Operations and the bottom-line? Part I

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As an expert in operations efficiency and effectiveness, I am often asked how much of a difference back-office operations can make to a firm's profitability? After all, sales are what drive any business, and so the front-office should be the primary focus. While I agree wholeheartedly that sales drive a business - one of the best stories I have heard in this regard is of a startup where everyone had a little box on their desk that went "cha-ching" with each sale, reminding everyone that the company lives or dies by sales - sales are only the tip of the iceberg. If the company cannot deliver on its promises, or if it fails to collect its payments in a timely manner, a profitable sale can quickly turn into a loss. Too many losses and the business is history.

There are a lot of areas to focus on when it comes to operations. For the purposes of this article, we will focus on that historical bastion of efficiency, the finance department.

In addition to strategic issues relating to issuance of debt and equity, as well as currency and commodity hedging, a finance department has several operational functions. These include:

  • Payroll: making sure all employees gets paid on time and the appropriate amount
  • Expense processing: making sure employee expenses get reimbursed on time and the appropriate amount
  • Accounts payable: paying vendors more or less as agreed, whether upon receipt, net 30, 45, 60, 90, etc.
  • Invoice processing: closely related to accounts payable, ensuring that invoices get entered and tracked as rapidly as possible
  • Accounts receivable: making sure the firm gets paid for its products and services on time, more or less as agreed, or preferably faster
  • Invoice issuance: closely related to accounts receivable, making sure invoices get issued to the firm's customers, that the invoices reflect all the information needed to process the invoice, and that the information is correct.
  • Reporting: the department is responsible for managing all of the above so that management can understand the current and future cash position of the firm.

Suboptimal operations in any of these areas can significantly impact a firm's profitability. Since these are all processed by one department, they normally move together. Worse, these are all considered fixed costs, and thus come after the gross margins. In this section, we will examine each of the functions in turn. In part 2, we will look at a hypothetical firm and the impact on its business.

Payroll

Payroll must be paid on time and accurately. What happens if payroll is late?

  1. Angry employees: Very few employees, if any, are willing to work for a firm that does not pay them as agreed. The rare exception is employees of a startup that has no cash, and thus have agreed to be paid in equity. Other than that, however, your employees expect to be paid. If they are regularly paid incorrectly or late, turnover increases and lawsuits are sure to come your way. What is the cost of turnover? The general rule of thumb is somewhere from 50-200% of the employee's annual compensation, depending on the level of an employee. Put in other terms, an $8/hour employee will cost you from $8,000 upwards in loss and replacement costs. Higher-wage salaried employees cost much more. Additionally, if word gets out that people left because of payroll issues, replacement may be near impossible, until the issue is fixed and significant funds are spent marketing the improvements. 
  2. Lawsuits: It is hard to travel a subway or through an airport nowadays without an ad for some law firm that is only too happy to sue anyone who wronged you, however accidentally. For payroll negligence, you can expect to be sued. The costs of these potential suits is difficult to estimate, but one can expect to spend at least $20,000 in legal costs alone defending a single lawsuit, even if filed the suit is dismissed. If there are multiple employees, large amounts of pay, or you have to settle out of court or, worst of all, lose the costs can be orders of magnitude greater.
  3. Penalties: Some states assess penalties for late payroll. However, the IRS and almost all states assess significant penalties if you do not pay withholding and payroll taxes on time. 

Fortunately, most firms outsource their payroll nowadays, from small business providers like PayCycle and SurePayroll to the giants like ADP, which reduces the likelihood of problems. Nonetheless, all of these payroll providers depend on timely input from their customers' management to ensure that the payroll information is correct and approved, and that the appropriate cash is in the bank.

Expense Processing

Even the best-run firms regularly have difficulties with expense processing. I have rarely seen a firm that handles it expeditiously. Even when the approval requirements are onerous, most employees will get the appropriate approval within a few days... after which it languishes in the expense processing area of the finance department.  This is partially because it is an "unimportant" back-office function, and partially because some firms view their employees as a bank. Because of this, expectations for expense processing are so low that as long as the rest runs well, most employees have greater tolerance for expense processing. Conversely, a place that reimburses in a timely manner will gain a large amount of employee goodwill. What happens if expense processing is late or incorrect?

  1. Angry employees: Employees are more willing to work for a firm that is late in reimbursing expenses than one that is late in paying salaries. Nonetheless, resentment does build.
  2. Reduced investment by employees: Assume you are working for a firm that asks you top travel to San Francisco for 5 days on business. You whip out your AmEx, and buy a JetBlue plane ticket for $400, 4 nights in a hotel at $800 including taxes, another $300 in food and $200 in cabs here and there, a grand total of $1700. The trip is a grand success and you close two new accounts. Now your employer takes 7 weeks to reimburse you, in which time you need to pay off the AmEx bill with your own funds, money you may or may not have lying around. You never intended to become your employer's bank, and are quite stressed during the lag. The next time an opportunity comes for you to fly to Miami to close a big account, how likely are you to go?

Accounts Payable

Assuming you know what invoices you have received and what you have to pay by when, you have an obligation to pay these invoices on time, or reasonably close to on time. Some businesses explicitly rely on paying invoices late as a way to generate cash; I have worked with and for several firms like this. What happens when firms do not pay invoices on time?

  1. Loss of vendors: Some vendors refuse to do business with the firm. No one wants to spend time chasing down accounts receivable. Most vendors are in business to sell a product or service, get paid for it, then do it again. If chasing down payment becomes too burdensome, thus reducing the profitability of a client, eventually some vendors will simply refuse to do any more business with the firm. The cost of switching vendors as well as the increase in prices due to less competition both have direct costs to the firm.
  2. Higher prices: Other vendors raise their prices or impose penalties. In many businesses, when dealing with firms of questionable payment practices, vendors have imposed percentage penalties per day late. When compounding comes in, that can get very expensive. Effectively, even if you can get services, their prices increase.
  3. Worse payment terms: Other vendors insist on upfront payment. This can make managing cash flow particularly difficult. The difference between net 30 and upfront payment on a $10,000 sale at 12% cost of capital is $100 more than it was the last time you did it. 
  4. Bad business reputation: This makes it even harder to close deals with vendors at reasonable prices, or get decent payment terms. It may also affect your credit rating and banking relationships. A firm with annual revenues of $10MM and debt of $1MM that sees a difference in rates of 2% can pay an extra $20,000 a year in interest.
  5. Bad owner reputation: Unlike poor service or products, if the firm does not pay its bills responsibly and on time, the stigma attaches to the people. Quite simply, people expect business owners and managers to be responsible and pay their bills. If they do not, the person himself or herself is viewed as contemptible.
  6. Higher processing costs: Every time a vendor does not get paid, they call you, they harass you, they harass your staff. Besides the lowered morale and turnover among the staff, you are paying for the staff's time. 

Invoice Processing

Before bills can possibly be paid on time, invoices received from vendors must be processed and managed. What happens when invoices are not properly entered?

  1. Delayed payments to vendors: Accounts payable are delayed, with all of the negative impacts discussed above.
  2. Higher processing costs: Since each payment is now a scramble to find, enter and process an invoice, your costs increase.
  3. Impossible cash-flow planning: Without an understanding of what invoices are due in the next period of time, management cannot do short-term cash management. It then will find itself either keeping too much cash on hand, depriving it of investment income or returns on investment in growth of the business, or too little, leaving it to scramble at the last minute for more expensive, usually high-interest debt, cash to pay its bills.

Accounts Receivable

Accounts receivable is directly responsible for turning sales made into the cash the business needs to survive. What happens when accounts receivable is poorly run?

  1. Lost payments: Cash due to the firm is never received. This might be because the invoice was not known about or never issued, the customer is intentionally or accidentally slow, the check was never received, or any of a myriad of other reasons. Either way, this is worse than a lost sale. If a $10,000 sale was never made, it was never made. But a $10,000 sale that has a gross margin of 20% has already cost the firm $8,000 in direct cost of sales or cost of goods sold. 
  2. Late payments: Cash due to the firm is received late. Every time you do a sale on receivable, you are lending your customer money. If a $10,000 payment is received 30 days late, you just lent your customer $10,000 for 30 days. You never wanted to be a banker, and you certainly don't want to be one if it means lending money for zero interest.
  3. Higher processing costs: Since inevitably management realizes it is missing cash, a "fire drill" occurs in which everyone in accounts receivable scrambles to find and recover the missing payments. This processing time is expensive.

Invoice Issuance

Before payment can be received, an invoice must be issued. What happens if invoice issuance is not running smoothly?

  1. Wasted multiple processing runs: Since invoices are not entered and managed properly, many invoices will need to be submitted multiple times. This eats up time from: finance staff, who must issue the invoice; management, who need to understand and give special approval to an unusual invoice; and sales staff, who need to follow up and explain the sale and its terms. These sales staff do not want to spend time on administration, let alone doing so twice, and cost far too much to do so. Not only is their time expensive, but could have been spent making sales rather than processing invoices.
  2. Late payments: Even if the customer is responsible and timely, they are only responsible to pay an invoice based on the days from issue. If the terms of our $10,000 sale specify net 30, and the invoice is issued 30 days late because of invoice sloth, you just lent them $10,000 for another 30 days at zero percent interest.
  3. Rejected payments: Many businesses have a "maximum invoice by" policy. Quite simply, you must invoice within a certain time period of service rendered or product sold, or the invoice will be rejected. This is understandable. If you issue them an invoice months late, it is difficult for them to manage their cash reliably.
  4. Impossible cash-flow planning: Just like outgoing invoice management allows you to predict cash outflow, incoming invoice management allows you to predict cash inflow. Both are critical to cash management.

Reporting

The finance department has a critical role to play in providing historical, current and future information on the financial state of the business to management. It is expected to have accurate and timely information. What happens when this information is incorrect, slow or out-of-date?

  1. Impossible short-term cash-flow management: The business will not know what bills are due nor what payments can be expected in the near future. As a result, the business will either have too much cash on hand, leading to lost investment opportunities - how many businesses do you know that don't wish they could have had an extra little bit of cash to invest in an opportunity - or too little cash on hand, leading to a scramble for cash when the bills are actually due. This additional cash will have to come either from suddenly cancelled investments, which lead to lost future revenue and demoralized staff, or high-interest lending facilities, which increase unnecessary interest costs.
  2. Impossible customer profitability management: The business will not know with any level of reliability what percentage of its receivables comes late or not at all. This makes: provisions for lower profit impossible; provisions for bad debt difficult or inaccurate, a significant problem in public companies that must report accurately; management of customers for maximum profitability impossible. Put in other terms, management cannot know which sales are truly profitable and which ones look profitable but are actually low-margin or losers, and thus a drag on profitability. 
  3. Weakened negotiations: Since management does not know what the historical payment record of its customers and suppliers has been, it is in a weak negotiating position for its next negotiating round, either with a new customer/vendor or renewal of a contract.
  4. Difficult long-term planning: As the business does not have accurate and timely information on its revenue and expenses, it will have a severely delayed view of its future position. Without this information, it is difficult, at best, for the firm to plan hiring, capital investment, growth or other initiatives. Significant growth opportunities will be missed, while downturns that could have been better managed will be dealt with in crisis mode.

Summary

Efficiently and effectively running operations are important to any organization. Looking at the finance department, we can see how just one poorly run department, one that is not even sales or front-office, can significantly impact the profitability of an organization and its owners and managers.

In a follow-up post, we will look at a case study using real numbers and see the impact of these operations on the profits of an organization.