A guide to keeping the books to drive profit
In working with over 150 privately owned businesses, it's evident that accounting practices (keeping the books) can greatly vary. While larger entities might use the Generally Accepted Accounting Principles (GAAP) as a framework for keeping the books, they often meld their unique styles within these boundaries. However, for SMEs, the landscape can be more complex and varied.
Disclaimer: Each business has its unique financial dynamics, and a one-size-fits-all approach is unrealistic.
What follows is an imaginary conversation between Fred, who owns a medium sized business, and his Mentor. It looks at what Fred has learned as he looks into better, more useful ways to keep his books. It is followed by a more objective discussion of the topic.
Level: Intermediate to Advanced Reading Time: 5 minutes
A Conversation between Fred and his Mentor
(created with the help of ChatGPT and based on my own experience)
Mentor: Fred, in all your years of business, how have you approached the matter of keeping your books and understanding how the money is made?
Fred: Ah, Mentor, when I began, I trusted the usual cost accounting methods. But a particular event changed my perspective. I remember running an aggressive promotion on one of our products. It sold incredibly well, which reduced the overall margin for that department. Now, if I had followed the cost accounting logic, this should've decreased our profits. But, to my surprise, our dollar profit increased, and quite significantly at that!
Mentor: Fred, are you saying you found that conventional ways of keeping the books sometimes don't align with the primary goal of maximizing profit?
Fred: Ah, Mentor, you've hit the nail on the head. I had used conventional methods, believing they would guide me to profitability. However, I soon realized they could worked against my goal of earning more.
Mentor: That's quite the revelation, Fred. So, what did this experience teach you?
Fred: It made me question everything I thought I knew about accounting. My faith in allocating costs to each product to calculate a desired margin evaporated. In fact, I observed that in some cases, like with high-cost, high-priced items, a margin lower than what was traditionally recommended could lead to increased sales. This, in turn, contributed more money to our operations, helping us cover other expenses. It became clear to me that it wasn't about cutting costs or the typical return on investment; it was about having clarity to make the best overall decisions for the business.
Mentor: So, in essence, by looking beyond traditional methods, and focusing on the actual flow of dollars you were able to keep from sales, you were able to better understand your business's financial dynamics. What accounting method can provide such clarity? Does it exist? Almost sounds too good to be true!
Fred: Precisely, Mentor. I leaned into Throughput Accounting. Because it focused on the money retained from sales after covering the raw materials and true variable costs, I was able to more easily understand the flow of this money. I could see how to maximize profitability, manage inventory more effectively, and weigh the timing of raw material purchases better, for instance.
Mentor: So this understanding shaped your subsequent decisions in business? Can you share another instance where this clarity aided you?
Fred: Definitely. I decided to replenish stock only when items were sold. This step dramatically lowered our inventory, allowing me to use straightforward metrics, even when facing challenges in supply. For instance, when time to replenish a product became an issue, I employed a Par Ordering System as a buffer. It was transformative.
Mentor: It seems, then, that your experience underscores a broader lesson. That businesses, especially SMEs, might benefit from pivoting away from traditional accounting practices for managing daily operations, focusing instead on Operational Reporting: understanding how money is made and how it flows. What are your thoughts on this?
Fred: Absolutely, Mentor. One size doesn't fit all in business. It's vital for businesses to find their rhythm, emphasizing what genuinely matters to them. For many, it's not about merely cutting costs or chasing a return on investment. It's about achieving clarity to make the most informed, and often, the most profitable decisions. More money won, more money left over after paying the rest of the bills.
Mentor: Your journey, Fred, highlights the importance of clarity and understanding over copying what others do.
Reimagining Accounting for SMEs
SMEs can harness accounting as a powerful tool for business insight and profitability enhancement. Here’s how:
- Accounting shouldn't just be about compliance but about clarity. SMEs need an accounting system that transparently models how money is made, ensuring a clear picture for the owner/manager to make informed decisions.
- Though SMEs in the US aren't always bound to GAAP, adopting it can be a strategic move keeping the books that way, for some. Yet, its primary focus on financial reporting may not address SMEs' operational nuances.
The Value of Throughput Accounting & Beyond
Throughput Accounting is one method that can serve SMEs well, particularly those in manufacturing, distribution, or sales. However, what's crucial is recognizing and emphasizing what really counts:
- Retained Earnings: The core of any effective accounting system for SMEs should highlight the money retained from sales after deducting raw material and true variable costs.
- Optimizing Flow: The ultimate aim should be to ensure that this retained money flows as generously as possible through the business, maximizing profitability.
Navigating the Maze of Accounting Software for SMEs
Redefining Inventory Management
Conclusion
Further Exploration
We extend various resources, with our IDW Method™ Rapid Earnings Workshop being a focal offering. This workshop enlightens businesses on crafting insightful operational reports and mastering throughput earnings, supplemented with hands-on mentoring. IDW ™ Method Rapid Earnings Workshop.