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What does it mean to truly live?

By | 2018-04-08T19:05:25+00:00 April 8th, 2018|Tags: |

W. H. Davies

Leisure

WHAT is this life if, full of care,
We have no time to stand and stare? —

No time to stand beneath the boughs,
And stare as long as sheep and cows:

No time to see, when woods we pass,
Where squirrels hide their nuts in grass:

No time to see, in broad daylight,
Streams full of stars, like skies at night:

No time to turn at Beauty’s glance,
And watch her feet, how they can dance:

No time to wait till her mouth can
Enrich that smile her eyes began?

A poor life this if, full of care,
We have no time to stand and stare.

Machines have changed the world. They have made life so much easier. Tasks that once took five people to complete, now takes one person? However, the invention of machines brought about a pendulum shift in the way we think about time. With the invention of machines, the routine of our daily work lives was forever transformed.

For years people have scheduled their time around machines. The time you slept, ate, or woke was scheduled around the machine. As long as the machine was running, industries expected employees to stay in tune with the machine for production. The problem is machines never sleep but humans too. Machines brought about an increase in the pace in our daily lives.

The funny thing is even though technology has evolved, we are still bound by these very thoughts. The time we wake, eat, sleep is still scheduled around production. Hence the inherent meaning of the saying, time is money. But should time really be just about making money? What is the point of life, if all we do is make money? Studies have shown that once we meet a certain threshold, making more money does not make us any happier. So, what does it mean to truly live?

What does it mean to truly live?

What motivates you? Is it bigger profits, higher revenues, more employees, etc.? If your business is only focused on bigger and higher then you will certainly hit the wall emotionally someday. This will happen even though you have a huge bank account. So, if bigger profits and higher revenue does not fulfill us then we spend so much time focused on these measures? You will think the more money you have, the more time you should have to enjoy life. But I have found this is not the case. People who are successful are driven to become even more successful. Thereby spending even more time working.

However, the real problem is not the hours we put in at work, but how much we give up to put in those work hours. In other words, what do we trade for money? We tend to see life in sequences. I cannot do B unless I do A. This is the foundation of our problems and this is why we have the work life balance debate. Sequencing forces us to put away the important for the urgent. One big example that comes to mind, is sequencing time with our loved ones after we have put in 12 hours at work. The problem is your loved ones get the least energetic part of you. Another example is waiting to start a family till your career is “successful”. The problem with sequencing is “life is short” and by the time A happens, B is too late. Your 5-year-old daughter will be 24 by the time you finally have the time or your ability to have children has greatly declined by the time your career takes off. Life consists of a series of event, a lot of which we cannot control. So, the idea we can control life by having perfectly sequenced life is absurd. So why do we do it? I think the reason is because everyone else does.

So back to my original question, what does it mean to truly live. To truly live, means to love. First, we love God and then we love man. This is the very essence of life. When we love, we feel deeply, we seek to push boundaries and we are not limited by the ordinary. We strive because we love. When we love, sequencing holds less significance because we are moved by something bigger than time or profits.

How does this apply to business?

You can choose to see your business as a set of systems whose primary goal is to make profits? Or, you could choose to see your business as a community of people working together to achieve a common meaningful goal. Meaningful in that families and society are better because your business exists. In other words, the lives of the people who work for you are better because of their association with you. And in turn they produce work that matters to society.

A very well sequenced business will aim for bigger profits by creating well oiled system that churns profits. However, this type of business lacks a soul. Bigger profits and higher revenues as a primary motivation is not sustainable. The business owner is sure to hit an emotional wall which begins the downward spiral of the business.

A business that operates because of love, cares about people as well as the vision. It attracts people who share the vision to change the world. People who work for this business learn to integrate life with work. And the love they feel at work is transferred to the home. In the short run, a business like this might look like a fool’s game but in the long run it reaps the most rewards.

In summary, tick tock says the clock. No one knows when they will hear the last tock. Why keep deferring the important for the urgent? Choose to live, laugh and most important of all is to love …

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Real Differences between Profit and Cash

By | 2018-03-18T22:28:56+00:00 March 18th, 2018|

Anyone who has run a business knows there is a big difference between profit and cash. Profit is an accounting term while cash is what you can actually spend. You need cash to run your business, however without profits you cannot get excess cash. While the two terms are related, they do not always happen at the same time. After all, it is not unheard of to see broke profitable businesses.

So why do broke profitable businesses exist?

Below are four reasons why cashless, profitable businesses exist:

1) Too much accounts receivable: Profit is your revenue minus your expenses. Revenue is money you get from operating your business. Revenue often comes in the form of cash but not all cash that flows in the business is revenue. Sometimes your customer engages in a transaction with you but promises to pay later. In that case, you have revenue with no cash.

2) Selling inventory too slow: If your inventory is moving slow, you will not be able to generate cash fast enough from your inventory purchases. This inventory eats up cash but does not show as an expense till you sell the inventory. So, in that case, your business could be showing it is profitable but you have too much cash tied up in inventory.

3) Having too many loans: When you have too many loans, cash that should be used to run the business will go to the lenders. While your business may be looking profitable, there will be less cash to support future growth.

4) Taking too much money out of the business for personal use: It is okay to reward yourself for the risks you take in your business. But doing this in a non-systematic way could be bad for your business. This is because you are not purposely about how much you take out. You could end up taking out too much leaving your business starved for cash. Your business might be profitable but yet has very little cash to support it.

Take a look at this video, to see how profitability and liquidity are connected.

 

To grow and manage a business, you need both profit and cash at the same time. Maintaining the balance between cash and profits is essential for long term survival.

If you are interested in template in the video or other templates that can help you understand your business better visit bizexceltemplates.com


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Advantages of LLC

By | 2017-10-14T23:42:24+00:00 October 14th, 2017|

As a Certified Public Accountant I often encounter the question should I become a s-corporation or LLC? What are the advantages of LLC? Even though I understand why people ask the LLC or S Corp question, I realize the information is based on incomplete knowledge. You can be a straight s-corporation or a LLC taxed as a s-corporation. Which one is most beneficial depends on your unique situation.

S Corporation versus LLC

When choosing your business structure, there are 2 different levels to consider:

  1. The Legal structure: This is normally done at the state level. Paperwork is filed with the state to determine the legal form of operation. For example the LLC, corporation or partnership
  2. The Tax Structure: Once your legal structure is formed you can elect to be taxed more favorable by making applicable elections with the internal revenue service. An example is the s-corporation.

A s-corporation is simply a corporation which operates under the Subchapter S rule of the Internal Revenue Code. The creation of these rules allowed more flexibility for small business owners. To become a s-corporation one would have to incorporate under state laws and then elect to be taxed as a s- corporation with the Internal Revenue Service.

On the other hand, a LLC is an unincorporated association and it is formed under state law. A LLC could have one or more members. A LLC once formed can elect to be taxed as a partnership, corporation or s-corporation.

Advantages of LLC

While the s-corporation is a great structure to provide limited liability and asset protection, it comes with a few limitations. As a straight s-corporation shareholder, your interest in the business is an actual holding of shares. These shares are often personal assets in a lawsuit and subject to attachment by the courts. This means, that in a law suit the person suing you could obtain your shares and become an unwanted shareholder in your corporation.

Having a creditor with ownership of your shares is very undesirable and can be avoided by forming a LLC. The LLC entity is great for asset protection because of the charging order provision (check state law for application). What does this mean? This means the person suing only has rights to the distributions and not the member interest itself. Therefore, if the owner never pays out any distributions, the owner never gets any income.

Moreover, the creditor could be taxed on distributions that was never received. It would not take long for any creditor to realize that holding on to the judgment is not a wise idea.

Another advantage of the LLC is you get the flexibility of what kind of tax entity you will like to be. You could be taxed as a c-corporation, s-corporation or partnership.

Charging Order Example

If you think you will never get involved in a law suit, think again. People are taken to court for all kind of reasons like divorce, debt, auto accidents, unintentional side effects of your actions, just to mention a few. If you are taken to court, your business assets will be brought under the radar. It is your creditor’s lawyer’s goal to take all they can.

LLC Taxation: C Corporation, S Corporation or Partnership?

Now we know why we want a LLC over incorporation (the legal structure), what tax structure should we choose? That is, should you be a LLC taxed as a s-corporation or partnership? The answer depends on what you want to put in the entity. Corporations are bad structures for assets like real estate because of the problem of higher taxes when transferring your property.

Moreover, the main deciding factor in choosing between s-corporation and partnership is self-employment tax. Real estate is not subject to self-employment tax and so no money is saved by putting an asset like real estate in a s-corporation. Since there are no self-employment tax savings why not use the tax structure that will save you taxes in the long run.

To summarize, the advantages of the LLC are as follows:

  • Charging order protection
  • Tax savings on assets when placed in a partnership
  • More flexibility
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How to Become an S Corporation

By | 2017-10-14T21:55:02+00:00 October 14th, 2017|

If you run your business as a corporation or a LLC you can choose to become an s corporation. The benefits of becoming an s corporation if you are a corporation, is the elimination of double taxation. As an s corporation you pay taxes on all profits and pay taxes again when you pay dividends.

If you are a LLC taxed as a sole proprietor, the benefit of being taxed as an s corporation is you have more control over how your income is taxed.

How to become an s corporation

To become an s corporation you must

  1. Meet s corporation requirements
  2. File the election
  3. Meet the election deadline
  4. Or file for a late election

S Corporation requirements

To become an S corporation you must meet the following requirements:

  1. No more than 100 shareholders
  2. One class of stock
  3. All shareholders must be us citizens
  4. All shareholders are either individuals, estates, some exempt organizations or some trusts

Filing the election

The election is made by filing form 2553, Election by a Small Business Corporation.

Election deadline dates

Election effective current tax year

No later than 2 months and 15 days after the beginning of the tax year in which the election is to take effect. Example Joe Blow forms his LLC January 1, 2014. Joe Blow must elect to become an S Corporation by March 15th, 2014 to be recognized as an S Corporation in his first taxable year.

Election to take effect in a succeeding year

An election can be made anytime during the year before the year an election is to take effect. For example:

Joe Blow has been in existence for a while and decides he is ready to switch to an s corporation in 2015. Joe Blow can elect by filing form 2553 any time during the 2014 tax year.

Word of caution: although you have ample time to elect S Corporation status in the preceding tax year, you might not want to wait. If the IRS rejects your first application, you want to have enough time to make corrections before the next tax year.

Late Election

The IRS can show some sympathy for late elections if there is enough cause as to why the tax entity is filing late. However, it is not advisable to depend on the sympathy of the IRS.

Effect of election

Once the S Corporation status has been approved, the old status seizes to exist. The S Corporation must remain so for a period of 60 months after the effective election date. Certain exemptions can be applied for early termination.

For more information access the IRS form 2553 form by clicking here.

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Four essential factors to achieving goals

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

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

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

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

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

PREDICTING OVERHEAD FOR A PRODUCT BUSINESS

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

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

Every business has 2 categories of cost

Every business has 2 categories of cost namely:

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

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

Overhead associated with making your product

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

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

Predicting overhead

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

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

Steps to predict overhead

Follow these steps to predict overhead:

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

First, list all business activities

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

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

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

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

  • Indirect material
  • Indirect labor
  • Indirect- other

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

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

Third, figure out the cost of one unit of activity

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

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

See the example for “My Cake Shop” below:

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

See an example for “My Cake Shop” below:

Fourth, determine a buffer

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

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

Lastly predict the cost for these activities

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

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

See the illustration above for variable and fixed cost.

Conclusion

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

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

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

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

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Predicting Labor Cost

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

PREDICTING DIRECT LABOR COST FOR A PRODUCT BUSINESS

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

  1. Number of hours needed
  2. Price per hour

Number of hours needed: The automate versus hire decision

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

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

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

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

Number of hours needed: Skilled versus unskilled labor

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

Number of hours needed example

We summarize number of direct labor hours as follows:

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

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

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

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

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

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

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

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

Price per hour

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

Price per hour can be calculated as follows:

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

Price per hour: Average market price

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

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

Price per hour: Premium for skill sets with limited labor

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

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

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

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

Summary

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

Direct Labor = Number of hours needed * Price per hour

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

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

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

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Investment KPIs

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

THREE KPIS  EVERY BUSINESS OWNER SHOULD KNOW BEFORE MAKING NEW INVESTMENTS

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

When to make capital investments

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

Required rate of return

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

Capital investment decisions take into consideration

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

Capital Investment KPIs

Cash payback period

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

Cost of capital investment/ net annual cash flow

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

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

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

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

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

Net present value

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

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

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

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

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

Internal rate of return

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

Questions for thoughts

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

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

Summary

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

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

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

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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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