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Lean Finance; Breaking Down a P&L Statement and its Components

Nowadays, when we examine financial reports for small or medium sized enterprises (SME), we see that interpretations are being made based only on sales revenues and certain expenses. Since many vital decisions affecting the future of a company are determined by considering only these charts, many decisions are based on incorrect information.

First and foremost; value drivers, which are of vital importance, must be analyzed. Revenue, expenses, margin, inventory and cash are all components which should be defined and followed in a strict and concise manner.

Financial reports consist of numbers which can only be understood by comparing with other numbers. A financial chart which does not have a target column means nothing. There must be a target column and a realized column in order to understand if you are on the right track or not.

Therefore, the financial targets must be identified. Targets should be determined according to budget analysis, as well as market conditions. Hence, the targets of a fiscal year should be determined with contributions from all departments from the beginning of the year.

Generally, budget and Profit & Loss (P&L) reporting formats are identical. The only way to understand the point of deviation is by creating a budget with various components and then duplicating the budget in the P&L format.

Budget and P&L formats constitute only main items and revenues thereby generating totals.  See below…

Örnek Profit and Loss Structure

A – Direct Material Cost

Sale targets should be set while making a budget. How much of each product will be sold? It is a difficult process and it should be done realistically because deviation from the budget and company strategy should be avoided. Suppose that you bought a new machine thinking you would sell it at a higher price. What if you do not achieve the sale targets or on the contrary, you sell more than predicted and changed all the processes of the supply chain without any plan. In prediction, both negative and positive deviations are a failure. The ideal use of a budget is a 1-3% deviation.

This is why you must create revenue targets that are product-oriented with accurate estimations.

Product-oriented estimation is necessary to defray sources and costs which are used in making a product sellable. We should decide how much material we need to achieve a target by using production analysis, which is used in order to make the bill of material a real product.

This proportion can be changed according to sector and product. However, we’ll take 65% of revenue as an example. That is to say, we targeted 100 TL in the budget, 65 TL of which consists of purchasing sub-components or raw materials which is a part of the direct product, known as DMC.

Gross Margin can be defined as the part of revenue from which we deduct raw material costs because it is the real playground. We should focus on gross margin as our first target. We should have revenue between 65 TL and 100 TL. If our targeted revenue shows as 67 TL and 100 TL on the P&L report, than we had an extra 2 TL in material costs than targeted which means there was a deviation.

B – Material Supply Chain Cost

Raw material costs are known by everybody. Even customers may follow this number better than you. Normally, making profit from raw material and sub-components is not expected. Profit is included in sales figures and in operational processes because if you are productive, your expenses and material costs will reduce. This will provide you with an opportunity to offer discounts. Thus, you will have a competitive advantage by being less costly for customers.

Raw material costs are generally the factory prices. However, all expenses should be identified in this area; such as cost of customs, freight, inventory, delivery, white and blue collar workers and exchange differences of purchase.

Another important subject when creating a budget is the cost of inventory. For example, you have a 100 million TL purchase budget. You do not use a warehouse and you rent storage which costs 3€ per m^2. If you have 100 million purchases at 4 different times – it means an annual 4 inventory turnover rate.  You will need 25 million TL and an inventory area that costs 25 million TL. For example, this area is 9000 m^2.

However, if you have an inventory turnover rate of 12 instead of 4, than you will need 8.3 million and 3000 m^2 as an inventory area.

That is why all these components should be taken into consideration when creating a material analysis, known as MSCC.

This proportion can be changed according to sector and product. However, we’ll use 5% of revenue as an example. That is to say, we targeted 100 TL of which 5 TL consists of the material supply chain cost, known as MSCC. This is our second target.

We should have 100 TL of revenue and 65 TL of raw materials by using the 5 TL MSCC. If our targeted revenue is showing in the P&L report as 100 TL, then using 5 TL MSCC means that we have an extra 1.5 TL in material costs than was targeted which arises from storage, demurrage and additional logistics.

C – Transformation Cost

This is the most important cost for companies. Transformation cost is the most significant area because it is used to make a difference in the competition and is, therefore, related to profit and loss. In DMS and MSCC, almost all companies can have similar proportions.

Essentially, TC is the expenses of all processes involved when making a raw material into a sellable product, and then placing it in the inventory area. In fact, all expenses of operational processes, equipment depreciation, production expenditure materials, energy and maintenance-repair, direct and indirect labor are identified in TC. Also, production leads time and operational productivity can create unexpected expenses in this area. Machine breakdown, long-term change over durations, capacity planning problems, high inner-wastes, customers returns, performance problems of production and operator mistakes all cause deviation of the budgeted targets.

In order to achieve targets in the TC area, flow should be found in all processes. Material and information flow should continue without interruption; as should lead time: material preparation, to stage and delivery of production, to storage. Elements which make this time longer, known as MUDA, can be eliminated with Lean production systems.

A Lean transformation process starts with Value Stream Mapping which is used for observing waste; next is the organization of work areas which consists of 5S, visual factory and standard work. After this process, the next step should be dissemination of Kaizen for each process and transition to Kanban and pull system in order to provide product flow by building supermarkets. This process should be supported by line balancing and sequencing and SMED techniques which will provide quick product transformation.

At the same time, a TPM (Total Productive Maintenance) system and quality assurance system should be put into place so as to achieve the cost target in TC.

TC costs can change according to different factories even when they are in the same sector. As stated above, the factor which creates this division is how margin is used effectively and costs are reduced. To achieve this, the only choice is to be Lean.

This proportion can be changed according to sector and product. However, we’ll take 12% of revenue as an example. That is to say, we targeted 100 TL of the budget of which 12 TL consists of costs of the transformation process, known as TC.

It is the TC target. We should have 100 TL revenues and make the product 5 TL instead of 65 TL by using 12 TL TC. If our targeted revenue shows in the P&L report as 100 TL by using 14 TL MSCC, it means that we had an extra 2 TL in transformation costs than was targeted, which arises from unproductivity as mentioned above.

D – Service and General Administration Cost

This area is not related to production, but it is related to sales. Also, this area should be used for indirect expenses such as executive expenses, finance, accountancy, human resources, executive acts, advertisement and marketing.

You may not be able to change to change anything in this area but generally advertisement and marketing expenses are argued over. As opinion leader and merchant John Wannamaker (1838-1922) said, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” This proportion is always unpredictable.

The other important issue about Lean is that there is a huge waste in ‘front office processes’. Waste exists in all processes, however, the main aim is meeting customers’ requests in product and service as soon as possible. In other words, lead time reduction should also be the in office processes. An office process which has an unproductive design and poor management causes wastes that effect both customer satisfaction and production in the background. Thus, a Lean enterprise should be Lean in not only the production processes but in every area.

The processes of order entry, planning, designing, product development, purchase and accountancy/finance consist of steps should all create value.

As we know, value is is any and all services for which a customer pays; this makes product and service functional and meaningful.

Waste is any and all kinds of activities apart from these. Waste in the office can be described as defined in production:

– Long lead time and disruptions

– Paperwork like inventory

– Excessive and unnecessary process steps and operation; repetitive work, unnecessary steps and consents

– Unnecessary movements and researches; defective lay-out office design and bad ergonomics

– Mistakes; incomplete and wrong data communication

– Transport and movement; complicated monitoring system, bad process design, bureaucracy

Office processes create value in a 5% time frame like production processes. Reduction of lead time, as well as cost and quality improvement can be provided by eliminating waste in the rest of the 95% time frame.

Therefore, it should be stated that process flow is described by identifying all work processes with value stream mapping (process analysis of current state). All operational and informational processes and material flow, which trigger the process of receiving order and production, should be described with detailed operations and visual aids. For example: the process of receiving and registrating an order.

The main target is to show how material and information flow is used in order to deliver a product or service to customers.

These are necessary for the above processes:

– Training of team for basic level of Lean

– Paper and pencil (usage of paper and pencil instead of computer makes the idea more productive for value stream mapping)

When a visual process map emerges, the team will understand easily that which does not create value and how waste can be removed. Probable new scenarios should be applied with trial progress. (The ideal way for observing waste is mapping processes visually.)

After identification of the process analysis, as well as the new processes which are extinctive for waste, it is necessary to map out the next process. (New work steps which will improve processes and flows and make operation time of people and equipment more productive.) As a result of this work, you will observe that quality of production and service in process output increased and there is a profit in time management and improvement of lead time between 25% and 75%.

Demand forecasting, productive and effective order management, fast and well-responded customer services and value added new processes of improving product will provide an advantage for corporate image, profitability and market competition.

E – Profit

The main aim of every company is to make a profit. In the past, a profit formula was Revenue = Expense + Profit. Product selling prices were increased in order to increase producer profit rate; however, expenses were not considered.

Presently, the situation is very different from the past. Purchase prices are determined by customers. If you do not have a rare and extraordinary product which is demanded by all markets, you have to accept prices which are determined by customers and you should change your system according to this new formula.

Profit = Revenue – Expense

It means that standard profit margin is determined by customers according to market conditions. The main ways to gain more profit and a competitive edge are reduction in expenses and increasing productivity.

Budget and P&L main items are done for whole operations in many areas of business. This situation focuses on general performance of management. However, in order to understand where real wastes are, P&L reports should be more detailed.

For example, while we make a 5% profit from one product, we can make a 13% profit from others or take a -2% loss from another product. When reports are general-based, people believe they are seeing positive results and think everything is okay. In fact, if products effect loss of or less profit than targeted as indicated in detailed reports, this situation can be questioned.

You cannot fix what you did not observe or measure. If our job is being profitable thru our management, we should be familiar with the elements that effect profitability and should set targets and measure them regularly.

We recommend to report and measure by using value stream management. VSM can be a customer group or product family. In fact, creating an analysis with a sense of the product family creates good results and we can observe the financial value or waste easily.

However, getting to this step is not easy. Good information technology is required to make a detailed process analysis and to distribute expense centers as product family based. As stated, in order to understand where wastes are as well as what you are doing correctly, you need financial reporting with a P&L structure based on VSM.

For example, a company had some dealers with whom they compromised under special conditions. A discount rate for each company was established according to the revenue proportion and, partially, to the relationship with the boss.

Although revenue of the company seemed closer to the targeted level, they were still not in the intended place from the point of profitability. I wanted a financial analysis which was customer-based in a P&L format from the financial department. An interesting situation emerged.

We saw that although some companies were on the top in revenue, they were low in profitability and, in some cases, even caused loss. This situation surprised everybody. The profit from popular customers was almost nonexistent. It would be better if there was no sale to these customers. However, this could not be understood or visualized until the making of the customer based P&L analysis.

We made this work for the product family by detailing it. Both customer based and product based analysis indicated that profit could not be made from all products and even some customers. If a product or customer does not have strategic importance, it is not meaningful to keep them. The most important feature which separates a business and a charitable institution is that the former seeks profit and the latter is public spirited.

Well, we should make a decision. Will you be a business enterprise or a charitable institution?

Lütfi Apilioğulları has built a successful career based on his enriched experience gained in automotive, telecommunication & electronics industries both in nat’l and int’l companies. He worked in various positions in these industries as an Engineering Manager, Lean Manufacturing Manager, Operational Excellence Director and General Manager.

He worked together with Lean Sensei’s in the Lean transformation and factory operations management a long time and has hands-on “Lean Six Sigma” and “Manufacturing Operations Management” experience. He wrote a book “Lean Transformation / Code of Productivity” which was published by Sistem Publications on February 2010. He has Bachelors degree in Electrical – Electronics Engineering, Dokuz Eylul University, Izmir and Master of Business Administration degree (MBA) from the same university. Lutfi is married with two children.

As an expert in the areas of Toyota methodology in plant management, advanced level Lean & Six Sigma applications and change management, he provides high profile consultancy services in the field of “Operational Excellence / Lean Six Sigma” at Lean Ofis | Turkey Consulting Group as Principal consultant. Contact him at lutfi.apiliogullari@leanofis.com 

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