ONLY TRENDS MATTER

Trafford Publishing

Contents

Foreword.......................................................................................viiPreface........................................................................................xiIntroduction...................................................................................xvChapter 1: How the Presentation of History Can Help You Predict the Future.....................1Chapter 2: New Ways of Categorizing Costs......................................................31Chapter 3: Trends, Graphs, and Budgeting.......................................................67Chapter 4: Including Rolling Forecasts in Management Accounts..................................107Chapter 5: Using Graphical Management Accounts in Practice.....................................148Chapter 6: Non-financial Performance Indicators (NFPIs)........................................182Chapter 7: Final Thoughts......................................................................199

Chapter One

As outlined in the introduction to this book the conventional numeric, tabular approach to the presentation of management accounts that has been prevalent for many decades is stuck in a time warp, no longer adequate for the dynamic environment that business and other organizations find themselves operating in today. Comments from managers gathered during the research for a better way of presenting these financial reports reinforced this. Some of these comments are repeated verbatim below:

• "What I really need to know is are we getting better or worse."

• "Management accounts are a sea of numbers and I don't have time to decipher them."

• "These columns of figures don't tell me whether I shall hit my target this year."

• "Management accounts are history, what we really want to know is how the future is looking."

• "They show a result of what I have done, rather than pointing me to the future."

• "They're too narrow a view, too historical and backward thinking. Not enough trends."

• "They don't show the consequences of anything you want to implement."

• "Looks mainly at how well costs have been controlled against the budget."

When the managers were asked in which format reports were easier to understand (graphical or numeric), the overwhelming majority said "Graphical."

These manager's comments were supported by my own experience; board meeting after board meeting was dominated by discussions about history prompted by traditional numeric management accounts with too much emphasis on examining variances from budget and intensive, time absorbing quizzing of the director responsible for any adverse comparisons with the budget. This occurred despite the fact that all knew the budget was several months old and that times and circumstances had changed; it was out of date and the "fixed" budget clearly didn't reflect this.

What boards and managers really need to know is what impact the implications contained in the accounts have on future performance and in what direction the company is headed, which parts are getting better and which are deteriorating. They want management accounts that not only tell them what their latest results are, but also point to the forthcoming critical areas that need attention; accounts that attempt to forecast what would happen if they failed to act and what could happen if they did.

This does not denigrate the value of historical or variance analysis. Carried out correctly, this is a necessary diagnostic tool, so long as actual results are being compared to a relevant budget. However, if management accounts could look forward and track the trends in income and cost then preventative measures and earlier action could be taken when adverse conditions are forecast. Trend analysis combined with reliable forecasting foresees shortfalls, rather than discovering them after they have happened. The early action this prompts can be critical to an organization's success

Transforming the management accounts to include these crucial factors is a major step forward in management accounting and the new routine encourages a forward-thinking approach that becomes embedded both in the minds of the accountant and the management. But it also leads to better cost control, monitoring of margins, quotation conversion rates, product and service sales cycles, optional cost decisions, and much more. When achieved this is a step change.

Led by the research, the development of a new convention for the presentation of management accounts identified a number of objectives:

• Any presentation of columns of figures to managers must be supplemented, if not substituted, with the same information presented graphically. This included comparisons with budgets.

• The addition of trend lines was vital.

• New-style management accounts must indicate what is likely to happen in the future as well as show the history. The inclusion of forecasts was critical.

• It was necessary to find an improved way of monitoring and controlling costs supplementing that offered by a budget.

These were simple objectives, but how could a complex financial document that contains thousands of numbers be converted into a set of simple graphs that would not only report historic financial results in the current year compared to budget, but also show trends in current performance and forecast what is likely to happen to the results in the future, as well as contain much more information about cost movements and structure than already shown in traditional management accounts? It was evident that this extra information had the potential of further complicating the report and making it even more difficult to understand than the numeric, tabular version it was replacing. Furthermore, this change had to be achieved without dramatically increasing the workload of the accounting department or incurring significant extra costs. All new ideas have to be sold to the receiving audience and this would be even more difficult if it raised costs.

The advantages offered by graphical presentations soon became clear; trend analysis enables a virtually instant view of whether a present situation is getting better or worse and at what rate the change is occurring. An added benefit from utilizing graphs is that two or more sets of numeric data relating to the same timeframe could be compared simply by using more than one data line on a graph. Including all this extra information in a set of numeric, tabular management accounts was just not feasible, but when presented graphically it actually became easier to read despite all the extra data it contained.

In addition it was possible, by using the same format, to better compare internal departments, products, salesmen, non-financial indicators, quotation conversion rates, and much more; the addition of trends to these comparisons revealed a whole new dimension. So much more information was revealed, it was difficult to believe we were looking at the same numbers as those in the numeric version.

During this process certain critical questions had to be answered: the time span of the graphs, how far forward and back the graphs should reveal, how the continuity of business from one year to the next was to be represented, how trends were to be calculated, how many graphs to produce, how to deal with extraordinary items of cost and income, whether inflation would distort the trends and critically how to monitor and evaluate costs when income was not as predicted or budgeted. The initial research, evaluating answers to these questions, putting the system on trial, coming up with the best solutions, and training the managers took around two years to complete, but it was all worthwhile. The results achieved were much better than anticipated and the whole team was talking trends; crucially our net results year by year following the introduction of the system improved significantly.

This book summarizes the research and describes the final system adopted. It will tell you how we got there.

Time Span of the graphs

Consider the simple graph in Fig. 1.1 showing actual sales month by month for a current financial year that runs from January to December, a period currently in use by many organizations, but it could be any financial year whatever the start and end dates.

This graph assumes that the organization concerned produces management accounts every month. However, the accounting periods could equally be four weekly or quarterly. It will not alter the theory, but for the purposes of consistency throughout this book the financial years will run from January to December, and the accounting periods are monthly.

Such graphs are probably in general use in many organizations for a miscellany of reports, although not usually as part of the management accounts.

The time span in the horizontal axis shown in Fig. 1.1 only shows the current financial year, and the figures it contains would be the same as would appear in conventional, numeric management accounts. They begin at the start of the financial year and report monthly and cumulatively each month until the financial year-end.

This financial year time-span convention omits any information contained in last year's accounts, thereby treating all previous results as history and no longer relevant. This means that there is therefore no consistency in cumulative timeframe within each set of management accounts; i.e., each management account covers a different time period from one month to twelve months. This lack of consistency in each report appears not to be questioned, yet consistency of presentation is considered an important criterion for performance measures—a contradictory situation that will be discussed in more detail later.

What can be concluded from the above graph from a manager's point of view? It shows the result month by month in the current year but not the result to date. Does this presentation allow management to see a trend? Does it help anyone visualize what may happen throughout the rest of the financial year or into the next?

Sales appear to be rising, but with only seven months of the year visible it is unlikely that such a short period can be enough for establishing a meaningful trend. Are there any factors such as bank holidays or seasons that need to be taken into account? Clearly more information is needed before any conclusions can be made.

In conventional numeric management accounts the only visible results are those for last month and the cumulative to-date total, each individual month is not visible. Any judgment of performance, therefore, can only be based on a comparison with budget and reliance on this is, at the very least, uncertain. The defects of budgets will be examined in some detail later together with their application to the trend charts.

But there are also defects in the graphical presentation in Fig.1.1. It is well known that when viewing a graph for the purpose of estimating a trend people are sometimes led to see what they want to see; there has been much research into this and we know from these studies that seasonal variations and exceptional or abnormal events can skew the figures; that gradual trends are hard to detect by eye and that people can be drawn to "outliers" and miss subtle changes. Outliers are those points on a graph outside the usual operating areas, usually caused by some abnormal event.

Any graph developed for the presentation of management accounts would need to address these known defects. Any subjective influences need to be eliminated because the consequences of misreading the graphs could be serious if they lead to wrong decisions by managers.

As a first step toward improving the picture, the graph could be extended in the time range so that a period of at least twelve months is visible. This would be the first step toward seeing a trend because it would include all seasonality.

The monthly sales values, to the beginning of the previous financial year, have been added in Fig 1.2.

It is evident from this additional information that the business portrayed by this expanded graph may have some seasonal factors; for example, Christmas appears to be a time of poor income/sales. However, it's not immediately apparent if any other seasonality exists. There appears to be higher sales during the summer months but there also appears to be a reduction in the sales trend last year followed by a rise in the trend after Christmas, even if the Christmas dip is excluded. It is not clear whether this post-Christmas rise is a recovery or a seasonal rise. Are sales really improving or is the rise simply one that would be expected following a seasonal dip? Could this just be an illusion? Was there indeed a downward trend in the first place? It is clear that the graph is actually raising more questions than it answers.

Within any organization it is usually well known whether seasonality exists; Christmas can be the best month in some retail businesses or the worst month for the building trade, which effectively closes down over Christmas and the New Year. Staff holidays can limit production over summer and Easter in many businesses, and the absence of customers, for some enterprises, over school holiday periods can be a factor, while for others, e.g. organizations operating in holiday areas, it is relied upon to be the best time of year. In some businesses, seasonality can be a factor on more than one occasion over a year; summer holidays and spring bank holidays lead to a consequent loss of working days, which affect performance; and then there is the weather, which can have an impact, prolonged winter snow for example. These seasonal variations will be well known to you for the circumstances in which you operate, but whatever knowledge you may have regarding the seasonality in your organization, it is plain to see from the seasonal variation in the graph in Fig. 1.2 that it is still difficult to visualize a trend using monthly figures only. If your organization has no seasonality this may not apply but there aren't many types of organizations like this, even the insurance industry, which may be able to spread its premiums equally throughout the year, may find that claims can be seasonally effected. Car insurance companies, for example, find that snow and ice in winter pushes up claims even though their income remains steady. Even many public operations that have "even" incomes through the year can find that costs vary during the year depending on the seasons: more flu in winter pushes up costs in the Health Service; treating road ice in the winter adds to the costs of local authorities.

Establishing Trends

It is clear that if we are to establish a trend from the month-by-month graphs such as that in Fig. 1.2, it is necessary to find a statistical method of creating a trend that will eliminate any impact of the seasons and smooth the slight variations experienced month to month.

To consider seasonal factors when depicting trends, it is necessary to consider what happened in the same period in the previous year; building a trend from data taken only from the current financial year within any seasonal business cannot be calculated without complex mathematics and other compensating factors, so it is simpler and more understandable to use data from the corresponding months of the previous year.

This conclusion prompts another associated question that must be addressed before examining the most suitable trend-calculation method.

The irrationality of current financial year only reporting for managers

Why, when businesses are continuous processes, do accountants persist in dividing their results into discreet financial accounting years and only presenting the current year in their management accounts? At the end of each financial year a line is drawn under its results and it all starts again from zero as if the previous year had not existed. The process has been simply mirrored to reflect the financial accounts (the end-of-year accounts for the auditors, shareholders, and the Revenue) without regard for the different needs of managers. Perhaps when management accounts were first created the needs of managers were much less. This could be true because these were the days without computers, the Internet, emails, mobile/cell phones or even fax machines, when Telex machines reigned and the excitement of the day was one of the new, exciting electric adding machines (if you were lucky) or an NCR accounting machine, which was the envy of many, akin to an enormous typewriter with rows and rows of numerical buttons and a long carriage that chattered from side to side and into which an account card was inserted and updated. Business was largely completed by post or phone and the pace of change was very slow by comparison with today. Management accounts then were largely drafted by hand and possibly copied by a typist for final presentation. Today's business life would have been impossible to forecast forty years ago and very little current technology could have been imagined, but management accounts now are not much different from the way they were presented then.

(Continues...)

Excerpted from ONLY TRENDS MATTERby DAVID WILLCOX Copyright © 2013 by David Willcox. Excerpted by permission of Trafford Publishing. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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