Personal Finance

Hidden costs firms must tackle to stay profitable

Hiddencosts

Summary

  • The single most advantage of strategic planning is the benefit of having a 360-degree view of the business where strategy development has followed a well thought analysis framework.
  • Pursuing single-minded goal of profitability without looking at the interconnectedness of the drivers of profitability is risky.

The single most advantage of strategic planning is the benefit of having a 360-degree view of the business where strategy development has followed a well thought analysis framework.

Pursuing single-minded goal of profitability without looking at the interconnectedness of the drivers of profitability is risky.

There are five main hidden costs that stand on the way to sustainable profitability and overall organisational success including; suboptimal investments, uncollectible debts, foreign exchange losses, stock loses and legal contingencies.

All investment projects have the potential of generating long-term cash flows with positive net present values over the life of the project. The viability of the project is ascertained in a feasibility study, and for new ventures scale up is preferred to allow for learning curve and experience.

Suboptimal investments have negative net present values and therefore they carry hidden costs that can lead to massive loses. Such projects are prevalent in both private and public sectors. We are all too familiar with the much-hyped Sh7 billion Galala-Kulalu food security project in Tana River and Kilifi counties.

This was a Jubilee government flagship project that was to place some 10,000 acres under irrigation and transform Kenya into a food secure country. The project collapsed after the contractor, Green Arava Limited, abandoned work, sighting payment delays.

However, the Auditor-General revealed in 2017-2018 financial report that Sh5.9 billion or approximately 80 per cent of the total cost had been paid to the contractor despite no meaningful work undertaken. The other case can as well be the Kenya Pipeline Company’s Kisumu Oil Jetty.

The project was completed in 2018 at Sh2 billion with the Auditor-General noting in the company’s 2018-2019 financial report that Sh11 million was charged as depreciation for the facility, however, the facility has remained unutilised due to lack of infrastructure on the Uganda side to receive and store the product.

Bad debt is another hidden cost that often times imperils a company’s financial performance. Bad debt is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible. Bad debt is a contingency that must be accounted for by all businesses that extend credit to customers, as there is always a risk that payment will not be received.

When it is finally determined that the debt is irrecoverable, or it can only be recovered at greater expense than the amount outstanding, the amount can be written off from the books, often with Board of Directors approval. Companies with excellent credit policies have minimal bad debt exposures compared to companies that do not.

Bad debts can easily reverse all profits already reported if the credit risk is not managed prudently. In its 2019 published financial statements, EAAGADS Limited wrote off Sh3,543,000 in bad debts against a reported net profit of Sh2,647,000, or rather, bad debtors took away from the company twice as much as was available for ordinary shareholders.

Stock losses and obsolescence can wreak havoc on commodities oriented companies or companies selling tangible goods. Companies lose millions of shillings worth of stock annually due to weaknesses associated with financial systems, poor stock management practices and malfeasance.

Establishing proper receipt and verification procedures for inbound and outbound goods can cut stock losses significantly, but having a proper functional financial system with inbuilt controls can almost eliminate stock losses. Slow moving stock is equally costly as they may deteriorate in value and even becoming obsolete. These stock management issues represent lost value to the shareholders.

Companies can easily eliminate these problems by implementing best practice inventory management strategies bearing in mind lead-time and cyclic demand surges. A good ERP can go a long way in improving stock control environment as inconsistencies in stock movements can be picked out easily and remedial measures immediately put in place.

Companies dealing in foreign exchange transactions but have a different reporting currency usually experience challenges caused by foreign exchange rate fluctuations. These fluctuations in rates may result to foreign exchange gains, but more often than not, result to painful losses.

Foreign exchange losses can wipe out all of a company’s profits and companies are strongly advised to have strategies in place to mitigate adverse impacts if the foreign currency exposure is material.

Due to the unpredictability of future exchange rates, multinational companies usually hedge their positions as a matter of corporate policy. Hedging generally involves the use of financial instruments known as derivatives with the two most common derivatives being options and forwards. With derivatives, a company can develop trading strategies where a loss in one investment is offset by a gain in a derivative.