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THE PRODUCT BUDGET – PUTTING IT ALL TOGETHER

By | 2018-04-22T04:40:12+00:00 July 7th, 2017|

We have talked extensively how to figure out the cost of making your product and putting together the product budget. We discussed direct material, direct labor and overhead cost. Knowing your product cost will ensure that you price your product high enough to fully recover the cost.

Computing product cost

Most entrepreneurs struggle with how to price their product. By taking the time to create a budget, you can quickly determine a baseline for a price. Below is the summary product budget for baking 1,000 cakes at  “My Cake Shop”.

By taking the time to create my budget, I know it cost me $105.03 to bake a cake. This is my product cost which becomes a starting point for my pricing strategy.

Questions for thoughts

Here are some key questions to ask as you make your product budget:

  1. What industry do I belong to and who are the key players in that industry
  2. How do the key players affect the cost of goods in my industry
  3. How can I cut cost by partnering with the key players
  4. What activities are essential to delivering my product or service to my customers
  5. Are there any activities I am engaging in that are not value creators for my customers but yet eating up cash

Summary

We have discussed knowing your product cost goes beyond just knowing what you pay; but understanding why you pay, what you pay. By accounting for the factors of production that make up your product cost, you can analyze if there are possible ways of reducing cost.

This helps you stay pro-active rather than being reactive in your business.

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PREDICTING DIRECT MATERIAL COST FOR A PRODUCT BUSINESS

By | 2018-04-21T20:23:00+00:00 July 7th, 2017|

Previously, we talked about how to predict cost of goods sold. In this article, we discuss how to predict direct material cost in a product business. Specifically, we will be using a bakery as our example.

As we learned from the previous article cost of goods sold consists of:

  • Direct material
  • Direct Labor
  • Applied overhead

I will take each of these components and discuss them in more details below.

Direct Materials

Cost of goods sold forecast is directly related to the forecasted sales units. Once you know how much you plan to sell, you can begin to forecast the units you need to fulfill your sales requirement. However, there are other factors that affect the actual quantity bought besides the number of units you plan to sell as discussed below

Determine the standards for making your product

Before you can effectively forecast the cost of your inventory, you need to start by forecasting the quantity you need. A good way to do this is to create standards as to what it takes to make one unit of your product or service.

I will be illustrating my point by using examples from my sample bakery shop.  In my bakery shop, I sell only one product, my famous cake relished by every one in my little town called “Themiddleofnowhere”. To make my cake I need the following ingredients: (for simplicity I am limiting my ingredients to only 2 items):

  1. 10 cups ready to bake flour
  2. 5 cups of cooking oil

Prep time for one cake (depending on skill level): 35 minutes

Bake time for one cake: 45 minutes

Include an allowance for normal waste

One of the biggest causes of stress in life, is people don’t add buffers to their schedules. In the same way not adding a buffer in life can be stressful, not adding buffers to tasks or materials needed could increase stress.

An allowance should be added for normal wastage. For example: time can be allocated to increased time needed for new staff. Or for unforeseen difficulties in carrying out their tasks. Or for the parts of the flour that is wasted if unusual shapes are needed.  Whatever it is, it is important to think of what type of wastage is normal in your line of business and incorporate that into your standards: No business has perfect processes.

In my cake business,  I decide to increase the quantity needed by 5% to allow for normal wastage.

Determine quantity to purchase for direct materials

Continuing with my example from above,  at a minimum I will want to purchase what I need to bake the 1,000 cakes as shown below:

However there are some other factors to consider before deciding what my purchasing behavior should be for the upcoming here.

Deciding quantity to purchase: External factors

Knowing how much material I need for my cake is not sufficient. There are other external factors I should consider that will affect my final budget. There are two (2) main reasons I want to consider external factors in deciding how much quantity to purchase.

  1. Firstly, I will need to know how much inventory I need on hand besides what is needed for production.
  2.  Secondly, I want to know whether my market has enough products to meet my sales forecast.

The external factors we consider are reflected in our quantity equation:

Market supply

Analyzing market supply, allows me to  answer the question, “Are there any crisis going on in my external environment that could hamper my supply of flour?” Flour is derived from wheat. Are there any issues being faced by resource owners (wheat farmers) that might affect my supply of wheat down the line.

On the other hand, I may want to see if there are any substitutes for wheat that could be cheaper but provide the same or better results. The number of substitutes available reduces my risk of limited market supply.

If after my research I find nothing, then probability is I will be able to get the supply I need for the cake. Thinking about this beforehand, helps me become proactive rather than reactive to circumstances.

It’s good business practice to be aware of what is going on in your industry.

If I predict market supply is low, I might want to increase the quantity I buy at time. In other words, in addition to the amounts I am ordering, I will always want to have a sufficient ending inventory on hand to make sure I meet my forecasted sales need.

Besides, considering the national/ international supply, I will want to consider my local circumstances. In my case, my bakery is located in a small town called Themiddleofnowhere. Supply in my small town is very limited and goods sold tend to be marked up at least 30% above market because of the high cost of transportation. So this means, I often have to travel at least 50 miles to get my supply of flour at normal market price. As a result, I like to carry at least 40% more inventory than I need for non perishable items. This bring my new quantity forecast to:

Business capacity

The next question I should ask myself is: “What will it take to sell 1,000 cakes?” In other words,

  • Do I have access to the financial resources required?
  • How much ingredients can I store at a time, etc?

Taking into account your limitations does not mean you cannot go ahead with the sales forecast, it just means you need to address them as you move forward. Admitting limitations is not a form of weakness but rather a sign of wisdom.

It might be that my business is capable of handling 200 units of flours at a time so I have to order in batches of 200. When inventory falls below 100, I order a new batch.

Also, I have to take into account the lead time between the date I order and the date I am likely to get my inventory. When a bigger lead time is anticipated, I will need more inventory on hand.

For my cake shop, I have both the financial resources and storage capacity to handle the inventory.

Quantities at which economies of scale occur

In my example above, I plan to buy 14,700 units of flour over a year. What if after talking to my supplier he promises a discount of 50 cents a pound if I agree to buy 800 more units. This decreases my cost of goods sold by 50 cents. This also means that I am tied into a 12 month contract with the vendor. 15,500 units is the minimum quantity at which the vendor enters contracts with customers.

The first thing I should do before accepting an offer like this is adjusting my sales forecast to see if I am able to sell the extra units. My little town can only eat so much cakes and raw materials only have so much shelf life. It is important to know if I can sell the extra inventory before it expires. Also, I do a quick check to see if I have the financial resources and business capacity to handle the demands required by those extra units.

For example, extra inventory might mean:

  • I have to increase marketing by another 5% to sell the excess products.
  • Have more cash tied into inventory (Do I have the financial resources?). ,
  • Increase the amounts of items I have to store (Do I have the storage capacity?)

It is important to be aware of the consequences of our decisions. While they may not stop you from taking action, being aware of alternative uses of resources is very wise.

I decide going into a 12 month contract to buy 15,500 units of flour makes more sense than not having a contract and buying the 14,700 units required by my sales forecast. A contract also works in my favor, because I can be assured of what my inventory will cost during the year. This keeps my cost stable. Also, I decided not to increase my sales forecast but keep the extra as ending inventory. Since flour has a long shelf life, it will reduce the number of units I need to purchase in the following year. My new quantity forecasted is as follows:

Quantity Purchased Summary

Now that I am done analyzing elements of my quantity equation. I ended up buying 15,500 units of flour and 7,350 units of oil.

You will have to undergo the same diagnosis for every significant item your purchase as inventory. If an item makes a very insignificant fraction of your cost, then going through this analysis might not make sense. You have to weight the cost against the benefits.

Price per unit

Once I have decided the quantities I need for my budgeting period, I can now forecast my price per unit as follows:

The purpose of thinking through this elements is to help you think through factors that could increase or decrease your cost. By taking proactive action, you stand a better chance of minimizing your cost and maximizing your profit.

Industry value chain cost

The value chain analysis is the cost of the (resource owners + all convergent agents) * their markup

(Resource owner cost * Resource owner markup) *(Markup for the number of touch points in the industry value chain before the goods gets to you)

It is important to evaluate the value chain for the product you buy. Sometimes cutting one link to the chain can significantly reduce your cost. For example, the oil I need, comes from the corn farmers, who sell it to the oil manufactures, who engages a distributor or  wholesaler,  before it finally it gets to the retailers.  Each business in the value chain adds their own markup.

The higher you go up the chain, the more it will cost you in investment to reduce your cost. Sometimes business owners get so accustomed to buying from retailers because that was their only option when they began. But as you grow in size, you gain more power to go up the value chain. And if you become really big, you can even acquire your resource owners or convergent agents.

After analyzing my value chain for my bakery, I decide at this point my business is small enough and I am limited to buying from retailers.  Nationally, the average retailer sells the oil I need at $1.83 per unit based on the quantity I am purchasing.

On the other hand, the price for my flour is under contract so my price is fixed at $4.50 per unit. This is actually better than the industry value chain cost of $5.00. Unless circumstances changes, further analysis of future price will do little good when I am on a contract.

Markup for scarcity/ markdown for surpluses

Since I reside in the middle of no way, the materials I need are usually scarce in my local area. This affects what I will be paying for oil. Since I buy lower quantities for oil, I could not secure a contract like I did for flour. Moreover, assuming oil has a lower shelf life than flour, the quantity I can carry at a time is very limited. So, I know majority of my supply will have to come from the local vendor who marks up his inventory by 30%.

In my case I will have to add a 30% markup due to the scarcity of the product in my area.

On the other hand, if I live in a city with tons of businesses that sell my product, my item will probably be on sale a lot. I can markdown my cost and plan to stock up when sales price goes down.

As said, thinking about these factors as individual items in determining price, forces you to think of alternatives rather than just accepting your normal.

Markup for inflation

Overtime the price of goods go up, you can use historical data to predict what percentage price might go up. Or you can just use the current inflation rate of 1.06%.

Price Estimation

After my analysis I come up with a unit price for flour of $4.50 and $2.40 for oil as follows:

The Direct Material Budget

Again, the point of this exercise is not to attain perfect accuracy but to help you think of factors that affect your business and where you can reduce cost. The lower your cost the higher your profitability. In the next post, I will discuss how to predict labor cost for my cake business.

Next – Predicting labor cost

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PREDICTING DIRECT LABOR COST FOR A PRODUCT BUSINESS

By | 2018-04-21T21:15:21+00:00 July 7th, 2017|

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: 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 at the level of skill needed. This will determine the total hours I need to hire.

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:

 

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HOW TO EFFECTIVELY PREDICT COST OF GOODS SOLD

By | 2018-04-22T04:45:28+00:00 July 7th, 2017|

If you are in business, you have heard of the terminology cost of goods sold. But what exactly is it?

In a product based business, cost of goods sold is the inventory you have sold to your customers. Before inventory is sold, the cost sits on the balance sheet as “merchandise inventory” and when sold, it moves to the profit and loss statement as “cost of goods sold”.

In a service business, your cost of services is what it cost you to directly service your customers. Since services are usually consumed as they are provided, there is no inventory in most true service businesses.

Here is how it works:

  1. When a merchandise business buys products for resale it is an inventory asset.
  2. When a merchandise business sells the product, it becomes cost of goods sold

Effectively predicting cost of goods sold

Inventory is the number one consumer of cash on the balance sheet. So effectively predicting your cost, is an essential part of cash management. A rise in cost of goods sold cause’s margins to diminish.  Rightly predicting cost of goods sold starts with accurately predicting sales. Once sales have been predicted, then we use sales numbers to effectively predict what our inventory level should be (i.e. quantity).

However, predicting the cost of the goods you sell is not as easy. Because besides knowing your sales level, there are other factors that affect the final cost.  This is what this article will focus on.

Inventory/ cost of goods sold cost is split into 3 parts

There are 3 components to inventory cost:

  1. Direct materials
  2. Direct Labor
  3. Product overhead

The total cost of your goods sold will be tied in to the cost of these individual components. Click on each hyperlink to see details of each component. Each of these components have many factors that affect their estimation while developing your budget. Once you have learned about each component, click here to see how they all tie together.

Next:  Predicting Direct Materials

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CREATING A RELIABLE REVENUE FORECAST WITH KPIS

By | 2018-04-22T03:24:48+00:00 July 7th, 2017|

Every business owner will like to make more profits, but becoming the master of your business is a disciplined act. You can never master your business if you do not take the time to plan and execute. In this series, I am going to take line items from the financial statements and discuss how to use KPIs to determine those numbers. I start with revenue on the income statement, and then discuss the other items on the income statement, balance sheet and cash flow statement in other posts.

The Income Statement/ Profit and Loss Statement

The income statement tells the business owner how much was made, spent, and left during a period of time. The entrepreneur has to be careful he/she does not overspend labor, cash and other resources. If the business is taking out more than it is putting in, bankruptcy is inevitable. Anticipating what is required to achieve the planned growth is essential. With careful planning, problems can be better diagnosed and the right solution can be implemented.

This article focuses on the revenue line item on the income statement. To achieve growth, pay close attention to the KPIs discussed on this page. Growth is the natural result of using the right systems with the right right product /market fit. To be the best in your chosen niche, you need metrics. You can try to wing it but your lack of a measurement system will always pull you back!

Choosing Key Metrics: Revenue

There are two (2) systems required to accurately predict revenue:

  • The customer acquisition system: For a business to consistently bring people in, the market has to be big enough to have people who need your service or product. If you were a dog walker but only 10 people in the world had dogs, your market will be limited to only 10 people.
  • Customer retention system: Not all customers return after their first purchase. So therefore while projecting revenue, the customer retention rate needs to be considered. To increase your customer retention rate, you will need to develop a system for engaging customers. Acquiring new customers is more expensive than retaining existing customers. Keeping existing customers happy has to be a part of your marketing strategy.

Customer Acquisition KPIs

#1) The Target Market Size

Your market size is based on how many people have the problem you are attempting to solve. For example if I make the best pizzas and will like to solve the problem of eating a quick lunch in downtown Chicago, my target market will be the number of people looking for a quick lunch in downtown Chicago.

The more defined the problem you are solving, the easier it is to define the size of your target market. It is important to note that defining your target market is not a one time event. For those who want to expand, brainstorming other markets that need your solution will be a great way to grow. But it is best to start with a very targeted market and then grow from there. The more targeted you are, the easier potential customers can find you. Having a clearly defined market, is your first task in using predictive accounting. Without knowing who your target market is you cannot move on to the next step.

#2) The Market Reach

Market reach are the number of people you can reach through your promotional efforts. Whether you are a brick and mortar business or an online business, you need a way of getting in-front of your targeted market. For a brick and mortar store, the location determines how many people will see the business in a day. For an online store, the ability to pop up in searches is one of the criteria’s used to determine traffic. There are many techniques used to drive traffic to your site or store which will not be discussed here.

Using our pizza business example, if the market size is 600,000, and you plan to reach potential customers through social media and foot traffic, your market reach will be calculated as follows:

  • Number of people who walk past store during lunch = 5,000
  • Number of people that can be reached through social media strategy = 100,000
  • Total market reach = 105,000

The key is to go where your potential customers hang out.

#3 Response Rate

The response rate are the percentage of people who are reached by your message and respond. For example, in our pizza business example, a passerby might agree to have a taste test.  This is different from the conversion rate which we discuss next. A responder simply takes an action but has not yet brought out his or her wallet. At this stage you have a prospect. A prospect is a potential customer.

#4 Conversion Rate

Congratulations! You now have traffic and people are beginning to notice and respond to your messages. But unfortunately, getting new customers is not that easy. Your next step is making them bring out their wallet. Depending on what you sell, you might need a funnel to encourage people to buy. A funnel is a series of steps your prospects go through to convince them that you are worth spending money on. In our pizza example, the conversion is very simple. Convert your foot traffic by having them try free samples or convert your social media followers to stop by with a coupon. If they like the offer, they come in the restaurant to make an order.

However, when you sell professional services, you have to convince prospects they should trust you so the process is more involved than getting people to buy a slice of pizza. You will need to get prospects into some type of marketing funnel where you can reach out to them on a regular basis with valuable resources that will enrich their life. The more you can enrich people lives, the more likely they will eventually pay you for your services.

If you have a long funnel, you have to track the conversion rate at each point of the funnel. This is the only you can figure out how to improve your conversion.

#5 Price

Depending on how big you want to become you need a pricing model that can scale. Sure you can charge 10,000 dollars an hour but how many customers can you realistically attract at that price point. Your price is not a function of your cost but what the market is willing to pay.

You can be successful in defining your target market, getting the traffic to your door, converting them to almost paying customers and then just as they bring out their wallet, you tell them the price. They put their wallet back in and say maybe another time.  You have to understand your target market and how much they are willing to spend on a problem. Using our pizza example, the average person who eats lunch in downtown Chicago will not spend more than $10 for a personal pan. So if your personal pan is $20, you might get people to try it once but it is not a scalable price.

On the other hand, if the average Chicago pizza lover who eats downtown is used to spending $10 on a personal pan, and your cost is $2, they will walk away because they will think something is wrong with your pizza. Your probably have rat & cockroach meat disguised as sausage toppings.

There are so many factors that affect the price you charge, but the bottom line is your price depends on how much power you command in the market place. Some ways you can affect price are:

  • Innovate a product people are willing to pay for but no one else produces a substitute (monopoly). Here you have the most power because if it is a product people really want, they will pay what you are asking for it.
  • Or you may choose a product that only few other people produce but highly differentiate yours to drive consumers to you (oligopoly).
  • Or if you choose to compete with everyone else, be sure to develop a strategy to differentiate yourself or become the cost leader.

Customer Retention KPIs

#1 Number of Existing Customers

Depending on your business, the way you define customers will vary. You can choose to define a customer as someone that patronizes your business, or someone who visited once, etc. For my purposes, a customer is someone who has done business with you at least once with whom you have enough information to contact frequently for repeat business. In other word, someone who is interested in building a relationship with your business over time.

For example, in our pizza business, 12,200 people visited the establishment last year but only 12,000 of them agreed to give contact information. 200 of the first time visitors never returned or provided contact information. I personally will not define the 200 as customers because I have no way of building a relationship. For my purposes, they were tire kickers.

The way you define customers will determine how you spend your retention marketing dollars. Do you want to spend money on tire kickers or do you want people who are willing to build a relationship with your business? I think you are better off letting the 200 go and focusing on the 12,000.

#2 Average Number of Repeat Sales Per Customer

The average number of repeat sales, is the number of times the typical customer comes to visit during the measurement period. If the typical customer visits once a month (over a year), then your average number of repeat sales is 12.

#3 Retention Rate

Retention rate is the percentage of customers you keep engaged. Using our pizza business example, of the 12,000 that chose to build a relationship, 100 of them stopped responding. For whatever reason, they decided not to patronize the business or respond to any of the offers.

When a customer has initially shown interest in patronizing and all of a sudden stops, this is worth investigating. It might be a new competitor, a bad experience, etc. Unlike the tire kicker, you do not want a once interested customer to simply die out without finding out why. If you ignore the problem, it might be the beginning of the end of your business.

To compute your customer retention rate, use the following formula:

(Number of customers at end of period – New customers acquired during the period)/Number of customers at start of period.

The Formula for Predicting Revenue with KPIs

Using the above KPIs we can predict your revenue as follows:

  • Target market size * Market reach * Response rate = Prospect
  • Prospect * Conversion rate (how many customers convert at the last stage of your funnel)= Acquired customers
  • (Acquired customers) + (Existing customers * Retention rate) = Total customers
  • Total customers * Average price * Number of repeat sales per customer = Total Revenue

The more systematized your processes are, the more reliable your predictions will be.

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Understanding the Financial Statements

By | 2016-09-26T00:25:40+00:00 September 26th, 2016|

There are 3 questions that should be answered when starting a business as follows:

  • How much profits was generated by the business over a given time
  • What is the accumulated wealth of the business at any point in time
  • How much cash flowed through the business

These three questions are answered by the:

  • Profit and loss statement
  • The balance sheet statement
  • Statement of cash flow

When these 3 statements are viewed together they tell the financial health of the business.

Grouping the elements of financial statements into financial reports:

The element of financial statements are grouped into 2 main financial statements or reports:

  • The Balance Sheet
  • The Profit & Loss Statement

The other 2 financial statements (statement of changes in equity and the cash flow statement) are derived from the 2 statements mentioned above.

The elements of financial statements are represented in the balance sheet and profit and loss statement as follows:

Balance Sheet

1.    Assets

2.    Liabilities

3.    Equity

4.    Investments by owners/ contributed capital

5.    Distributions to owners

Profit and Loss Statement

6.    Revenues

7.    Expenses

9.    Gains

10.    Losses

 

The Balance Sheet

The balance sheet is the statement that expresses the accounting equation Assets= Liabilities + Equity. It is the statement of the financial position at any point in time. The balance sheet can be compared to a picture. A picture freezes a moment in time.

An example:

Its family picture day and you are taking a picture with your children. Just before the picture, your children are teasing each other and making faces. But, just before the picture is taken, everyone puts on a big smile and then, snap, the picture is taken. This is exactly what a balance sheet does, it takes a snapshot so when we see the picture we only see what happened as of that date. Just before the snapshot, assets and liabilities could have changed hands to make the picture look better.

The profit and loss and cash flow statement is a great complement to the balance sheet because it shows the teasing that took just before the picture.

The elements of the financial statement and the balance sheet statement

The elements of financial statement that show up on the balance sheet are as follows:

1.    Assets

2.    Liabilities

3.    Equity

4.    Investments by owners/ contributed capital

5.    Distributions to owners

Element #1: Assets

An asset, is a resource controlled by the business. The major characteristics of assets are as follows:

  1. A probable future benefit: this means that there is expectation of some future monetary value. If Uncle Joe owes you money for lemonade he bought today, the amount he owes you is an asset because you expect to collect in the future.
  2. The business controls the resource and the benefit: unless the business has control it cannot be considered an asset of the business. If a business leases a vehicle, the vehicle cannot be considered an asset to the business if the business does not control or have exclusive rights to the vehicle.
  3. The event or transaction bringing about the benefit must have occurred: For instance if I agree to purchase a piece of equipment next month, the equipment is not an asset to me just yet.
  4. The asset must be measured in monetary terms: you have to be able to assign a value to the asset. The value of loyal customers are hard to determine so do not appear on the balance sheet.

Once an asset has been recognized on the books of a business, it will continue to be considered an asset until the benefits are exhausted or the business disposes of the asset. Also, assets does not have to be a tangible items: There are also intangible assets like patents and copyrights.

Example problem

State which of the following items will appear on the balance sheet as an asset:

  1. Uncle Joe buys lemonade from your lemonade stand and promises to pay later
  2. A business hires a new marketing director who is expected to increase profits by 40 %
  3. Purchased equipment which is expected to save the business $15,000. However, the equipment was purchased on credit.
  4. Purchased inventory which is expected to be resold at 40% profit
  5. A $5,000 debt from a customer who will never pay

Asset Accounts

Detailed information of the elements of the financial statement is kept in records called accounts. For instance, a business usually maintains more than one asset, so dumping every asset into one account will not tell much about the business. An informative statement will have different categories for each asset like cash, equipment, inventory, etc.

Other examples of assets and their definitions are as follows:

Account

Definition

Cash Currency, checks, balances in checking and saving account, money orders, certificate of deposit, and any other item that is payable on demand
Accounts Receivable Expected future cash from current or past sales. Accounts receivables arise from allowing customers to buy now and pay later
Inventory Goods finished and ready for sale
Prepaid Expenses Future benefits arises from prepaying for an expense. For example if you pay your insurance premiums 12 months in advance, the prepayment is an asset to you as you still have unused benefits.
Supplies Items used in the business. Supplies are often bought in bulk and not immediately consumed. The unconsumed portion is an asset to the business. When an asset is consumed it is expensed to supplies expense.
Land Land
Buildings Buildings
Computers and Equipment Computers and equipment

Classification of Assets

Assets are further classified into long and short term.

Long term assets

Long term assets: are assets that will produce future benefits more than a year from now or a business operating cycle.

Long term assets are often referred to as fixed asset. Fixed assets are defined according to the purpose they were acquired for. For example if you buy a vehicle for marketing in the balance sheet it will be labelled “Marketing Vehicle” on the balance sheet. Fixed assets are held with the intention of generating future revenue. Examples of fixed assets are land, building, computer and equipment, etc.

Short term assets

On the other hand, short term assets produce future benefits less than a year/ operating cycle. An operating cycle is the average time it takes a business to convert inventory to accounts receivable and finally into cash.

Short term assets are also referred to as current assets. Current assets are expected to be converted to cash (or use up related benefits) over a relatively short period. The most common type of current assets are cash, accounts receivable and inventory.

Claims on assets

A claim is an obligation of a business to provide some type of benefit to another party. There are 2 types of claims to asset in a business:

  1. Liability
  2. Equity

Element# 2: Liability:

Liabilities represent the claim of parties outside the business on the business assets. These claims arise from past transactions or events. Examples of events that create liabilities are loans from a bank or buying inventory on credit. Once a liability has been incurred, it remains a liability until it has been settled.

An example which is not so obvious to students learning accounting for the first time is unearned revenue. Unearned revenue is liability you incur when customers pay you in advance for a product or service. When customers pay in advance, you are indebted to them until you perform the service or deliver the product.

Other examples of liabilities and their definitions are as follows:

Account

Definition

Accounts payable Is a promise to pay a supplier or vendor for goods delivered now. It’s analogous to buying on credit or buying on account. That is, buy now and pay later.
Short term notes payable Short term notes are promissory notes due in less than 12 months. Short term notes should be used to finance short term cash needs.
Line of credit A line of credit is credit extended by a bank and is available to the borrower at their discretion. A line of credit works a lot like a credit card in that you are extended a credit limit and you do not have to reach your limit every month. The total amount is due in the next billing cycle and any amount not paid is charged interest. Line of credit are good for stabilizing cash flow.
Wages payable Wages payable is an account used to record the cash amount you owe your employees for time they have worked but not being paid. This amount is usually determined at the close of an accounting period.
Interest payable This is the interest owed on unpaid loans, notes or any other payables the business may have.
Unearned revenues Unearned revenue is a prepayment for goods and services. As a result, you owe the customer the good at a later date. You do not earn the cash given to you until the service is performed.
Long term notes payable Is a note with a payment due longer than 12 months
Long term loans A loan is paid in installments and is normally due over a 12 month period.

Classification of liabilities

Just like assets, liabilities are also classified as long or short term. Long term liabilities are debt that are payable in over a one year term frame and short term liabilities are payable under a year time frame.

Exercise

State which of the following will appear on the balance sheet as a liability:

  • A loan from a bank
  • Inventory bought from a vendor on credit (also called on account)
  • Uncle Joe paid you for a cup of lemonade in you lemonade stand and said he will get the cup of lemonade later
  • Aunty Lucy bought a cup of lemonade but promised to pay later

Element 3: Equity

Equity is the claims of the owner against the business.

How can the owner have claims on the business?

Owners have claim on the business because the owners of the business are regarded as separate entities from the business. This even applies to sole proprietors. In accounting a clear distinction is made between the owner and the business. Therefore, any funds contributed by the owner is seen as a claim against the business.

Retained Earnings: A very important equity account

Retained earnings is the cumulative earnings of the business less distributions. In other words, net income from the profit and loss statement gets added to retained earnings. Owners of the business have claims/ rights to this earnings.

The retained earnings account increases the equity account.

Retained Earnings This is the accumulative earnings of a business less the withdrawals and distributions.

There are 2 elements of the financial statement that are classified under the equity namely:

  • Element 4: Investments by owners/ contributed capital
  • Element 5: Distributions to owners

Element 4: Investments by owners/ contributed capital

Are increases in equity due to contributions from owners? Owners frequently transfer assets (usually cash) to the business in exchange for equity (ownership). A contribution by owner increases equity.

Other accounts that define owner’s contributions are as follows:

Common Stock Common stock represents ownership in a corporation. It is the owner’s contribution to increase equity in the business.
Owners capital In a sole proprietorship or partnership, ownership is represented by capital contributions. Capital contribution increases equity in the business

Element 5: Distributions to owners

Amount withdrawn by owners from the equity of the business. Distributions reduce equity and could take various forms. For example: In a corporation, distributions to owners are called dividends. In a sole proprietorship, these distributions are called drawings.

Owners drawing This is the amount a sole proprietor takes away from the equity of the business
Dividends This is money paid to owners of stock in a corporation

Putting it altogether: The Balance Sheet

Once we know what elements belong to the balance sheet statement, we can draw up our first balance sheet. The balance sheet is the statement that represents the accounting equation. The balance sheet has 3 main sections namely:

  1. Assets
  2. Liabilities
  3. Equity

Let us do an example to see what a balance sheet looks like:

A balance sheet example

Uncle Joe deposits $15,000 in a business checking account on January 2nd, 2014 in order to begin Joe & Co., Inc. Uncle Joe is 100% owner of Joe & Co., Inc.

Uncle Joe also borrows money from his sister (your mom) Cecil in the amount of $5,000. Prepare the opening day balance sheet statement.

Joe and Co. Inc.

Balance Sheet as of January 2, 2014

Assets
Cash $20,000
Total Assets $20,000
Liability
Loan from Cecil $5,000
Total Liability $5,000
Equity
Common Stock $15,000
Total Liability and Equity $20,000

The assets of the business must equal the liabilities + equity.

Interpreting the balance sheet

  • The liquidity of the business: Liquidity is the ability of the business to meet short term obligations with its cash. Liquidity is important because business failures happen when business cannot meet it short term obligations.
  • The mix of the assets held by the business: The relationship between fixed and current assets is important. Businesses with funds tied up in fixed assets are vulnerable to financial failure. This is because fixed assets are not easily turned into cash to meet short term obligations.
  • The financial structure: the ratio of debt to equity financing is important. More debt financing means more interest expense and less profits in the business. Debt financing have to be repaid regardless of the cash position of the business and can be a really burden in economic downturns.

Profit and Loss Statement

The balance sheet tells us the financial position of a business at a particular time. However, business exists to generate profits and businesses need a way of knowing how much they have made in their business over a period of time. The profit and loss statement fills this need. The profit and loss statement has been often defined as a moving picture. Unlike the balance sheet, the profit and loss statement tells a story of a period in time.

Revenue is a measure of the inflow of assets (cash) or the reduction of liabilities (unearned revenue).

Relationship between the profit and loss statement and balance sheet

The profit and loss statement links the balance sheet at the beginning of the period with the balance sheet at the end of the period. In other words, the profit and loss shows the wealth generated during the period.

The relationship of the profit and loss to the balance sheet can be expressed in the following way:

Assets = liabilities + owners’ equity

Assets = liabilities + capital contribution + retained earnings

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

Remember – retained earnings is the accumulation of prior earnings retained in the business.

The revenue and expense elements are represented in the profit and loss statement.

The elements if the financial statement represented in the profit and loss statement

Element 6: Revenue

Revenue is income received from the services and products of a business as part of its normal operations. As we mentioned earlier, accounting is a language and just like any language one object could have multiple names. Other names of accounts that represent revenue are shown below:

Service Revenue Is money received in exchange for service provided by the business as part of its operations
Product Sales Money received in exchange for a product a business sells as part of its operation
Consulting Revenue Money received in exchange for consulting provided by the business as part of its operations

Element 7: Expenses

An expense is the outflow of assets or increase in liabilities which is incurred from generating revenue. Expenses can also be defined as cash paid out or liabilities incurred to fulfill the needs of the business operations.

Classification of expenses

The classification of expenses is often a matter if judgment of those who design the financial statement. For instance some businesses choose to group all insurance expense into one account and some businesses may break out insurance expense into auto insurance, liability insurance, etc.

The classification is based on the kinds of information useful to the user.

The following are examples of ways expenses are classified in a business:

Salaries/ Wage expense This is money paid to employees in exchange of services provided.
Supplies expense This is money spent on supplies
Rent expense Money paid in exchange for using an asset like a building
Utilities expense Money paid for utilities
Marketing expense Money paid to promote services and products
Insurance expense Money paid to protect the business from risks

Non-operating revenues/ expenses, gains and losses

Non-operating revenue is revenue received by a business from events not part of its normal operations. For example interest received from loaning money to another party. If loaning money is not part of the business operations then the interest received is non-operating revenue.

Examples of non – operating revenue/ expenses are:

Interest revenues Is revenue received from loans made

Element 8: Gain

Gain is the difference between the sales price and the cost of an asset. When the sales price exceeds the cost we have a gain.

Element 9: Loss

 

Loss is the difference between the sales price and the cost of an asset. When the cost exceeds the sales price we have a loss.

Difference between an asset and expense

The main difference between an asset and an expense is that an expense is consumed in the process of earning revenue while an asset is used in future revenue production.

Putting it altogether: The Profit and Loss Statement

Once we know what elements belong to the profit and loss statement, we can draw up our first profit and loss statement. The profit is the statement that tells how much a business has made in a given period. The profit and loss has has 3 main sections namely:

  1. Revenue
  2. Expenses
  3. Non-operating income

Let us do an example to see what a balance sheet looks like:

A profit and loss example

Uncle Joe received $15,000 in exchange for providing consulting services on January 2nd, 2014. In order to complete the consulting service, Uncle Joe hired Lucy and paid her $5,000 in wages. Uncle Joe also sold business equipment and gained $500 from the sale.

Prepare the profit and loss statement.

Uncle Joe’s Inc.

Profit and Loss Statement

For Period Ended January 31, 2014

Operating Income:
Consulting Revenue $15,000
Operating Expenses:
Wages Expense $5,000
Net Operating Income $10,000
Non-Operating Income
Gains $500
Net Income $10,500

Review questions

  • There has been an ongoing debate about placing the value of human assets on the balance sheet. Do you think humans should be treated as assets? Why or why not?
  • Uncle Joe started a t-shirt printing business. He got $20,000 in cash from Auntie Annie as a loan. Uncle Joe contributed $5,000 of his own money.
    • Define the element of financial statement affected by these transactions
    • Create accounts for each transaction
    • Match the elements to the financial statement
    • Represent the transaction using the accounting equation
  • The following is a list of assets and claims of Uncle Joe’s Kitchen as of December, 31st 2014
    • Cash 20000
    • Vehicles 30000
    • Loan from mom 15000
    • Cash from personal funds 35000

    Required:

    • Define the element of financial statement affected by these transactions
    • Create accounts for each transaction
    • Match the elements to the financial statement
    • Represent the transaction above using the accounting equation
  • What characteristic of an asset differentiates it from an expense?
  • The following account titles were drawn from the general ledger of Joe Co, Inc.
    • Computers
    • Rent Revenue
    • Building
    • Cash
    • Accounts Payable
    • Office Furniture
    • Salaries expense
    • Rent Revenue
    • Service Revenue
    • Dividends
    • Utilities expense
    • Gains
    • Losses

    Required

  1. Match these accounts to the elements of financial statement
  2. Match the element to the right financial statement
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Redefining Business Success: Income Creation versus Value Creation

By | 2016-05-18T19:23:25+00:00 May 18th, 2016|

In its most basic term, success means to achieve ones goal. So to achieve success, there has to be goals. In this article, I will be discussing financial success from a business owner’s point of view.

Most business owners I see define success by the amount of revenue they bring in. It feels good to say I bring in over a million dollars in revenue. However, I have seen business owners who bring in over a million in revenue but are laden with debt. So we can see revenue alone, does not define success. If you cannot live the life you envision, no amount of money can make you successful.

So if revenue does not define financial success what does?

What does business success look like? I think most business owners will agree with me that being successful in your business falls into 2 main categories namely:

  1. Accomplishing personal goals
  2. Meeting financial goals

However, personal goals are often ignored as most entrepreneurs strive to achieve financial goals. Why should one be in exclusion of the other? Entrepreneurs need to learn that a business exists to meet your goals
and not the other way around. Being married to your business is not useful to you in the short or long run. In the short run it causes excessive stress and in the long run it makes your business unsellable. The more you strive for revenue, the more profits run away from you.

Even more stress – striving for financial goals.

Maybe as an entrepreneur you skimmed on a few personal goals. The consequences will not be as bad if the entrepreneur did not also mess things up financially. A lot of entrepreneurs I meet are not very smart in financial matters. Most have an income goal but never even think of having a net worth goal. As an entrepreneur, how do you define value in your business?

Business value is defined by how much a willing party is willing to pay to acquire your business. The more an acquirer is willing to pay, the more value your business has. If no one is willing to pay anything for your business then you really need to rethink your strategies because you are running a worthless business
regardless of how much income you bring in. What you have created for yourself is a job and not a business.

The amount an acquirer is willing to pay is a function of risk. One way to evaluate the value of a business (what an acquirer is willing to pay) is:

Business Value = Present Value of Cash Flows, discounted back at the discount rate.

The discount rate has 2 elements – the cost of capital element and risk element. The discount rate is increased if potential buyers believe your business is risky. The cost of capital – is the rate that you must pay to obtain funding from lenders or equity investors. In other words, if the cash flows to the firm are held constant, and the cost of capital and risks are minimized, the value of the firm will be maximized. By minimizing risks, you maximize the value of your business. Simultaneously, the higher risk, the higher your cost of capital. Your first task as an entrepreneur is to de-risk your business so business value can be maximized. There are several ways to do this but that is not the focus of this article.

Re-evaluating debt financing: Using debt to increase business value

Every day you make decisions that affects the value of your company. One of those decisions is choosing to finance your growth with debt. While I do not encourage personal debt, business debt can actually be a good thing if used wisely. Business assets are either built from equity or debt. If you can use debt to increase assets, then it is better for the business.

So, when is it good to take on new debt?

For debt to affect value, there has to be a tangible benefit. There are 3 scenarios you should consider:

  • Benefits exceed costs – when benefits exceed cost, the returns on the investment exceed the cost of the investment. When this is the case, the business owner will have an increase in income which causes an increase in equity, assets and value. For example, a retailer borrows $80,000 from a line of credit to buy inventory, the interest rate on that inventory is 6% per annum. The retailer knows they can sell the inventory within a month and pay the amount borrowed plus interest with no problem and still have $70,000 left after both principal and interest payment. In this case the retailer pays $400 to make $70,000. I see no reason why the retailer should not go for this. When benefits exceeds costs, there will be an increase in value.
  • Benefit and cost are equal – when benefits exactly equals the cost of investment, then business value is not affected. In scenarios like this you should have other compelling reasons to take on the investment.
  • Benefits are less than the cost: If the benefits are less than the costs, increasing debt will lower value. In this case, debt becomes a value destroyer.

Your optimal debt to equity ratio, is the one that maximizes your overall business value.

Summary

Eighty percent of businesses today are worthless.

To have value a business owner must manage risks effectively. Value is a function of risks. Everything you do that mitigates risks enhances value. Moreover, a business owner must be able to create value above the businesses’ required rate of return/ discount rate. Any investments executed below the required rate of return should be rejected because this will destroy value.

Build a good foundation before growth. Growth in itself does not necessarily generate value. Slow down
and form a solid foundation. Every business should have a rhythm which drives up value. Remember, business success is not achieved until you can live life like you envision it. The way to do this is to focus on creating value rather than simple income goals. You are in control of your business, you should use your business to get what you want from life and not the other way around.

Take some time to reflect on the following questions before doing anything else:

  • Who do you want to be?
  • What do you value most?
  • What kind of life do you want?

These are the values that will direct your business and determine your definition of success ….


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Why should small business owners have a budget?

By | 2016-05-04T02:44:39+00:00 May 4th, 2016|

Jacob a 14 year old boy is a straight A student. His method each school year is to study just enough to get an A. He never really stopped to think how his performance compared with other students in other schools or never really had a plan for college. His mindset was as long as I keep getting A’s I am fine. When Jacob applied for college, he did not get into the first school of his choice because he applied to a very competitive schools where other students had done more than simply get A’s.

A lot of business owners are like Jacob. They think, “As long as I sell as much as I can, and keep my employees paid, I’m doing OK”. The danger of this thinking is, without planning you will find yourself left behind some day. Sales number could start dropping due to market changes you failed to keep track of because you were too busy doing “ok”. Budget and planning forces you to think and examine the market you operate in. It also forces you to look for new opportunities that could take you to a whole new dimension. A good budget also helps with cash flow management. It balances receivables with cash flow.

A budget can have a significant impact on human behavior. For instance it can inspire top management to achieve a higher level of performance. What gets tracked, gets improved. Doing as much as you can is not the same as systematically building up. The budget exists within the framework of a sales forecast that shows potential sales for the industry and the company’s expected share of such sales. By constantly comparing to the industry, you can see opportunities much clearer than trying to “do as much as you can”.

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How sellers can forecast better to manage cash flow

By | 2016-04-30T15:41:39+00:00 April 30th, 2016|

There are so many factors to consider when forecasting.  The processes required to forecast correctly are many but interconnected. For example you cannot manage cash flow if you don’t have a good forecasting system. In this article, I will be discussing the main steps to take in developing a budget/ forecast. Budgeting and forecasting work hand in hand. Once you have a budget in place, you can determine how much cash is needed to run the business.

Below are the steps to take before planning for cash:

Get an overall plan

 Any serious business owners should sit down at least annually to decide what direction the business is going to take. At this time a budget should be put together. A budget is simply a formal written statement of the business owners plan for a specified time period, expressed in numbers. A budget signifies agreed upon objectives and goals of the business. Budgets promote efficiency.

Without a budget it is hard to forecast because you have no basis for which to draw on. Budgeting and forecasting work hand in hand.

Sales forecast

A budget is designed around the sales forecast. The sales forecast is the very first step one must take to develop a budget. Most business owners use past performance as a starting point in developing a sales forecast. This is why keeping track of marketing activities is vital. The better the data is, the better the forecast.  A sales forecast must take into consideration the following:

a)    Potential sales for the industry and general economic conditions:

b)    Marketing plans

c)    Technological development that can help improve productivity

Forecasting is highly dependent on your marketing system. A good marketing system will achieve the following:

a)   Increase the predictability of sales: A good marketing system should be able to estimate what kind of outcomes to get from various marketing campaigns. Also a good marketing system packages and prices products in a way that increases the recurring nature of the sale.

b)   Increases the reliability of data: A good marketing system tracks “relevant metrics”. Note the word relevant: You have to know what is important to the success of your business. Tracking the wrong metrics is worse than not tracking.

c)   Increases the accuracy of the budgeting process: With good data and effective pricing and packaging, the accuracy of data in the budgeting/ forecasting process is increased.

Once the sales forecast is completed a sales budget is developed.

The Purchase Budget

Once the sales budget is done, the next step for a retailer (steps are different for manufactures and service businesses) will be to develop the purchase budget. The purchase budget shows the number of units to purchase to meet the forecasted sales. The purchase formula is as follows:

Budgeted sales unit + Desired ending inventory – Beginning inventory = Required purchase units

It is important to realistically estimate ending inventory based on the forecast. Excessive inventories is a problem especially if you sell perishable goods. There is additional cost to the business in keeping more inventory than needed. For example your cash is tied up in inventory and you can’t do other things you need in your business. On the other hand, too little inventory could mean lost sales.

Direct Labor Budget

 Once the sales and purchase budget are done, the next step is to determine how much labor is required to make the forecast come to reality. At this level, we are only worried about labor that directly interacts with the product (all other labor is part of the business overhead).  For example, you will need to pay someone (or do it yourself) to assemble the product if required, manage the logistics, manage the warehouse (assuming you sell a physical product), etc. The higher the volume, the more labor required. With a good budgeting system, you will be able to narrow down to how much labor is required to move one unit. The formula to determine your total direct labor budget is:

Units to be purchased * direct labor hours per unit * Direct labor cost per hour = Total direct labor cost.

In this phase, using activity based costing is so useful in determining how much labor is needed per unit.

Marketing Budget

Once you have created your sales, purchase and labor budget, you should create a marketing budget. A marketing budget is putting your marketing plan in numbers. This is directly related to your sales forecast. Here determine how much it will cost you to achieve those numbers.

Overhead Budget

Of course we all know that it is hard to run a business without some type of overhead. We want to minimize overhead as much as possible. Your overhead budget should distinguish between fixed and variable cost. At this point, you should have determined your optimal cost structure. Your optimal cost structure is the ratio of fixed to variable cost that maximizes your profitability. Your overhead is the catch all for all your expenses that don’t fall into the essentials such as purchasing, direct labor and marketing (remember, this is for a retailer). Your overhead will include things like rent, taxes, management salary, etc.

Budgeted Income Statement

Once you have the above budget in place, you are now ready to create your budgeted income statement. As a retailer you should use a multistep income statement as follows:

Revenue – Cost of goods sold (this comprises your purchases and direct labor budget. How you come up with the cost of goods sold is a topic for another post) = Gross Margin

Gross Margin – Marketing expenses – Overhead = Net Income

The Cash Budget

Finally, we come to the cash budget.  Anybody who has been in business long enough knows that cash, revenue and expenses are not always simultaneous. This is why you need a good understanding of how cash flows through your business. Cash is the life blood of your business.

Your cash budget should comprise of the following sections:

1)   The cash receipts section

2)   The cash disbursement section

3)   The financing section

Your cash budget should be divided into intervals that are important to the business. This depends on how quickly cash flows in and out of the business. For most businesses, forecasting monthly will be sufficient. If you use the monthly interval, and cash disbursements are expected to be less than cash receipts then some type of financing is required. A prudent retailer should aim to build long term relationship with some type of lender. I have clients that do vendor financing, some have line of credits and some just have high enough margins where they hardly ever have a cash short fall, so therefore need no financing. The cash budget should show expected financing and repayments plus interest. More details of how to do this will be discussed in a later post.

For the more ambitious retailer: The budgeted balance sheet and capital expenditure budget

For the retailer looking to increase the financial value of their business overtime either to pass it down or sell it, it is recommended to have a budgeted balance sheet and capital expenditure budget. That is all I am going to say about this for now.

Phew! No wonder people pay CFO’s to take care of this. Retailers who have sophisticated financial systems like the one described above sell at higher multiples.  Hope to see you in my next post …

Excellence is continuously putting yourself out there even after repeated failures. Mediocrity is resting on your laurels.

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Pricing in a very competitive market

By | 2016-04-29T03:09:48+00:00 April 29th, 2016|

Pricing is an important topic faced by all entrepreneurs. There are many factors that affect the price of a product or service. The purpose of pricing is to enable the entrepreneur to gain market share while achieving a target rate of return. Pricing must be high enough to cover the cost of doing business while earning a reasonable profit. In some cases, due to high level of competition, a business owner is unable to set the price of its products or services. This happens with mostly commodity services or products where customers see little difference between competitors’ products. If this is your case, then you need to get serious about watching your cost.

As a small business owner in a competitive market, you are a price taker. To stay profitable, you need to control cost by setting a target cost of making your products or services. The formula for target cost is as follows:

Market price – desired profit = target cost.

If the business owner cannot reach this target cost, then it will not reach its desired profit. Once a target cost is reached, the business owner will need to work with its team to make sure that the cost of production stays within the target cost.

It is difficult to operate in a competitive market. It is even more difficult if cost is not controlled. A small business owner facing fierce competition must set a target cost and must be careful to stay within the target limit.

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Lifestyle CPA

Financial Keepers, LLC
Innovate Springfield
15 South Old State Capitol Plaza,
2nd Floor Springfield, IL 62701
Telephone: 417-812-5945

Phone

417-812-5945