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Building a Profitable Business: Input, Process, Output

By | 2018-07-22T00:58:06+00:00 July 22nd, 2018|Tags: |

 

A business is a linked sequence of activities that transforms inputs into sellable outputs. In order to build a valuable business, you need very defined inputs, processes and outputs. The more specific you are about what you do, the easier it is to scale and the more profitable you are. If you know exactly what your customers expect from you, then you know how to compute your targeted profitability. You do this by:

  • Determining the cost of acquiring the inputs
  • Determining the cost of processing the input to the desired output
  • Determine the cost of serving the output


The total cost of providing a service of product= cost of input + cost of conversion.

There is also the cost of providing customer service for after the sale, but this is not discussed in this article.

The difference between what your customer is willing to pay and what it cost you to provide the service or product, is called profit. Thinking about cost from a process prospective helps you streamline your process.

Input

Input consists of the resources that are put into a business, also called raw materials. Let us use a dry-cleaning business as an example: In the case of the dry-cleaning business, the process, will include using a chemical solvent to clean the clothes. This chemical solvent is material directly needed to get the clothes clean.

Processes

Processes are the resources needed to convert the input into the output desired by the customer. Processes require investments in labor and overhead. In the case of the dry-cleaning business, the process, will require an employee and investment in a facility to get the clothes clean. The cost of paying the employee is known as labor cost and the cost in running the facility is known as overhead cost.

Output

Once the clothes go through the process, the customer gets his or clothes clean. The clean clothes are the results of taking the input through the process.

The input, processes, output in a dry-cleaning business are quite easy. This makes it very easy for a dry-cleaning business to explain what it does, which makes it easier to grow.


Suggestions

It is hard to grow a business when there are no defined inputs and processes. Be sure to:

Define what you do:
Be very clear about what customers can come to expect from you. Be sure to address the 5 W’s: what, why, when, who and where. Without these specifics, the customer determines the direction your business goes and you are forever playing catch up. While you should get input from your customers, they should not run your business.

Define how you do what you do: Once you address what you do, the next step will be how to do it. To stay competitive, you should take a look at how your competitors currently execute, and then see how you can improve upon it to gain a competitive advantage.

Define what you will need from your customer: the last step is to define what you will need from the customer to get the given output.


Summary

Building a valuable business could be a long ride. But be persistent and seek help when stuck. The question ultimately come to this: What exactly do your customers want and how can you best deliver it to them. Being a jack of all trade is the best way to stunt your growth. By giving your customers what they most desire, actually makes you a more desirable provider.

On the other hand, being a jack of all trade, decreases your overall business value. You are good for everything but best for nothing.

Here is a free spreadsheet to help quickly compute profitability

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Busy but unproductive!

By | 2018-04-22T16:42:41+00:00 April 22nd, 2018|Tags: , |

As entrepreneurs we sometimes confuse busyness with productivity. Busy means having a lot to do while productive means getting a lot done. We never have a problem with being busy, no matter how unproductive we are. Most materials about productivity have to with having a list, setting goals, etc. While all those things are important, being productive boils down to your willingness to do the boring stuff. Busyness is easy because having a lot to do distracts us from what really needs to get done. For example, the small business owner wants more cash but does not want to deal with the boring stuff that saves cash. Most businesses that are cash machines have learned to get on top of the boring stuff. In business boring equal cash and exciting equals broke. When someone comes to you with an exciting idea that’s just another way of saying, “I have not really figured out how to make money”.

Whoever works his land will have plenty of bread, but he who follows worthless pursuits lacks sense. (Prov. 12:11)

Passion has to be balanced with consistency and consistency is most often boring. Not being consistent is like driving a car with a back seat driver. Everyone else in your life tells you where to go. You have to learn to commit to the vision: The reason you started the business in the first place.

The only real risk in business is losing the vision. If you are focused with direction, risk is greatly minimized.

Just before you think, business is one boring exercise, there are always going to be new challenged to reignite passion. But you will never experience these new challenges if your never conquer the basics.

Do you see a man skillful in his work? He will stand before kings; he will not stand before obscure men. (Prov. 22:29)

I wish you a very productive day!

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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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Bad Accounting, Bad Information, Wrong Action!

By | 2016-02-04T15:49:48+00:00 February 4th, 2016|

Accounting is the language of business. To make good business decisions you need to understand this language. Take for instance the difference between the cost of making your product and the cost to support the existence of your product. Both are vital information but mistaking one for the other could be very costly mistake.

Cost of making your product

The cost of making your product also called your product cost should consist of the cost you absolutely need to make your product available to the market. Due to the nature of the cost, it is often stored as an asset on the balance sheet statement until it is sold. This is an accurate depiction of how the cost behaves. Just like an asset, product cost has future value and should not be expensed right away.

So what happens if you include cost that are not absolutely needed to make your product? For starters, you do not know what it cost you to make your product. Product cost should be examined on its own merit. Knowing what it cost you to make a product, would help you examine if there are better more productive ways to create the same thing. It also helps you determine the profitability of each product on an individual basis. Adding cost that are not essential to making the product distorts this cost.

Cost to support the existence of your product.

On the other end of the spectrum, a business cannot exist with product cost alone. If this was so, there will be no such thing as a broke entrepreneur. Every product needs a support system and this is what we call your period cost. Unlike product cost, period cost is expensed at the time they happen. A good example of a period cost is marketing. We all know that marketing is the life blood of any business. While it is not part of your product cost, your business will not survive very long without it.

Also, note that period costs exist to support the product. This is key because I see a lot of financial statements with cost that have no bearing to any revenue stream. This is why it is very important to fully understand the way the cost in your business behaves. Accounting for cost in the wrong way, would lead to bad information and finally taking the wrong action.

If you want more, get my free e-book categorizing transactions.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

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What is profit?

By | 2016-01-20T15:51:31+00:00 January 20th, 2016|

Profit is the way a capitalistic society allocates its resources. In a capitalist society, profit is determined by markets. A market is the group of people who decide whether or not your business is worth existing. To be a successful entrepreneur you have to create value worth more than the sum of your inputs. Profit is a measure of the value you bring in the market place. In other words profit is equal to cost minus value. The more value you bring, the more profits you make.

What is needed to create value

To create value entrepreneurs need resources. There are two main forms of resources needed to start any venture namely:

Financial resources

Depending on what type of business you operate, you may need financial resources to get started. For instance if you want to start a lawn mowing business, you will need to buy the lawn mower. You could either borrow the money, use your savings or get an investor. Using debt and investors means that you are giving others claims to your business assets. There is nothing wrong in doing this but you need to be aware of what you are giving up, in exchange for what you are getting.

Labor resources

Regardless of your type of business, you will need someone to do the work to make profits. Starting out most entrepreneurs do all the work, but need to learn to delegate as the business grows.

Conclusion

The bottom line of any business is to survive you need to create value. To create value you need to convert financial and labor resources to things customers’ value. To accomplish this, you need to understand what your customers want. Anyone can create a profit in the short term but to create long term sustainability takes insight and planning. Sustainable businesses are NEVER accidental but are successful by design!

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My advice for 2016

By | 2015-12-11T21:15:51+00:00 December 11th, 2015|

Don’t build to your own destruction

There are two components of economic freedom: money and time. It is not unusual for entrepreneurs to trade one for the other. You could have all the money in the world but without the time to enjoy it, it is useless. The idea is to grow smartly. Growing too big too fast could suck out the joy of the entrepreneurial life. As an entrepreneur, it is not advisable to consistently trade money for time. But, with smart planning you can have both time and money without wearing yourself out.

Give up control.

You cannot do it all. If you want to grow your business but keep the high level of customer service your customers have come to expect from you, you have to learn to give up control. You don’t have to do everything yourself. Being the go to person for every little task in your business is not sustainable. Automate when possible and delegate if not. The only things left on your schedule should be the things only you can do.

Clearly define your problem

Without goals, you can’t have a strategy and without a strategy you don’t fully understand where you have problems. You have a sense that things are not working the way you want, but are not sure why. Develop goals for 2016 and have strategies to accomplish them. By doing this you can readily see what problems you need to solve for your business to grow.

In summary, I can give the small business owner a lot of advice, but I believe less is more. The less you have to focus on the more you can do. I hope you gain clarity this upcoming year. With clarity, you gain focus and with focus you grow more efficiently.

 

 

 

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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