Wednesday, May 12, 2010

Managerial Finance



Managerial Finance

By Christopher Jetton

     Managerial finance is one of the most misunderstood positions in the business world. The title brings to mind someone staring at a spreadsheet with a bunch of numbers. This may be part of the job, but there is much more to it. Look at “managerial” and “finance” separately. The word “managerial” relates to decision making. The word “finance” relates to the control of money. If you think of them separately in this context and then put them together, you will have a better understanding of what managerial finance really is.

     Critical thinking plays a key role in the everyday life of a managerial finance employee or consultant. They look at the organization as a whole and use all information, not just a spreadsheet, to make bottom line decisions. They look for solutions to problems that may not even be apparent such as, “Can this or that be done more efficiently, at less cost, and if changed, how will that affect the rest of the operation?” You can see that they need to understand processes, people, and money related aspects.

     Recently there was a company decision to be made about an item carried in a retail store. The manager of the store requested that the item be removed from the store since it was causing problems at the store level. Corporate looked at the sales of that item and decided that the sales were too great to remove from the store. Who was right? Were the sales great enough to justify the item stay in the store? Let us take a managerial finance journey.

     First, we will compile the historical data concerning the sale of the item. The store stocks twelve of the item and they sell one a month. That means that the item has a turn of one. Turn is a term that represents how many times the inventory will be restocked during the period of one year to keep current levels. If they were selling one per week, it would take twelve weeks to sell all twelve items. There are fifty-two weeks a year, so in order to find the turn, you would divide fifty-two by twelve and come up with a turn of 4.33. In other words, the shelves would be full and empty of that product four and a third times per year.

     Each item cost the company 5 dollars and it sells for 15 dollars in the store. That means the company is investing $60 per year and receiving $120 on that investment. The breakdown looks like this: $60 to purchase the items that sold for $180 minus the $60 equals a $120 return on investment. This is really good since the store is doubling its money, right? Well, sort of.

     Out of the $120 dollars, you will need to pay for the overhead for the business. If all of the items in the store are the same size and require the same square footage of store space, you can simply take the overhead that includes all expenses such as salaries, rents, and everything else required to keep the doors open and dividing the overall expenses from the number of items carried in the store. Since we do not know what the numbers are in this situation, let us say that the expenses are 500k a year and you carry 10k items. That means that each item will need to produce $50 per item to break even. Now take the return on investment which is $120 and subtract the $50 from that. You will come up with $70 as the real return on the $60 investment. The company has more than doubled its money on this product. Fine, let the store keep it, right?

     Is it good to stop there and make the decision? Maybe we should look at the reasons the manager requested the product’s removal. The product is the only one of its kind in the store. It is a novelty item that represents a political figure. Who the political figure is does not matter since no political figure is loved by all. The manager knows that he must manage to keep the taboo conversations out of the workplace. Those are politics and religion. There are no other religious or political goods being sold in the store, and because of that, the focus is on the one item that brings politics into the equation.

     The manager was noticing that a good portion of the potential customers in the store would focus on that one item and express their opinion pro or con. Each time the politics where brought up, the manager would glance around the room and see that everyone in the store produces an agreeing smile or disagreeing frown. Many of the people simply walked out as soon as the store was perceived as a sponsor of the political figure. When the manager ran the math, it appeared that they were losing no less than one average customer sale during his half day shift per day. The average customer sale in the store is $30. The daily sales were reflecting an even greater amount, but for the sake of argument, we will use the one average customer a day loss.

     Take the average customer sale and put it into the equation. That is $30 a day in a store that is open 365 days a year. $30 times 365 days is $10,950 a year is what carrying that product is costing the business. Since there is only one item that is causing the loss, you will take the return on investment of $70 and then subtract $10,950 and come up with the estimated cost of carrying that product at $10,880. If you were to throw those items that cost the company $60 into the trash, the company would save over ten thousand dollars a year.

     This could be the end of the story since when the stuff hits the fan, most people duck for cover, but one more consideration concerning the manager is the workplace environment when politics is constantly being brought up by customers due to the political nature of the product. The employees take notice of who is for and against the politics related to the figure the product represents. This could very easily cause a perceived hostile work environment for a mere $70 in profit a year. It seems hardly worth the risk of a legal battle, doe it not?

     We could stop here, but in this particular company the buyer has the last say in what goes into the store. The buyer has been with the company for years and it has to be noted that the buyer has maintained the sustainability of the company. The buyer feels that if her decision is encroached on, she will need to seek employment elsewhere. Since she is a valuable asset to the company, with all things considered, the corporate decision may be to keep the buyer pacified. In this case, you would take the profits, let us say it is $100,000 per year and subtract the cost of carrying that product, $10,888 and come up with an $89, 120 argument to keep the buyer on the staff. If the company was to lose the buyer, it costs the company an estimated average of $10,000 to replace. This figure is not set in stone and since the buyer’s position is very important to the bottom line, the new buyer may cost the company a lot more, including all profitability.

     This exercise was not intended to make a mountain out of a mole hill or make business decisions more complicated. It should however help with understanding managerial finance and how it affects businesses as a whole. When the focus is concentrated on only one aspect of the decision process, the final decision may not be the best one. The next time a decision is made, look at it from all views and possibilities and put on the managerial finance hat. The more you practice this, the better business person you will become, and the health of the organization will be better because of it.

     "The above article was based on a real scenario and the final decision in the article matches the real life situation. As a consultant, I disagree with the final decision since it accepts huge risks in the sustainability of the organization. I can only consult and not make the final decision." Christopher Jetton 2010

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