Building the foundation of a hardware business: the chart of accounts

Hardware leaders in sales, engineering, and operations underestimate how the design of their accounting system can make or break their business.

Let’s imagine you build a house. The natural place to start is the foundation—it supports the building. It must be built to be strong, but also able to be used flexibly. Strong enough to support future additions and modifications, but flexible enough to adapt to changes in plans over time. What happens if you fail to give the foundation due consideration? No one knows until it’s too late, at which point it’s a very expensive fix.

For a company, the Chart of Accounts (“COA”) is the financial foundation. A well designed COA is the roadmap that guides your business and ensures accurate data to make well informed decisions. A poorly designed COA makes a business unpredictable and inefficient, which impacts every leader and manager who relies on numbers.

This isn’t just about extreme examples, this is about clear organization driving the effectiveness of your entire business.

Why the chart of accounts matters

Before diving further, let’s be honest: the COA isn’t glamorous! Akin to the house foundation, it’s buried underneath. On top of the foundation are the walls, and those walls determine how people flow through the space.

Just like the foundation impacts the whole house, the design of the COA impacts everyone in the business. It governs how transactions are entered. And the transactions determine how reports are produced. Thus the design of the chart of accounts ultimately dictates all future financial reporting for the business.

This process flows from left to right, but we will review it in reverse order to emphasize the importance to all teams. How do you like to see your department’s financial data? How easily can you access and understand that information? What are your pain points? The COA can make or break these questions.

Key outputs: The value that a good chart of accounts drives for each function

The overriding utility of the chart of accounts is to be able to generate information quickly and easily. That information should be usable by anyone in the company. And it should be able to address business questions, whether or not they are anticipated in advance. There are 4 business principles that a strong COA should have:

1. Able to create a high-level summary
2. Able to drill down to different levels of granularity
3. Able to group pieces for different stakeholder areas
4. Applicable to the particular company and business model

These principles together prove out the most important output of the accounting system and its underlying COA: reporting. It’s how people within the company use the financials to manage their business.

For example, a marketing manager needs to develop a budget for the coming year: he needs to understand how various expenditures are grouped, and a reasonable level of detail without drowning in minutiae. Or the head of engineering needs to understand spending patterns: she needs well constructed accounts to provide clarity about certain components.

Able to create a high-level summary

In all of these examples, generating reports at a high level is an important principle. These reports have just a few “captions” that make sense for the reader. From there we can ask new questions, whether to drill down or for business users to analyze trends and make actionable decisions.

Able to drill down to different levels of granularity

Inventory is a good example of this principle. The Balance Sheet may just have “Inventory” as a caption, but underneath you need to have multiple accounts to drill down. A company may have Raw Materials Hardware, Raw Materials Electronics, Work In Process-Direct Labor, and Finished Goods. A good design might allow all of these accounts to capture all current and future Inventory needs

Able to group pieces for different stakeholder areas

Let’s take Personnel as an example of this principle. A payroll system can break out costs by department, but the CEO doesn’t need to see 20 line items of payroll. Now, a department head may want to see all the relevant salary and benefits line items for their team. That’s easily extracted in an ad hoc management report.

Applicable to the particular company and business model

Operating Expenses speaks well to this principle. One company might break out Personnel (e.g., payroll and benefits), G&A (rent, utilities, office supplies, and overhead costs) and Software (very large line item for all departments). This makes sense for that company, but another business may want to see this differently. The Acme Robotics company might not care about separate accounts for “Envelopes” and “Pens,” but Office Depot certainly does!

Key inputs: Why categorizing transactions correctly in the chart of accounts is so important

How does data become able to drive value for the organization? Through the ongoing business of running the company! Each of these are “transactions”—such as billing customers, buying supplies, and paying employees. This culminates each month in  “closing the books”: aggregating, analyzing, and finalizing all these transactions. This is what keeps accountants up all night at the end of the month!

Let’s take purchasing inventory as an example. An engineer at ABC Robotics orders and receives a robot arm. The invoice from the vendor goes into the accounting system. For the engineer to do this correctly they will need to understand the COA. But how do they know what’s right?

• If ABC sells robot arms directly… the arm might be “Inventory”
• If ABC buys parts just in time and robot arms go straight to the factory floor… the arm might be “Work in progress”
• If ABC stores robot arms in a warehouse until they are later used to build systems… the arm might be “Raw materials”

It’s critical that someone understands the particular transaction enough in order to place it correctly in the COA, so that business reporting is accurate. Often this means the engineer has to understand just enough about the COA to have a sense where the invoice fits. And the accounting team has to understand just enough about engineering to have the same sense. If not, then engineering and accounting will have to have a deep discussion about every single invoice to record transactions that make sense for the business.

The process repeats itself in a similar fashion for the payroll system, billing system, and other adjacent platforms. The accounting principles should be consistent—all users have clear descriptions of accounts, and enough context to be able to process their transactions.

Key building blocks: How the chart of accounts comes together

The “Natural Account” is the building block for all financial activity. It’s typically a four-digit number with a brief description, which typically lines up like the list below.¹

The permutations here are almost endless, but one of the most important concepts should make this a little easier: use clear and concise nomenclature. Business users of the COA need to understand the wording. Keep in mind as well that some systems may allow for splitting transactions—one invoice can get coded to more than one Natural Account—make sure that’s easy to do.

This all takes work! It takes work to come up with the right reporting. It takes work to log transactions to deliver that reporting. And it takes work to design a chart of accounts that is able to handle transactions, guide the business in the right direction, and deliver the needed reporting.

Particular challenges for hardware, robotics, and as-a-service

The hardware industry, and robotics in particular, has nuances beyond the general challenges outlined above. In particular, these businesses have nuances that SaaS companies do not.

One of the most important differences is manufacturing. A fairly standard inventory accounting construct would include three main types of inventory — Raw Materials, Work In Process (WIP) and Finished Goods. Raw Materials are input (primarily through purchasing), then get added to WIP (with direct labor and overhead costs), and finally result in Finished Goods (ready to sell or lease). Compounding this complexity, many hardware companies keep spare parts on hand as a component of inventory, which may be used or sent out to customers if something breaks.

Hardware and robotics companies often have two types of fixed assets—equipment used in the production process, and machines that are sold or leased to a customer. Depreciation for each is handled differently. It’s helpful to have separate accounts for each. More robust systems may even allow for tracking and classifying by serial numbers (e.g., a certain tranche of serial numbers is mapped to Fixed Assets For Sale versus Internal Fixed Assets). The main point is to keep these types separate and allow the COA to track them independently.

There are some COA aspects that are unique to the world of hardware-as-a-service (HaaS) and robots-as-a-service (RaaS) as well.  It is common to have multiple revenue streams and costs of sales in the hardware and robotics world. For example, companies may sell a robot to the end user (sales revenue) and charge a recurring software fee (licensing revenue). With this type of bundled offering, cost of goods sold (COGS) for the sale ties back to the accounts used in building the unit, while COGS for software ties back to engineering and service accounts. Be sure to allow the financial statement mapping to keep these separate, because margins for each vary widely.

Given the nuances of the hardware industry it may be helpful to set up separate allocation accounts in your COA. For example, some depreciation expenses may need to be recorded as COGS. One would typically set up an allocation expense account at the bottom of the COA, so it’s easy to segregate and record the COGS expense and offsetting allocation amount. This does not change the bottom line, but allows for easier reporting.

The chart of accounts isn’t just for finance

Whether you’re building, re-design, learning or using your COA, keeping in mind the following principles should lead to a successful outcome:

• The COA is for everyone. If nothing else, remember that the COA is a tool for everyone in your organization, whether they know it or not. It’s for the sales team coding their expenses, the engineers building your hardware, and the marketing team planning their campaigns—just as much as for the accountants and FP&A teams. Every single transaction in your business hits the COA one way or another.
• Keep it flexible. A great COA is flexible. There are placeholders for growth and scaling; as your business grows and changes a good COA will adapt accordingly.²
• Keep it simple. Use plain English and steer clear of jargon when presenting it to users. In prior roles I have gone so far as compiling a data dictionary to accompany the COA.³
• Balance thoughtfully. There is always the temptation to pile detail upon detail, or to keep things as high-level as possible. Avoid the extremes and find the middle ground. As a general rule, it’s always easier to add than subtract!

1 As an example, every industry has terminology unique to itself. I worked at a movie studio and we had an account called “Home Video Exploitation” (DVDs!); Construction has its “Billings in Excess of Costs”. The main point is to know your audience and the words that resonate with them.

2 For example, take the Balance Sheet. Your business may have four bank accounts (checking, savings, payroll, investment account) and they have Natural Accounts 1000, 1001, 1002 and 1003. Senior management cares about total cash, not each individual account, so you would have a caption on your Balance Sheet, most likely called “Cash and Cash Equivalents” and underneath it you will roll up accounts 1000-1003. If you design your COA effectively, you’ll build a buffer and perhaps reserve Natural Accounts 1004 to 1015 for all current and future cash accounts. Even though you don’t have anything put there yet, you want the latitude to do so.

3 There’s a cost to granularity. Creating a separate Natural Account for each spare part may seem like a great way to give users limitless optionality, but it also creates confusion—the paradox of choice! Focus on what matters and what’s useful. This requires really understanding the needs of the business. And don’t be afraid to push back a bit in both directions.