In this episode, we have our guest Aaron Spool from Eventus Advisory Group, who describes what it means to have a cash flow mindset in the organization. He also touches on business drivers and why tax and accounting should not drive business decisions. Finally, he discusses many scenarios of cash and revenue misalignment and the resulting implications because of this issue.
- [0:24] Intro
- [2:09] Personal journey and current focus
- [5:24] Perspective on growth
- [6:35] Cash-flow focused CFO
- [8:19] Revenue vs cash
- [13:57] Mixing personal finances vs business finance
- [17:21] Misalignment of revenue and cash
- [24:34] Product costing issues
- [29:57] Closing thoughts
- [31:06] Outro
- Why are you buying such a giant amount of inventory in bulk with the hope that you can sell it, and that’s where the cashflow thing came in is, is that you’re sitting on a whole bunch of inventory. So you’re using cash, a vital piece of fuel, and you’re sitting on a whole bunch of inventory, which you’re hoping you can sell. That is a recipe for disaster.
- You end up showing next to no profit. Therefore, you bought a building or whatever you buy these physical assets, that’s fine in the short term because you don’t pay taxes if that’s your goal.
- You have this new piece of equipment that hopefully you can use to make more money off of, but the cost is that you’re not bankable anymore because I looked at your income statement and your balance sheet, and as a credit issuer, as a credit committee and a bank looking to see if I’m willing to loan you money.
- All those little fun things you did to prevent yourself from paying taxes suddenly come to bite you in the proverbial back because you’re not bankable.
- When it comes to businesses, don’t let the accounting that also means the taxpaying lead the business decision. This decision needs to be led about things like profitability, cash, market share, and pleasing the customer.
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Aaron is a 20+ year finance exec who has helped entrepreneurs and executives grow, adapt, and fix their companies through operational improvements and data-driven decisions. He’s helped raise tens of millions of dollars for companies and guided eight-figure exits. He’s a Partner at Eventus, an on-demand CFO, Finance, and Accounting firm, as well as a CPA and CFA holder. He is a frequent writer for Forbes, CrossFit enthusiast, and Scoutmaster for his children’s Scout troop.
Aaron Spool 0:00
You’re sitting on a whole bunch of inventory, which you’re hoping you can sell. That is a recipe for disaster. Now, there’s probably a whole bunch of people who could tell me, Oh, you know, Aaron. This is like we’ve had cases, and this worked out perfectly. That’s nice. I don’t deal in those cases ideal, proper practicality. So the number one lesson learned here, you don’t have the buyers.
Growing a business requires a holistic approach that extends beyond sales and marketing. This approach needs alignment among people, processes, and technologies. So if you’re a business owner, operations, or finance leader looking to learn growth strategies from your peers and competitors, you’re tuned into the right podcast. Welcome to the WBS podcast, where scalable growth using business systems is our number one priority. Now, here is your host, Sam Gupta.
Sam Gupta 1:00
Hey everyone, welcome back to another episode of the WBS podcast. I’m Sam Gupta, your host, and principal consultant at a digital transformation consulting firm, ElevatIQ.
Most of my positions focus on growing revenue. Sure, getting revenue is always the hardest part. But did you move at the increased time between earning revenue and collecting cash that could result in giant write-offs impacting your growth? Also, how would you define the right customers to focus on? Would it be based on revenue or their ability to pay? Having a cash flow mindset is critical for growth, especially for capital-intensive organizations such as manufacturing.
In today’s episode, we have our guest Aaron spool from Eventus Advisory Group, who describes what it means to have a cashflow mindset in the organization. He also touches on business drivers and why tax and accounting should not drive business decisions. Finally, he discusses many scenarios of cash and revenue misalignment and the resulting implications because of this issue.
Let me introduce Aaron to you.
Sam Gupta 2:09
Aaron is a 20 plus year finance exec who has helped entrepreneurs and executives grow, adopt and fix their companies through operational improvements and data-driven decisions. He has helped raise 10s of millions of dollars for companies and guided eight figures exits. He is a partner at Eventus, an on-demand CFO, finance, and accounting firm, as well as a CPA and CFA holder. And he is a frequent writer for Forbes, CrossFit enthusiast, and a Scoutmaster for his children’s Scout troop.
With that, let’s get to the conversation.
Hey, welcome to the show. Aaron.
Of course, my pleasure. Just to kick things off. Do you want to start with your personal story and a current focus?
Aaron Spool 2:56
Sure, absolutely. So I’ve always been, I guess, a combination of an entrepreneur and a finance person at heart and kind of melding the two together. As you think about the typical kind of business that you ran from a lemonade stand to selling kids candy, things like that all the way through the childhood you get all the way through, getting into college focused on your finances, econ came out and had a whole bunch of different roles and different sized companies, accounting, financial analysis, eventually business intelligence, where I dealt with big data and making data-driven decisions.
And then all the way that culminated and being CFO of small and midsize firms and I guess the story that I like to say is I’m a very cashflow focused CFO, and there’s a huge reason for that. What do you learn from pain? And one of the CFO gigs I was that actually was my first major one. I was super excited to be it. And it was an industry that I really cared about. It’s a combination of manufacturing and tech, really, really cool.
And we ended up right after I joined I took over all the financial modeling, I started studying everything they went on a hiring spree because they raised a whole bunch of money and soon afterward, did some analysis of mine I remember the day I looked at our revenue, I looked at all of our cash collections I said oh my god, we’ve got four months left before we run out of money.
Sam Gupta 4:14
That’s not a pretty situation to be, I guess.
Aaron Spool 4:17
Oh no. And trust me, the board was like what because entation until here I remember that the CEO even said it’s like you know this the first like when I first put them all before he saw the results is the first like an actually hardcore data-driven model we’ve ever had and really excited to see the results for it just with stories like stories.
Stories might vote yes, yes. Yeah, exactly. It’s like stories might make a great podcast what we’re doing here, but stories don’t make money. So what’s really interesting about cash, and this is kind of an I tried to get everyone says there is no good reporting on a day to day basis about cash. There’s not, and if you think about it from an accounting perspective, everyone’s thinking about the income statement balance sheet. They’re thinking about profitability.
All-important stuff but things like there’s your sales group care about cash, maybe if there comps on it, do you even know your cash and no one’s gonna end there’s no easy way because you can look at a bank statement. But that’s a point in time the cash is especially for manufacturing firms. And that’s where cash becomes incredibly important. So I’m happy to go. I know we’re going to talk about that a lot. But that’s my story and why I’m super focused on cash as a CFO.
Sam Gupta 5:24
Okay, amazing. So I’m super excited to talk about cash as well, because cash is king, whether you are a small organization or bigger organization, and as you correctly pointed out for manufacturing companies that are so capital intensive, so for them, cash is definitely king. But before we get into cash, one question that we have for everyone who comes on the show is going to be the perspective on growth?
Aaron Spool 5:50
That’s a great question. So I think real true growth is not incremental. You can eke out a 5% additional. You could call it growth, additional gains from anything. Yeah, but true growth is transformational is something that doubles the size of your sales.
Yeah, adding multiple different, you know, new offerings. So I would say when you get to 50% or more increase that in my mind is growth and that increase better growth gonna be two ways growth could be my expenses have grown. We’ll keep it there. Because that’s the essence of your question is something transformational. And when you say at least minimally, you’re half as big as you were before that, my mind is growth.
Sam Gupta 6:35
Okay, amazing. So let’s go back to your comment about the cash flow-focused CFO. So obviously, there are a lot of different CFOs. And they all have their own leadership styles. They all have their own ways of managing things. So how does a cash flow-focused CFO differ from the other CFO mindset that you may have seen in the industry?
Aaron Spool 6:59
Sure. So, I would say that like so while I’m cashflow focused, especially for manufacturing, a really versatile CFO wears multiple hats, there’s thinking about your profitability, that side of the house, thinking about the capital side, and where you’re going to get your money, whether it is to maintain operations, or to fund growth, or to get a really good exit, or new investors.
But those are all different mindsets, and they’re really good mindsets, and they have a point in time. The difference between all those mindsets and the cashflow mindset is cash flow is eternal. And when you take your eye off cash in which and really if you think about cash is the essence of what you’re doing.
Yeah, what you’re doing in your business, eventually it’s to get paid. And if you don’t just have enough. Cash is the fuel of business. Not only do you have enough cash to fuel it, eventually, but you also have to have enough cash to pay yourself. And I don’t want to sound like you’re not in business to be a charity. But in the end, like, what’s the point of all this stuff, the point is eventually to get paid. You pay yourself in cash. And you might pay yourself in something else.
But I’ll tell you this. Your energy bills are not paid anything but cash or mortgage is not paid with anything but cash. Your kids’ college tuition is not paid with anything but cash. So I go back to cash as the fundamental unit, the fundamental substance, whatever fancy word or in a small word you want to use of what’s going on? It is the fuel for your business life.
Sam Gupta 8:19
Okay, so let’s go back to your comment about or maybe just compare the revenue versus cash, right? So the majority of the time, organizations are going to be very revenue-focused. Yes, they are cash-focused as well, but not as much, right? Their assumption always is if they are doing well in terms of revenue, then maybe their cash problems are not going to be as big. So in your experience, have you seen any stories where everything was going well, from the revenue perspective, but they ran into real business troubles because of cash management?
Aaron Spool 8:54
Sure. There are two stories with this. And one is a general story. And the other one is significantly manufacturing-focused. Okay. So the classic case, and I’ve seen this, and this is going to be so many companies I work with, they have great sales, which shows ever-growing revenue, and really doesn’t matter the business and they don’t realize that they haven’t collected then they start investing more into this business, you start these and investing more could just be resources put it could be inventory put, which we’ll get into a little bit later, but they haven’t collected.
And if there’s enough time that passes between sales and collections. Yeah, you start to eventually have the come to your deity talk about it. It’s a giant write-off. So right off means Okay, we’re not going to collect this. Yeah. What I’ve seen especially repeatedly I’ll say this, the company I told you about in my first story about cash, we assumed that we were going to have a lot of sales, we started getting a lot of sales, but collections weren’t necessarily there.
It’s what you find is that who’s tied to the sale, almost always not the person that’s tied to the collection. And not everyone wants you to harass the person that owes you money. Because they want to continue the business, but I always like to say the following. It’s that sale isn’t real. And that relationship isn’t real unless they’re actually paying you.
Aaron Spool 10:09
I agree that that’s a high level. Now let’s get into specifics, right. So what makes manufacturing different than your traditional services business or your point of sale business is that it has two interesting things that align with capital and make it so much more capital A, capital B, capital E, cash cash-intensive.
The first is, odds are you’re going to have machinery, which costs a heck of a lot of purchase, to lease to finance, whatever word you want to use lots of lots of money, how you get that money, an entirely different conversation.
The second thing, and this is the operational piece, is that odds are you have to buy something, put money down, and this is your inventory, right? You might even have to do something to that inventory. And that’s the work in progress. You have to change it. But this all costs even more money before you can actually sell it.
So it’s not like a sale that you already have the services, or you have the technology because technology companies go with it. There’s no like inventory of the amount of program that you’re selling.
Aaron Spool 11:08
Because it’s digital, there’s an unlimited supply. This is something very specific. You’re selling a good example clothing manufacturer, so where and you said exactly a specific question and the story of like where cash flow kind of gotten away of sales. So I knew a company that actually brought us on. They were expecting a huge amount. They were predicting a huge amount of sales. So they made a deal overseas to buy a whole bunch of clothing products, then it came time to pay the bill for the clothing product.
And they didn’t have all the money upfront. And so they wanted to be able to find it some either through extra investment dollars or for financing, and I and it wasn’t a case where they had pre-sales. So they were just assuming they were going to be able to sell this entire product. And they were panicking because now they had this big invoice due, they weren’t going to get them they weren’t going to get the product shipped. So they could actually sell it until they could pay for it.
Aaron Spool 11:57
And they didn’t necessarily have the buyers in order to purchase it. So it became a really difficult financing decision. Yeah. And we were able to get the financing because they had a really good rap. And the finance was based on this is acid-based finance was based off the inventory.
So there’s something there, they were able to finance it, they finance it. And the interesting thing was, they didn’t learn their lesson, because they tried to do the exact same thing six months later than the people that we gave them for financing. And they were like, No, you have to be smarter than this. You can’t, you can’t just assume, and this is where the cash will think of you don’t have any money in the bank to be able to afford this purchase. And you don’t have the other side is you don’t have pre-sales lined up.
Aaron Spool 12:36
So why are you buying such a giant amount of inventory in bulk with the hope that you can sell it, and that’s where the cashflow thing came in is, is that you’re sitting on a whole bunch of inventory? So it’s you’re using cash, a vital piece of fuel, and you’re sitting on a whole bunch of inventory, which you’re hoping you can sell. That is a recipe for disaster.
Now there’s probably a whole bunch of people who could tell me, Oh, you know, Aaron. This is like we’ve had cases, and this worked out perfectly. That’s nice. I don’t deal in those cases. So that’s the number one lesson learned here is if you don’t have the buyers lined up, yeah, be careful how much inventory you’re holding.
Aaron Spool 13:14
And if there’s a button, there is a medley way beyond this podcast, way beyond this discussion. There’s a medley of ways in which you can finance inventory. So you can get just-in-time inventory. Yes, you’ll lose a little bit of margin, but the security of knowing that you’re not going to be sitting on stale inventory, or you’re not going to be, you know, so out and owing people money is worth it every day of the week.
Sam Gupta 13:37
Yep. And you had the second story as well, or did you already cover that story?
Aaron Spool 13:40
No, that was the first one. So I’ll talk about a second story. And this is, and this is kind of it’s, and you see this more with personal owners. So what I mean by that is, it doesn’t have to be people in the call you the founder, owner, or whoever says this is one person that owns the company.
Sam Gupta 13:57
So we have had a lot of guests. They actually call lifestyle business the term Yes.
Exactly. He said, and I’ve even Yes, it’s a lifestyle business, somebody. So what I find with a decent amount of lifestyle businesses is that they are going to mix their personal finances and their business finances.
Aaron Spool 14:02
And this is a recipe for disaster. So just for emphasis, Sam, I’m going to say it again, mixing your personal and business finances is a recipe for disaster. This is transcribed bolded and underlined a recipe for disaster. And let me walk through why in this. This is very, very pertinent. Personal finances. The number one thing you’re thinking of most likely is I don’t want to pay a lot in taxes.
Yeah, there’s a whole bunch of things you can do legally or illegally, right and illegally. Yeah, to pay taxes. And usually, that’s spending money. Yes, I’ve seen manufacturing especially say, oh, I’ve got this lump of cash. I don’t want to pay taxes on I’m going to buy more equipment, and then I’m going to be able to depreciate that accelerate, depreciate that, okay?
Aaron Spool 15:00
Well, you end up showing up next to no profit and no profit. Therefore, yeah, you don’t have to pay taxes and or you bought a building or whatever you buy these physical assets, that’s fine in the short term because you don’t pay taxes if that’s your goal.
And now you have this new piece of equipment that hopefully you can use to make more money off of, but the cost is that you’re not bankable anymore because that I looked at your income statement and your balance sheet, and as a credit issuer, as a credit committee and a bank looking to see if I’m willing to loan you money.
So you haven’t made a profit in three years. And I might say, Oh, you have all this excess. And it’s probably not in inventory you’re sitting on because that’s gonna handed you sitting on all this equipment.
Aaron Spool 15:39
And then you look at the various different ratios, your return on net assets is super low, you have this revenue, but you have all these additional manufacturing assets, you’re not even running efficiently.
And so let’s just this might, so I don’t want this timestamp, this podcast, he’s kind of want this thing to be eternal. But today, there’s, let’s just say, hinted there was a global pandemic. Yeah. And you’re a manufacturer, and you’re desperately looking for sources of capital?
Well, all those little fun things you did to prevent yourself from paying taxes suddenly come to bite you in the proverbial back because you’re not bankable. Yeah. And so that’s where I would say, from a cash flow perspective, if you’re a person, don’t combine your personal and your business finances. There are ways to minimize a tax bill. But I go back to the fundamental principle of accounting and finance.
Aaron Spool 16:31
When it comes to businesses, don’t let the accounting that also means the taxpaying lead the business decision. Yep. Is this decision needs to be led about things like profitability, cash, market share, pleasing the customer?
All those things are business decisions. But what is the accounting going to make this look like from my revenue reporting? What is the accounting going to make this look like from my tax reporting can be a consideration? And it shouldn’t be.
But it should never be the top consideration because you’ll get into situations like this, that you’re making sub-optimal long-term or even short-term business decisions, just to have good accounting. And the secret is like, okay, you made these accounting adjustments? Well, if someone’s a sophisticated investor, they know what you did, they can figure it out. They’re just gonna adjust everything you did. And so they’re gonna see what you’re really looking like as it is,
Sam Gupta 17:21
Yeah, interesting. And now we are going to dig a little deeper into the misalignment of revenue and cash. So obviously, if it is actually misaligned, that’s a real problem. But we have seen cases where it could look pretty just because of the way it is recorded and reported.
So we were talking about the scenario yesterday related to tail spend. And I don’t know if you are familiar with a term called tail spend, when it’s typically the 80-20 rule in the procurement community, and it is called the expenses that don’t really matter, and people don’t care for it. Right.
So that’s going to be your supplies, the marketing expenses, Petty expenses that we are talking about from the procurement perspective, and there was a story, in one case, they had the expectation or the assumption that they had the tail spend of $200k. But then they started tracking that in the accounting, okay, but that’s because their systems were not really integrated. They were relying on accounting to provide the information.
Sam Gupta 18:19
And there was a big disconnect overall in the operations and finance. And because of that, finally, when they started digging, they found out that the actual tail spend for them was $5 million. Okay, so this situation could very well happen.
In the case of a manufacturing scenario where you have your revenue and cash look perfectly aligned, but maybe they are not aligned. So that is the number one problem. And number two, one scenario I see a lot more commonly, especially in the lifestyle manufacturing businesses, they don’t even track product cost. And product costs could be so important.
You really need to track how much machine you are consuming towards the product. And that product costing could be very, very important because it provides great insight in terms of your profitability, which products are profitable, which products are not so from the cash perspective. Aaron, when you look at this situation when let’s say the product is not getting costed appropriately, if not getting reported appropriately, let’s say from the production floor. How would you see this from the cash perspective?
Aaron Spool 19:20
There’s gonna be a couple of things you talked about, actually two different things what I would call unrecorded liabilities. That’s the technical accounting term. Yeah. And the second is product profitability. You could also call it customer profitability. You could call it job costing an essential duty of the people running your plant besides actually running the plant and making it, so the number two the number one duty is to make a good product as safely as possible as efficiently as possible.
The second is to actually record everything that went into it. So if you’re not able to tie the inventory to the product to the sale and you’re not able to tie in the shipping cost to the product to the sale, and you’re not able to tie the labor to the product to the sale, you will inevitably make a poor decision you could have, and you’re not going to see that from an overarching perspective.
Aaron Spool 20:07
So you say, so what I could do is to samples. Alright, so I’m going to see my P&L, and it shows that I’m profitable. But if you had two products, the classic case, two or three products, and one was the majority of the profitability, and the other two were actually unprofitable. You got to ask yourself, why do you care about those other two products?
Now there could be a whole bunch of strategic reasons. Let’s just assume that they’re not. Let’s just assume that you didn’t know that they’re unprofitable. And if you could change those resources over, that’d be great. Or you could do something in from staffing or manufacturing, whatever. So make them profitable.
So if you can’t break your profitability into both customers, job, and product, depending upon the type of products that you sell and how your business is run, you’re missing out. And odds are you’re making a lot of poor decisions. And where that comes to cash is a couple of things.
Aaron Spool 20:56
One, your pricing. So you could be selling something at a price and even collecting it, and the cash is totally fine. But guess what? That cash coming in is less than the cash going out? Yeah, that’s the classic case of everything you talked about with Job Costing. That’s really where it is.
But let’s talk about the other thing because this is a lot of practicality that happens and calls it an unrecorded liability. Liability is money that you owe something that you’re there for you’re liable for. It is don’t bang me up on the accounting terminology here. Yeah. So a lot of times what will happen will be is that you’ve got the classic cases way before things ever got digitized, who’s sitting on invoices, who’s sitting on requests, who’s sitting on bills, and they just put in their desk drawer, and they forget about it, you’ve incurred all these expenses, your oldest, but no one ever recorded it. So you don’t even know that it’s due. And then one day the power goes out? Or one day the service stops?
Aaron Spool 21:46
And like, why did the service stop? Why are you repossessing my machine? Oh, well, you didn’t pay your bill. What bill? What are you talking about? Now, it’s easy. If it’s like the power bill, right, it’s coming monthly, you’re kind of used to that there are ways to figure that out.
But if you enter into a long-term contract or something that requires installments, and those installments aren’t monthly, you could easily forget about it if it’s not properly recorded. And that and just and that’s part one. So to be aware of that what you’re really supposed to be seeing is like money out the door should be recorded on your liability side things that you owe should be there, what you’re not going to get.
Essentially, what you’re not going to get from your financial statements is when is it due? And that goes all into cashflow management, and there’s no standard accounting report. And there’s probably no standard, and people say that they have this stuff, but I haven’t really seen it.
Aaron Spool 22:37
Well, a standard reporting package is easily going to show you what all your cash flow in your cash flow out is coming that usually has to be done customized. And as should be the most important thing that you focus on.
From a tactical perspective, is your cash flow in and your cash flow out? So how do you catch this stuff is one who’s allowed to give to some contracts, you should be very few people in your company, very few who shall have the authority to do that. And then once you sign a contract and So that’s written down. It’s recorded somewhere in the reporting tools that you use, and the finance team, whoever it is, should have that record, and it should be front and center. And it should be all part of your cash flow forecast. If it’s not, make it happen.
Aaron Spool 23:24
That is key because you’re going to know your classic Oh, I have a payroll that’s due twice a month, I’ve got my rent and my power all this stuff. You know that, but you’re talking about the talents. And really, what you’re talking about here are unrecorded liabilities. These are expenses that either are not reoccurring or not normal is, as I say, not reoccurring.
And they should also never surprise you because you’ve agreed to them. Where it gets a little bit more complicated is if you have a service agreement. And based on a level of usage, it’s suddenly spiked. Well, that gets into more sophisticated. Who’s managing the level of usage? Yeah, and that could be anything but let’s make it super, super simple. Over time, are you managing overtime properly?
And there’s a whole bunch of philosophies why and the like, but overtime is the classic case of an unexpected cost. You have a factory floor, that or you don’t have the right staff, or you have surge sales and the like it, you can easily get into a place where you’re spending a ton of dollars in overtime. And if you don’t have a pricing mechanism, in order to pass that on to your customer, you are going to incur a lot of cashflow pay.
Sam Gupta 24:34
Yes. So obviously, the point that you made that makes sense that’s slightly more black and white. But the scenario that I was talking about is not necessarily because of the unrecorded liability. It’s slightly different, okay.
So it’s because of the operational and financial disconnect. Just because the finance is not going to have as much understanding of the operation and operation is not going to have as much understanding of the finance. So here in the center. What is happening is these expenses are being recorded, but they are being recorded differently.
Okay, they are not being recorded in the right category on the P&L the way they should have been recorded. Right. That’s where the disconnect is. So that actually affects the product cost, in my opinion, that should affect the cash as well. Do you agree that this is different? Or do you still think that this is going to be an unrecorded liability?
Aaron Spool 25:25
Oh, it depends, right? So it depends upon what, so if they’re recorded as an expense, they’ve got to get paid. Right. So from a cash flow perspective, your high level, if it’s a technology expense, and I suddenly recorded it as rent expense, all right, yeah, that’s, that’s bad from understanding perspective.
Sam Gupta 25:44
But it’s not as black and white, right?
Aaron Spool 25:48
So I think what you’re really talking about, and I could be wrong here, is gross margin, right, versus net margin, because you said something very interesting. You said it should have been part of the job. And it wasn’t recorded. It was recorded elsewhere.
Sam Gupta 25:59
So there are many different scenarios, right. So I have seen where they what they would do, as opposed to doing the real product costing. What companies do is they are recording the material for each of the jobs. And they are recording that the labor and equipment usage for each of the jobs. Rather than doing that, what they would do is, let’s say if you have the equipment, and let’s say if you’re running 5000 jobs, they will simply divide by five 5000. And they will record against those rights. So that’s not actually the true cost. Sometimes it could be negligible, but sometimes it could be significant.
Aaron Spool 26:28
So you’re talking about allocating out a cost. You’re doing cost allocations there. So there’s a couple of different things here. Right? Yeah. One is cost allocation. So what can too, I would say, so it’s what you’re really trying to do. Right?
The essence of what you’re trying to do is how much does a job cost? Exactly? That’s what you’re asking yourself now. Yeah, odds are, you don’t have a way to get people to record their exact time to the exact job, because and so if that’s the case, okay, then then you have to come up with an estimating structure.
So I like to say the following cost allocations, the purpose of a cost allocation is influenced behavior, where the classic case where it makes in my mind, next to no sense is if you take a department and you say, oh, I’ve got a piece of real estate.
Aaron Spool 27:17
Alright, so I got to allocate rent. So I’m going to allocate rent out of maybe headcount. So based on the number of heads that you have, that’s how much your department is going to pay for the rent is going to, in my mind, that makes no sense.
Part one is that none of these people have any say in what rent is. They’re not negotiating leases, right? They’re going to be then incentivized to be very careful with their headcount. Well, they met the cake, the Hey, great, y’all have, we’re gonna make sure that they don’t have a headcount wonderful, no high headcount.
That’s wonderful until that’s a position that’s desperately needed. And so, taking that aside, says you got to be careful with the allocations. You only need to be concerned with the allocation of specific costs that are directly related that these people have.
Aaron Spool 28:02
So you do have power over the machine usage. And you definitely don’t want to call peanut butter things. That’s the worst thing to do. And peanut butter is you’re just exactly just headcount. We just go spread it over by peanut butter is a great condiment. Peanut butter makes a great sandwich. Peanut butter is bad for finance. That’s another tag I get, is it?
No, that peanut butter effect is very, very bad, what you want to be able to do, and there’s a whole bunch of ways to do this is like, where you can apply to talk about allocation of costs, or where you can, you can apply, if it’s people as people on the floor, the closer you can get to the action of what the people did, and then be able to allocate the cost, the better you are, you might not be able to do it on a per hour basis.
Or maybe they’re doing five jobs at once. And you know, they’re, and it’s by seconds. So that allocation doesn’t make as much sense. Yeah, I go back to practicality, know what’s happening on your factory floor, look at the processes that are going right, make a rational than a judgment of what these people are doing, and then out and then allocate out accordingly.
Aaron Spool 29:05
And you also then have to ask yourself, when you’re done with all this stuff, does it actually make sense? Do the numbers make sense? Because that’s what a lot of people don’t think of it, they make some really bad decisions because the allocation model says x, but if your intuition is different, yeah, the model still has to make sense.
If I make a financial model, and it says we should do x decision, and that decision is the dumbest thing in the world. Because no one’s ever gonna buy it, then there’s something wrong with a model. So does this stuff makes sense? And the practical cases, so if you’re running something on the factory floor, see how many runs you’re doing, see how many people are there.
And see if there’s is parallel processing is two machines are being used at the same time, and it’s the same person watching both machines. Well, okay, but you have to know that before you make an allocation decision.
Sam Gupta 29:57
Yeah, amazing. So that’s it for today, Aaron. Do you have any last-minute closing thoughts, by any chance?
Aaron Spool 30:03
Sure I, I’ll give you this, if you can’t figure out what you’re paying for something in total, and you can’t figure out how much money at the end of the day you made off of something, you got a problem.
So always look at your business transactions, and especially every sale that you make as to how much money I’m making off of this. And if you actually really look at every expense that how much money am I making off that expense? And if the answer is not much, you don’t have to stop the expense, but it just gives you a different perspective of why you’re incurring that expense.
Sam Gupta 30:37
And that’s it. Okay, love it. So my personal takeaway from this conversation is going to be in my mind, everybody in the organization should be cash-focused, as opposed to just the CFO.
And if you can have that mindset of being cash-driven, because revenues not only the earned it has to be collected, the collection is equally important. So on that note, Aaron, I want to thank you for your time. This has been a very insightful and fun conversation.
Sam Gupta 31:06
I cannot thank our guests enough for coming on the show for sharing their knowledge and journey. I always pick up learnings from our guests, and hopefully, you learned something new today.
If you want to learn more about Aaron or Eventus Advisory Group, head over to eventusag.com. Links and more information will also be available in the show notes.
If anything in this podcast resonated with you and your business. You might want to check other related episodes, including the interview with Brian Goffenburg, from VitalHub, who discusses the difference between accounting for a public and private company. Also, the interview with Jim Gitney from Group 50, who shares his thoughts on each inflection point for companies and what we need to know to identify them and move to the next by making necessary changes.
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