If no one is held responsible for the results of a cost center then the finance system might as well be designed and maintained by chimps.
EXECUTIVE SUMMARY
If no one is held responsible for the results of a cost center then the finance system might as well be designed and maintained by chimps.
Shining a Light:
Transparency in finance is like sunlight in a room; it reveals hidden issues and responsibilities.
Effective financial systems report profitability through revenue and costs, using responsibility areas.
Sunlight vs. Cleaning:
Like sunlight, a top-notch accounting system exposes issues, but it can't solve them.
Accountability is crucial—accounting systems need responsible users to be effective.
Responsibility Centers:
In organizations, responsibility centers (like cost centers) offer transparency, as each has an accountable individual.
Cash Generation Quest:
Our goal remains reporting profitability through cash generation or convertible assets.
Transparency and accountability go hand in hand for financial success, just as in Shakespeare's world, each character plays a crucial role.
INTRODUCTION
If reporting the results of cash generation is difficult to do, someone is lying to you!!!
Transparency of financial results are a hallmark of effective financial systems. Such systems are designed to highlight key cost areas and allow for results to be measured based on responsibility and accountability. In short, all effective systems are designed to report on business performance (profitability through revenue less costs) that are reported through activity, functional, or responsibility areas.
How does one make transparency and accountability produce actionable outcomes? Like a house without sunlight, it is easy to hide the dust, mold, and grime, but with Sunlight, a mop and other cleaning supplies, all is revealed and subsequently cleaned. The same goes for a finance system; if it is not designed to be aligned with how the business activity flows, there will always be disconnect between actual results and cash generation.
Sunlight is one of the best disinfectants so shall we say “let the sun shine in”
There is a famous quote by Louis Brandeis “Sunlight is one of the best disinfectants”. However, in the context of organizations, sunlight cannot help clean a dirty floor; it can only highlight that it is dirty. You still need a mop and water to remove the dirt. Similarly many organizations and finance professionals believe that a top notch accounting system will be the Sunlight that provides transparency and will lead to improved financial outcomes. While transparency helps identify shortcomings and areas of concern it alone cannot create an environment for a successful organization. There is still a need to hold people accountable to make the organization focused on financial effectiveness. The use of cost centers within an accounting system provides the transparency into the financial performance of an organization; as every cost center has someone who is ultimately held responsible and accountable for its performance. If no one is held responsible for the results of a cost center then the finance system might as well be designed and maintained by chimps.
ONE BUCKET, TWO BUCKETS...OH NO - LET'S CHANGE THE SIZE OF THE BUCKETS!
Many organizations have some notion of a responsibility center which may take the form of cost centers, profit centers or investment centers. While these concepts have been around for a long time, the use of these over time in some large organizations has been more directed towards creating full time work for a selected few who have been tasked to reflect the outcomes of organizational changes. Cost centers are the most commonly used type of responsibility centers so we have focused on this aspect, while acknowledging that ultimate reporting of profitability through cash generation, or the creation of assets that can be converted into cash, is the one and only goal.
One can have several cost centers within one line of business. However, cost centers are not meant to change on a monthly basis; not even yearly, unless there is a split of responsibilities within one cost center that necessitates such a change. A cost center is exactly what it implies…. A department or area that incurs costs, the management of which is responsible and is held accountable for such costs. Cost centers are akin to the key responsibility areas within a household, if the responsibility for taking out the trash is transferred from one person to the next, it does not mean that the activity no long exists or somehow is new. The fact that we get older with time, does not make the need to incur costs for food and shelter go away. Until one pays off the mortgage on their house, the mortgage payments continue to be incurred, and even after such costs no longer exists, utilities are still used and food is still consumed, though in different quantities. So too are cost centers, even in growth companies or those that move from growth to mature in a company’s life cycle, as management should always seek ways to optimize processes and reduce costs; despite the fact that the key costs and their drivers likely remain.
The idea here is that the cost center stays the same, irrespective of who performs the activity within the cost center or whether the costs profile has changed. There are times when an organization is growing rapidly where in order to establish accountability it is important to create specific and defined cost centers to ensure that costs are controlled. Many businesses that do not have rapid growth or do not change their overall business will never see changes in cost centers. The basic structures should follow the way in which the company is managed to assign accountability to the lowest level. If designed and managed in an optimal manner, there would be no need to continually tinker with them. Therefore, spring cleaning should never be needed to be performed in this area but sadly, it is often performed. This is mainly because over time there is a tendency to create cost centers for project related work, organizational changes or resulting from corporate or operational executives wanting to keep an eye on certain costs within a specific area. When this need goes away, the cost centers remain and no one uses the cost centers anymore, or some may use it to record certain transactions arbitrarily, sometimes in light of the fact that the costs often eventually roll up into the same line on the financials.
This makes the administration and reporting of true costs by legitimate cost centers extremely time consuming, often resulting in meaningless or misdirected and unnecessary questions. Imagine always having to explain why the extra line or extra costs are included in another area or why it takes the Finance team longer to prepare simple cost center reports. This eventually leads to a decision to fix the issue once and for all with a spring cleaning measure. Sadly, this is often a once every 3 to 5 year activity. We believe that if companies are disciplined in their resolve to not have employees waste time on unnecessary tasks, they would insist on rigid protocols that are only changed if the fundamental business changes. Many use the word flexible instead of rigid to allow themselves to remain inefficient as they can create thousands of accounts, cost centers, etc… at their leisure. We do not believe that inefficiency is the hallmark of world class finance teams that are meant to support the operations and senior management to create value for shareholders.
CLEARING THE AIR
Creating responsibility centers such as cost centers does not by itself create a culture of striving to produce better returns. The use of cost centers needs to be paired with capturing all relevant costs, creating budgets and forecasts for cost centers for accountability and measuring the effectiveness of the cost center managers. Capturing costs does not in any way include the petty tennis matches that cost center owners have to pass off some costs to look better. Segregating costs incurred between controllable items and uncontrollable items (i.e. allocations) is helpful. However, while we understand the use and need for allocation of some common costs, there are organizations where a department is solely dedicated to allocate expenses. Such an endeavour is neither productive nor a great provider of shareholder value. If allocations are complex where it requires several people to ensure this exercise is carried out then we should ask what value are we adding? We believe that applying an 80:20 rule when designing a finance system with cost center is paramount to ensuring the key costs necessary for the success of the company continue to be in the right place and responsibility and accountability for such is as intended by management; that should form 80% of the effort involved in arriving at the appropriate responsibility areas. The remaining 20% should be considered not reflecting key costs and therefore less effort should be made to creating special cost centers to track stationary, unless the purchase of stationary is a key costs necessary to the success of your company.
The use of cost centers also needs to engender thought processes on who is responsible for ensuring the vendors or service providers used by the cost center have provided all of the services or products that the expenses relate to. Cost centers owners should be empowered to ensure that invoices received for costs incurred are reconciled to goods and services received. Too often we have seen this become a significant reconciling item within procurement and operations, which we acknowledge is not entirely a finance system issue but more so a People and process issue in terms of competence and poor internal controls. A simple example would be if an operations systems is configured to obtain data when certain actions are undertaken by operations staff, the cost center owner for that operations department should be responsible to verify that the costs charged by the vendor are accurate.
NO NEED TO SPRING CLEAN WHEN YOU HAVE MAINTAINED A CLEAN HOUSE ALL YEAR ROUND
Finance systems that are misaligned with how the business is run and, more importantly, the key drivers of the business’s success, are destined to fail. In such cases, they will most definitely be in need of an overhaul or the strain and painful disappointments of management in not being able to receive information that helps them make important business decisions, will continue indefinitely.
The reason why we emphasize on the key business drivers, as one should be aware of the fact that many business are run poorly and through their very structures promote inefficiencies… In short, many businesses are the architects of their own failings when it comes to poorly structured and poorly implemented systems and processes. That is why our fundamental underpinning to the Spring Cleaning series is having the right PEOPLE in every step of the process, starting with management.
We hope that these articles will stimulate thought and discussion amongst all of us that will hopefully result in our finance teams thinking and operating differently; all with a mindset of continuous improvement in all what we do.