Don’t let GAAP lure you into bad business decisions
July 22, 2012A recent article in CFO Magazine caught my eye. It was fascinating to read how Fortune 50 companies – including the Big 3 US automakers – have been making the same mistake that I and my colleagues see at many middle market companies. In the case of the Big 3, however, they actually knew it was wrong and were doing it on purpose, thereby providing an excellent example of how misguided compensation plans and rubber-stamping Boards can damage a company. But that is a story for another day. Instead I want to focus on how middle market companies who use GAAP can reach wrong conclusions.
Firstly, a little background on GAAP. (This is not intended to be a complete or rigorous definition so would any accounting professors reading this please refrain from letting me know how I am riding rough shod over arcane territory.) Generally Accepted Accounting Principles or “GAAP” in the US follows the rules, guidelines, and principles promulgated by the FASB for entity financial reporting. Which means if a company issues financial statements which purport to comply with GAAP, (and almost always that is what lenders, investors, and other users of the information want to see), then it has to follow the rules. Among other benefits, it enables users of the financial statements to compare one company with another; a reliable apples-to-apples comparison. What do those accounting rules have to do with making decisions around, for example, pricing products or factory utilization? The answer is at best not much and probably nothing, but following those rules in situations where they are not meant to apply will lead to bad business decisions.
Under GAAP accounting, companies use “absorption costing” to value inventory and therefore cost of sales. The inventory units produced “absorb” all of the manufacturing costs for that period of production, including not just direct materials, direct labor, and variable manufacturing overhead but also, and this is the key issue, fixed manufacturing overhead. This may be fine for external, company-wide, financial reporting. However, using GAAP financial reporting for internal management decisions is a mistake.
There are many scenarios which illustrate this mistake, so let’s use a common one we see today: an underutilized production capacity. This is common because many companies invested in additional plant capacity, equipment, systems, etc. in the good years leading up to 2008 and since then sales have not grown as expected and may even still be below 2008 levels. To the extent manufacturing costs are not absorbed into inventory then they must be recorded as period costs – i.e. instead of sitting in inventory (on the balance sheet) the expenses hit the income statement. Due to this accounting rule some companies are tempted to produce more inventory than they really need to meet forecasted sales. Which is unfortunate because a high inventory level is a very bad thing for a middle market company as it ties up a lot of cash. Okay perhaps for a giant company which can access the capital markets (and the federal government) but not good for a smaller company. So what might that smaller company eventually be motivated to do? Lower prices and make special offers that otherwise weren’t needed just to move excess product out the door, resulting in a lower gross margin and also potentially damaging the brand. Now we have a situation where, by transferring costs from one year to another by playing an accounting game, we end up with true economic damage.
There is an even bigger trap to avoid, however. The company that is computing its product costs using GAAP may choose not to reduce prices to be competitive with market because “if we did that our margins would be too low!” By believing that the unit cost is, for example, $100 then it is understandable that one would not sell at $90. But what if we knew that the actual unit cost was $80 (without absorbing the full amount of the fixed overhead costs for the period when produced)? Obviously we would accept an opportunity to sell at $90 – especially when the company has equipment and people who are underutilized.
So what factor should drive smart decision-making in this example? The relevant metric per unit of production is the “contribution margin.” The contribution margin is revenue less applicable variable production and sales expenses. Yes, one must take into account sales expenses, which GAAP absorption costing does not include in computing the gross margin (gross margin is sales less cost of goods sold). For example, if a company can sell $1 million of its products in a month and it had variable manufacturing expenses of $550,000 and variable sales and other applicable expenses of $200,000, then its contribution margin would be $250,000. This $250,000 goes towards covering the fixed costs. If it exceeds the fixed costs, then there is a profit for the month. In fact, knowing the foregoing, one should be willing to be even more competitive on price and increase units sold – so long as the contribution margin, not the gross margin, is acceptable. More than that, one might also choose to spend more on sales and marketing to drive up volume if that can be done with an acceptably positive contribution margin.
We often hear companies say “we can’t lower our price further because our gross margin is only $X” or “we can’t afford to increase sales commissions or pay a distributor fee” when there is really lots of room based on contribution margin. The fixed costs are just that, fixed, whether you sell more or less. So don’t let GAAP lure you into wrong decisions. By the way, this issue applies to service companies as well as manufacturing.
We should note that figuring out contribution margin by product or service line is not necessarily easy and it is certainly harder than just using some broad brush “overhead recapture” method to compute GAAP gross margin. However, doing the right analysis is an expense that will pay for itself many times over. That’s one reason we like working with middle-market companies; applying profitability analytics to guide smart decision-making: e.g., where to place their efforts, how to price their products/services, and which channel partners with which to work – all important decisions that shouldn’t be made by blindly following GAAP.