point of view, the organizational structure of a business consists of profit centers and cost centers:

1. A profit center could be a product line, or even a specific product model. For example, a profit center for Apple Computer is its iPod line of products; another profit center is its iTunes Music Center (where customers download audio and video files). Within each broad product line, Apple has sub-profit centers. For example, each type of iPod is a sub-profit center.
2. A cost center is an organization unit that doesn’t directly generate sales revenue. For example, the accounting department of a company is a cost center.
3. The accounting reports that go to the manager of a profit center should be oriented to the profit performance of that organization unit. The accounting reports that go to a manager of a cost center should be oriented to the cost performance of that organization unit.

Helping Managers Understand Their Accounting Reports

Most managers have limited accounting backgrounds; their backgrounds are usually in marketing, engineering, law, human resources, and other fields. Not to sound critical, but most business managers have their desires to learn accounting under control. Furthermore, they’re very busy people with little time to spare. Yet, accountants often act as if managers fully understand the accounting reports they receive and have all the time in the world to read and digest the detailed information they contain. Accountants are dead-wrong on this point.

One of the main functions of the management accountant is to serve as the translator of accounting jargon and reports to business managers — to take the technical terminology and methods of accounting and put it all into terms that non-accounting managers can clearly understand. Of course, being a controller for years (became more generalist rather than specialist as accounts are), I may be biased, but I believe that management accountants can perform a very valuable service by improving their communication skills with non-accounting managers.

Involving Managers in Choosing Accounting Methods

Some business managers take charge of every aspect of the business, including choosing accounting methods for their businesses. But many business managers are passive and defer to their chief accountants regarding the accounting methods their businesses should use. In my opinion, the hands-off approach is a mistake.

Ultimately, the chief executive officer (CEO) of the business is responsible for these decisions, as he or she is responsible for all fundamental decisions of the business. But such accounting decisions may not be on the radar screen of the chief executive.

In choosing accounting methods, the chief accountant shouldn’t allow managers to sit on the sidelines and be spectators. The chief accountant shouldn’t select an accounting method without the explicit approval and understanding of top-level managers. In particular, the head accountant should explain the differences in profit and asset and liability values between alternative accounting methods. The business’s accounting methods should reflect its philosophy and strategies, so if the business is conservative in its policies and strategies, it should use conservative accounting methods.

The chief accountant can find himself or herself between a rock and a hard place when top-level managers intervene in the normal accounting process. This interference may be referred to as massaging the numbers, managing earnings, smoothing earnings, or good old fashioned accounting manipulation. If the accountant accedes to management pressure, he or she should make clear to the manager what the consequences will be the following year.

Generally speaking, there’s a compensatory effect, or trade-off, between years; pumping up profit this year, for instance, causes profit deflation next year. Massaging the numbers produces a robbing Peter to pay Paul effect, and the accountant should make this very clear to the manager.

Designing Profit Performance Reports for Managers

The accountant needs to read the mind of the manager in designing the layout and content of reports to the manager. Ideally, the profit report should reflect the manager’s profit strategy and tactics. For example: a manager of a profit center focuses on two main things — margin and sales volume. Therefore, the profit report should emphasize those two key factors. It sounds simple enough, but one impediment exists in designing internal profit reports for managers based on management thinking.

In designing internal profit reports for managers, accountants too often follow the path of least resistance. They use the format and content of the income statement reported outside the business, but this won’t do. An external income statement conceals as much information as it reveals. External income statements don’t disclose information about margins and sales volumes for each profit center of the business.

The accountant has to break out of his or her external income statement mentality and think in terms of what managers need to know for analyzing profit performance and making profit decisions. My main advice on this point is straightforward: Listen to how the manager explains his or her profit strategy, which is called the “business model”. Get inside the manager’s head. Do your best to understand the mindset of the manager regarding how he or she sees the formula for making profit. Listen carefully to which particular factors the manager thinks are the most important drivers (determinants) of profit. Don’t try to remodel the manager’s thinking into the accountant’s way of thinking. Don’t forget that the manager is the boss — even though you might think the manager should go back and learn accounting.

In short, don’t try to educate the manager on accounting; let the manager educate you on what he or she needs to know in order to make profit.

Designing Cash Flow Reports for Managers

The conventional statement of cash flows is far too technical and intimidating for most managers to make sense of. What managers don’t understand, they don’t use. In my view, accountants are too bound by their “debits and credits” thinking when it comes to the statement of cash flows. The statement of cash flows is designed to reconcile changes in the balance sheet during the period with the amounts reported in the statement. But, should this function also be the purpose of reporting this financial statement to managers? I don’t think so.

In mid-size and large businesses, the financial officers of the business manage cash flow. Other managers don’t have any direct responsibility over cash flow — although their decisions impact cash flow. Managers of profit and cost centers should have a basic understanding of the cash flow impacts of their decisions. They don’t necessarily need cash flow statements, but they need to know how their decisions impact cash flow.

The cash flow reports to managers of profit and cost centers should focus mainly on the key factors that affect cash flow from operating activities. These internal management reports should concentrate on changes in accounts receivable, inventory, and operating liabilities (accounts payable and accrued expenses payable). These are the main factors for the difference between cash flow and profit that the managers of profit and cost centers have control over and responsibility for.

Designing Management Control Reports

Management control is usually thought of as keeping a close watch on a thousand and one details, anyone of which can spin out of control and cause problems. First and foremost, however, management control means achieving objectives and keeping on course toward the goals of the business. Management control covers a lot of ground — motivating employees, working with suppliers, keeping customers satisfied, and so on. But there’s no doubt that managers need control reports that include a lot of detail.

The trick in management control reports is to separate the wheat from the chaff. Being very busy people, managers can’t afford to waste time on relatively insignificant problems. They have to prioritize problems and deal with the issues that have the greatest effect on the business. Therefore, the accountant should design management control reports that differentiate significant problems from less serious problems. In control reports, the accountant should use visual pointers to highlight serious problems. In other words, control reports shouldn’t be flat, with all lines of information appearing to be equally important.

Developing Models for Management Decision-Making Analysis

For decision-making purposes, business managers need a model of operating profit that, theoretically, fits on the back of an envelope. Here’s an example of such a compact profit model, which I adapted from the “Contribution—Margin—Minus—Fixed Costs Analysis method” with the following formula:

(Unit Margin × Sales Volume) – Fixed Expenses = Operating Profit

Suppose the sales price is $100 and variable costs equal $65 per unit. Therefore, unit margin is $35. Assume the business sells 100,000 units, so its total contribution margin for the period is $3,500,000 ($35 unit margin × 100,000 units = $3,500,000 total contribution margin).

Last, assume its fixed expenses for the period equal $2,500,000. So its operating profit is $1,000,000 for the period.

The accountant should develop a condensed profit model, which is limited to the critical factors that tip profit one way or the other. This profit model helps the manager focus on the key variables that drive profit behavior. For example: continuing with the example just mentioned, suppose the manager is contemplating cutting sales price 10 percent to boost sales volume 20 percent. Using the profit model the manager can quickly do a before and after comparison of the proposed sales price cut:

Before: ($35 unit margin × 100,000 units) – $2,500,000 fixed expenses = $1,000,000 operating profit

After: ($25 unit margin × 120,000 units) – $2,500,000 = $500,000 operating profit

Giving up 10 percent of sales price for a 20 percent gain in sales volume may have intuitive appeal, but this decision would cripple profit. Operating profit would drop from $1,000,000 to only $500,000; the manager would give up $10, or 29 percent of the $35 margin per unit. The sacrifice is too great in exchange for only 20 percent gain in sales volume.

Working Closely With Managers in Planning

One of the most important managerial functions has two parts: forecasting changes that will affect the business and planning the future of the business. This task includes plotting the sales trajectory of the business, the need for additional capital, and shifts in size and makeup of its workforce and other factors. The accountant should be involved in the planning process from the get-go. Otherwise, the accountant is at a disadvantage in preparing budgets and financial projections. The better the accountant understands the planning process, and the closer the accountant works with managers in developing plans, the more useful the financial forecasts and budgets will be.

Establishing and Enforcing Internal Controls

Internal controls are the forms and procedures established in a business to deter and detect errors and dishonesty. Internal control certainly isn’t the most glamorous accounting function in a business organization. Even if everyone in the business and everyone the business deals with are as honest as the day is long every day of the year, errors are bound to happen.

Here’s a nice real example: One of my personal client recently started receiving retirement income from the organization that manages his retirement investment account. He completed a rather lengthy form giving the organization all the information it asked for, and being an accountant, I appreciated that it needed all this information. He has no problem with that, anyway. But the organization made a data input error, entering his wife’s year of birth as 1965 instead of 1945. This is called a “transposition error“, and it’s a common error in accounting systems.

Every business should have internal control procedures in place to prevent, or at least to quickly catch, this type of error. Fortunately, I caught the error when he shown his document during our last meeting (he wanted me to check about why he received such low amount). I called the error to the company’s attention, and it took 15 telephone calls and over two months to get the error corrected! What bothered me is that the company didn’t have internal control procedures in place to prevent or to quickly catch the error.

Back to the main topic…. Well, a business is the natural target of all sorts of dishonest schemes and scams by its employees and managers, its customers, its vendors, and others. To minimize its exposure to losses from embezzlement, pilfering, shoplifting, fraud, and burglary, the accountant should establish and enforce effective internal controls in the business. As my uncle once said, “There’s a little bit of larceny in everyone’s heart.” Internal controls are an example of the principle that an ounce of prevention is worth a pound of cure.

Keeping Up-to-Date on Accounting, Financial Reporting, and Tax Changes

Accountants are very busy people because they carry out many functions in a business. Like business managers, they don’t have a lot of time to spare. One thing that gets short shrift in a crowded schedule is keeping up with changes in accounting and financial reporting standards. However, it’s absolutely essential that accountants stay informed of the latest changes. I personally recommand; Accountants simply have to set aside time to read professional journals, peruse Web sites, and keep alert regarding developments in accounting and financial reporting.

The baseline payment terms that a company should consider offering to its customers is the standard terms offered in the industry, which may range from immediate payment to 60-day terms. The key issue is to give the appearance of offering competitive terms, so that prospective customers will not be turned away. However, it is quite acceptable to modify these baseline terms considerably if a customer appears to present a credit risk.

One solution is to shorten the terms of sale. For example; a customer may plan to place 10 orders for $3,000 each within the company’s standard 30-day terms period, resulting in a required credit line of $30,000. Reducing payment terms to 15 days would mean that the customer should be able to purchase the same quantity of goods from the company on a credit line of just $15,000. This approach works only if a customer is placing many small orders rather than one large one, the orders are evenly spaced out, and the customer’s own cash receipts cycle allows it to pay on such short terms.

Another possibility is to offer a leasing option to customers, which allows them to make a series of smaller payments over time. Though the company could offer this service itself and earn extra interest income on the sale, this still leaves the risk of collection with the company. An alternative is to engage the services of an outside leasing firm, so the company receives payment from the lessor as soon as payment is authorized by the customer, thereby eliminating the collection risk in the shortest possible time frame. A company can also earn a small interest percentage on the lease as part of its outsourcing agreement with the leasing company, usually in the range of ½ to 1 percent. This approach is most effective when the company and the leasing agency have come to a joint leasing agreement well in advance of a customer sale, so the sales staff can present the leasing option to the customer as part of the initial sale presentation. This frequently gives the company a distinct advantage in making the sale. Of course, a lease is a viable alternative only when the company is selling a fixed asset that the customer intends to retain.

Another approach is to leave the payment terms alone, but to have an individual with personal assets guarantee payment. The personal guarantee makes collection easier, since the signer knows that he or she is responsible for the amount of the receivable, and will make sure that this invoice is paid before other unsecured invoices. If possible, obtain a joint guarantee from the individual and his or her spouse.

By doing so, the company can get around some state-level community property laws requiring collection only if the spouse also agrees to a guarantee.

Finally, consider leaving the payment terms alone, but obtaining credit insurance on the invoice. This is a guarantee by an insurance company against customer nonpayment.

Credit insurance is available for domestic credit, export credit, and coverage of custom products prior to delivery, in case customers cancel orders. If a credit insurance policy stipulates a maximum credit limit per customer, the insurance company must make the decision to increase the credit limit, or the company can take on the uninsured risk of granting extra credit. If a customer is considered by the insurance company to be high-risk, it will likely grant no insurance at all. Also, goods being exported to countries with a high perceived level of political risk will not be granted credit insurance. The cost of credit insurance can exceed half percent of the invoiced amount, which varies considerably by the perceived risk of each customer. The company does not have to absorb this cost; where possible, consider rebilling it to the customer, who may be willing to pay it in order to obtain a larger line of credit than would otherwise be the case.