When Revenues Aren't Revenues

5.5 minute read... 

Oh, the inherent simplicity of the basic measures of a company’s performance.

Profits = revenues minus costs
Return on assets = profits over the value of the assets

And oh, the complexity we add in our quest to make good decisions for our businesses. Decisions that we hope will lead to increasing profits and return on assets now and into the future.

A week doesn’t go by that I’m not with a client or student hacking the assumptions that drive how they view their revenue and cost numbers. This week, we’ll look at how we distort revenues and next week, we’ll look at how we distort costs.

Case in Point: Transfer Pricing

Many companies engage in transfer pricing, which records sales from one department or business unit to another as illustrated below.  

The historical reason companies use transfer pricing has to do with taxes.  When companies have subsidiaries that report their own profits, using transfer prices as a basis for cost can help reduce the overall tax liability even though the financials of all subsidiaries are ultimately consolidated for the corporation’s financial reports. 

But just because an accounting method is used for calculating tax liability doesn’t mean it’s a good basis for operational performance measures or day-to-day decision making.

When Is Revenue Really Revenue?

Revenue is the amount of money a company brings in from selling goods, products, and/or services. A company’s revenues are generated via sales from the company to its external customers because that is the only time money is actually “brought in” to the company. This is the historical definition and one we want to keep.

But when is revenue not really revenue? It’s not revenue when one department delivers something to another department. That’s just money moving around within the company.

Confusing this first definition with the second (and it happens often) is really harmful to the overall health and profitability of an organization.

Here’s why. 

Conflicts and Distractions

Using the simple example illustrated above, imagine each of the two departments are measured on “their profits”. Which means each is focused on maximizing revenues and minimizing costs. If I’m Department A, I want to sell my product to Department B for at least the same price that I can sell it to my external customers. If I’m Department B, I want to buy that product for as low a price as I can. 

So then the negotiating begins. And with that, the “us vs. them” mindset takes hold, and the departments become more adversaries than teammates. Because doing what’s in the best interests of the individual departments starts to be in conflict with the best interests of the company as a whole. 

I’ll share a case with you to illustrate.

Shops, Sales, & Other Silos: A Case Study

Note: Names hidden and numbers changed to protect the innocent.

Let’s say you’re a car dealer. You sell vehicles, parts and accessories, as well as services such as mechanical repairs, oil changes, body work, and vehicle detailing. When you acquire used vehicles (via trade, auction, or other channels) they typically need to go through a process of reconditioning to get them in the shape that will be appealing to resell to consumers. 

Once your team has inspected a newly acquired used vehicle, they determine the reconditioning work required, set a target selling price, and buy the parts and components your shops will need to do the reconditioning.  

In an attempt to keep negotiating and infighting at bay, company policy authorizes each department to “sell” to the other departments at up to a 20% gross margin.  

In this case, a customer has just purchased a new car from you.  As part of that deal, your dealership paid the customer $15,000 for the car they traded in. 

After the vehicle was inspected, parts were purchased from suppliers for $3,500. Once the parts arrive, the parts team delivers them to the shops and records “internal sales” to the shops for $4,375.

The shops’ technicians put in 24 hours of their time to get the reconditioning work done. For the sake of simplicity, let’s assume the burdened hourly rate of tech labor is $100. So, when the work is done, an internal sale is recorded from the Shops to Sales for $8,469.

The vehicle now waits on the lot for the customer who will buy it, carried at a cost of $23,468. If you’re keeping track, that’s $15,000 paid for the vehicle itself plus the $8,469 that Sales has “bought” from the shops for the reconditioning work.

The last step, of course, is selling the reconditioned used vehicle to a customer. In this case, a new customer pays the dealership $25,999 cash for the car. The gross margin recorded is $25,999 selling price minus $23,469 cost, which is $2,530 (or 10% of selling price). This is the gross margin that the Sales Department is graded on.

At this point, we’re at $25,999 in revenue, which is the amount the dealership’s customer paid the dealership. The sales recorded from department to department was not revenue. It was nothing more than moving money from one department to another in the information system. 

The dealership generated $5,099 in gross margins, which is the difference between the revenues and the reported costs directly attributed to those revenues.  No department on its own generated any gross revenue.  (As an aside, stay tuned for next Tuesday. We’ll hack some assumptions that shape our view of costs.)

Going through the case study above, can you see similar dynamics playing out in your organization? How much time, effort, and relationship do you consume negotiating revenues and margins that aren’t? Or how about mediating the conflicts between your departments due to measuring them on revenues and margins that aren’t?

Your answer to these questions could have a considerable impact on the profitability and health of your organization as a whole.

Until next Tuesday!