I had a client call me earlier in the week with product pricing questions for a potential wholesale agreement.  Owner labor and future growth can be important considerations in this type of analysis for a small business (especially when the owner does all or some of the labor in producing the product).

There are a few different ways to arrive at a price for a product (both retail and wholesale price).  Often the price is set by the market and the business has no real leverage to adjust it but in some cases the business does have the ability to determine a sales price.  In these instances price setting is critical.  A price too high will stifle demand and a price too low could stimulate so much demand that production would be inadequate or the price would be at a level where no profit can be made.  When the business has the ability to set its own price a cost plus markup system is often used.  Basically a desired profit margin is added to the cost of producing the product.  This is an excellent strategy but caution should be taken to include ALL the expenses of the product.

Here is a quick list of what a small business should consider as product costs:

  • Raw materials
  • Direct Labor
  • Supplies (labels, containers, small uninventoried raw materials)
  • Benefits on direct labor (often applied as a percentage of direct labor cost)
  • Direct overhead (equipment cost, electricity for equipment, rent for production space)
  • Indirect Labor
  • Indirect Overhead

If pricing for a wholesale transaction you would use the above accumulated cost and then add a percentage for a desired profit.  If the price were for retail you would take the above cost and add additional cost for selling expenses (advertising, marketing, sales staff) and then you add the profit percentage.  In the retail case your final profit percentage might be higher than in the wholesale situation.

Problems arise when small business owners only include raw materials and direct labor before calculating the price.  If an owner is doing all the production labor they may use only the cost of raw materials.  This allows for a lower price and more sales but it would make it extremely difficult to earn a normal profit if the business grows and the owner needs to hire additional staff for production.  If new labor is needed and the price is difficult to change once it is set in the market then the desired profit will be eroded by the additional labor costs.

In a cost plus markup situation the owner should take great care to price the product to include compensation (at least at a market rate of labor) for the production work they are doing AND the desired profit. This will create a proper business pricing model for the company.  The model will be effective for the current situation and if the product demand grows and new labor is needed.

There could be situations where the price is intentionally lowered to drive traffic and build a customer base.  This can be an excellent strategy but remember it is a business or marketing strategy.  Time and effort should be taken to calculate the accurate cost of production.  That cost should be used to create and monitor the pricing strategy as well as create a potential ‘exit strategy’ from the temporary discount pricing model.

Hi All,

Let me apologize for the very long absence.  I think it is time to get back to it.  My goal is to get a new post out in the next few weeks.

I would like to invite anyone (and everyone) to consider posting a question or real life scenario here on the PTCFO blog.  Sometimes it is difficult to find the right topics to tackle this vast management accounting scope.  It helps to have examples and questions.  Plus it is more interesting for you that theoretical ramblings.

Please send me those questions/situations if you have them.

 

Mark

Year end is a common time for all businesses to assess their profit for the previous year. Unfortunately, for some businesses, this is the only time they analyze their financial results.   A business’ annual profit has tax ramifications for that business (C-corp) or the business owners (S-corp, LLC, Sole proprietorship), so individuals are interested to know the profit or loss and how it will affect their tax situation.

The question I hear most often from clients at this time of year is “where is the cash?”  The question usually arises when the business has a profit of a certain amount, but the cash (checking) account has not increased by a similar amount.  The simple assumption is made that if the business made a profit of $10,000 then the cash should be $10,000 higher.

The Cash Flow Statement is the easiest tool to answer this question, but most small business do not produce (or have their bookeepers or accountants produce) a cash flow statement.  Cash flow statements are a very useful tool for business owners and managers, but cash flow statements are also harder to understand than Profit and Loss Statements or Balance Sheets.

Whether or not you use or understand cash flow statements, the same information can be obtained by examining a comparative balance sheet.  A comparative balance sheet (see PDF example Comp Bal Sheet) is a balance sheet for one time period compared to another time period.  All accounting software packages allow you to produce these statements.  At year end, create a balance sheet for the year just completed and add to it the balance sheet for the previous year.  If your accounting software allows it (QuickBooks and Peachtree do) have the system calculate the change from the previous year to this year.  Everything on this statement will answer your cash questions.

The first two items to review are the “net income (loss)” and the cash (checking) account.  Net income (loss) should be shown in the Equity/Capital/Shareholder’s Equity section of the balance sheet.  The net income for the current year will be shown in the current year column.  Ignore the “change” column for net income.  A net profit for the year will be shown as a positive number, and a net loss will be shown as a negative.  Compare this number to the change from one year to the next in cash.  The change column on the remaining items on the balance sheet will illustrate the differences between the net income (loss) and the increase or decrease in cash.

  • Depreciation/Amortization – The change column for the accumulated depreciation and/or amortization accounts is important to notice.  Depreciation and amortization are “non-cash” expenses.  So these items reduce profit but do not reduce cash.
  • Creation or use of cash – The remaining change column items should be reviewed to determine if they are a creation of cash or a use of cash.
    • Increase in an Asset – any increase in an asset from one year to the next is a use of cash
      • Example- If in 2009 inventory was $12,000, and it was $20,000 at the end of 2010. This is a use of $8,000 in cash.
      • An increase in the amount of inventory does not affect profit, so it helps explain a difference between the change in cash and net income.
    • Decrease in an Asset – any decrease in an asset is a creation of cash
      • Example- accounts receivable (accrual accounting only) in 2009 is $50,000 and in 2010 is $40,000.  This is a $10,000 creation of cash.
      • The net income number “assumes” you were paid only for the amount of sales you recorded, but the change in cash includes payments for sales recorded in prior years.
    • Increase in a Liability or Equity- any increase is a creation of cash
      • Example – 2009 Bank line of credit is $40,000 and 2010 is $65,000.  You have created cash of $25,000 by additional borrowings
    • Decrease in a Liability or Equity- any decrease is a use of cash
      • Example – 2009 Notes payable-company auto is $24,500 and 2010 is $19,750.  You were making cash payments on the loan for the company car.  Each payment included interest (would be included in the net income number) and principal (not included in net income number).  You have used cash to pay down debt.

The cash flow statement illustrates these changes in a certain format.  The most commonly used cash flow statement is the indirect method.  This method starts with net income (loss) and ends reconciling to the change in cash.  The changes to the balance sheet accounts are grouped into one of three categories by business function.  Changes in accounts like AR, inventory, accounts payable or sales tax payable deal with the day-to-day operations of the business and are included in the Operating Activities section.  Changes to the accounts in the fixed assets and equipment accounts are included in the Investing activities section of the cash flow statement.  Notes payable and borrowing changes are in the Financing Activities section.  The net cash change from net income (loss) is totaled with the amount of change from each of these three types of activities to reconcile cash at the beginning of the year to the year-end balance.

The cash flow statement or a comparative balance sheet is a great place to answer the question “where is the cash?”

From “what should I sell?” to your exit strategy.

Questions and decisions you may face as your small business moves through its life cycle and the management accounting techniques to help with those questions and decisions.

  • What product/service do I sell most?
  • How much should I sell it for?
  • How do I increase revenue?
    • Concerned with revenue of the business
    • This provides information to make decisions about what product/service to offer and how the quantity of what you can and do sell is affected by your pricing decisions and changes.
  • How much does that product cost to make?
    • Measures the Cost of Goods Sold
  • How much profit do I make when I sell the product/service?
    • Gross Margin of the Business (Revenue minus Costs of Goods sold)
    • These questions deal with the fundamental question of your business: can you sell enough of a product/service at a price that will create a profit?
  • Does the cost of each product include all the expenses it should?
  • How do I save expenses and become more efficient?
  • Product x is very labor intensive.
  • Product y is very machine (machine cost, depreciation, electricity, etc.) intensive.
    • Concerned with allocating as much expenses possible into cost of goods sold
    • Called Job Costing
  • What should I make the most of?
  • Should I raise or lower the price of one or more products?
  • Should I get rid of a product?
  • Should I add a product?
    • Profit Maximization, Product Mix
    • This is often an issue of limited resources and their most efficient use.  Many issues like cash flow, space or equipment may limit your ability to produce everything you could sell.  Profit maximization is the adjusting of the product mix to make and sell the highest profit-margin products.
    • This also often involves increasing the price of the smallest profit-margin items to 1) increase their margin and 2) reduce the demand for them to the amount you are able to produce

All of the above information creates a framework to produce “What if scenarios” that can be used to analyze important business decisions.

  • Business growth
    • Should I purchase the equipment/new plant?
    • Should I finance expansion through debt or new investors?
    • Should I add more staff?
  • Business contraction
    • Can I make more profit if I outsourced?
    • Would downsizing be more profitable?

All this information can be used to make better initial decisions, but it should also be used to monitor prior decisions.  Did I make the correct decision?  Was my initial information accurate?  Can it be better?

All this information can also help you at the end of your business.  What is my business worth?  The details can provide important comparable information about the return that can be expected if someone would buy your business.

http://ohioscpa.com/PublicArticle.aspx?ID=1903

As stated earlier, the main motivation for financial information is to make the best decision possible with the best information possible.  Financial information that is timely and accurate is crucial to make the best decision possible.  Another valuable use of accurate and timely financial information is feedback.

When developing a system to collect financial information an effort should be made to create procedures allowing the success of the decision made to be tracked and measured.  The ability to monitor the success of a decision is important if aspects of the decision can be ‘tweaked’ for better performance.  The ability to do this requires timely feedback.

In addition to adjusting prior decisions, feedback can provide new information for future decisions.  Feedback can also identify information that isn’t yet being tracked by you financial system but would be useful in the future.

Benchmarking.  Another one of those buzzwords.  If I used benchmarking, would it help my business be more profitable?  What you should be asking is “if I did benchmarking more often and more accurately, could it improve my businesses profitability?”  The fact is you are already benchmarking.

When you look at last month’s or last year’s financial statements and compare them to this year’s, you are benchmarking, which is simply comparing your results to another set of results to gain useful information.  The goal is to use that new information to make better business decisions.  When “benchmarking” is used as a buzzword in business, it often means comparing your financial results to those of similar businesses or competitors.  Often what is gained from this type of comparison is information about your businesses strengths and weaknesses.

Benchmarking against other companies is very useful, but the best place to start benchmarking is with your own company’s historical data.  Using your own historical data allows quicker identification of accuracy issues as well as illustrates some risks and pitfalls of benchmarking.

The most important aspect in benchmarking is the accuracy of your financial data. Another aspect of benchmarking closely related to accuracy is comparability.  The easiest way to explain comparability is the “apples-to-apples” standard.  If you are going to gain useful information from a comparison of data, you want both sets of data to be measuring the same thing.

Consider the following examples of the importance of accuracy and comparability:

  • You are comparing gross sales amounts of your rainbow colored widgets for 2010 with last year’s sales.
    • Last year, your invoices only showed total sales and not sales by product type.
  • You want to compare the cost of goods sold for “tacos” this year vs. last year.
    • Last year, you often purchased raw materials at Costco with a credit card.
    • You only reconciled your checking account last year. The credit card account was not reconciled, and the credit card payment was entered as a lump sum and not as individual charges for goods.  You don’t remember to what expense account the credit card payment was coded.
  • Through an industry trade association, you have found cost of goods percentages for similar-sized businesses who manufacture the same product as yours.
    • Your costs are significantly higher.
    • Are you inefficient?  Do you need wholesale changes to your processes?
    • Maybe by reading this blog you have begun to better “job-cost” your product.  Your cost-of-goods percentage includes rent, overhead and production support staff.  The comparison data only includes raw materials and labor.

Banks are big users of benchmarking, a great risk analysis tool.  Ratios are a form of benchmarking.  The computation of a ratio (such as times interest earned or current ratio) and its comparison to industry averages or historical data is used by banks to determine your creditworthiness.   Have you ever wondered why some loans from banks require periodic reviewed or audited financial statements?  Reviewed and audited financial statements give banks more assurance about the comparability (apples-to-apples) of the financial statements and the categorization of assets, liabilities, equity, revenue and expenses. Financial statements reviewed or audited by an CPA are more comparable than those provided by the client.   The more accurate the comparability, the more accurate the ratios and the better the risk analysis.

So one way you can become more profitable is by having accurate financial statements that show how strong your company really is.  This allows you to get bank financing at a reasonable rate, and you use the funding to buy new equipment or pay down that high-interest credit card.

Benchmarking is a topic we will address again in the future, but remember, you are already doing it.

Buzzwords- Is a blog post category devoted to explaining some trendy words and techniques you might hear in management or finance.

We have taken some time in the first few posts to discuss why financial information is important, some of the attributes you want your financial information to have, and how to assess/improve the process of collecting financial information.  Now let’s dive into some types of financial information.

The first and best source of financial information are your financial statements.  Even the most simple (a statement containing very few accounts) can provide you with valuable information about your company’s performance.  Regular review of the financial statements is the first step to accuracy in your financial information.  You need to understand and get used to the flow of financial data through your financial statements in order to identify incorrect information.  An understanding of the financial statements also is the first step to changing how you quantify the data in them (adding detail through more accounts or a system of classes) to give yourself more information to make better decisions.

Types of financial statements – There are three basic financial statements

  1. The Balance sheet – Think of this statement as a “snapshot” of your business on a particular day.  It quantifies the “net worth” of your business on that particular day.  It shows everything you own (assets), everything you owe (liabilities), and the difference between the two (equity).  The balance sheet accounts are called permanent accounts because they are the summation of all the activity in the company since its inception.
  2. The Profit and Loss Statement (P&L) – This statement is not a snapshot in time but rather a report of operations over a given period of time.  The P&L shows the revenue (can be called sales) during that period as well as the expenses for the period.  The difference between the two is Net Income (revenue higher than expenses) or Net loss (opposite).  There are different formats for the P&L. We will discuss more about them later.  The different formats are aimed at presenting the information in a way that gives P&L readers the most useful information for their type of business (a service business would have a different P&L format from a manufacturing business).  The profit and loss accounts are called temporary accounts.  They are used to accumulate activity for a period of a year and then they are closed out (reset to zero) into the balance sheet (permanent) accounts.
  3. The Cash Flow Statement – The cash flow statement is the most misunderstood and underused statement of the three.  It is also the statement that answers the question I get asked most by small business owners.  “If I make $xxxx.xx of profit, how come I don’t have $xxxx.xx in my checking account?”  The cash flow statement will tell you why you have less or more cash than you have profit or loss.  The cash flow statement is also not a snapshot; it’s for a period of time.  It starts with your profit or loss for the period of time and then shows the creation (inflows) or uses (outflows) of cash.  It segregates the creation and uses of cash by three different types of activities (this segregation is useful for information purposes).  The three categories are Operating Activities (regular business activities), Financing Activities (purchase or sale of assets), and Investing Activities (debt or equity financing or the repayment of debt).  There will be more posts dedicated to the cash flow statement in the near future.  What you should remember now is the cash flow statement is a very important source of information and for a given time period shows you why your cash (checking account) balance changed.

After completing the financial information assessment of your small business using the F.I.R.S.T. Diamond©, it is important to look at ways to improve your information collection.  This post is dedicated to breaking down the four categories of the F.I.R.S.T. Diamond©  and giving you some areas to on which to work in order to improve your data collection.

Accuracy

  • Procedures need to be in place to identify and correct inaccuracies in your financial information
    • Reconciliations are important – Any account directly tied to cash (checking, savings, credit cards) should be reconciled monthly.
    • Discrepancies need to be researched to correct them and determine if they are one-time issues or recurring issues that need procedure changes in order to eliminate them.

Timely

  • Financial statements and information reports need to be completed and examined (for accuracy) as quickly as possible.
    • The goal should be for financial statements to be completed within 15 days of the period end.
    • Using accounting software, it may be possible to have immediately accurate financial statements with the correct procedures.
    • The goal for information reports should be immediate access.

Useful

  • Accurate and timely information is important, but you also need the information to be useful in decision making.  Procedures are needed to gather financial information “on demand” for decision making.
    • Feedback on needed information – Feedback needs to be given to perfect the information necessary for decision making.  Feedback also needs to be given for new information necessary for decision making.
    • Monitoring – procedures need to be built to collect information on monitoring of prior decisions.

Efficiency

  • The goal should be to create procedures that provide the other goals of financial information as efficiently and  cost effectively as possible.
    • Software – The most efficient use of time involves using accounting software – QuickBooks, Peachtree, or an industry-specific software should be used.
    • Data entry – The goal should be to have information entry done by someone other than the owner or manager.
    • Excel usage – Excel is an excellent tool for data manipulation (the ability to take a “stock” report and get new useful information out of the data).  The goal should be to export data directly from the accounting software into Excel.  No duplication of data entry into Excel should be done.

    Case study examples for financial information assessment tools

Some interesting questions raised in this New York Times blog post.  I responded with a quick comment on the blog but a more thorough discussion is contained in my CPA vs. CMA blog post.

http://boss.blogs.nytimes.com/2010/08/02/what-should-i-ask-of-my-accountant/