It’s Time to Change your P&L Analysis

Money

Performance management is a term often used in discussions around improving an organization’s results. It includes activities that ensure goals are being met consistently, effectively and efficiently. It can focus on the performance of an organization, a department, employee, or even the processes to build a product or service, as well as many other areas. One of the key performance management tools businesses traditionally use is the profit and loss review, which compares actual results to budget projections. But the analytical approach that this tool presents is now well out of date.

Why?

In many cases, if not all, the largest percentage of a profit and loss review uses a fixed budget approach. This approach can be effective in a manufacturing operation, where production in relation to top-line revenues is more controllable but,for service-related businesses, it falls short.

The goal of a manufacturer is to maximize throughput of a factory operation; in essence, making sure that if a machine or a production line can produce 1,000 widgets an hour, the performance of that line meets this “standard.” There are no outside forces; staffing levels for the machine or line are established based on work stations and other internal requirements to meet the 1,000 widgets-per-hour rate, and those widgets are then placed in inventory. With inventory as a buffer to help optimize production, a fixed budget approach works pretty well. And its dominance was understandable when the U.S. economy was heavily slanted towards manufacturing.

But that has changed

Three out of four jobs today are coming from service industries, where measurable external forces impact day-to-day production. Look at a restaurant, hotel, casino, retail or other dynamic operating environment—the budget projections that lead to cost expectations are highly variable from a production standpoint. And with this variability of production volumes comes a demand for better performance management techniques.

The alternative that I believe service-related businesses should fully embrace is variable, or flex, budgeting and performance analysis. This approach is not new; in fact, it has existed far longer that I have been in business. But for organizations that have limited control over how much they produce on a particular day (consumer demand varies, after all) a variable/flex budget approach enables a more thoughtful application of cost parameters when assessing performance.

Let’s compare two examples: a car production plant and a restaurant

For the car producer, once a design has been developed, a cost is calculated based on all the aspects of the car, from chassis to electronics to seats, and so forth. The nice thing about this cost standard is that once the determination is made to build Model A, the cost of producing that model is clearly known and can be measured easily during the P&L review. And the production is to inventory, without the variability of day-to-day changes in requirements.

The restaurant, by contrast, involves setting parameters that define the cost of serving a customer, from labor to food to other related operating costs. Some of these costs are, in essence, fixed and some vary significantly based on the volume of guests served. The challenge arises in getting an accurate forecast of that volume. Customer demand can vary widely from period to period and rarely is the budgeted top line accurate. And not only are customer counts difficult to predict months in advance, but the revenue per customer also varies.

Despite this, in my experience most organizations still ascribe to the fixed budget review approach, comparing actual costs to budgeted costs even as it produces inaccurate results. And they’re losing out.

Replacing fixed budget with a flex/variable budget approach would enable service businesses to factor the following into their P&L review: original budget, updated plan (if applicable), actual and flex. The flex is developed by taking the actual volumes serviced and applying the cost model that was used to develop the original budget. If, for example, the labor cost per customer is $2.25 in the original budget and the number of customers budgeted was 5,000, the budget labor would be $11,250. Assume the actual labor is $13,000. A fixed budget approach would show the business went over budget by $1,750, or 16%–a poor result. But a flex/variable perspective would factor in the actual volume of customers, in this case 5,800. At that volume, the cost of labor should be $13,050. Now the cost is under .5% variance—a much healthier result, and one that won’t trigger an unnecessary performance discussion.

If organizations in the service space would embrace flex/variable budgeting and P&L analysis, performance management would be far more accurate and the issues that truly need addressing would be easier to discern.



Add Comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Simon Hu
10 Things You Didn’t Know about Simon Hu
Coors Light
The History of and Story Behind the Coors Light Logo
Papa John's
The History of and Story Behind the Papa John’s Logo
Susan Zirinsky
10 Things You Didn’t Know about Susan Zirinsky
Successor Trustee forms
What is a Successor Trustee Form?
Savings Bonds
Five Most Common Bond Scam to Watch out For
Savings Bonds
What Is a Certifying Officer for Savings Bonds?
ETF
Should You Consider the Vanguard Momentum ETF?
Kimpton
The 10 Nicest Places to Stay in Taipei
Hiking Chile
A Traveler’s Guide to Hiking in Chile
Borago
The 10 Best Places to Eat in Chile
Chile Beaches
A Traveler’s Guide to the Best Beaches in Chile
1971 Cadillac Medic I Fleetwood ambulance
Did You Know That Cadillac Makes an Ambulance?
BMW Z4
The 10 Most Reliable BMW Models of All-Time
BMW Vs Mercedes 1
BMW Vs Mercedes: What’s the Verdict?
BMW Engine
What Separates a BMW Engine From the Competition?
Patek Philippe
How Do You Even Pronounce Patek Philippe?
Patek Philippe
The Patek Philippe Twenty 4: A Buyer’s Guide
Patek Philippe Ref. 4910
The Five Best Patek Philippe Quartz Watches of All-Time
Patek Philippe Ref. 4947
The 10 Best Patek Philippe Women’s Watches of All-Time
Sonja Morgan
How Sonja Morgan Achieved a Net Worth of $8 Million
Dustin Moscovitz
How Dustin Moscovitz Achieved a Net Worth of $17 Billion
Ann Coulter
How Ann Coulter Achieved a Net Worth of $8.5 Million
Playboi Carti
How Playboi Carti Achieved a Net Worth of $9 Million