Internal financial reporting traditionally means compiling and distributing generic reports that show a company's past, short-term financial performance. The financial reports at one company look the same as they would at any other company. And the information leaves management without insight, unable to link what happened yesterday with how the company will meets its financial targets of tomorrow.
Internal financial reporting does not have to be that way. A company can invent any format it likes; after all, internal reports are completely at the company's discretion. The company may have a single page of key indicators of the health of the business, juxtaposed to data on the same measures from the previous year or compared with competitors' numbers or to world-class performance numbers. A company may break down financial performance any way that makes sense for its business -- by geographic region, perhaps, or maybe better by distribution channel or by customer -- however profits flow. The traditional profit-and-loss framework is not obligatory, unless it happens to work for the company.
Newer technologies play an important role in improving the effectiveness of internal financial information. For example, the cost-volume-profit (CVP) analysis technique and other methods of analyzing costs and margins give management the subtle information it needs to make short- to medium-term financial decisions. Activity-based costing (ABC) opens up a whole new approach to matching costs and resources to their true causes. A state-of-the-art financial information system lays the foundation for consistent and reliable reporting, regardless of the way the company analyzes the information.
Best practices in the area of providing internal financial information can be quite technical and complex. For example, the best practices address the fundamental assumptions and structure of internal financial reporting, the selection of performance measures at the company, approaches to financial analysis, and choices in the financial information system. As daunting as these best practices may appear, companies should keep in mind that they have complete control and flexibility in the area of internal financial reporting. After all, it is internal reporting, so it is completely up to the company to decide what serves it best. Inasmuch as these best practices are intricate and complex, a company in the end should select the approaches and technologies that support its own decision-making process. A discussion of the best practices follows.
- Identify information needs
- Report by market segment
- Integrate financial analyses
- Use cost-volume-profit analysis
- Improve information systems
- Understand information limits
- Use activity-based costing
Identify and understand the information needed by internal customers to execute the business strategy, satisfy customers, and evaluate business process performance.
The traditional dozens -- or even hundreds -- of pages of financial reports distributed at the end of a period typically do not help management to run the business. Usually the reports contain much data, yet very little of it is relevant to the current strategy of the business, and readers cannot decipher what data relates to the key factors that affect revenues and expenses. An effective internal financial reporting process starts with the finance group meeting with senior management and key decision makers to define and understand their information needs.
Once the finance group understands management's financial information needs, the next step is to design, or redesign, the financial information systems to meet those needs. At this point, most companies shift from the traditional focus on historical financial data, which provides after-the-fact record keeping, to a new emphasis on information for decision making. For example, reports that include activity-based costing, target costing, and life cycle costing link financial performance with factors that affect revenues and expenses. These costing methods also uncover trends in financial performance and indicate the effects of the current trends on the company's attainment of strategic objectives.
Measure and report profit contributed by appropriate segments, such as product line, customer, channel, division, and geographic location.
Meaningful internal financial information differentiates profitable customers and business segments from those that are not. To achieve this all-important goal, the company needs to structure financial reports appropriately, so that recipients of the reports can plainly grasp the profitability analysis. To collect the appropriate information to analyze, a company first needs to identify how to segment its business to reflect the flow of profits, such as by market segment, by distribution channel, by customer, or by division. Then the company assigns to each segment the appropriate revenues, variable costs, and fixed costs. For example, for a channel profitability analysis, costs would include channel management costs; channel maintenance costs; advertising, promotion, and marketing costs; trade show costs; and marketing staff costs. Through assigning the relevant revenues and costs to the business segments, the company may identify high-profit and high-loss segments, and then set objectives for avoiding costs relevant to high-loss segments.
Integrate financial analysis with operational and industry analyses to identify opportunities for improving business performance.
Many companies could use more sophistication in their financial reporting, with techniques such as analysis of ratios and comparisons to industry and peer performance. These techniques give management insight into where the business may be vulnerable and where it might enjoy unique strengths. However, it's easy to go overboard with sophisticated financial analysis techniques; keeping the measures simple and relevant to strategic business issues is a reliable, powerful course of action.
Companies that apply best practices select a small number of key financial statistics and ratios to watch closely, keeping in mind the company's circumstances and objectives. Ratios and statistics are more meaningful if evaluated in terms of their trends over time. To broaden the focus of financial analysis, high-performance companies compare their numbers to those of competitors and best-of-class performers.
The balanced scorecard approach to financial reporting is particularly powerful. For a balanced scorecard, the company selects a short list of measures that not only indicates the operational and financial health of the business, but also its level of customer satisfaction and the creative health of the business. An example of a balanced scorecard is one that chooses measures that focus on four critical issues:
- The customer perspective: how do customers see the company?
- The internal business perspective: what must the company excel at?
- The innovation and learning perspective: can the company continue to improve and create value?
- The financial perspective: how does the company look to shareholders?
Taking a balanced scorecard approach, a company creates performance measures to track all levels of the company that reflect these four critical issues. For example, on periodic internal reports, customer satisfaction metrics and statistics on the number of employees participating in coursework are reported right alongside finance and operations numbers. To create meaningful report content, employees from finance, operations, and other functional areas need to collaborate with one another.
Use cost-volume-profit analysis, contribution margins, and relevant costs and qualitative factors to evaluate business opportunities.
From time to time, a company considers special business opportunities such as special order requests and outsourcing possibilities. Specific reporting and analysis methods assist a company in deciding whether or not to take advantage of such opportunities.
Methods such as cost-volume-profit analysis, contribution margin calculation, and relevant cost calculation help a company to evaluate the impact of expected changes in the volume of sales on resulting costs and profits.
Special business opportunities require a company to look at short-term financial issues -- such as revenues, expenses, and cash flow -- as opposed to long-term financial issues such as equity distribution and indebtedness. Also, when evaluating special opportunities, in addition to looking at the numbers, companies need to consider qualitative factors. Market expectations and customer expectations should always play a role in a company's decision to accept a one-time special order or to outsource its core business. Will existing customer schedules be affected? Will the company lose expertise in a key skill area? Are there hidden costs, like training and supervising time, that do not appear in the original analysis?
Use the attributes of world-class financial information systems to evaluate and improve the company's existing financial information systems.
At the foundation of effective internal financial reporting is a robust information system that collects and disseminates information flexibly and reliably. Best practices companies study the attributes of a world-class information system and look for computer hardware, software, and systems design for their business that deliver these attributes:
- Standardized: the system captures and processes information consistently throughout the company
- Complete: the system handles the information requirements of diverse groups of users
- Appropriate: the information is relevant, predictive, exception oriented, and at the right level of detail
- Unified: the system has information links to customers and suppliers, and changes to data in one area move through the whole system
- Flexible: applications may be tailored to the company's needs
- Cost-effective: the system makes efficient use of hardware and software licenses
- Easy to use: all types of users are comfortable with the system
- Timely: the system provides information when it's needed
Ensure that key decision makers understand the strengths and weaknesses of internal financial information.
Internal information has its limitations. The information is more meaningful and relevant when decision makers understand its limits, how it is produced, and how it can help them.
The finance group can assist management in understanding internal financial information by explaining the processes that underlie it. For example, the finance group can explain how the financial system measures, records, and classifies transactions; how the finance group periodically summarizes and reports financial information; and the meaning and limitations on interpreting the information. One limitation of internal information is its bias toward analyzing the past and focusing on short-term profitability. Another is its tendency to focus on issues important only to the company, opposed to issues of concern to customers as well.
Provide accurate and reliable activity-based cost information for resource allocation decision making.
Activity-based costing (ABC) is a powerful tool that companies use to determine which activities contribute to profitability. The concept of ABC is to distill a company's production process into a set of activities and then attribute and analyze costs by activity. With ABC, a company sees which activities cause its costs.
Implementing ABC lets a company allocate resources based on critical activities; eliminate redundant activities and costs; eliminate activities that do not add value to the customer; set budget levels in accordance with activities that cause costs; and place more reliable information on activities and processes into the hands of management.
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