Putting cost control in its proper context

Cost control is part of the larger management function of revenue/cost/profit analysis. So, the best place to focus is your P&L report. (Book 3, Chapter 2 explains the P&L report, also known as the income statement.) This profit performance statement summarizes your sales revenue based on the sales prices in effect during the year and your expenses for the year based on the amounts recorded for the expenses. (There are some issues regarding the accounting methods for recording certain expenses, discussed in the upcoming section “Selecting a cost of goods sold expense method.”)

Suppose your business is a pass-through income tax entity, which means it doesn’t pay income tax itself but passes its taxable income through to its shareholders, who then include their shares of the business’s annual taxable income in their personal income tax returns for the year.

Figure 5-1 presents the income statement of a hypothetical business (you can say it’s yours) for the year just ended and includes the prior year for comparison (which is standard practice). This report includes the percents of expenses to sales revenue. It also breaks out a facilities expense — the cost of the space used by the business — and reports it on a separate line.

Facilities expense includes expenditures for leases, building utilities, real estate taxes, and insurance on your premises. Depreciation isn’t included in facilities expense; depreciation is an unusual expense and it’s best to leave it in an expense by itself.

In this case, the business moved out of the red zone (loss) in 2018 into the black zone (profit) in 2019. Making a profit, however, doesn’t necessarily mean your costs are under control. Dealing with the issue of cost control requires closer management analysis.

You can attack cost control on three levels:

• Your business as a whole in its entirety
• The separate profit centers of your business
• Your specific costs item by item

Figure 5-1 is the income statement for your business as a whole. At this level, you look at the forest and not the trees. It’s helpful to divide your business into separate parts called profit centers. Basically, a profit center is an identifiable, separate stream of revenue to a business. At this level, you examine clusters or stands of trees that make up different parts of the forest.

For example, Starbucks sells coffee, sure — but also coffee beans, drinkware, food, CDs, and other products. Each is a separate profit center. For that matter, each Starbucks store is a separate profit center, so you have profit centers within profit centers. Last, you can drill down to particular, individual costs. At this level, you look at specific trees in the forest.

Beginning with sales revenue change

You increased sales $634,062 in 2019 (refer to Figure 5-1). This is good news for profit, but only if costs don’t increase more than sales revenue, of course. For revenue/cost/profit analysis, it’s extremely useful to know how much of your sales revenue increase is due to change in volume (total quantity sold) versus changes in sales prices. Unfortunately, measuring sales volume can be a problem.

An auto dealer can keep track of the number of vehicles sold during the year. A movie theater can count the number of tickets sold during the year, and a brewpub can keep track of the number of barrels of beer sold during the year. On the other hand, many small businesses sell a very large number of different products and services. A clothing retailer may sell several thousand different items. A hardware store in Boulder claims to sell more than 100,000 different items.

Exactly how your business should keep track of sales volume depends on how many different products you sell and how practical it is to compile sales volume information in your accounting system. In many situations, a small business can’t do more than keep count of its sales transactions — number of sales rung up on cash registers, number of invoices sent to customers, customer traffic count, or something equivalent. If nothing else, you should make a rough count of the number of sales you make during the year.

In the example portrayed in Figure 5-1, you increase sales volume 20 percent in 2019 over the prior year, which is pretty good by any standard. You made much better use of the sales capacity provided by your workforce and facilities in 2019. You increased sales per employee and per square foot in 2019— see the later sections “Analyzing employee cost” and “Looking at facilities expense.” The 20 percent sales volume increase is very important in analyzing your costs in 2019. A key question is whether changes in your costs are consistent with the sales volume increase.

The example portrayed in Figure 5-1 is for a situation in which product costs remain the same in both years. Therefore, cost of goods sold expense increases exactly 20 percent in 2019 because sales volume increases 20 percent over the previous year. (Of course, product costs fluctuate from year to year in most cases.)

Sales revenue, in contrast, increases more than 20 percent because you were able to increase sales prices in 2019. In Figure 5-1, note that sales revenue increases more than the 20 percent sales volume increase. Ask your accountant to calculate the average sales price increase. In the example, your sales prices in 2019 are 7.7 percent higher than the previous year.

You did not increase sales prices exactly 7.7 percent on every product you sold; that situation would be quite unusual. The 7.7 percent sales price increase is an average over all the products you sold. You should know the reasons for and causes of the average sales price increase. The higher average sales price may be due to a shift in your sales mix toward higher priced products. (Sales mix refers to the relative proportions that each source of sales contributes to total sales revenue.) Or perhaps your sales mix remained constant and you bumped up prices on most products.

In any case, what’s the bottom line (or maybe top line, for sales revenue)? In 2019, you had $634,062 additional sales revenue to work with compared with the prior year. More than half of the incremental revenue is offset by increases in costs. But $261,921 of the additional revenue ended up in profit. How do you like that? More than 41 percent of your additional revenue goes toward profit (see Figure 5-1 for data):

$261,921 profit increase ÷ $634,062 additional sales revenue = 41.3% profit from additional revenue

This scenario may seem almost too good to be true. Well, you should analyze what happened to your costs at the higher sales level to fully understand this profit boost. Could the same thing happen next year if you increase sales revenue again? Perhaps, but maybe not.

Focusing on cost of goods sold and gross margin

For businesses that sell products, the first expense deducted from sales revenue is cost of goods sold. (You could argue that it should be called cost of products sold, but you don’t see this term in income statements.) This expense is deducted from sales revenue to determine gross margin. Gross margin is also called gross profit; it’s profit before any other expense is deducted from sales revenue. Cost of goods sold is a direct variable expense, which means it’s directly matched against revenue and varies with sales volume.

This expense may appear straightforward, but it’s more entangled than you may suspect. It’s anything but simple and uncomplicated. In fact, the later section “Looking into Cost of Goods Sold Expense” explains this expense in more detail. For the moment, step around these issues and focus on the basic behavior of the expense. In the example in Figure 5-1, your business’s product costs are the same as last year. Of course, in most situations, product costs don’t remain constant very long. But it makes for a much cleaner analysis to keep product costs constant at this point in the discussion.

The 20 percent jump in sales volume increases your cost of goods sold expense 20 percent — see Figure 5-1. Pay special attention to the change in your gross margin ratio on sales. Your basic sales pricing strategy is to mark up product cost to earn 45 percent gross margin on sales. For example, if a product cost is $55, you aim to sell it for $100 to yield $45 gross margin. However, your gross margin is only 42.0 percent in 2019. You gave several customers discounts from list prices. But you did improve your average gross margin ratio over last year, which brings up a very important point.

How is it that your sales volume increases 20.0 percent and your sales prices increase 7.7 percent in 2019, but your gross margin increases 40.2 percent? The increase in gross margin seems too high relative to the percent increases in sales volume and sales prices, doesn’t it? What’s going on? Figure 5-2 analyzes how much of the $351,741 gross margin gain is attributable to higher sale prices and how much to the higher sales volume.

Note that the 7.7 percent increase in sales prices causes more gross margin increase than the 20.0 percent sales volume increase. That’s because of the big base effect; the smaller sales prices percent increase applies to a relatively large base (about $2.3 million) compared with the volume gain, which is based on a much smaller amount (about $.9 million).

Suppose you want to increase gross margin $100,000 next year. Assume that your 42.0 percent gross margin ratio on sales remains the same. If sales prices remain the same next year, then your sales volume would have to increase 8.15 percent:

$100,000 gross margin increase goal ÷ $1,226,636 gross margin in 2019 = 8.15% sales volume increase

If your sales volume remains the same next year, then your sales prices on average would have to increase just 3.42 percent:

$100,000 gross margin increase goal ÷ $2,920,562 sales revenue in 2019 = 3.42% sales price increase

In short, a 1 percent sales price increase has more profit impact than a 1 percent sales volume increase.

Analyzing employee cost

As the owner of a small business, your job is to judge whether the ratio of each expense to sales revenue is acceptable. Is the expense reasonable in amount? Your salaries, wages, commissions, and benefits expense equals 22.7 percent of sales revenue in 2019 (refer to Figure 5-1). In other words, your employee cost absorbs $22.70 of every $100.00 of sales revenue. This expense ratio is lower than it was last year, which is good, of course. But the fundamental question is whether it should be an even smaller percent of sales. This question strikes at the essence of cost control. It’s not an easy question to answer. But, as they say, that’s why you earn the big bucks — to answer such questions.

It’s tempting to think first of reducing every cost of doing business. It would have been better if your employee cost had been lower — or would it? Could you have gotten by with one less employee? One less employee may have reduced your sales capacity and prevented the increase in sales revenue. In the example, you have ten full-time employees on the payroll both years. For your line of business, the benchmark is $300,000 annual sales per employee. In 2019, your sales per employee is $292,056 (see Figure 5-1 for sales revenue):

$2,920,562 annual sales revenue ÷ 10 employees = $292,056 sales revenue per employee

Summing up, your employee cost looks reasonable for 2019, assuming your sales per employee benchmark is correct. This doesn’t mean that you couldn’t have squeezed some dollars out of this expense during the year. Maybe you could have furloughed employees during the slow time of year. Maybe you could have fired one of your higher-paid employees and replaced him or her with a person willing to work for a lower salary. Maybe you could have cut corners and not have paid overtime rates for some of the hours worked during the busy season. Maybe you could have cut health care and vacation benefits during the year.

Business owners get paid to make tough and sometimes ruthless decisions. This is especially true in the area of cost control. If your sales prices don’t support the level of your costs, what are your options? You can try to get more sales out of your costs. In fact, you did just this with employee costs in 2019 compared with 2018. Your sales revenue per employee increased significantly in 2019. But you may be at the end of the line on this course of action. You may have to hire an additional employee or two if you plan to increase sales next year.

Analyzing advertising and sales promotion costs

The total of your advertising and sales promotion costs in 2019 is just under 7 percent of sales revenue, which is about the same it was in 2018. As you probably have observed, many retail businesses depend heavily on advertising. Others don’t do more than put a sign on the building and rely on word of mouth. You can advertise and promote sales a thousand different ways (see Book 5 for a lot more on marketing and promotion).

Maybe you give away free calendars. Maybe you can place ads in local newspapers. Maybe you make a donation to your local public radio or television station. Or perhaps you place ads on outdoor billboards or bus benches.

Like other costs of doing business, you need a benchmark or reference point for evaluating advertising and sales promotion costs. For the business example, the ratio is around 7 percent of annual sales. This ratio is in the typical range of the advertising and sales promotion expense of many small businesses. Of course, your business may be different. Retail furniture stores, for example, spend a lot more than 7 percent of sales revenue on advertising. Locally owned office-supply stores, in contrast, spend far less on advertising.

You should keep watch on which particular advertisements and sales promotions campaigns work best and have the most impact on sales. The trick is to find out which ads or promotions your customers respond to and which they don’t. Keeping the name of your business on the customer’s mind is a high marketing priority of most businesses, although measuring how your name recognition actually affects customers’ purchases is difficult. Nevertheless, you should develop some measure or test of how your marketing expenses contribute to sales.

Of course, you can keep an eye on your competitors, but they aren’t likely to tell you which sales promotion techniques are the most effective. You increased your advertising and sales promotion costs more than $30,000 in 2019, which is more than 20 percent over last year (see Figure 5-1). Sales revenue went up by an even larger percent, so the ratio of the expense to sales revenue actually decreased. Nevertheless, you should determine exactly what the extra money was spent on. Perhaps you bought more newspaper ads and doubled the number of flyers distributed during the year.

Appreciating depreciation expense

Depreciation expense is the cost of owning fixed assets. The term fixed assets includes land and buildings, machinery and equipment, furniture and fixtures, vehicles and forklift trucks, tools, and computers. These long-term operating resources aren’t held for sale; they’re used in the day-to-day operations of the business. Except for land, the cost of these long-term operating resources is allocated over the estimated useful lives of the assets. (Land is viewed as a property right that has perpetual life and usefulness, so its cost is not depreciated; the cost stays on the books until the land is disposed of.)

As a practical matter, the useful life estimates permitted in the federal income tax law are the touchstones used by most small businesses. Instead of predicting actual useful lives, businesses simply adopt the useful lives spelled out in the income tax law to depreciate their fixed assets. The useful life guidelines are available from the IRS at www.irs.gov/publications. Probably the most useful booklet is Publication 946, How to Depreciate Property. Your accountant should know everything in this booklet.

You should understand the following points about the depreciation expense:

• The two basic methods for allocating the cost of a fixed asset over its useful life are the straight-line method (an equal amount every year) and an accelerated method, by which more depreciation expense in recorded in the earlier years than in the later years; the straight-line method is used for buildings, and either method can be used for other classes of fixed assets.
• Businesses generally favor an accelerated depreciation method in order to reduce taxable income in the early years of owning fixed assets, but don’t forget that taxable income will be higher in the later years when less depreciation is recorded.
• In recording depreciation expense, a business does not set aside money in a fund for the eventual replacement of its fixed assets restricted only for this purpose. (A business could invest money in a separate fund for this purpose, of course, but no one does.)
• Recording depreciation expense does not require a decrease to cash or an increase in a liability that will be paid in cash at a later time; rather the fixed asset accounts of the business are written down according to a systematic method of allocating the original cost of each fixed asset over its estimated useful life. (Book 3, Chapter 4 explains the cash-flow analysis of profit.)
• Even though the market value of real estate may appreciate over time, the cost of a building owned by the business is depreciated (generally over 39 years).
• The eventual replacement costs of most fixed assets will be higher than the original cost of the assets due to inflation; depreciation expense is based on original cost, not on the estimated future replacement cost.
• The estimated useful lives of fixed assets for depreciation are shorter than realistic expectations of their actual productive lives to the business; therefore, fixed assets are depreciated too quickly, and the book values of the assets in the balance sheet (original cost less accumulated depreciation to day) are too low.
• Depreciation expense is a real cost of doing business because fixed assets wear out or otherwise lose their usefulness to the business — although a case can be made for not recording depreciation expense on a building whose market value is steadily rising. Generally accepted accounting principles require that the cost of all fixed assets (except land) must be depreciated.

One technique used in the fields of investment analysis and business valuation focuses on EBITDA, which equals earnings before interest, tax (income tax), depreciation, and amortization. Amortization is similar to depreciation. Amortization refers to the allocating the cost of intangible assets over their estimated useful lives to the business. By and large, small businesses do not have intangible assets, so they’re not discussed here.

One last point about depreciation expense: Note in Figure 5-1 that your depreciation expense is lower in 2019 than the prior year. Yet sales revenue and all other expenses are higher than the prior year. The drop in depreciation expense is an aberrant effect of accelerated depreciation; the amount of depreciation decreases year to year. You have a year-to-year built-in gain in profit because depreciation expense drops year to year. The aggregate effect on depreciation expense for the year depends on the mix of newer and older fixed assets. The higher depreciation on newer fixed assets is balanced by the lower depreciation on older fixed assets. One advantage of the straight-line method is that the amount of depreciation expense on a fixed asset is constant year to year, so you don’t get fluctuations in depreciation expense year to year that are caused by the depreciation method being used.

Ask your accountant to explain the year-to-year change in depreciation expense in your annual income statement. In particular, ask the accountant whether a decrease in the depreciation expense is due to your fixed assets getting older, with the result that less depreciation is recorded by an accelerated depreciation method.

Looking at facilities expense

The income statement shown in Figure 5-1 includes a separate line for facilities expense. You should definitely limit the number of expense lines in your income statement. But this particular expense deserves separate reporting. Basically, this expense is your cost of physical space — the square footage and shelter you need to carry on operations plus the costs directly associated with using the space. (You may prefer the term occupancy expense instead.)

Most of the specific costs making up facilities expense are fixed commitments for the year. Examples are lease payments, utilities, fire insurance on contents and the building (if owned), general liability insurance premiums, security guards, and so on. You could argue that depreciation on the building (if owned by the business) should be included in facilities expense. However, it’s best to put depreciation in its own expense account.

In this example, your business uses 12,000 square feet of space, and you’ve determined that a good benchmark for your business is $300 annual sales per square foot. Accordingly, your space could support $3,600,000 annual sales. In 2019, your annual sales revenue is short of this reference point. Therefore, you presumably have space enough for sales growth next year. These benchmarks are no more than rough guideposts. Nevertheless, benchmarks are very useful. If your actual performance is way off base from a benchmark, you should determine the reason for the variance. Based on your own experience and in looking at your competitors, you should be able to come up with reasonably accurate benchmarks for sales per employee and sales per square foot of space.

In the business example portrayed in Figure 5-1, you use the same amount of space both years. In other words, you did not have to expand your square footage for the sales growth in 2019. The relatively modest increase in facilities expense (only 5.2 percent, as shown in Figure 5-1) is due to inflationary cost pressures. Sooner or later, however, continued sales growth will require expansion of your square footage. Indeed, you may have to relocate to get more space.

Looking over or looking into other expenses

In your income statement (refer to Figure 5-1), the last expense line is the collection of residual costs that aren’t included in another expense. A small business has a surprising number of miscellaneous costs — annual permits, parking meters, office supplies, postage and shipping, service club memberships, travel, bad debts, professional fees, toilet paper, and signs, to name just a handful. A business keeps at least one account for miscellaneous expenses. You should draw the line on how large an amount can be recorded in this catchall expense account. For example, you may instruct your accountant that no outlay over $250 or $500 can be charged to this account; any expenditure over the amount has to have its own expense account.

The cost control question is whether it’s worth your time to investigate these costs item by item. In 2019, these assorted costs represented only 1.5 percent of your annual sales revenue. Most of the costs, probably, are reasonable in amount — so, why spend your valuable time inspecting these costs in detail?

On the other hand, these costs increase $15,594 in 2019 (see Figure 5-1), and this amount is a relatively large percent of your profit for the year:

$15,594 increase in other expenses ÷ $95,651 net income for year = 16.3% of profit for year

Ask the accountant to list the two or three largest increases. You may see some surprises. Perhaps an increase is a one-time event that will not repeat next year. You have to follow your instincts and your experience in deciding how deep to dive into analyzing these costs. If your employees know you never look into these costs, they may be tempted to use one of these expense accounts to conceal fraud. So, it’s generally best to do a quick survey of these costs, even if you don’t spend a lot of time on them. It’s better to give the impression that you’re watching the costs like a hawk, even if you’re not.

Running the numbers on interest expense

Interest expense is a financial cost — the cost of using debt for part of the total capital you use in operating the business. It’s listed below the operating profit line in the income statement (see Figure 5-1). Putting interest expense beneath the operating profit line is standard practice, for good reason. Operating profit (also called operating earnings, or earnings before interest and income tax) is the amount of profit you squeeze out of sales revenue before you consider how your business is financed (where you get your capital) and income tax.

Obviously, interest expense depends on the amount of debt you use and the interest rates on the debt. Figure 5-3 shows the balance sheets of your business at the end of the two most recent years. At the end of 2018, which is the start of 2019, you had $400,000 of interest bearing debt ($100,000 short-term and $300,000 long-term). Early in 2019, you increased your borrowing and ended the year with $600,000 debt ($200,000 short-term and $400,000 long-term). Based on the $600,000 debt level, your interest expense for the year is 8.3 percent.

Because you negotiated the terms of the loans to the business, you should know whether this interest rate is correct. By the way, the interest expense in your income statement may include other costs of borrowing, such as loan origination fees and other special charges in addition to interest. If you have any question about what’s included in interest expense, ask your accountant for clarification.

Comparing your P&L numbers with your balance sheet

You should compare your P&L numbers on the income statement with your balance sheet numbers. Basically, you should ask whether your sales and expenses for the year are in agreement with your assets and liabilities. Every business, based on its experience and its operating policies, falls into ruts regarding the sizes of its assets and liabilities relative to its annual sales revenue and expenses. If one of these normal ratios is out of kilter, you should find out the reasons for the deviation from normal. (See Chapter 3 in Book 3 for more about balance sheets.)

A small business owner should definitely know the proper sizes of assets and liabilities relative to the sizes of the business’s annual sales revenue and expenses.

Three critical tie-ins between the income statement and balance sheet are the following:

• Accounts receivables/Sales revenue from sales on credit: Your ending balance of accounts receivable (uncollected credit sales) should be consistent with your credit terms. So, if you give customers 30 days credit, then your ending balance should equal about one month of credit sales.
• Inventory/Cost of goods sold expense: Your ending inventory depends on the average time that products spend in your warehouse or on your retail shelves before being sold. So, if your inventory turns six times a year (meaning products sit in inventory about two months on average before being sold), your ending inventory should equal about two months of annual cost of goods sold.
• Operating liabilities/Operating costs: Your ending balances of accounts payable and accrued expenses payable should be consistent with your normal trade credit terms from vendors and suppliers and the time it takes to pay accrued expenses. So, if your average credit terms for purchases are 30 days, your ending accounts payable liability balance should equal about 30 days of purchases.

You should instruct your accountant to do these calculations and report these P&L/balance sheet ratios so that you can keep tabs on the sizes of your assets and liabilities.

A business can develop solvency problems. One reason is that the owner keeps a close watch on the P&L but ignores what was going on in the balance sheet. Assets and liabilities were getting out of hand, but the owner thought that everything was okay because the P&L looked good.

One additional purpose for comparing your P&L numbers with your balance sheet is to evaluate your profit performance relative to the amount of capital you’re using to make the profit. Your 2019 year-end balance sheet reports that your owners’ equity is $741,780 (see Figure 5-3). This amount includes the capital the owners (you and any other owners) put in the business (invested capital), plus the earnings plowed back into the business (retained earnings). Theoretically, the owners could have invested this $741,780 somewhere else and earned a return on the investment. For 2019, your business earned 12.9 percent return on owners’ equity:

$95,651 net income for 2019 ÷ $741,780 2019 year-end owners’ equity = 12.9% return on owners’ equity capital

Keep in mind that the business is a pass-through tax entity. So, the 12.9 percent return on capital is before income tax. Suppose that the average income tax bracket of the owners is 25 percent (it may very well be higher). Taking out 25 percent for income tax, the return on owners’ equity is 9.7 percent. You have to decide whether this percentage is an adequate return on capital for the owners (you, but also any other owners). And don’t forget that the business did not pay cash dividends during the year. All the profit for the year is retained; the owners did not see any cash in their hands from the profit.

Selecting a cost of goods sold expense method

The cost of goods sold expense is the largest expense of businesses that sell products, typically more than 50 percent of the sales revenue from the goods sold. In the business example, cost of goods sold is 58 percent of sales revenue in the most recent year (refer to Figure 5-1). You would think that the accounting profession would have settled on one uniform method to record cost of goods sold expense. This isn’t the case, however. Furthermore, the federal income tax law permits different cost of goods sold expense methods for determining annual taxable income. A business has to stay with the same method year after year (although a change is permitted in very unusual situations).

This chapter is directed to small business owners, not accountants. There’s no reason for a small business owner to get into the details of the alternative cost of goods sold expense methods. Your time is too valuable. Like other issues that you deal with in running a small business, the basic question is this: What difference does it make? Generally, the method doesn’t make a significant difference in your annual cost of goods sold expense — assuming that you don’t change horses in the middle of the stream (in other words, that you keep with the same method year after year). Instruct your accountant to give you a heads up if your accounting method causes an unusual, or abnormal impact, on cost of goods expense for the year.

Your cost of goods sold expense accounting method affects the book value of inventory, which is the amount reported in the balance sheet. Under the first-in, first out (FIFO) accounting method, the inventory amount is based on recent costs. For example, refer to the balance sheet in Figure 5-3. Inventory at year-end 2019 is reported at $250,670. Under the FIFO method, this amount reflects costs of products during two or three months ending with the balance sheet date. Instead of using FIFO or LIFO, a business can split the difference as it were and use the average cost method. The average cost accounting method reaches back a little further in time compared to the FIFO method; the cost of ending inventory is based on product costs from throughout the year under the average cost method.

If you use the last-in, first-out (LIFO) accounting method, the cost value of your year-end inventory balance could reach back many years, depending on how long you have been using this method and when you accumulated your inventory layers. For this reason, businesses that use the LIFO method disclose the current replacement cost of their ending inventories in a footnote to their financial statements to warn the reader that the balance sheet amount is substantially below the current cost of the products.

Which cost of goods sold expense method should you use, then? You might start by looking at your sales pricing policy. What do you do when a product’s cost goes up? Do you wait to clear out your existing stock of the product before you raise the sales price? If so, try the first-in, first-out (FIFO) method, because this method keeps product costs in sync with sales prices. On the other hand, sales pricing is a complex process, and sales prices aren’t handcuffed with product cost changes. To a large extent, your choice of accounting method for cost of goods sold expense depends on whether you prefer a conservative, higher-cost method (generally LIFO) — or a liberal, lower-cost method (generally FIFO).

Dealing with inventory shrinkage and inventory write-downs

Deciding which cost of goods sold expense accounting method to use isn’t the main concern of many small businesses that carry a sizable inventory of products awaiting sale. The more important issues to them are losses from inventory shrinkage and from write-downs of inventory caused by products that they can’t sell at normal prices. These problems are very serious for many small businesses.

Inventory shrinkage stems from theft by customers and employees, damages caused by the handling, moving, and storing of products, physical deterioration of products over time, and errors in recording the inflow and outflow of products through the warehouse. A business needs to take a physical inventory to determine the amount of inventory shrinkage. A physical inventory refers to inspecting and counting all items in inventory, usually at the close of the fiscal year. This purpose is to discover shortages of inventory. The cost of the missing products is removed from the inventory asset account and charged to expense. This expense is painful to record because the business receives no sales revenue from these products. A certain amount of inventory shrinkage expense is considered to be a normal cost of doing business, which can’t be avoided.

Also, at the close of the year, a business should do a lower of cost or market test on its ending inventory of products. Product costs are compared against the current replacement costs of the products and the current market (sales) prices of the products. This is a twofold test of product costs. If replacement costs have dropped or if the products have lost sales value, your accountant should make a year-end adjusting entry to write down your ending inventory to a lower amount, which is below the original costs you paid for the products.

Recording inventory shrinkage expense caused by missing products is cut and dried. You don’t have the products. So, the cost of the products is removed from the asset account — that’s all there is to it. In contrast, writing down the costs of damaged products (that are still salable at some price) and determining replacement and market values for the lower of cost or market test is not so clear-cut.

A business may be tempted to write down its inventory too much in order to minimize its taxable income for the year. You’re on thin ice if you do this, and you better pray that the IRS won’t audit you.

In recording the expense of inventory shrinkage and inventory write-down under the lower of cost of market test, your accountant has to decide which expense account to charge and how to report the loss in your income statement. Generally, the loss should be included in your cost of goods sold expense in the income statement because the loss is a normal expense that sits on top of cost of goods sold. However, when an abnormal amount of loss is recorded, your accountant should call the loss to your attention — either on a separate line in the income statement or in a footnote to the statement.

CART: Complete, Accurate, Reliable, and Timely

Complete, Accurate, Reliable, and Timely (CART) applies to all the data and information you need to prepare for the projection model. It doesn’t matter where the information is coming from or how it’s presented; it just must be complete, accurate, reliable, and timely:

• Complete: Financial statements produced for a company include a balance sheet (see Chapter 3 in Book 3), an income statement (see Chapter 2 in Book 3), and a cash flow statement (see Chapter 4 in Book 3). All three are needed in order to understand the entire financial picture of a company. If a projection model is incorporating an expansion of a company’s manufacturing facility in a new state, for example, all information related to the new facility needs to be accumulated to prepare the budget. This data includes the cost of the land and facility, how much utilities run in the area, what potential environmental issues may be present, whether a trained workforce is available, and if not, how much will it cost to train them, and so on. Although overkill is not the objective, having access to all material information and data is.
• Accurate: Incorporating accurate data represents the basis for preparing the initial budget. Every budget needs to include the price your company charges for the goods or services it sells, how much you pay your employees, what the monthly office rent is, and so on. The key to obtaining accurate information is ensuring that your accounting and financial information system is generating accurate data.
• Reliable: The concepts of reliability and accuracy are closely linked but also differ as well. It may be one thing to obtain a piece of information that is accurate, but is it reliable? For example, you may conduct research and find that the average wage for a paralegal in San Diego is $24 per hour. This figure may sound accurate, but you may need a specialist paralegal who demands $37 per hour.

• Timely: The information and data accumulated must be done in a timely fashion. It’s not going to do a management team much good if the data and information that is needed is provided six months after the fact. Companies live and die by having access to real-time information on which to make business decisions and change course (and forecasts) if needed.

SWOT: Strengths, Weaknesses, Opportunities, and Threats

Don’t be afraid to utilize a Strengths, Weaknesses, Opportunities, and Threats (SWOT) analysis, which is an effective planning and budgeting tool used to keep businesses focused on key issues. The simple SWOT analysis (or matrix) in Figure 5-4 shows you how this process works.

A SWOT analysis is usually broken down into a matrix containing four segments. Two of the segments are geared toward positive attributes, such as your strengths and opportunities, and two are geared toward negative attributes, such as your weaknesses and threats. In addition, the analysis differentiates between internal company source attributes and external, or outside of the company source attributes. Generally, the SWOT analysis is meant to ensure that critical conditions are communicated to management for inclusion in the budget.

As an owner of a business, you must be able to understand the big picture and your company’s key economic drivers in order to prepare proper business plans, strategies, and ultimately, forecasts. The ability to understand and positively affect the key economic drivers of your business and empower the team to execute the business plan represents the end game. Getting lost in the forest of “Why did you spend an extra $500 on the trip to Florida?” is generally not the best use of the owner’s time.

Flash reports

Flash reports are a quick snapshot of critical company operating and financial data, which is then used to support the ongoing operations of the business. All types of flash reports are used in business, and they range from evaluating a book-to-bill ratio on a weekly basis, to reporting daily sales activity during the holiday season, to looking at weekly finished goods inventory levels.

The goal with all flash reports remains the same in that critical business information is delivered to you for review much more frequently. As such, flash reports tend to have the following key attributes present:

• Flash reports tend to be much more frequent in timing. Unlike the production of financial statements (which occurs on a monthly basis), flash reports are often produced weekly and, in numerous cases, daily. In today’s competitive marketplace, small business owners are demanding information be provided more frequently than ever to stay on top of rapidly changing markets.
• Flash reports are designed to capture critical operating and financial performance data of your business or the real information that can make or break your business. As a result, sales activities and/or volumes are almost always a part of a business’s flash reporting effort. Once you have a good handle on the top line, the bottom line should be relatively easy to calculate.
• Flash reports aren’t just limited to presenting financial data. Flash reports can be designed to capture all kinds of data, including retail store foot volume (or customer traffic levels), labor utilization rates, and the like. Although you may want to know how sales are tracking this month, the store manager will want to keep a close eye on labor hours incurred in the process.
• Flash reports obtain their base information from the same accounting and financial information system that produces periodic financial statements, budgets, and other reports. Though the presentation of the information may be different, the source of the information should come from the same transactional basis (of your company).
• Flash reports are almost exclusively used for internal management needs and are rarely delivered to external parties. The information contained in flash reports is usually more detailed in nature and tends to contain far more confidential data than, say, audited financial statements, and are almost never audited.
• Flash reports are closely related to the budgeting process. For example, if a company is experiencing a short-term cash flow squeeze, the owner will need to have access to a rolling 13-week cash flow projection to properly evaluate cash inflows and outflows on a weekly basis. Each week, the rolling 13-week cash flow projection is provided to the owner for review in the form of a flash report, which is always being updated to look out 13 weeks.

Flash reports should act more to “reconfirm” your company’s performance rather than representing a report that offers “original” information. Granted, though a flash report that presents sales volumes for the first two weeks of February compared to the similar two-week period for the prior year is reporting new sales information, the format of the report and the presentation of the information in the report should be consistent. Thus, you should be able to quickly decipher the results and determine whether the company is performing within expectations and what to expect on the bottom line for the entire month.