SPEAKING ACCOUNTING to OPERATIONS
SPEAKING ACCOUNTING to OPERATIONS Ken Hood MBA, CPA
Let’s chat about 5 issues: • • • • •
Capital vs. Expense treatment of a transaction USED vs. NEW equipment purchase decision Controllable vs. non‐controllable classification Performance Indicator impact What is “INCOME AFTER TAX” and “CASH FLOW” (hint: only “1” difference)
Over my 46+ years in the oil patch: • These are the 5 issues that have resulted in the most “spirited” conversations between me and OPS
“OPS”
“ME”
CAPITAL vs EXPENSE treatment • Ever been told “if we can’t capitalize this work, we just won’t do it”! I have many, many times.
REMEMBER, classification of expenditures is a matter of compliance with GAAP, COPAS Operating Agreements, consistency and NEVER HOW SOMETHING APPEARS ON A PERFORMANCE APPRAISAL or PERFORMANCE METRIC.
Its a never ending battle. At stake is compliance with GAAP, the Joint Operating Agreement and keeps everyone out of court and possibly jail. An effective tool I have used a lot is: You are asking me to do something that will put my CPA certification at RISK. I have never asked you to put your PE certification at risk!
FACTS about this decision: • Where a transaction is recorded in the financials is a matter of “compliance with the LAW i.e. GAAP”. • Where a transaction winds up (i.e. Balance Sheet or Income Statement) has never made a “good decision” out of a “bad decision” or a “bad decision” out of a “good decision”. • It’s just a matter of compliance. • This is the chance to explain the relationship of the Balance Sheet to the Income Statement and why certain things must be booked in a certain way.
NEW vs USED equipment • Does OPS always want to “buy new”? • Does OPS know what is on the “SURPLUS/IDLE EQUIPMENT LIST”? • Does OPS understand COPAS treatment of USED assets, and how it impacts their “PERFORMANCE MEASURES”? • IF NOT, THEY MUST to ensure “good business decisions” are being made.
LARGE MEDIUM SMALL
Eagle Ford oil wells optimally need different size pumping units at the various stages of their life cycle (it’s the nature of SHALE operations). So, size does matter if you want to match the mechanical needs of a well to the well’s life cycle stage and hence optimize profitability for the field. Ask OPS if they really need to buy a NEW LARGE PU, or could they get by with purchasing a new MEDIUM PU and moving a USED LARGE PU from a well that no longer needs a LARGE and can get by with a MEDIUM one.
CONTROLLABLE vs NON‐ CONTROLLABLE EXPENSE • Ever been asked by OPS to change the coding of an invoice from one account to another? (and the request seemed to be in conflict with your Chart of Accounts) • Could one of the accounts in question be “controllable” and the other “non‐ controllable”! • Is “controllable expense” on the OPS performance appraisal?
If your company distinguishes between “controllable” and “non‐controllable” expenses, and then evaluates performance based on one and not both, then you have a recipe for “manipulation”.
PERFORMANCE measurement impact is not the criteria for how a transaction “must” be booked.
PERFORMANCE INDICATORS • Call it what you want: performance indicators, appraisal criteria, goals, objectives. • It’s what ever determines your next bonus, raise, or assignment. • You get what you “inspect”, not what you “expect”. Said another way, you get what you PAY for, therefore, you get what you ASK for.
So, WHO IS TO BLAME if poor business decisions are being made?????? (OPS or Management or perhaps even Accounting) Can you really blame OPS if they make decisions based on their next “performance review” ???????????
Or, does the blame rest with the people setting the performance indicators?
REMEMBER……… YOU GET WHAT YOU “INSPECT”
NOT WHAT YOU “EXPECT”
You get what you MEASURE!!!!!
QUICK CASE STUDY
I once participated in the re‐ engineering of a U.S. E&P operation • I led a cross functional team of professionals (containing OPS, engineering, a consultant, management, and 2 bean‐counters). My “natural work team” was one of 22 different teams, and my team’s task was to figure out why, and how were we making “bad business decisions”! At the time our Return on Assets was a stellar 1.8%.
Here were the 3 things on every OPS person’s annual appraisal: • Produce your volumes. • Spend your Capital Budget. • Stay within your “controllable expense” target.
After 6 weeks of work my team gave its “findings” to the Steering Committee • We put on a “one act play” about how a Production Foreman made a decision to workover a producing well that needed some down hole repairs. • I then asked the other team members to leave the meeting. • I then said “ good news and bad news”…….
Team findings: • GOOD NEWS
• BAD NEWS
• We have learned why we make poor business decisions!
• It’s YOUR FAULT. You are measuring performance on the WRONG set of criteria!
WHY • The well needed work because foreman had cancelled the downhole chemical treatment program (to manage controllable expense). • Plus, now the tubing had to be totally replaced (which spends capital) instead of only a few bad joints (which would be controllable expense). • And the well could then meets it production target. PERFECT TRIFECTA
After some ugly finger pointing, denials, and disbelief on the part of the STEERING COMMITTEE (which included some Corporate honchos responsible for crafting annual performance criteria) cooler heads prevailed (after a couple of days). RESULT:
Volume component remained unchanged.
Controllable expense became a component of a more comprehensive “cash flow” target. Capital budget became a component of a “Return on Asset” target.
OVERALL, a pretty HAPPY ENDING
What is IAT (Income After Tax) • I have been amazed over the years to find that OPS (and sometimes very high up OPS) may not fully understand what IAT really is!!!!! • I was once asked by our PhD Producing Manager (and next GM)“Ken, how can our Return on Assets only be 1.8% when every capital AFE I approve shows a DCF‐ROR of at lease 20 to 25%?”
Carthartic event time on a Saturday morning of the re‐engineering project !!!
And, this is when I truly understood the value of having both a CPA and an MBA.
How do you explain the difference between a static measure of an asset’s performance (ROA) to a discounted cash flow measure (DCF/ROR) created to determine the “best” project among many alternative projects???????
My team suddenly had another mission • Over one very long weekend, we developed a model for a revision (an upgrade if you will) to the standard P&L program used to support and gain approval of all capital spending in the company. • And, the basis was a simple formula.
IAT
CF(cash flow) =
____________________________________________________________________________________
TIME
It’s as simple or complex as that • Income after tax spread out over time. • So, its all about the CASH, and when you spend it, and when you get it. • So, if you want to make a good business decision, or pick what projects to do or not do ………….. just follow the CASH.
THANKS FOR YOUR TIME ANY QUESTIONS?
Let’s chat about 5 issues: • • • • •
Capital vs. Expense treatment of a transaction USED vs. NEW equipment purchase decision Controllable vs. non‐controllable classification Performance Indicator impact What is “INCOME AFTER TAX” and “CASH FLOW” (hint: only “1” difference)
Over my 46+ years in the oil patch: • These are the 5 issues that have resulted in the most “spirited” conversations between me and OPS
“OPS”
“ME”
CAPITAL vs EXPENSE treatment • Ever been told “if we can’t capitalize this work, we just won’t do it”! I have many, many times.
REMEMBER, classification of expenditures is a matter of compliance with GAAP, COPAS Operating Agreements, consistency and NEVER HOW SOMETHING APPEARS ON A PERFORMANCE APPRAISAL or PERFORMANCE METRIC.
Its a never ending battle. At stake is compliance with GAAP, the Joint Operating Agreement and keeps everyone out of court and possibly jail. An effective tool I have used a lot is: You are asking me to do something that will put my CPA certification at RISK. I have never asked you to put your PE certification at risk!
FACTS about this decision: • Where a transaction is recorded in the financials is a matter of “compliance with the LAW i.e. GAAP”. • Where a transaction winds up (i.e. Balance Sheet or Income Statement) has never made a “good decision” out of a “bad decision” or a “bad decision” out of a “good decision”. • It’s just a matter of compliance. • This is the chance to explain the relationship of the Balance Sheet to the Income Statement and why certain things must be booked in a certain way.
NEW vs USED equipment • Does OPS always want to “buy new”? • Does OPS know what is on the “SURPLUS/IDLE EQUIPMENT LIST”? • Does OPS understand COPAS treatment of USED assets, and how it impacts their “PERFORMANCE MEASURES”? • IF NOT, THEY MUST to ensure “good business decisions” are being made.
LARGE MEDIUM SMALL
Eagle Ford oil wells optimally need different size pumping units at the various stages of their life cycle (it’s the nature of SHALE operations). So, size does matter if you want to match the mechanical needs of a well to the well’s life cycle stage and hence optimize profitability for the field. Ask OPS if they really need to buy a NEW LARGE PU, or could they get by with purchasing a new MEDIUM PU and moving a USED LARGE PU from a well that no longer needs a LARGE and can get by with a MEDIUM one.
CONTROLLABLE vs NON‐ CONTROLLABLE EXPENSE • Ever been asked by OPS to change the coding of an invoice from one account to another? (and the request seemed to be in conflict with your Chart of Accounts) • Could one of the accounts in question be “controllable” and the other “non‐ controllable”! • Is “controllable expense” on the OPS performance appraisal?
If your company distinguishes between “controllable” and “non‐controllable” expenses, and then evaluates performance based on one and not both, then you have a recipe for “manipulation”.
PERFORMANCE measurement impact is not the criteria for how a transaction “must” be booked.
PERFORMANCE INDICATORS • Call it what you want: performance indicators, appraisal criteria, goals, objectives. • It’s what ever determines your next bonus, raise, or assignment. • You get what you “inspect”, not what you “expect”. Said another way, you get what you PAY for, therefore, you get what you ASK for.
So, WHO IS TO BLAME if poor business decisions are being made?????? (OPS or Management or perhaps even Accounting) Can you really blame OPS if they make decisions based on their next “performance review” ???????????
Or, does the blame rest with the people setting the performance indicators?
REMEMBER……… YOU GET WHAT YOU “INSPECT”
NOT WHAT YOU “EXPECT”
You get what you MEASURE!!!!!
QUICK CASE STUDY
I once participated in the re‐ engineering of a U.S. E&P operation • I led a cross functional team of professionals (containing OPS, engineering, a consultant, management, and 2 bean‐counters). My “natural work team” was one of 22 different teams, and my team’s task was to figure out why, and how were we making “bad business decisions”! At the time our Return on Assets was a stellar 1.8%.
Here were the 3 things on every OPS person’s annual appraisal: • Produce your volumes. • Spend your Capital Budget. • Stay within your “controllable expense” target.
After 6 weeks of work my team gave its “findings” to the Steering Committee • We put on a “one act play” about how a Production Foreman made a decision to workover a producing well that needed some down hole repairs. • I then asked the other team members to leave the meeting. • I then said “ good news and bad news”…….
Team findings: • GOOD NEWS
• BAD NEWS
• We have learned why we make poor business decisions!
• It’s YOUR FAULT. You are measuring performance on the WRONG set of criteria!
WHY • The well needed work because foreman had cancelled the downhole chemical treatment program (to manage controllable expense). • Plus, now the tubing had to be totally replaced (which spends capital) instead of only a few bad joints (which would be controllable expense). • And the well could then meets it production target. PERFECT TRIFECTA
After some ugly finger pointing, denials, and disbelief on the part of the STEERING COMMITTEE (which included some Corporate honchos responsible for crafting annual performance criteria) cooler heads prevailed (after a couple of days). RESULT:
Volume component remained unchanged.
Controllable expense became a component of a more comprehensive “cash flow” target. Capital budget became a component of a “Return on Asset” target.
OVERALL, a pretty HAPPY ENDING
What is IAT (Income After Tax) • I have been amazed over the years to find that OPS (and sometimes very high up OPS) may not fully understand what IAT really is!!!!! • I was once asked by our PhD Producing Manager (and next GM)“Ken, how can our Return on Assets only be 1.8% when every capital AFE I approve shows a DCF‐ROR of at lease 20 to 25%?”
Carthartic event time on a Saturday morning of the re‐engineering project !!!
And, this is when I truly understood the value of having both a CPA and an MBA.
How do you explain the difference between a static measure of an asset’s performance (ROA) to a discounted cash flow measure (DCF/ROR) created to determine the “best” project among many alternative projects???????
My team suddenly had another mission • Over one very long weekend, we developed a model for a revision (an upgrade if you will) to the standard P&L program used to support and gain approval of all capital spending in the company. • And, the basis was a simple formula.
IAT
CF(cash flow) =
____________________________________________________________________________________
TIME
It’s as simple or complex as that • Income after tax spread out over time. • So, its all about the CASH, and when you spend it, and when you get it. • So, if you want to make a good business decision, or pick what projects to do or not do ………….. just follow the CASH.
THANKS FOR YOUR TIME ANY QUESTIONS?
