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How to Recognize (and Avoid!) the Tyranny of Financial Statements

December 14, 2016 - By Paul Fenaroli

As a business strategist who was once a practicing CPA, I was intrigued by a recent Wall Street Journal article that implicitly highlighted a managerial process I see repeated over and over again: overreliance on traditional financial statements to measure company performance against opportunities.

The article in the Journal touted Inditex’s Zara and its incredibly fast supply chain. In short, Zara can take product from concept and manufacture in Spain to delivery in a store in New York in about 30 days. In contrast, most retailers have a six month lead time and more than nine months if they are vertically integrated (which Zara is).

“How” Zara does this is a topic for another day. Sensing trends, rapid designing and approval, sourcing proximity, and expedited logistics — all with best-in-class speed — enable Zara to create not just close to the season, but also in season. Few retailers can even restock meaningful quantities in season!

“Why” Zara does this is a subject more broadly applicable to almost any company. It recognizes the hidden cost of long lead times and the corollary: the opportunity created by speed. Most companies in most industries do not fully recognize hidden costs or hidden opportunities. I call this “the tyranny of financial statements.”

The Manifestation in Retail

While the tyranny may take many forms, depending on industry, the pathology is always the same. Financial statements, and the underlying general ledger and reports, capture actual historical results for a given period. In other words, they capture what happened and, more specifically, what was transacted. They are silent as to what didn’t happen.

How does this relate to Zara? In retail, “the tyranny of financial statements” results from “the supremacy of the markdown.” Merchants have careers shortened by markdowns. If an item sells out five weeks into a 13-week season, retailers pat themselves on the back for having been “on” a hot product. But how much more could have been sold in weeks six through 13 if inventory allowed? How much was left on the table in sales and margin?

Worse still, did the retailer “walk” the customer to a competitor … for that item … or for life? Burt Tansky, former Chairman of the Neiman Marcus Group, once said to me, “Our customers are the top 2% of the population. If I don’t have what they want, they’ll walk over to Saks and I may never see them again. These people don’t grow on trees.” Burt knew instinctively that the cost of stock outs would exceed the cost of markdowns (which they can manage with the Private Sale, First Call and Last Call events, and outlets).

Zara has resolved the dichotomy between stock outs (not in the ledger) and markdowns (in the ledger) through speed. Small initial orders minimize inventory that doesn’t move. A sub-30-day supply chain allows the company to chase demand and replenish within the current selling season, with or without design tweaks. The cost of speed — driven by manufacturing in Spain versus Asia and air shipment direct to stores versus ocean shipment to regional distribution centers — is high … much higher than slower alternatives. Yet those costs are lower than markdowns and much lower than the cost of stock outs.

Tyranny across Industries

As another example, the financial sponsor of a recent home services client engaged me to evaluate the company’s marketing. While the company was highly profitable and growing with plenty of runway, the sponsor believed that marketing was not fully delivering. Assessment of the various elements of the marketing programs indicated they were in line with others in the industry and improving steadily over time. In pushing further, hard-to-gather operating data — including scheduling data, call center results and follow-up calls to customers — revealed that more than 12% of existing volume was falling through the cracks through poor scheduling, cancellations and missed appointments. Spending more resources on marketing would merely increase call volume and exacerbate the amount of fallout. Looked at another way, without spending any more in marketing, the company could raise revenues and profits substantially through enhanced operating practices. Meanwhile, the financial statements pointed out none of this. Dropped calls and cancellations were not “booked” anywhere in the paperwork.

Let’s examine this tyranny in the automotive industry. Honda/Acura has realized that complexity (if you can’t charge a premium for it) can be a profit drain. In the late 1990s, Honda redesigned its Acura TL. The model had only 24 SKUs (stock keeping units, or unique products). There were 10 exterior colors, eight of which had a designated interior color. Two of those colors had a choice of a second color interior. The 12 total color combinations then were paired with the option of whether or not to include a navigation system. When Car & Driver magazine compared $30,000 sports sedans, it chose the TL over offerings from BMW, Audi, Volvo, Lexus, Infinity and Mercedes, in part because the car cost 10% to 30% less than its peers for a well-equipped, high-performance vehicle. The TL was a great car, especially for the money.

By way of contrast, Ford routinely sold more than 400,000 units annually of its Taurus each year during the first decade of production. In each of those years, there were more than 300,000 variations of the car made. Myriad options drove complexity and costs … though the general ledger did not capture the specific cost of such complexity. The result? Not exactly a great car for the money. Now if you’re Porsche and can charge premium prices for complexity, then you publish a list of high priced options and smile as customers “tick the boxes.” Just keep in mind that’s a different customer segment than Ford targets altogether, with very different price elasticity.

Identifying Hidden Costs and Opportunities

Whether a Director, CEO or Business Unit President, take a moment to ask yourself some important questions the next time you review a set of financial statements. “What is not being reflected in here — more specifically, what costs and what lost opportunities?” Ask these questions of your CFO. It may take a periodic study by Financial Planning & Analysis, Strategy or Operations staff to get valuable answers. Invest in the effort once to determine how big the issue truly is. If big enough, create a strategic initiative to work it down and create a process to measure it. Alternatively, there may be a pricing initiative needed to capture the premium for providing preferential service, tiered features or other complexities which value.

In an era of slow global growth, which appears to be the “new normal,” companies must challenge existing practices to find pockets of growth and/or opportunities to reduce costs. Don’t allow traditional financial statements to rule your decision-making alone; rather, you must leverage other tools to guard against such tyranny and prevail with keener insight.

As managing director at Verus Strategic Advisors, Paul Fenaroli leverages 30+ years of senior management, consulting and leadership experience to help businesses address an array of strategic issues and achieve sustainable growth. He pairs analytical insights with the vision and guidance that bring everyone from the C-suite to the frontlines together in support of a common goal. Satisfied clients range in size, industry and sales, but all have experienced the meaningful difference Paul has made in their business.

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