Wednesday, January 12, 2011

Importance of Financial Forecasting

Happy New Year to everyone!

As we turn the calendar to 2011, we look forward to a fresh start and hopefully better times ahead.  Many, if not most or all, businesses know what they are looking to accomplish over short, intermediate and longer time horizons.  They are looking to arrive at a destination and mile markers along the way.  In order to track how the organization is doing in achieving its financial goals, a roadmap should be created.  If a business goes astray in achieving its financial goals and has no barometer to measure against on a line item basis (think income statement line items) to determine why it is off course and by how much, it runs the risk of not being able to timely identify the problem areas and take corrective action.

As we’re mid-way through January if you aren’t done, or at least close, to getting a final financial budget in place for 2011 you should begin immediately.  It really isn’t too difficult a task and it provides a great tool for the business owner to measure actual against expected results.  Rather than simply looking at the bottom line on the interim financial statement and wondering why it’s not what it should be, the budget, used in a regular and timely fashion, provides the much needed benchmark management should have to run the business efficiently and profitably.

In addition to creating a financial forecast/budget, it’s also very important to create a cash flow forecast.  A typical time horizon is 13 weeks, updated on a rolling basis, however you can also create a longer view cash flow forecast as well.  There are few industries, if any, where cash flow forecasting is more important than in the construction industry.  Knowing when, and where, your cash is coming from and going is vital.  Additionally knowing if, when and how much financing from your bank partner, in the form of the working capital line of credit and other debt facilities, is also of the utmost importance in helping you run your business.

There are other advantages to creating these plans as well.  Important business partners for most of our clients include the bond company, the surety broker as well as the bank.  These businesses that extend credit to contractors obviously prefer to work with contractors who have their “act together” in terms of running and managing their businesses.  How do you think your bond company or bank would react if, during your annual or semi-annual meeting with them, you handed over these plans in addition to other management reports that are critical for those business partners to continue extending, and maximizing, the credit you need?  How many of your competitors would you guess actually hand over these financial and cash flow forecasts?  The answer is some perhaps, but certainly not all.  You must take any advantage you can in order to maintain, and again maximize, surety and bank credit.

If you would like templates for either a financial or cash flow forecast, please contact me and I’ll be sure you get a copy.

Parkinson’s Law and the Pareto Principle

You may not have heard these names before, but I’d guess you have heard the concepts that each address by other names/phrases.  I thought it made sense to address both of these as they impact business each and every day.  Also, since my other article this month addresses budgeting and forecasting essentially to aid in business efficiency and effectiveness, I thought these concepts all fit well together.

Parkinson’s Law, in a nutshell, is the concept that work expands to fill the time allotted for such work.  That means that if we tell a worker that he or she must work from 9AM to 5PM every day, that worker will at the end of the day clock 8 hours worth of work regardless of whether they provided 8 hours of productivity.  I’d venture to guess that in many cases, if you told one of your employees that if they completed the tasks they needed to for the day by 3PM, they could go home, they would have little problem getting their work done by 3PM.  This scenario may ring true to some of you reading this.  You may be thinking about the two hours that are essentially “wasted” by requiring someone to stay in place until 5PM just because.  You may also be thinking this is a problem or challenge and I’d tend to agree!

One of the greatest areas of risk, particularly for subcontractors, is the management of labor.  It is also one of the greatest areas of opportunity as well.  In a competitive bid environment, there are many variables that don’t change dramatically from one contractor to the next in terms of putting together a number, or price such as materials and fixed overhead.  One area that has the potential to be a “game changer” in making you extremely competitive is how you manage and incentivize labor.  In my above scenario, the employee gets paid the same whether they do a full 8 hours, or 5 or 6 hours, of work in a day.  The employee most likely fully realizes they are not producing 8 hours of quality work and they either know how to get to 8 hours of work in a day or they are just purely underutilized and there is possibly too much labor in the company relative to the real need.  

What if you as a business owner, both empowered and incentivized your employees to produce more quality work in less time?  What would that mean to a subcontractor’s pricing potential if they could be lower by say 20% in their labor line item to their bid?  What would that capability mean to their overall business?  We all have many intelligent people who can be utilized more effectively if we allow them to do so and reward them when they produce results.  If in fact you could tap into the inefficient and wasted time in the labor area of your business and maximize that potential?  If you reduced labor costs on a bid by 20% across the board (easier said than done I understand, but it can be done if executed correctly with your team), that would save a typical subcontractor doing say $20 million in revenue $800,000 (assuming a 20% direct labor starting point).  If you split the savings evenly with your labor force, you would be able to hand out $400,000 in bonuses and increase your equity in the business by almost $250,000 (your 400K share less taxes)!  I’d venture to guess that many of your employees would be interested in their share of $400,000 annually (or whatever your savings would be) if given the opportunity to help identify inefficiencies and maximize productivity.  Further if you were a contractor offering total compensation, including this bonus, which exceeded that of most of your competition, you would be better able to attract top talent further potentially enhancing efficiency and capability.

Pareto Principle

The Pareto Principle is best known as the “80/20” rule.  Examples often used are 80% of your business comes from 20% of your customers, 80% of your HR/employee headaches come from 20% of your employees, etc.  It doesn’t necessarily have to be 80/20, it could be 70/30 or 90/10, but 80/20 tends to be the more likely scenario/example.

When doing a business plan, it may make sense to focus on your 20% if it’s a good thing (as in the 20% of your customers/sources of business) or mitigate/reduce the 20% of your headache areas (those employees and/or customers not worth doing business with).  Focusing and growing the more productive areas in your business is an excellent use of time producing the highest yield.  It will allow for more time to do what matters to you whether that be continuing to focus on how to grow your business and employees as well as perhaps spending more time with family and friends.

If 20% of the activities you do yield 80% of your desired results, do more of those types of activities and/or do them better!  Borrow the time from the 80% of the lesser productive activities (ideally the bottom, lowest productive percentile of course) and re-allocate to that top 20%.

We’ve known these principles all the while, I thought it would be nice to discuss them as well as offer the proper names for these often discussed, important and solid theorems.