The Stream by River Logic

5 Ways Optimization Enables Financial Maturity

October 30, 2015 | By Carlos Centurion

Financial maturity starts by first understanding how your business has performed. In other words, can you produce a P&L, balance sheet and cash flow statements for the business? As the organization matures, the financial knowledge goes deeper.  Financial statements are produced faster and, more importantly, the organization starts to apply cost accounting principles to understand where it's making money (products, customers, regions, channels) and where it isn’t.

Even deeper knowledge is achieved as the organization begins to apply more complex analyses that look at marginal contribution, achieved by tagging variable, direct and indirect costs. You might be familiar with standard costing, activity-based costing and other approaches that attempt to provide additional information.

Cost accounting is intended to enable business decision making. Up to this point, however, everything we've analyzed is historical in nature. As the organization continues to mature, it begins to look forward into the future. For example, standard- or activity-based costing can be created on a pro-forma basis. Furthermore, driver-based planning enables companies to develop budgets and forecast profitability.

Optimization Provides the Ability to Truly Look Ahead

So what does optimization have to do with the financial maturity of a company? It turns out that when optimization considers financials, a company can truly look forward into the future. Significant insights and information are unlocked, and the organization is able to develop shared knowledge about key drivers of success for the business.

The Key Ways Optimization Brings Financial Maturity:

 

  1. Financial plans must be achievable and worthy of pursuit. If they constantly beat the numbers or underperform, the CFO and CEO quickly lose credit with shareholders. Optimization ties financials with business planning by ensuring all the key realities of the business are properly represented in the plan, therefore avoiding sand-bagging or targets that are not feasible
  2. Finance informs business decisions by producing the official unit costs and unit profitability calculations. These are typically based in the past, sometimes with some adjustments to account for large fluctuations in material costs. Decisions, however, must be tied their marginal impact on business performance on a forward-looking basis instead of simply using last year’s adjusted numbers. Consider a scenario where a CPG company promotes a product aggressively – unbeknownst to the financial and commercial teams, this is causing the supply chain to accumulate extra stock, expedite shipments and run the plants on Sundays.   Combined with the promotional discounts, the promotion may result in negligible, if not negative returns. By its very nature, optimization makes decisions on the margin. More importantly, it can produce forward-looking average and marginal profitability analyses that provide much richer information about the business than the standard costing approaches.
  3. Capital expense allocation is intimately tied to operational expenses and can be optimized. A typical organization, whether a hospital, utility or manufacturing firm, faces hundreds of opportunities a year to implement new programs. Many of these require capital investments, and all of them impact operational expenses. Optimization provides a new level of understanding by helping find the best combination and sequence of programs, investments and OPEX changes that maximize corporate performance
  4. It's essential that new factors of a business be understood. For example, imagine if your CEO says “we are making a commitment to sustainability and will be reducing our carbon emissions down to our 2005 levels by 2020.” What does this mean for the business? A mature organization is able to translate this commitment into optimal response plans that properly balance CAPEX, OPEX and, more importantly, forecast the impact on product and customer profitability such that the business can make the appropriate decisions.
  5. Embedded planning processes must be tied to financial metrics. For example in Sales & Operations Planning (S&OP), the typical metrics that drive decisions are mostly driven by customer service (e.g. which customer to short or prioritize) or some kind of policy (e.g. stocking, ordering lead times) calculated separately. In reality, S&OP decisions should be driven by both customer service and financial performance, while the policies should be evaluated explicitly within the process. Only optimization can achieve this, since it can make financial metrics explicit drivers of the plan (i.e. plan to maximize profit) and also constraints (i.e. how much working capital can we deploy) while also considering the realities of demand and supply planning.

Closing Remarks

We have seen several companies leverage optimization to mature the understanding of their business, first by tying their financial and business plans and ultimately through rigorous application of marginal impact concepts when they make decisions. In all cases, it has brought finance and business much closer together, and it has delivered significant improvement in performance.

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