Best Practices: Provide Internal Financial Information
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
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.
