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Are You Making the Right Costs Decisions as a Business Owner?

By | 2018-06-17T05:19:33+00:00 June 17th, 2018|Tags: , |

The world of business is rapidly changing! Outsourcing which used to be only for a few special projects is now becoming a common part of most business processes. This changes the way a business owner looks at costs they have to incur in the operation of their business. Take for instance the world of online business: people are making hundreds of thousands from the comfort of their home. Just ten years ago, what is happening today seemed impossible. Making this kind of money without incurring the high expenses associated with a business was a laughable concept.

It is time to think differently.

Thinking to grow your business the way grand ma did is not going to cut it anymore.

There are two broad categories of costs I will like you to consider when choosing your cost structure namely:

  1. Committed costs
  2. Discretionary costs

Committed Costs

Committed costs are costs an organization commits to for an extended period of time. It usually requires a contract and there are usually consequences for breaking the terms of the contract. An example is a 2 year phone contract.


Discretionary Costs

Discretionary costs are money wilfully assigned to a purpose. An example will be supplies bought in your business. It is important to note here that a discretionary cost does not mean costs you do not need in your business but rather it means costs that is more flexible in nature and can change as your business changes.

 

The rapid change in the business world is changing the structure of what can be called committed versus discretionary costs. It used to be labor used to be a committed costs but now with outsourcing it is becoming more discretionary. Most business costs are also moving in the same direction: That is from committed to more discretionary in nature. A good example is the cellular phone: most phone companies are beginning to realize in order to survive in the long run they have to get away from only offering long term contracts and giving people an option to only pay for services they need when they need it.

Discretionary costs allows for flexibility. That is you are able to change as the market changes. When your circumstances change, you will need the flexibility to change your cost structure to reflect the changes in the environment. Today it is possible to be more nimble in handling your business costs and taking on more than you should is never advisable.

Starting your business with discretionary costs

You have heard the term it makes money to make money. On the other hand, I think it takes wisdom to make money. There are lots of people out there that have taken very little money and turned it into a fortune by being disciplined. People who often say it takes money to earn money have not given much thought to how money can be made with very little resources. The costs of starting an online business are very negligent in nature. If you are willing to put time into growing your followers, you do not need a lot of financial resources.

The problem with people who unsuccessfully start businesses is that they start asking the wrong questions. Take a look below at 3 common questions asked and what should be asked in its place:

Wrong questions

Right Questions

How can I afford the “committed costs” needed to start this business (Committed costs could be machinery, rent, etc.)? What are the minimum resources I need to effectively serve my customers?
How much do I expect to spend in my first month or year of starting this business? How many units am I likely to sell and how do I directly link my profits to my costs per unit so I am not coming out of my pocket?
How much do I need in my marketing budget? How do I engage my audience so I can influence them to patronize me?

 

The wrong questions have one thing in common, they all deal with committed costs and the right questions are more discretionary in nature. It is difficult to stop thinking like grandmother; especially since things are still evolving. But, the idea that you need to have committed expenses to start a business is becoming ludicrous in today’s society. This is especially true in the labor market which used to be a business’s biggest committed costs. Websites like freelancer.com, elance, odesk make it easy to get what you need when you need it and only pay for what you use. Even seasoned companies are beginning to realize the change in the external environment and are structuring their labor force to become more flexible. Having more discretionary costs makes you nimble.

Cost Analysis

So now we know the difference between discretionary and committed costs, there is one more thing we need to do to stay nimble. At least on a quarterly basis analyze your costs to see if you are being efficient in the way you are running your business. It might be you have subscribed to services you are no longer using and will need to cancel.

Always, ask yourself how the costs you currently have add value to your customers.

The end result is you want to enrich your customer’s lives and the cost you incur should reflect this. If your costs are discretionary in nature then getting rid of non-value added costs will not be very difficult.

Non value added costs should not only be thought about in terms of money spent but also time spent on activities. The customer should always be in mind when adding or subtracting activities which consume time in your business. Your goal as the business owner is to continuously add value to the life of your customers. This process of continuously adding value is always on-going and the moment it stops, the business begins to die.

So do you have a business? How do you as a business owner determine what costs go into your business? Are your costs necessary? Do you add value to the lives of your customers?

 

Leave a comment below, I will love to help you make right costs decisions in your business.


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Four essential factors to achieving goals

By | 2017-08-16T12:58:32+00:00 August 16th, 2017|

Four essential factors to achieving goals
Four essential factors to achieving goals

To achieving goals, any goal, there are four essential factors that must be defined:

  • Your perspective: By clearly resolving what you want you are more likely to achieve it.
  • Your objectives: By quantifying what is really important to you, you begin to direct your efforts.
  • Your resources: By defining your existing resources, you know what you have and what you need to close the gaps.
  • Your priorities: By establishing your priorities you are equipped to make informed choices
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Achieving financial freedom from your business: Your Finances

By | 2017-08-15T21:18:05+00:00 August 15th, 2017|

Your financial system is the most important key to the puzzle to unlock your financial freedom. Marketing is the lifeblood of your business and with great marketing you can make great money. However, without a handle on your finances you can still end up broke.

Finance

Achieving financial freedom

Figure 1: Financial Freedom Plan

Your financial freedom system begins with having a financial freedom map.

Your financial system is made up of:

  • Your financial map: Your financial system starts with a map
  • Budget: Next the map is converted into numbers using what we call a budget
  • AIS: Update your budget in your accounting information system for comparison with actual results. While your accounting information system does not have to be done on a computer, using a computer eases the process.
  • Optimize: Develop processes and procedures around your financial system and optimize them overtime.

The steps to financial freedom are outlined in the map below:

Figure 2: Financial System

Business as a part of your financial freedom plan

The purpose of a business is to accumulate assets to produce future revenue. In determining your financial map you need to diversify where your financial freedom funds will come from. Your map should state what percent of your  freedom funds will come from various assets. Some of your financial funds might be allocated to real estate, some to paper funds and some to business. For instance my plan consists of 70% from business, 20% from real estate and 10% from paper sources.

You attain freedom when your assets are able to generate enough income to meet your needs so you no longer have to work for a living. You work because you want to. You attain financial freedom from your business, when your business gets to the points where it has enough assets that generates enough income. For this to happen, your business should have developed to the point where it has enough assets encapsulated by systems that consistently churn out income.

Beginning entrepreneurs attain majority of their income from transactions with customers. This plan cannot support financial freedom. To become financial independent you must become a level 5 entrepreneur where assets with the right systems consistently churn income.


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Income Statement Rich but Balance Sheet Poor

By | 2017-07-21T04:08:50+00:00 July 21st, 2017|

Income statement rich but balance sheet poor

People are so accustomed to boasting about how much they make but I think that is irrelevant. What is more important is how much of what you make do you get to keep. In other words you could be income statement rich but balance sheet poor.

Income statement

The income statement is the financial statement that tells you what is left over after subtracting what you spend from what you make. For instance if you make the average American income of $54,000 but spend $60,000 a year, you spend $6,000 more than you make. At the end of the year, you have nothing to show for what you made but more DEBT.

Balance sheet

Balance sheet is the statement that tells you what you have, less what you owe. Another way to say this is it tells you your net worth by subtracting your liabilities from your assets.

Any good wealth building strategy will take the excess from the income statement to build assets instead of liabilities. For instance, if you make $54,000 but spend $44,000 you have $10,000 left over to invest in income producing asset which in turn further increases your income.

When you overspend, it does not matter how much you make as you do not get to keep any of it. As a matter of fact, it seems the more you make, the poorer you really become. Poverty is when your balance sheet shows more debt than assets. Not only do you have nothing, you owe for what you don’t have. This is quite sad!

Proverbs 22:7 ESV

The rich rules over the poor, and the borrower is the slave of the lender.

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Achieving financial freedom from your business: Asset versus Transactional Model

By | 2017-07-20T18:10:28+00:00 July 20th, 2017|

The Asset versus the Transactional Model

The transactional model focuses on making money now while the asset model is more concerned with not just money earned now but can also produce income in the future. One of the characteristics of an asset is the ability to generate future revenue. To operate using the asset model, you need at least 3 systems as shown in the diagram below:

Income

Income

Transactional Model

It is very important to capture the value of what you do and be able to consistently replicate it without your direct involvement. For example, Ray Kroc does not have to be at every McDonald for it to run. Without capturing replicable value, your model looks like this:

Income

Income

Achieving financial freedom from your business

The asset model is more sustainable over the long run.

The transactional model earns income from the customer once without no way of repeating the sale. This is detriment to your financial freedom goals. If you are going to use your business as part of your financial freedom plan, you need a way of building recurring revenue. While the transaction model is a good way to start, it is not a good place to stop. To build financial freedom with your business, you need to work diligently at creating assets surrounded by system which in turn churns income.

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Achieving financial freedom from your business: Financial Independence

By | 2017-07-20T17:45:52+00:00 July 20th, 2017|Tags: |

A person becomes independent in their business by building assets.

Financial Independence

How does one become truly financially independent with their business?

Your main goal as a business is to build assets and then revenue from the assets (rather than building revenue directly). If you have just a product or service you will eventually hit the maturity and decline phase. However, when a business builds asset and then creates system around the asset to generate revenue, the business is sure to become a source of FINANCIAL FREEDOM. It also is a business that the business owner can sell if he or she so chooses to.


Assets could be tangible or intangible. When a business owner takes the time to develop systems so the revenue production process is not dependent on him, then he or she has built an intangible asset. This asset can be used to support the owners retirement goals.

Consulting/ Freelancing Model

In the freelancing model, the business owner derives revenue directly from the customer as shown in the diagram below:

become truly financially independent

The problem with this model is revenue is not preserved in assets. Therefore, as soon as the business owner walks out, the business dies also. This model cannot be used to preserve future revenue unless the owner was wise enough to take money out of the business to invest in other assets capable of meeting future retirement needs.

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Predicting Overhead

By | 2018-04-21T16:29:03+00:00 July 17th, 2017|

PREDICTING OVERHEAD FOR A PRODUCT BUSINESS

I want you to think of a person standing outside in the rain with an umbrella over their head every time I say the work overhead. The word taken in its most literal form means something that stands over the head of something to make sure all parts are covered.

Overhead expenses in business is the catch all for other expenses that does not fall into your direct material and direct labor cost.

Every business has 2 categories of cost

Every business has 2 categories of cost namely:

  1. Product cost – are cost associated with the production of your product or service. Product cost starts out as inventory and becomes cost of goods sold when sold. Product cost is made up of direct materialsdirect labor and manufacturing overhead.
  2. Period cost – gets its name from the way it is recognized in your accounting records. Period cost is accounted for in the same period it happens. Essentially, period cost are the costs that are necessary to run a successful business but not needed to make a finished product.

To keep this concept simple, I will be discussing only overhead involved in product cost here. My next article will discuss overhead classified as period cost.

Overhead associated with making your product

Previously, I mentioned that overhead consists of direct materials, direct labor and overhead cost. In this section, we break down overhead cost even further. Overhead associated with making your product can be broken down into indirect labor, indirect material and general overhead used in production.

  • Indirect material and indirect labor: Included in overhead, are labor cost and materials needed to finish your products but not directly used in the production of the product.  An example for my bakery, is someone is needed to move inventory from the storage space to the kitchen. While this is necessary, it is not a part of directly making the product.
  • Indirect- other: this is the catch all for all expenses not directly related to production. An example will be rent expense.

Predicting overhead

A prudent business owner keep overhead in line with business activity. The activity level in a business, are the set of activities that allows the business to meet the sales budget. With that said, smaller businesses need less overhead while bigger business usually but not necessarily spend more on overhead.

The mistakes some entrepreneurs make is engaging in more activities than is needed to meet the sales projection

Steps to predict overhead

Follow these steps to predict overhead:

  1. List all business activities
  2. Carefully detail what is needed to bring these activities to past
  3. Figure out the cost of one unit of the activity
  4. Determine a buffer
  5. Predict total cost based on activity level

First, list all business activities

Your overhead is determined by the level of activities needed to support your sales forecast.  In “My Cake Shop”, I start by describing my processes and list what activities are needed to support them. After brain storming, I come up with the following five main categories of activities:

  1.  Purchasing materials & supplies
  2.  Moving inventory
  3.  Preparing the ingredients for baking
  4.  Baking the cake
  5. Cleaning up after baking the cake.

Second, carefully detail what is needed to bring these activities to past

Every activity will need one of the following types of overhead to come to past ( we have already talked about direct material and direct labor and will not be including them here)

  • Indirect material
  • Indirect labor
  • Indirect- other

Below is the breakdown of activities in “My Cake Shop”

Notice how careful thought is given to each activity. One major advantage of budgeting is the owner can see how much time is needed to run his or her business. In the image above, you can easily see how many hours I am planning to devote to the business. As I become more profitable, I can hire out some of these tasks.

Third, figure out the cost of one unit of activity

To figure out the cost of one unit of activity, you will need to break down the cost to variable and fixed cost.

  • Variable cost: with variable cost, the price you pay for each unit does not change (or changes insignificantly during our budget year). An example will be detergent. We estimate variable cost by using the average price of one unit over a year. For example if on average I pay $5 for cleaning supplies, then my cost per unit is $5.

See the example for “My Cake Shop” below:

  • Fixed cost: fixed cost is cost that stays the same from month to month. An example will be rent. Estimate fixed cost per unit by :
  1. Figure out annual cost: For example if my monthly telephone bill is $80 a month, then my annual cost for operating the device is $960.
  2. Estimate daily usage:  It is important to note that you are not estimating based on what you need to make your product, but the total usage for the year. For example, if I am on the phone 50 minutes a day, I will estimate my total usage to be 50 minutes * 365 days. Some of these minutes might be personal and some of them might be for the general administration of my business (this is a topic we will visit later).
  3. Figure out the cost per unit: Cost per unit is annual cost divided by estimated daily usage

See an example for “My Cake Shop” below:

Fourth, determine a buffer

Life does not always go as planned. When you plan a budget, include a buffer to account for the unexpected. Based on past experience, you should be able to estimate how much buffer to add.

Buffers should account for wastage, unplanned activities, changes in the external environment.  If you live in an unstable economy, you will need a lot of buffer in your budget. For example, let us say you live in a city where the landlord can change the rent at any time. Let us also assume your monthly rent is $500. In the past your landlord has changed the rent once during the year at a 5% rate. If this is the case, you will need to add 5% buffer before finalizing your cost estimation. For my bakery, after careful analysis, I decide I do not need a buffer for my fixed expenses since I usually have contracts that guarantee the rate for the year. However, I decide to add a 5% buffer for variable cost as shown below:

Lastly predict the cost for these activities

Lastly, use the equation below to predict the cost for these activities:

Overhead cost =Activity level * buffer percentage * cost per unit.

See the illustration above for variable and fixed cost.

Conclusion

Activities are good predictors of overhead. By knowing what is required of your business, you increase your chances of succeeding.  Using activities to predict overhead is more efficient than historical data as it forces you to stop and ask “what is needed?”

Asking what is needed is crucial especially if you exist in an industry where the speed of discovery is quite fast.  Overhead cost could change rapidly due to the betterment of technology, number of substitutes available, etc. This causes the cost of goods to go down.

The long and short of this article is, “Know thy business!!!!

Next, we will put all this together to develop product cost. You can get free worksheets to begin your planning process here.

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Predicting Labor Cost

By | 2017-10-14T22:06:20+00:00 July 17th, 2017|

PREDICTING DIRECT LABOR COST FOR A PRODUCT BUSINESS

Previously,  we talked about estimating direct material for a product based business, now we shift our attention to direct labor. There are two main factors one must consider when deciding how much labor is needed to meet the sales forecast. Every business must consider:

  1. Number of hours needed
  2. Price per hour

Number of hours needed: The automate versus hire decision

Every business faces a decision when it comes to labor. The big question is how much should I automate or how much should I hire? When a business requires a large amount of labor, the business is known as labor intensive. On the other hand, a business that uses more automated equipment is known as capital intensive.

Choosing to be labor or capital intensive both have their good and bad side. Over the long run, automation saves payroll expenses, and is more reliable. However, it is not as flexible as hiring labor. Labor is trainable and can better adapt to change to the external environment. A capital intensive business will need a bigger investment to adapt to change.

It is easier for a highly automated/ capital intensive business to spend more time than necessary trying to save a concept that is failing. On the other hand, a labor intensive business can gather its workforce and initiate change much quicker. I personally think to be successful in today’s world, you need a good balance of both labor and capital. Leaning too heavily on one to the detriment of the other, is taking unnecessary risk.

The decision to automate versus hire, will affect the number of hours you need to hire. The more manual labor you hire, the more supervisors you need and the more complex to manage. So taking your time to decide the right balance is crucial. Once you decide your sales forecast, decide the right amount of automation versus labor hours that will be required to meet that forecast.

Number of hours needed: Skilled versus unskilled labor

Efficiencies increase with experience. An experienced labor set will cost more per hour but require less hours to complete the same task. For example, let us say you need an accountant and you hire Macy a recent college graduate with no experience. Because of her lack of experience you pay her less per hour. However, Macy could end up costing you more by increasing the amount you have to pay an experienced accountant to fix all the mistakes she made, all the delinquent fees you have to pay and let’s not forget the fines for missed obligations. So on one end, it looks like you saved money by hiring Macy but on the other end, you spent more than you would have spent if you just brought someone experienced.

Number of hours needed example

We summarize number of direct labor hours as follows:

Direct labor hours = Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set

In our previous example, My Cake Shop predicted it was going to sell 1,000 units. To figure out the number of hours I need to bring this forecast to past, I will need to:

  1. Figure out all processes I need to produce the number of cakes in my forecast. It will be most beneficial if I have written step by step processes.
  2. Figure how much I should automate versus do manually: For “My Cake Shop”, I decide that it will make sense to automate the icing process and manually do the other steps. There is no right or wrong answer, you just have to look at where you are headed in the long run and what makes sense for your business.
  3. Figure out the skill set needed for labor team and how much time it will take them to do it given their experience: Now that I know that I do not have to hire to ice the cake, I just need to figure out how many labor hours I need to make 1,000 cakes without icing.  First of all, I have to take a look the level of skill set I either have or plan to hire. Next, I estimate how much it will take a person with that skill set level to get the job done

Take a look at my estimation for “My Cake Shop” below:

Looking at the table it looks like hiring a level 5 skill to meet my labor needs will be most cost efficient. However, before I decide, I have to take into account how good my training process is and the learning curve effect.

In “My Cake Shop”, I have an excellent training program which can take a level 1 and turn them into a level 3 after making 200 units. So here is my new estimate based on my processes and taking into account the learning curve effect:

So just by having a good training program, I can reduce my total cost of hiring and get the same efficiencies as hiring level 5s. I enjoy an 8% discount on labor cost as a result of improving the skill set of my staff.

When you have clearly defined processes, and the job does not need lots of intuition or advanced education, it generally will cost you less to hire basic skills over the long run.

Price per hour

Price is affected by the supply of skilled labor. The wider the pool of candidates you can pull from, the lower the hourly wage you pay. Jobs that do not need an employee to be physically present can pull from a much wider range of candidates. The more candidates you can pull from, the lower the rate you will have to pay and vice versa. Moving your business to a location with a wide pull of candidates will drastically lower your total labor cost. Also, digitizing your work breaks down geographic boundaries.

Price per hour can be calculated as follows:

Price per hour = Average market price * premium for skill sets with limited supply

Price per hour: Average market price

The biggest factor that affects your cost of labor, is what the market is currently paying for that skill set. For example, the average hourly market rate for labor in the bakery industry in my area is as follows:

Because the minimum skill level I need in my bakery requires no formal schooling or experience, the pool of candidates I can pull from is so much wider. This makes it easier to attain the market hourly rate.

Price per hour: Premium for skill sets with limited labor

What of the opposite was true? That is, the minimum skill level needed required years of schooling, for example; a doctor.  In that case, my labor pool is more limited and the price per hour will significantly go up.

Let us assume my bakery needs someone to decorate cakes. And let us assume that the art of decorating was a very rare skill. In my community only 5 people possessed that skill, as a result, I will have to add a premium for the scarcity of the skill. So if I pay $18/ hour for a level 5 skill, the decorator will most likely expect $22/ hour.

One way to counteract the limited pool in the local market and bring price down is to find ways to digitize work.  In my bakery, I could hire someone outside of my community to make the design. I then program the design into my automated icing machine which works like a 3D printer.  In that way, I get very unique designs for half the cost.

In fields like accounting or medicine, this trend is becoming more common. By digitizing work, the labor force supply is increased and the hourly rate is decreased.

Summary

Industrial age training no longer suffices. We are in a new age which requires a new way of thinking. The world is no longer limited by geographic boundaries.  There is a big shift taking place in the labor market. Its time for a thinking reboot! The next time you want to hire, think of these sets of equations:

Direct Labor = Number of hours needed * Price per hour

Number of hours needed = Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set

Price per hour = Average market price * premium for skill sets with limited supply

Direct labor = (Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set) * (Average market price * premium for skill sets with limited supply)

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Investment KPIs

By | 2017-10-14T22:13:04+00:00 July 17th, 2017|

THREE KPIS  EVERY BUSINESS OWNER SHOULD KNOW BEFORE MAKING NEW INVESTMENTS

Occasionally, business owners find it necessary to make capital investments to further the purpose of their business. Capital investments are cash outflows beyond the normal day to day operations of the business. These cash outlays are usually made to increase revenue capacity or reduce cost. It is not financially savvy to make capital investments that bear no future benefits. You also should not use intuition to decide what these benefits are but logically determine estimates.

When to make capital investments

Capital investments are made when capacity needs to be increased or expenses can be decreased. Capital investments normally assist with streamlining operations and increasing efficiency. A capital investment should be made carefully. Sometimes an entrepreneur hears about a fancy new equipment, makes the investment, only to find out the equipment decreased overall profitability of the business. This is why you make capital investments knowing your required rate of return.

Required rate of return

You should go into an investment knowing how much you will like to get back in return. The required rate of return is the minimum return you wish to get from your investment. For example, if you are looking to make an investment and you are looking for a 20% return, then that is your required rate of return.  Your required rate of return is normally tied to the opportunity cost of your money.

Capital investment decisions take into consideration

  1.  Fund availability: Are there excess funds to make the investment or will the business have to take a loan. If a loan is taken, then the required rate of return must be higher than the cost of borrowing.
  2. Risk: The risk involved in the investment should also be considered. The higher the risk, the higher the minimum required rate of return should be.

Capital Investment KPIs

Cash payback period

The cash payback period is the time period it will take to recover the cost of your capital investment.  The cash payback period is computed as follows:

Cost of capital investment/ net annual cash flow

For example: Let us say you are contemplating buying a new office equipment. Your current equipment is at full capacity. You are turning away new business because your current equipment cannot deliver the work at a reasonable time. The missed work opportunities amount to $4,000 a month.

Your initial payment for the equipment is $15,000 with a monthly payment of $1,500 and monthly maintenance cost of $100. How long will it take you to recoup your initial investment (cash payback period)?

It will take as 6.25 years to get back your original investment. This number is neither good or bad. It all depends on your investment requirements and other qualitative factors.

In general, the shorter the cash payback period, the more desirable the investment. However, you should already have in place a policy regarding what types of returns are acceptable before making an investment. For example, you can say if the cash payback period is more than 50% of the equipment life, then reject the investment. In this case, it will take more than 6 years to get back your investment. According to our investment guideline, this is not an investment we should make. The lost opportunities will have to be more to meet our guideline of 5 years. With increased income also comes increased cash outflows.

However, quantitative factors should not be evaluated without qualitative factors. If this is a business with intense competiton, letting customers go to the competition might have long term consequences. The business can choose to make the investment and increase marketing efforts to  meet the investment guideline.

Net present value

The problem with the payback period, is that it does not take into consideration the time value of money. Using the net present value method, cash flow is discounted to its present value. The capital investment is subtracted from the net present value to see if there is a positive or negative return. In general, an investment is accepted if the return is positive.

Let us evaluate the same scenario mentioned above using the net present value method with a required rate of return of 5% and 12%.

The investment is acceptable at a 5% required rate of return but not at 12%. Be careful when choosing the discount rate. A discount rate should account for the associated risk. Higher risks means higher expected returns and higher discount rate. If the risk is under-estimated, then a lower than acceptable discount rate will be used. This will mean a bad investment will be made due to wrong assumptions.

While computing net present value, be careful to consider intangible benefits. For example, investment in an equipment might increase employee retention due to lower frustration. You can monetize intangible benefits by stating the benefits in dollars.

For example, on average you lose 2 employees a month at a cost of $5,000 a month including the cost of lost productivity. The cost savings from buying the equipment will be $5,000. To compute if the equipment is worth the investment, you will need to add the cost savings to the annual cash flow.

Internal rate of return

If you do not know what your required rate is, the internal rate of return could be a starting point. The internal rate of return is the point where your NPV (as discussed above) is zero. In other words it is the discount rate that will cause the capital expenditure to equal the present value of the net cash inflows. Using excel (formula =IRR(G9:G19)) we can determine the internal rate of return of the problem discussed above as follows:

Questions for thoughts

Here are some key questions to ask before making a capital investment:

  1. Do you know your investment return criteria? To increase your chances of success you must invest knowing what you hope to get from the deal. Sure, life does not always work as planned but your chances of succeeding are much higher if you invest carefully.
  2. Do you know the opportunity cost of your money? Is there anything else you can invest your money in to bring back higher returns. To set your investment criteria, you must understand your opportunity cost.

Summary

In summary, you must go into investments knowing what you hope to get from it and then using kpis to predict if these investments are likely to meet your criteria. Some example of investment criteria are:

  1. Payback period of must be greater than 50% of the assets estimated useful life
  2. Required rate of return of 20% based on opportunity cost of cash
  3. Return must exceed cost of borrowing

In most instances a company uses a required rate of return equal to its cost of capital — that is, the borrowing rate. Remember to set a good required rate of return you must consider your cost of capital and risk involved. Underestimating the risks will lead to bad investments.

Download the workbook related to this blog post

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THE SELLING & ADMINISTRATIVE BUDGET

By | 2018-04-22T11:08:41+00:00 July 7th, 2017|

We have talked about how to create a budget that coincides with making your product (product cost). What about the budget coincidental to selling and administering the existence of your product. The administrative budget consists of those expenses necessary to run your business but not needed to make your product. Example accounting fees, secretary, office, etc. The selling budget consists of expenses needed to sell the number of unit you plan to make. It should consists of retention and acquisition efforts.

Selling and administrative expenses can have a big impact on net income, thereby expenses here, need to be watched very carefully. It is important to create this budget by examining expense by vendor and ensuring each expense is still relevant to the smooth running of your business. It is possible to subscribe to services you needed in one year but bears no relevance to the next. However, because the fees are automatically deducted you still bear the expense.

The selling and administrative budget applies to both product and service businesses.

Budgeting for selling and administrative expenses

When it comes to selling and administrative areas, there are 4 key performance areas a business should be concerned about namely:

  1. Managing for growth
  2. Managing & protecting assets
  3. Legal requirements/ compliance issues
  4. Selling and Support services

Once you identify your key performance areas, your next step will be to list the activities and labor requirements needed in each key area. Do not forget to account for time needed to create the budget. The other activities are outflow of the budget.

My Cake Shop Example

In my cake shop, to sell 1,000 cakes,  I break my expense down into these 4 areas:

Managing for growth

  • Budget: Managing for growth starts with the budget.
  • Telephone: After creating my business plan and budget, I discover that in order to handle the sales call volume, I will need a phone system that can take up to 50 calls on a time while giving the customers automated options to take care of common issues themselves. This will cut down on the time me or my staff will have to spend answering phone calls.
  • Software: I also need a type of customer relationship management system. My fee to subscribe to such a system will be $500 per year.
  • Labor cost: I also need to hire a part time employee to make sales call and send direct mail.

Managing & protecting assets

Asset management includes the proper management of your cash, inventory, account receivables and other physical assets.

Cash management involves 

  • Making sure payments are made and deposited
  • Recording the inflow and outflow of cash in the accounting information system.
  • Creating weekly cash forecast to optimize the smooth running of the business
  • Investing excess cash to increase returns

Accounts receivable management involves:

A good accounts receivable management system starts with good policies and procedures. It is detrimental to start offering credit to customers before thinking about how you are going to get your money back. You also should not offer credit to customers who never pay their bills.

Accounts receivable is created when you perform work or provide a product to a customer in exchange for a promise to pay. It does not mean collecting money before work is completed. When this happens you have unearned income. This means that you now owe the customer either the obligation to complete the services or product paid for or refund their money. To effectively manage accounts receivable you need:

  • A policy and procedure system: these are written processes accessible by all staff. These policies should be consulted before extending credit.
  • An accounting information system: Your regular accounting system will most likely be able to effectively handle this. However, sometimes entrepreneurs find it beneficial to manage their accounts receivable outside their main accounting software. If this is the case, it is important to ensure your software is compatible for syncing purposes.
  • A/R staff: depending on the size of your accounts receivable you may need to hire a staff just to manage receivables.

Inventory management:

When you talked about direct materials, we talked about inventory. Besides making sure that you buy the right amount of inventory and pay the right price, someone needs to oversee the flow of inventory.  Someone has to be responsible for counting inventory, recording the quantity in the system. Also, you might need specialized software to manage inventory depending on how much inventory you carry. To effectively manage inventory you will need:

  • direct material budget/ previously discussed.
  • An accounting information system: Your regular accounting system will most likely be able to effectively handle this. However, sometimes entrepreneurs find it beneficial to manage inventory outside their main accounting software. If this is the case, it is important to ensure your software is compatible for syncing purposes. This accounting information system will play a big role in ensuring that inventory level keeps to the forecast. It also makes sure adjustments are made if actual revenue is below or above forecast.

Other assets

As we have moved from an industrialization age to knowledge age, financial reporting has to evolve to reflect it.  Other assets on a business’s balance sheet no longer includes just physical assets like building and furniture but should also include intangible assets.

Physical assets: The extent to which physical assets have to be managed will depend on the type of business. For real estate businesses the most valuable assets are the properties, for restaurants/ bakeries it will be the kitchen equipment. Managing assets involves developing a maintenance schedule, timely fixing of assets, etc.

Cost associated with managing assets include:

  • Repairs and maintenance cost: the routine repairs needed and following the maintenance schedule. Physical assets that follow a maintenance schedule last longer and are more reliable.

Intangible assets: includes the management of:

  • Trademarks, copyrights, patents: These are intangibles that can protected by the law. A business owner will need legal consultation to effectively file for these intangibles.
  • Content management: content developed creates additional value for the business owner. To manage content, a business owner will need a content management platform and database.
  • Human resource intangibles: include those activities used to increase the retention of your staff. High turnover is very costly to a business. And intangibles could be a great way to bridge that gap. Human resource intangibles could be broken down into 2 main categories:
  • Knowledge management: Knowledge:  knowledge management starts with the acquisition of knowledge, then using the knowledge to create assets, refinement of knowledge, storage and transfer. Proper knowledge management gives birth to innovation and promotes shared/ collective learning. The general outcome is an organizational culture with entrepreneurial spirit and improved relations with fellow employees, customers and vendors which leads to overall improved business performance. Happier employees are the key to customer retention. To effectively manage knowledge in a business, processes and procedures integrated into daily business practices must be created. Also, additional software must be purchased to secure content.
  • Employee Comforts: this is investment in physical assets to make the life of employees more comfy. For example, a gym, more comfortable chairs, etc. The difference between what is actually needed to perform the job versus what you buy is an intangible benefit.

My Cake Shop will be purchasing software to manage assets. The business is still small enough where a couple of hours, software and occasional consulting with an accountant will do.

Legal requirements/ compliance issues

As an entrepreneur, it is your responsibility to find out your legal requirements. You must develop systems to comply with this law or your business could be shut down. Most common laws business owners need to comply with are:

  • Tax laws
  • Human resource laws – minimum age requirements, minimum wage, payroll laws etc.
  • Business entity laws – the business structure you choose to operate in has specific set of rules you must comply with.
  • It is advisable to solicit the help of an attorney and accountant in navigating these laws. Trying to navigate it all on your own could cost you more lately.

Since My Cake Shop, is still very small, legal requirements and compliance obligations will be outsourced to an accounting and law firm.

Selling and Support services

It is not enough to make your products, you need customers to sell your products to. This could mean hiring a customer service rep, having a place to conduct your business (rent, utilities, insurance), hiring a sales force. Advertising in print and on social media, packaging the product for shipping.

All other activities besides making the product and selling the product falls under the administrative support overhead. Administrative support tasks include activities like answering phone calls and just making sure the little day to day task are accomplished.

In addition, investments made to improve the skill set are included as part of selling and administrative support expenses.

My Cake Shop selling and support activities are as follows:

  • Attend workshops on customer service and how to influence others. This includes  travel and meals.
  • Central hub for employees to sync processes. Get economically space.
  • Space to communicate with customers
  • Shipping expense
  • Attend conferences on leadership and growth

Steps to budgeting for selling and administrative expenses:

When budgeting for selling and administrative expenses, it is important to budget for the labor cost than you will the non labor cost. This will enable you to effectively access your labor needs.

To budget for non-labor selling and administrative expenses, follow these steps:

  1.  Break your business activities into the 4 key performance area
  2.  List the activities needed for each key performance area based on what it will take to meet your sales figure
  3.  List the vendors that provide  services for each activity
  4. Rank them in relevance – on a scale of 1-10, how important are they in performing the function they are designated to – consider what you get in return for what you pay:

Can you get these services or products for less without a decline in quality

 Is the vendor attentive to your needs as a customer

 Do you have a solid relationship with this vendor

Can you consolidate vendors so as to improve relationships which may privy you to deals available only to good customers 

5. Separate the fixed cost from variable cost

  • For fixed cost: estimate how much it will cost to execute the activity. In other words, what you pay the vendor each month. Since this amount is fixed per vendor, there is no need to apply the overhead formula discussed in the overhead section.
  • For variable cost:
  •   Figure out the cost of one unit of the activity
  • §  Determine a buffer
  • §  Predict total cost based on activity level

Selling & Admin Variable Overhead cost =Activity level * buffer percentage * cost per unit.

Eliminate Non Relevant Vendors

  • Any vendor in your current system who did not make it to the list is not relevant to your future success. If you have a subscription with this vendor, be sure to cancel it.
  • If a vendor performs more than one service, find an average score of all the services they provide, for example ABC corp in the diagram below provides 4 different services. Add the scores of all services together to get 34 and divide by 4 to get 8.5
  • If a vendor average score is less than 7, be sure to investigate alternatives. You want to maximize the benefits you get for what you pay.

Creating the budget for selling and administrative labor

Next, budget selling and administrative expenses based on your sales forecast. In other words, how much would you need to bring the sales forecast to reality? Do you plan to hire sales people? Remember the formula to determine labor cost:

Direct Labor = Number of hours needed * Price per hour

Number of hours needed = Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set

Price per hour = Average market price * premium for skill sets with limited supply

This formula holds true when specialized skills are needed. Most administrative jobs are easy enough that specialized skills are not needed. So the formula for administrative labor can be broken down to:

Direct Labor = Number of hours needed * Price per hour

However, be sure to account for skill surpluses and shortages if this is applicable to your business

Steps to creating the selling & administrative labor budget:

  1. Break your business activities into the 4 key performance area
  2. List the activities needed for each key performance area based on what it will take to meet your sales figure
  3. List the employees that provide services for each activity (contractors and vendors are part of your other overhead. Only services you perform in-house either by you or employee are listed here
  4. Rank them in relevance – on a scale of 1-10, how important are they in performing each designated activity. For each activity consider:

Examine workload and relevance of job

Can an employee be shifted into a new area more relevant to the business growth

Are employees stretched

Do you need additional employees to bring sales forecast to past

Can you outsource part of their job function and divert the employee to more productive tasks. If outsourcing is possible, add an outsourcing or automation cost to the non-labor budget and adjust your labor requirements accordingly.

Can you consolidate job functions so as to improve relationships with customers

 Is there any training you can provide to help employees become more efficient with the job

5. Separate the fixed salaries from variable salaries

  • Write salary by employee (including any proposed raise)
  • For variable cost:
  1.    Figure out the pay per hour
  2.    Multiply this  by the total estimated hours needed
  3.  If sales commission is part of sales structure, multiple commission rate by estimated sales

Notes for employees

If an employee performs a job function poorly, you might consider additional training, outsourcing or shifting the responsibility to another employee who performs it well. I believe in retaining hard working employees. Do not be too quick to let hardworking employees go because they perform an aspect of their job poorly. You can train, outsource or delegate to another employee the functions they do not perform as well. The budgeting period is a great time to evaluate changes you want for the coming year.

However If an employee scores below average on all functions, and you have tried training, you might want to consider letting them go. You are not doing the employee a favor by letting them say. They might not be a good fit for your business but might be a great fit for another.

Excel Worksheet Summary

Get the worksheet here

Not accounting for all activities brings about stress because you will have to take time for doing things that you did not account for. If one of the major activities is greeting customers as they walk in, then it is important time and expense for that be allocated. Do not leave anything to change. Also create a buffer in your budget because things do not always go as planned.

Summary

A budget helps you sort out the must haves, from the nice to have. With a budget you can evaluate the impact of an expense before you ever spend a dollar.

The selling and administrative budget is important because this is where a lot of expenses sneak into the business. If these expenses are not carefully evaluated, overtime expenses that are no longer relevant to sustaining your business stay on your income statement and reduce your profit. The goal is to operate as slim as possible. The less overhead you have, the more nimble you are!!!!

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