The Danger of Managing Manufacturing With Half Measures

Feb. 26, 2019
Understanding the composition of your company’s financial ratios is important to achieving a balanced perspective about where these metrics may lead you.

Manufacturers are often focused on and measured by financial ratio metrics—return on investment (ROI), cash flow ROI, return on net assets, return on sales, etc. These metrics are valid business indicators, but only to a point. Understanding the composition and boundary conditions of the financial metrics your organization applies is important to maintain a balanced perspective on where they may lead your company. Accountants, financial analysts and the financial press often make it sound like there is an exact science to financial analysis; but business and strategic fundamentals are very often overlooked in the tyranny of pursuing short-term, financially oriented goals. Let’s look at some examples.

First, any ratio has a numerator and denominator. But which one deserves the focus? In “return” type of ratios, you really want the numerator to be as large as possible. Shrinking the denominator to its limit—zero—means you are no longer a manufacturer, or you are using old, depreciated assets. Optimizing the denominator is important. However, focusing on it for short-term ratio-driven financial performance goals can be destructive.

Second, what is the composition of the numerator and denominator? How is a return calculated? Is it calculated using the same product cost calculated for inventory valuation and financial reporting? This calculation would seriously overestimate the return on a product that had a great deal of advertising spent on it, since advertising isn’t included in the inventory product cost. Another example is the impact of R&D on a return, since R&D is treated as a period expense yet it is vital for long run viability. The denominator can be tainted by the composition of investment or asset figures. Is the return on new assets being compared to depreciated assets?

Third, is the ratio a valid business measure? Return on sales provides a good example. Two products have total sales of $1 million each ($2 million total), and a 10 percent return ($100,000 each, $200,000 total) made on the same production line. Product 1 has direct material cost of $600,000, and direct labor and machine costs of $300,000. Product 2 has direct material cost of $300,000, and direct labor and machine costs of $600,000. If the company could sell more Product 1, then it could more money by using the Product 2 direct labor and machine resources to also make Product 1—thereby increasing sales to $3 million and return to $300,000.

Many ROI and asset calculations are based on traditionally calculated financial reporting and accounting practices that tend to discourage investment and encourage outsourcing and off-shoring if the denominator is a management focus. This may be good for developing countries that gain productive assets and a great deal of the experiential learning and growth associated with manufacturing. But is it good for individual manufacturer’s long-term growth and viability?

Effective metrics for any manufacturer must be grounded in a strategy to maintain long-term competitive capability and advantage. This requires economic information about your company that looks at its resources, activities, finances and customer experience and behavior with a clear, realistic and forward-looking perspective. It is important that manufacturers use financial information that clearly and causally reflects the organization’s resources and processes. This extends beyond production to also include marketing, sales, R&D, logistics, and both organizational financing and financing extended to customers.

Advanced managerial costing provides this perspective in a manner that facilitates forward-looking management decisions, whereas financial accounting primarily looks backward and the financial analytics derived project historical trends. In today’s turbulent competitive environment, manufacturers can’t afford to look backward or follow lagging management practices. Separate managerial costing information is rapidly becoming a competitive necessity.

>>Larry White, CMA, CFM, CPA, CGFM, [email protected], is executive director of the Resource Consumption Accounting Institute, which trains and advocates for improved cost information connecting operations to business performance.