EMH Insights

Financial Visibility: Understanding Internal Costs

Financial visibility is something you probably hear a lot about, but in reality, it means different things for different companies. At its core, financial visibility highlights certain financial indicators and allows a company to make well informed, data-driven managerial decisions. In this series of blog posts, we will discuss three areas within a company that can be addressed to enhance financial visibility.

For our first post, we discuss the idea of internal costing. Inefficiencies are most dangerous when they fly under the radar without definite price tags, and ultimately develop into bad habits that drive poor financial performance. In order to weed out these inefficiencies, companies must have in place a defined internal costing model that brings both direct and indirect costs to light. Because all good things come in threes, we look at three issues surrounding internal costs of which all companies should be aware.

1. Time is money
Perhaps the most difficult thing for employees of a company to directly value is time. For hourly employees, time is easier to measure, but any company needs to have in place specific metrics for valuing the time of its employees. Which projects are the most profitable? How can high-value employees be kept from executing low value tasks? These are questions that any company with a serious understanding of the internal cost of time must be prepared to answer in order to reasonably maximize the return on time (ROT) for a firm’s employees. It is also critical to remember your employees have an internal cost when making a decision about whether or not to outsource a project.

2.Cost of capital
Any firm undertaking a new project or expansion must consider how that project will be financed, through debt or equity, also taking into account the associated costs of the financing option selected. It is necessary for a firm to understand its costs of capital for two reasons:

i.Financing costs impact the return on investment of a new project, and
ii.Capital costs affect the company’s valuation; higher costs of capital result in a higher discount rate (weighted average cost of capital, or WACC) on a company’s future operating cash flows.

3.Cost controls
Being Bob and Bob is a hard job, but ultimately, someone has to do it. To their credit, Bob and Bob were on to something, as it is indubitably important to have in place a general infrastructure for cost control so that your company is not bleeding money. This must include a structured cost accounting process that allows senior management to analyze all variable and fixed costs to assess how expenditures on individual transactions and projects ultimately affect the bottom line.

At the same time, any company must be sure that they are not cutting costs to the point of hindering important investments. For example, while eating a typical New Orleans business lunch every Friday might not be necessary (although, perhaps it might), it is important to invest in “soft marketing” techniques like the occasional networking lunch. Cutting back on such costs, merely because the payoff is not immediately evident, can hinder future business development opportunities.

Internal costs can be hard to measure, but because elements like employee ROT and the WACC can have serious implications for business performance, it is critical for senior management to have a thorough understanding of how internal costs can be measured, and how they impact company-wide performance. It is equally important to not be too penny-pinching—failing to invest time and resources in certain areas that do not immediately pay dividends might hinder a company’s ability to grow and innovate.