Understanding Your Business – Charles Zeugner, CPA

Understanding Your Business: Setting the Right Price

One of the more challenging things for small business owners to do is to set prices correctly. Figuring out what to charge for goods and services requires figuring out how to charge enough to cover expenses and make a profit while not charging so much that potential customers will refuse to pay. There are several theories about pricing. One theory that works with commodity type products says to charge a very low price and try to sell a lot. Another theory that works with specialty items or very high quality items is to charge a premium. Your approach will probably be somewhere in between those two approaches. Before you can do anything, however, you must know what it costs you to produce your product.

If you break your costs into parts, you will find that you have both fixed and variable costs. Fixed costs are the costs that you have before you begin selling anything. Variable costs are the costs of each product that you sell. If your business is a coffee shop, your fixed costs are rent, utilities, payroll, and the like. You will have those costs even if you sell no coffee or food. Your variable costs are what it costs you for coffee, food, and whatever else you sell. Fixed and variable costs behave differently as your sales increase. Variable costs per unit sold usually stay the same. If costs you a dollar to make a cup of coffee, put it in a cup, and then wash the cup when the customer is finished, then if you sell 100 cups of coffee your cost is $100. If you sell 500 cups, your cost will be $500. Fixed costs, on the other hand, get less expensive per unit as you sell more. If your monthly rent and utilities total $2,000 and you sell 1000 cups, your fixed cost per cup will be $2.00. Your cost per cup will drop to $1.00 if you double your sales. In this simplified example, if you 1000 cups of coffee in a month, you will have to charge $3.00 per cup to cover your variable cost of $1.00 plus your fixed cost per cup. If you sell 2000 cups, your price can drop to $2.00. Even though the variable cost remains the same, your fixed cost per cup is only $1.00.

The lesson is that your price must be high enough to cover your variable costs plus some portion of your fixed costs plus a reasonable profit.

Understanding Your Business: Budgets

One of the things that I help my clients understand is budgeting. Using a budget seems like something that should be easy. Unfortunately, many people have some misconceptions about budgets, and that makes using a budget harder than it needs to be. In this article, I will briefly explain some common types of budgets and address the budgeting myth that makes creating and using budgets difficult.

Let’s begin by answering the question, “What is a budget?” There are a lot of ways to answer this. The easiest answer is simply that a budget is a plan for resources. In a business setting, budgets are plans for income and expenses. However, budgets don’t have to be just about money. They can be a plan about any type of resource. A SCUBA diver, for example, will budget air for a dive by considering how much air is contained in a tank and how rapidly a diver uses the air. Farmers may develop water budgets that consider rainfall, humidity, how much moisture crops need, and how much water must be purchased for irrigation.

Many small business owners get along just fine without using budgets. Their businesses may be small enough or simple enough that they can keep track of everything without a budget. However, at some point, most businesses need to begin budgeting to be successful. Service businesses need to consider how many hours of service they can provide, and they need to manage their overhead. Manufacturing businesses need to track raw materials and job costs as well as sales so that they can be efficient. Businesses that resell goods need to be able to track inventory and sales. All businesses need to keep track of their cash, and growing businesses need to plan for capital purchases. If all of that seems complex, don’t worry. Once you understand budget basics, then the budget will make these things easier.

While it seems like there are many ways to create a budget, we will consider three simple types: 1.) Operating, 2.) Cash, and 3.) Capital. The next few paragraphs will summarize each type. I’ll provide more detail in later articles.

Operating Budget

An operating budget is a plan for obtaining revenue. and managing expenses. The most difficult part of preparing an operating budget is making accurate estimates of sales. I’ll spend an entire article describing how to build an operating budget later. For now, simply recognize that your sales drives both your income and your expenses. Begin by estimating what you will sell. From that you should be able to develop an estimate for your gross sales. Then figure out what it costs you to produce the goods or services that you sold. That is your costs of goods sold. Subtracting your cost of goods sold from your gross sales will leave you with gross profit. Note that the sales and cost of sales figures are typically variable expenses. The next item in this type of budget is going to be your general and administrative expenses. This includes items such as rent, equipment, office supplies, and similar items. The key to successful budgeting is to put in the effort to make accurate estimates for each category of expense. Another important point about operating budgets is that they are typically used over a single operating cycle. It is possible to create an operating budget that covers several years, however the out years in a multi-year budget are frequently unreliable.

Cash Budget

A cash budget is a close cousin to the operating budget. However, the intent of the budget is to help plan cash flow. Cash does not always track business activity in a firm. Business owners extend credit to good customers, and vendors often offer terms. Businesses also borrow and repay debt, and they purchase expensive capital items. Most business owners recognize that they need some sort of minimum amount of cash. The aim of a cash budget is to help manage cash flow so that the business can maintain the minimum desired amount of cash on hand. For each month in your budget, begin with your cash on hand. Then add your cash income. This is going to be equal to any cash sales. Remember that not all sales are cash sales. Some sales are credit sales. Add the current collections for credit sales to the cash sales number. Add any other cash from other sources. Next subtract all of your cash expenses. Remember that if you purchase goods or services on terms that you may not have paid cash. Use only cash expenses. Then subtract all your payments for previous expenses that are unpaid. The balance will be the cash available to your business.

Remember your minimum desired cash on hand? Compare your available cash to your desired minimum. If your available cash is less than your minimum, then you need to find a way to increase your cash. If the available cash is greater than your minimum, then you may want to pay down a line of credit or use your excess cash in some other productive manner.

Capital Budget

Businesses frequently need to make large purchases that cannot be made from operating funds. It is one thing to purchase office supplies or inexpensive office equipment. It is something else to purchase expensive equipment, furnish an office, or replace a company-owned automobile. Sometimes businesses can save and purchase the types of things. Sometimes businesses must borrow. In either case, smart business owners plan these purchases. Remember that the operating budget typically covered a single year and included operating expenses. A capital budget covers many years and includes expensive items that would normally be capitalized and depreciated. For example, most computers have a working lifespan of three to five years. A smart business owner would develop a plan for replacing the computers periodically. A commercial property owner might also develop a plan for HVAC replacements and roofing.

Budget Myths

The biggest myth about budgeting is that once the numbers are entered, the budget is fixed. Remember that a budget is based on estimates. As more information becomes available or as circumstances change, estimates can change too.

Another myth about budgeting is that variance or results different than what was planned is bad or reflects some sort of failure. That is not necessarily true. The problem with budget variances is when they cannot be explained. I’ll write more about this at a later time.

The most important things to know about budgets

A budget is a plan based on estimates. The most important reason for preparing a budget is that it forces you to think about your business and make assumptions about sales, revenues, and expenses. It also gives you a plan for the operating cycle.

A cash budget helps you keep track of your cash flow.

A capital budget is a tool that you can use to plan expensive purchases over a period of time in the future.

All budgets are based on estimates and information that was available at the time. Budgets can be dynamic and change as information becomes available and circumstances change.

Understanding Your Business: Keeping the Books II

I’m frequently asked why it is important for small businesses to keep their books in good order. Some of my clients run their businesses with nothing more than a checkbook and a notepad. If you are a small business owner and you can keep track of everything that way, great. However, businesses grow, and when they grow they tend to become more complex. Many business owners discover that the simple checkbook is no longer sufficient. Keeping track of receivables and payables and inventory becomes increasingly difficult with a notepad and a spreadsheet. As a business owner, you use many tools to manage and grow your business. Those tools might include advertising and marketing, staffing, and bookkeeping. Your business toolkit should grow as your business grows. Whatever stage of business you are in, you need to be able to keep track of your activities and summarize your results.

You need to keep books your books organized and produce financial statements for two reasons. The first reason is that you need them to manage your business. The three financial statements give you a complete picture of the financial health of your business.

An income statement summarizes your revenue and expenses. It is a picture of the activity that took place over time. Some people call this a profit and loss statement.
A balance sheet summarizes your assets and liabilities. The balance sheet is a snapshot of what you own and what you owe.
A statement of cash flows summarizes your sources and uses of cash. If you want to know if you made or spent cash in operations, investing in your business, or financing your business, the cash flow statement is the place to look. The statement of cash flows is very important if you are using accrual accounting.

The second reason is that you may need to provide financial statements to other people such as lenders or your tax preparer. If you want to borrow money, your lender will want to have some assurance that you will have enough profit and cash flow to cover the debt service and that you will ultimately be able to repay the loan. Your tax preparer will need to be able categorize all your transactions to be able to prepare your return. Your business may be small enough that your tax return does not require a balance sheet, but you will still have to summarize your revenue and expenses.

Here’s a sad but true story that makes the point. Several years ago, I had a client with a small manufacturing business. He produced limited runs of very high quality goods on contract. In the beginning, he was the only employee. He made the sales to customers. He purchased the raw materials and made the goods. He ran his entire business with just a checkbook and he kept invoices, receipts, and records in a shoebox. As time went by, he grew. He had enough volume with his suppliers that they began offering him trade credit. He began expanding and started adding customers, including some large accounts. Some of his newer accounts took longer to pay. He wasn’t worried about the slow pay, because his vendors were giving him terms, and he was making a lot of money. Unfortunately, he was still managing his business using a checkbook and a shoebox. By the time I met him, he had lost track of what was going on in his business. The slow pay by some of his accounts could have been managed, but he did not know how. He could not keep up with his payables and his vendors began demanding cash on delivery. He was running a cash basis business and trying to manage receivables and payables, but he did not have a way to account for them. He started writing checks to pay vendors so that they would stop complaining that he was past due, and then his checks bounced. When I asked why he did not hire a bookkeeper or at least purchase bookkeeping software and learn to keep his own books, he told me that it cost too much. It is true that he saved money by sticking to his checkbook and shoebox. But the money he saved was more than offset by the cost of losing control of what was happening in his business. Losing access to trade credit meant that he needed more cash to run his business. He had to turn away business because he could not always purchase raw materials. Not having a robust bookkeeping system meant that he could not keep track of his slow paying accounts and he was unable to do anything to speed up collections. Finally, once he started losing control of his checkbook, the fees for overdrawing his account quickly added up. To make matters even worse, while he may have avoided paying bookkeeping fees, before his tax preparer could prepare his tax returns, he had to turn the shoebox full of receipts and invoices and the checkbook and bank statements into a set of financial statements. In effect, the tax preparer did a year’s worth of bookkeeping in two weeks. It turned out that he paid for bookkeeping after all. Unfortunately, it was too late to do him any good.

This example is a cautionary tale. As your business grows more complex, so should your accounting processes. The business owner above managed just fine with his checkbook and shoebox until his business began to grow.

My colleagues in the accounting world have similar stories of small businesses that outgrew checkbook and shoebox accounting. Savvy business owners realize that the processes they use in their business need to grow along with their business. Whether you hire a bookkeeper or do your books yourself, as your business grows, make sure that your management toolkit grows as well. However you manage your books, keep them in good order and make sure that you can summarize your results.

Understanding Your Business: Keeping the Books I

One of the things that I enjoy doing as a CPA is helping business owners understand their books and bookkeeping. I’m going to begin posting a series of bookkeeping tips that past clients have found helpful. If you have a question about something, let me know. You are probably not the only person with the question, and after I help you, I may be able to add another tip.

If you have a business, you keep books. I know that some business owners run everything just using a checkbook and a notepad. Other business owners use spreadsheets. Still other business owners use some form of accounting software. How you manage your business is up to you. The important thing is that whatever approach you use, it allows you to keep track of what is happening in your business. Your record keeping system should help you figure out where your money comes from and where it is going. Since this article is about accounting, we’ll use the terms revenue and expense.

Before getting too far into this topic, it is probably a good idea to cover two simple concepts. The first is the accounting equation. It is easy to remember, and if you are a business owner, you know it already even if you don’t know what it is called.

Assets = Liabilities + Equity

Most businesses start when the owner invests money and property that he or she already has or borrows money. Then as the business begins operations it starts having revenues and expenses.

Assets = Liabilities + Equity + Revenues – Expenses

One of the secrets of accounting is that everything ties back to the accounting equation.

The second concept is the accounting cycle. Accountants like to organize things by creating arbitrary cycles. In business, these cycles are typically quarters and years. You may find it helpful to use some other period such as a week or a month. The accounting cycle is simply the steps that are used to organize and report financial activity within a business. The first step in the accounting cycle is to analyze and categorize a transaction. All that means is figuring out how to classify a financial activity. Was it a purchase? Was it a sale? Did the business borrow money? Depending on the complexity of your record keeping system, there could easily be eight, nine, or more steps. For our purposes, we’ll keep it simple. Adjusting entrees and closing temporary accounts are beyond the scope of this discussion.

Analyze and record transactions
Assign the entrees to accounts
Prepare financial statements

You probably have a few questions. The most common question is, “What is an account?” The easiest answer is that an account is a category for transactions of similar types. For example, accounts might include sales or expense, and they would group transactions by whether goods were sold to a customer in exchange for payment or were purchased from a vendor. Accounts also categorize “things” such as assets like inventory or supplies, or debt. Businesses try to have accounts that represent all major types of business activities. The accounts themselves are organized by type: Asset, Liability, Expense, Revenue, and Equity. The types should be familiar now that you know about the accounting equation. The listing of accounts by type is called the chart of accounts.

Now that you know about the accounting equation and the accounting cycle, and you have been introduced to the chart of accounts, it is time for the first two tips.

Your chart of accounts should look like your business.
Simple is better.

What does it mean to say that the chart of accounts should look like your business? It simply means that you should have accounts that match the types of transactions that you are likely to have. For example, all businesses need revenue and expense accounts. If you are a simple service business, you might only need your cash accounts, a service revenue account, and miscellaneous expense accounts. If you purchase goods for resale, then you need a purchases account and an inventory account as well. If you manufacture products, then you may need raw materials, work-in-process, and finished goods inventory accounts. If you are required to collect and remit sales taxes, then you may need a sales tax payable account. If your business has employees, then you will need accounts for payroll and payroll taxes.

This is not as confusing as it seems. When you start planning your bookkeeping or accounting system, first think about your business processes. Then build your system around what you actually do.

The second tip is that simple is better. Avoid the temptation to have lots of accounts. Many business owners start out with too many accounts. This is easy to do if you confuse products with accounts. In my business, I work with individuals, small businesses, and not-for-profits. The products I provide are accounting services, consulting, and tax preparation. It might be tempting to have an account for each type of product and each type of customer. That is nine sales accounts! If I were a very large accounting firm with lots of employees and thousands of customers, I might find it useful to be able to analyze my sales activity that way. As a small business, however, I do not need to do that. Having nine sales accounts would make my books more complex and not provide any useful information. Business owners also tend to make their expense accounts too complex. Consider office supplies. Most business owners have a single office supplies account. However, other business owners have separate accounts for paper, file folders, pens and pencils, and more. It’s possible that those business owners need that detail. It is more likely that they don’t. Whenever you add an account there is a tradeoff between making your books more complex and the benefit you receive from the extra account. Keep in mind that it is possible to have too few accounts. I once had a client that had three loans: a loan from a family member, a bank loan, and money that he loaned the business. The business owner lumped all three loans into a single loan account. To further complicate matters, payments were simply recorded as loan payments without regard to the principal and interest component.

Remember when you are setting up and managing your books, they are a tool for you. The only reason to do anything is that you want to be able to see what is going on within your business. Your books help you track what you purchase and sell. They help you see your sources and uses of cash, and they help you keep track of the investments you make in the business.

Whether you are just starting out and creating a set of books or you are reorganizing your books, remember:

Your books should look like your business.
Simple is better.