Operations and the bottom-line? Part II

In the previous article, we laid out the main areas in which the efficiency and effectiveness of operations within a fairly small back-office finance department can impact the bottom-line. In this follow-up article, we will see just how severe the impact can be through a case-study, complete with actual numbers.

The Patient

The patient, firm X, is a $15MM annual revenue firm, so larger than a start-up, but still on the small side. All of the firm's revenues come from professional services, with an average hourly billing rate is $110, giving 136k hours billed per year. As a professional services firm, its primary costs are labor expenses to the staff who work on billable projects, both salaries to employees and payments to contractors. Using the US Department of Labor standard of 2,000 labor hours per year, the firm uses 68 person-years to deliver its services. The firm has 25 billable employees with a fairly high utilization rate of 80%, or 1,600 hours per year. The rest of their time is spent on training, development, non-billable travel and paperwork. The total billed by employees is 40,000 hours per year, or 29.4% of the firm's total revenues, with the remaining 96,000 or 70.6%, billed via contractors. The average billing per contractor is 700 hours per year.

The 25 employees cost the firm, on average, $100,000 in salary and benefits per year. Since each employee bills out 1,600 hours per year, for revenue of $176,000, the gross margin per employee is 43%. The average rate the firm pays its contractors is $80/hour, for a gross margin of $30/hour or 27%. Clearly, contractors are much more expensive than employees. However, the firm is subject to two forces that limit the use of employees.

1. Demand fluctuates greatly. Although the firm can reasonably expect to hold to its $15MM in revenues, it wants to keep its fixed costs down, and thus does not wish to be subject to layoffs when business takes a short or medium term downturn.
2. Demand is geographically dispersed. The firm cannot always expense travel costs and times to its customers. Thus, it uses contractors who may only bill 500 hours per year to the firm, but will be much closer to the customer.

Average gross margin for the firm is 27%*70.6%  (contractors) + 43%*29.4% (employees) = 31.7%. With $15MM in revenue and 31.7% average gross margin, the firm has $4.76MM in annual gross profit. Of that $4.76MM, $3MM should pay for various overhead - real estate, accounting, legal, and administrative, including, of course, the finance department. The remaining $1.76MM is operating profit that either goes to the shareholders as dividends or is reinvested in the business.

Back-Office: The Finance Department

The finance department is staffed by 5 people: a CFO and 4 employees. Its average invoice size to customers is $20,000, so it issues 750 invoices and receives an equal number of payments per year. It does no material business via credit cards, and most of its invoices are issued net 45, as is common practice in its industry. The average invoice received for payment to contractors is $2,000, so it pays 3,840 contractor invoices per year, in addition to invoices for basics such as real estate, consumables, bank interest, etc. Employee salaries are paid twice monthly, on the 15th and 30th of each month. Employee expenses are reimbursed at the "next available pay cycle," which employees understand to mean the second paycheck after approval, or 5 business days plus 2 paychecks. Thus, if an expense is submitted on the 1st, the employee expected to get paid on the 30th, whereas one submitted on the 10th is expected to be paid on the following 15th. Employee expenses consist primarily of travel expenses to customers and training materials, as well as mobile phone bills. Consumables and other incidentals are paid directly by the firm to vendors.

The Issues

Let us examine each of the issues raised, and the cost to the business. 

Payroll

As a small business with 25 employees, some sales people and executive staff, and the 5 people in finance, total regular payroll is 40 people, a fairly small operation. Payroll has been outsourced entirely to SurePayroll. One of the key advantages to SurePayroll is that it sends out reminders to process pay on a regular basis. Thus, X almost never misses payroll and is rarely, if ever, late. Employees like SurePayroll as they can pull their entire pay stub - and its history, as well as end of year tax forms - online. 

Expense Processing

Expense processing is handled by submission to the finance department in a paperwork process. Receipts are attached to paper using Scotch tape, along with printed or handwritten expense reports. The average employee submits $200 per month in expenses. The employee pays the expense out of their own pocket, then awaits reimbursement. The reimbursement is manually entered into the SurePayroll pay stub with the appropriate billing cycle.

Because of the slow paperwork process, the following occurs:

• 25% of expenses are submitted at least two weeks after occurrence, while the remainder are submitted end of the same week. 
• 15% are lost and must be resubmitted. However, without any method of employees tracking the status, it is only once an invoice has failed to be paid do employees know of the lost expense and resubmit.
• Expenses are normally actually reimbursed three pay cycles after submission, rather than two. 

With 25 employees submitting one expense sheet per week, 100 are processed per month. Each expense submission requires 15 minutes of employee time, and 15 minutes of finance staff time, for a total of 3,000 minutes, or 50 hours. At the fully loaded cost of $100,000 per employee shown earlier, direct basic expense processing costs are $2,500 per month or $30,000 per year.

Lost invoices require one hour of employee time and one hour of finance employee time, or two hours total. With 15% lost and requiring resubmission, that is 15 per month, or 30 hours per month, 360 hours per year. At the fully loaded cost of $100,000 per employee, reprocessing of lost expenses is $18,000 per year.

Slowness of paying means that each employee is out, on average, $400 awaiting reimbursement at any given moment. At consumer unsecured debt rates of 15%, each employee is paying $60 per year to finance the business. From the employee's perspective, however, all that they see is $400 in cash they need to carry for the business. As word has gotten around as to the slowness of paying of expenses, each new employee has insisted on a salary at least $400 per month higher than they would otherwise accept. This is an additional $5,000 per year per employee cost. With 25 billable employees, the cost to the business is $125,000. 

Total expense processing cost is $171,000 per year. Total cost due to late and missed payments is $141,000 per year. Average labor cost per basic processing is $25; this should be between $10 and $15. Cost due to inefficient process is $10-15,000 per year. 

None of these costs takes into account employee turnover and the cost of retaining new employees, which will not be calculated here.

Summary:$156,000 per year in direct waste.

Invoice Processing & Accounts Payable

X spends approximately $3.0MM each year in overhead. $500,000 of that overhead is the finance department, including benefits. Although slow accounts payable affects many vendors, we will focus on one area alone: consultant invoices. As described above, contractors bill the firm 96,000 hours per year. The average rate for contractors is $80 hour, for total billing of $7.68MM. These invoices are all due net 30. However, X loses approximately 15% of the invoices, a rate identical to the lost expense rate. Each lost invoice requires tracking down to ensure that it is truly lost, and then resubmission.

As stated above, 3,840 invoices by contractors are submitted per year, with each contractor performing, on average, 700 hours per year. The time to process invoices is similar to the time to process expenses, 15 minutes of finance department time and 15 minutes of contractor time. Due to the standard terms and conditions with contractors, the 15 minutes of contractor time is not billable. With 3,840 invoices and 15 minutes per invoice, basic invoice processing takes 960 hours per year, or $48,000 in costs. 

Lost invoices take one hour to process, including resubmission, if necessary. At 3,840 invoices per year and a loss rate of 15%, 576 invoices must be reprocessed at an hour of labor each, for a total cost of 576 hours or $29,000. 

The single largest element, however, is the increase in rates. Because the firm is known as one that pays late and frequently loses invoices  - and all contractors who do not know initially, find out very quickly - X is paying above-market rates for each contractors. The rate for this type of contractor is between $70 and $75 per hour. The $5 to $10 increment in rates is demanded by contractors to cover lost hours in following up on invoices as well as late payments. Since contractors bill 96,000 hours per year, the firm is paying, at minimum, $480,000 in excess fees, directly reducing its gross margin.

Summary: $509,000 per year in direct waste.

Invoice Issuance & Accounts Receivable

As stated above, X receives $15MM in revenue, spread over 750 invoices, each with an average amount of $20,000. Like X, most of X's customers have a "must invoice by y days after service" policy to be paid. On average, the policies provide for full payment if invoices are received within 30 days of service, 10% penalty for invoices received within 60 days, and option to refuse to pay for invoices received after 60 days. X does not have a structured invoice issuance and follow-up process. Almost all of X's invoices are issued net 45. The distribution for invoice issuance is as follows:

• 60% of invoices are issued within 30 days
• 30% of invoices are issued within 60 days
• 10%  of invoices are issued after 60 days, of which 3/4 are accepted with 15% penalty and the rest are rejected

Additionally, 25% of invoices are not paid within 45 days, but rather once finance personnel follow up, leading to payment within 75 days. Each invoice follow-up takes one hour of finance staff time. With 750 invoices per year, and 25% paid late, 187 invoices are late, costing 187 hours of employee time or $9,375.

The cost of late invoices is as composed of two components: reduced or lost revenues, and cost of carry. For simplicity sake, we will ignore cost of carry.

• 60% issued on time: no costs.
• 30% issued within 60 days: 10% * 30% * $15MM = $450,000
• 7.5% issued within 90 days but paid with 10% penalty: 7.5% * 10% * $15MM = $112,500
• 2.5% issued within 90 days and rejected: 2.5% * $15MM = $375,000

Summary: $937,500 in annual costs. 

Reporting

Cash management and reporting will not be calculated at this stage.

Summary

Total avoidable annual losses from suboptimal finance department management are as follows:

• Expense Processing: $156,000
• Invoice Processing and Accounts Payable: $509,000
• Invoice Issuance and Accounts Receivable: $937,500

Firm X is losing $1.6MM in direct profit each year due to the poor performance of a small back-office department. Recall that the total annual profit of the firm was $1.76MM. Of this $1.76MM, $937,500 is revenue recognized but never received in cash, leaving $662,500 in actual cash profits for the owners or reinvestment each year. This paper profit of $1.76MM but actual cash availability of only $662,500 induces owners to seek out assistance. An additional $665,000 would be available as profit but cannot be claimed.

Conclusion

Efficient and effective back-office operations can have a significant impact on a firm's profitability. This is especially true with back-office operations that sit at the nexus of the firm's business, whether finance, IT for information-intensive industries such as finance, supply-chain for manufacturing, and other critical departments. Firm X needed an operations expert to analyze the operations, isolate the costs and recommend improvements, at a reasonable cost to the business.