Business Improvement

/Business Improvement

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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Working Capital: Profitability is not Everything.

By | 2017-11-10T21:00:43+00:00 November 10th, 2017|Tags: |

Be careful of accounting definitions

  • The accounting definition of working capital = current assets – current liabilities.
  • On the surface this has very little meaning.
  • Current assets & liabilities could contain items that is not related to operations.
  • Know your numbers so you know your business

Working capital: Internal Vs External

  • Working capital is used to evaluate the efficiency of cash management in meeting the demands of the direct cost of goods/ services.
  • The more certain we are, the less working capital we need.
  • The more uncertain the more you need on hand
  • If you half operating cycle, you half working capital need

Summary

  • The whole point of WC management is to determine whether the company has enough cash to pay off short term operating liabilities as they come due.
  • Bad working capital management further reduces profitability due to limited cash for further investment
  • The goal is optimization and not maximization

Download the excel template in the video here: Profitability Vs Liquidity.xlsx

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THE SELLING & ADMINISTRATIVE BUDGET

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

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

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

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

Budgeting for selling and administrative expenses

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

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

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

My Cake Shop Example

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

Managing for growth

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

Managing & protecting assets

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

Cash management involves 

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

Accounts receivable management involves:

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

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

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

Inventory management:

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

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

Other assets

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

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

Cost associated with managing assets include:

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

Intangible assets: includes the management of:

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

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

Legal requirements/ compliance issues

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

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

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

Selling and Support services

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

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

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

My Cake Shop selling and support activities are as follows:

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

Steps to budgeting for selling and administrative expenses:

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

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

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

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

 Is the vendor attentive to your needs as a customer

 Do you have a solid relationship with this vendor

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

5. Separate the fixed cost from variable cost

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

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

Eliminate Non Relevant Vendors

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

Creating the budget for selling and administrative labor

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

Direct Labor = Number of hours needed * Price per hour

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

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

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

Direct Labor = Number of hours needed * Price per hour

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

Steps to creating the selling & administrative labor budget:

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

Examine workload and relevance of job

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

Are employees stretched

Do you need additional employees to bring sales forecast to past

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

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

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

5. Separate the fixed salaries from variable salaries

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

Notes for employees

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

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

Excel Worksheet Summary

Get the worksheet here

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

Summary

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

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

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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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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