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Some Banks Still Not Understanding Tax Returns

Posted on April 10th, 2020

Jack Kern
Owner/Pres.
Outsourced Accounting Department, Inc.

Marianne has been reading articles and comments by other CPA firms about what’s going on right now with these emergency SBA loan applications. One person said that the banker told their client “they should not have taken the 179 deduction because it reduced their income,” and there were other similar comments. This reminded me of several articles I wrote on this subject a while back about the difference between “book” and “tax” accounting, and the difference between “profit” and “taxable income:”

The Difference Between Your CPA and a Controller: M1

The Difference Between Your CPA and a Controller – Part 2

Profit vs. Taxable Income

The Risks of Misinterpreting Your Financial Statements 


Do What You Hate and the Losses Will Follow

Posted on September 5th, 2019

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Several years ago I read an inspirational book, “Do What You Love and the Money Will Follow” which in part, led to a few career changes I made.  Of course, nothing in life is quite that simple, especially in a society where supply and demand rule, and economic change, or “creative destruction” (as described by Alan Greenspan in his book, “Capitalism In America“) is the norm.  But it does make a good point, that if your work is closely aligned with your inherent talents, or in other words, your “spiritual gifts,” you have a much better chance of succeeding.

But what if the opposite is true, and you spend most of your time performing tasks that you hate doing?  In a recent article, “4 Reasons Why You Should Consider Outsourcing Your Bookkeeping,” I listed some reasons why it is advantageous for small business owners to outsource their bookkeeping, such as accuracy and the lack of accounting knowledge, or in general, avoiding making a mess out of your books that someone else eventually has to clean-up at tax time, and at your expense.  But reason number 4 in this article may be the most important, and that is, the other, more profitable activities you could be doing with your time if you weren’t spending it trying to do your own books.

This article from Entrepreneur Magazine,The 80/20 Rule of Time Management: Stop Wasting Your Time,” hits that nail right on the head with this statement:

“Sometimes you have to do everything when you start out. But now you’re doing a $10 or $20 per hour fix-the-faucet job and you’re not doing your No. 1 job, which is getting and keeping customers. That job pays $100 to $1,000 per hour.”

The author’s example of how this particular business owner is spending his or her time is an example of the old cliché, “penny-wise and pound-foolish,” and his point is a perfect example of an “opportunity cost.”  So how may this concept also apply to doing your own bookkeeping?

To illustrate, assume your sales are currently running at $100,000 a year, and your gross margin after your direct cost of sales is 50%.  Now assume that by shifting your focus from “bookkeeping” to “marketing” you could increase sales by say 20% per year to start.  The increase in your available profit would then be $100,000 times 20% times 50% = $10,000 (which flows right to your bottom line).

Now, assume that you can outsource all or part of your bookkeeping at say $350 per month, or $4,200 per year.  Your “opportunity cost” in this example would then be $10,000 minus $4,200, or $5,800 per year!  In other words, that’s the profit you are forgoing by doing your books yourself in an effort to “save money.”

Of course, there may be other marketing costs you would incur depending on how you go about increasing your sales, but you get the general idea.  The ultimate question is, as a small business owner, how would you prefer to spend your time, and is that the most profitable use of your time?

Related Articles:

What’s the One Task Most Small-Business Owners Loathe?

Part-Time vs. Full-Time Bookkeeper, Controller, and CFO

The Difference Between Your CPA and a Controller: M-1

The Role of Cost Accounting in Planning Your Business’ Success


What Is My Shareholder Basis?

Posted on July 23rd, 2019

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Recently I’ve had a couple of clients ask me how much money they can safely distribute to themselves without triggering additional taxes. In essence, the question they were asking me is “What Is My Shareholder Basis?” The longer answer to this question is contained in these two articles:  The Basis of S-Corporation Stock Basis,  and S-Corporation Stock and Debt Basis.  But at the risk of oversimplifying the matter, your shareholder basis is the (net) amount of money you’ve put into the business in the form of loans and/or equity capital, plus the profit you’ve accumulated over time (i.e., Retained Earnings).  These amounts are found on the balance sheet.  For example:

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On the balance sheet in the above financial statements, under the Projected 2019 column it shows the following amounts:

Due to Member / Stockholder:        $56,707

Total Capital:                                        60,875

Due From Member                           (10,000)

Shareholder Basis:                          $107,582

In this instance, Total Capital at Dec. 2019 consists only of the company’s Retained Earnings, and includes its 2018 Net Income of $18,704, plus its 2019 Net Income of $58,427, less “Dividends” (tax distributions) of $1,649 and $14,607 in 2018 and 2019 respectively, resulting in the ending Retained Earnings of $60,875.

However, note that in this business, the financial statements are prepared on an accrual basis, so the company’s 2019 balance sheet now includes the non-cash items of $41,096 in accounts receivable which is added to Net Income, and $25,149 in accounts payable which is subracted from Net Income. Assuming the company’s tax return is prepared on a cash basis, these amounts would be adjusted back out of Net Income (and therefore, out of Retained Earnings), resulting in a Shareholder Basis for tax purposes of $91,635 (page 4 of the above financial statements).

Thus, the maximum amount the owner can distribute to him or herself without incurring additional taxes (and ignoring the cash needed by the business to operate) is $91,635.  Why? The Due to Member amount, less the Due From Member amount, is the owner’s own money that he or she has lent to the business, and the Net Income has already been taxed (through the K-1 on the owner’s personal tax return which, in this case, are the above tax distributions of $1,649 and $14,607).

Again, the tax codes are more complicated than the above illustration. So if you think the amount you want to distribute would put you close to your maximum, seek advice from your CPA or tax preparer.

Related Articles:

Profit vs. Taxable Income

Analyzing the Components of Cash Flow

Whose Income is K-1 Income Anyway, Mine or My Business’?     


“Profit” is Not a Dirty Word

Posted on December 17th, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In the news recently, General Motors announced the closing of several plants causing an uproar in Washington, especially after the government bailed them out only a few years ago (which in truth was to rescue the economy, not just “GM”).  So what’s the problem?  Is GM just being greedy, or unappreciative, or what?

At the risk of over-simplifying the matter, a while back I worked for a company as its Vice President of Finance.  Due to the loss of a major contract the company had been counting on, the owner of the company was forced to cut expenses, which included among other things, temporarily halting some employee benefits such as matching contributions on the company’s 401(k) plan.  Shortly after these measures were announced, a disgruntled employee left a note on the bulletin board accusing the owner of being “greedy.” When the owner saw this note, he called me into his office to show it to me, and he was visibly heartbroken.

The truth of the matter was, despite the company’s losses and tight cash flow, and because of the owner’s compassion for his employees, he was avoiding making any staff reductions, even though reductions were warranted under the circumstances.  Instead, he invested more and more of his personal funds into the business to fund its operating losses and keep the company afloat, while continuing to attempt to “grow the business” to restore profitability – until, that is, the bank stepped in and put a stop on everything because the company continued to show operating losses. Ultimately, he was forced to sell the company in a distressed sale.  So a lot of those employees eventually lost their jobs anyway, and the owner ended up having to pay back a large amount of the company’s debt personally.

As I have talked about in several articles, profit is not just a “number,” it’s a critical component of cash flow, and without it, the business will eventually die.  To illustrate, the below Profit & Loss, Cash Flow Statement, and Asset-Based Credit Facility – Borrowing Availability, reflects the dramatic impact that operating losses have on cash flow:

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Note the large “over-advance” on the line of credit. This reflects the funding requirement from external sources caused by the operating losses. The reality however, is that a bank isn’t going to knowingly fund these losses, as profit is (ultimately) what repays debt in the first place.  So in lender jargon, there is no “source of repayment.”  Nor will most investors be interested who are also looking to the company’s earnings for a return on their investment.

The point is, when a business is losing money, those funds have to come from somewhere.  Those losses represent being drained out of the company to pay suppliers, loan payments, and yes, payroll!  When the funds eventually dry up, the business either dies, or makes the expense adjustments necessary for survival.  Or, in the case of what large companies like General Motors did a few years ago, allow the government (you and I) to fund their losses.  But sooner or later, even tax money can run out (whole different topic).

The moral of the story is, if a business cannot be made to operate profitably, someone is going to end up “holding the bag.” The only question then is, WHO?  The bank? As indicated above, not if they can help it, banks are risk averse by design; taxpayers? possibly, whether they like it or not (if the company is big enough to have an economic impact); or, the owner / shareholders – most likely, as they have the most at risk.  But (most) business owners and shareholders don’t invest their money into businesses just to lose it, and they are not going to keep pouring money into a losing proposition.  They are interested in a return on their investment (“ROI”), or in other words – “Profit,” the motive that led to the creation of those jobs in the first place, .

Related Articles

Analyzing the Components of Cash Flow

Which is More Important, Profit or Cash Flow

Case Study: The Risk of Sales Concentrations

Larry’s Fairy Godmother Strategies, Inc.

If We Build It, Will They Come?

Strategic Financial Management vs. Crisis Management

 


Part-Time vs. Full-Time Accounting Staff

Posted on December 9th, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In my previous article, “Difference Between a Bookkeeper, Controller, CFO, and Tax Accountant,” I briefly described the responsibilities of these various accounting roles.  In this article I will discuss the advantages of outsourcing these tasks vs. when it’s time to bring them in house.

To start, this article from the October 2016 issue of Entrepreneur Magazine provides a good overview of accounting roles: “How and When to Grow Your Company’s Accounting Function.” One role the article leaves out is that of the Controller, which falls between bookkeeper and Chief Financial Officer. The difference between the two is that the Controller’s position is more of an accounting role, while the Chief Financial Officer (CFO) role is more “big picture.” In reality, sometimes they are combined into one position, which I believe is what the author of this article was assuming.

Again, in our business, the organization chart would look something like this with the client in the traditional role of “Chief Executive Officer,” and the boxes in red are the services we typically provide:

 

In our business, the data entry may be performed to a degree by the small business owner using QuickBooks, and to a larger extent by a part-time bookkeeper on our staff.  Or in some cases, it’s performed entirely by our staff person when the owner doesn’t want to have anything to do with bookkeeping.

The next level up on the chart then is the Controller, who reviews, adjusts, and closes the books after everything has been entered and reconciled by the bookkeeper, and then issues and analyzes the financial statements (going back down the right side of the chart).  The emphasis here is on tying out the client’s books to source documentation such as loan documents, capitalizing and depreciating fixed assets, and matching costs to revenues (or in the case of the latter, on “management” and “financial” accounting vs. “tax basis” – see previous articles referenced above and below).  I refer to this “value-added” level of bookkeeping as “Part-Time CFO/Controller.”  This is where I believe we differ from individuals or firms that perform only data entry or QuickBooks consulting functions, who often leave it up to the tax preparer to “fix” the accounting at year-end, and often in their tax software, not your books (thus rendering your books completely useless for managing and planning your business).

While the business is small, the internal accounting can be accomplished on a part-time, “as-needed” monthly basis, with each accounting level remaining more affordable during the early growth stages.   Then as your business grows larger, the accounting functions become more full-time in terms of hours required, and that is when it’s time to consider bringing the positions in-house on your payroll.  While there are no hard and fast rules as to when it’s time to add a full-time accounting staff, I tend to use these rules of thumb:

Gross Revenues Accounting Staff Annual Compensation
Start-Up to $100,000 Outside Tax Accountant $500 to $2,000 (Tax Returns only)
$100,000 to $5 million Part-Time CFO/Controller $2,100 to $12,000 (Combined)
$5 to $10 million Full-Time Bookkeeper + Controller $35,000 + 75,000 = $110,000
Over $10 million Full-Time CFO $75,000 to $100,000 +

Obviously, every company’s accounting needs are different, so there will be some overlap between business sizes as to when you actually start adding a full-time staff, who, and at what salary.  Also, a major controlling factor as to when to hire a full-time staff person is the company’s bottom line profit.  A company with higher profit margins can afford to add staff people sooner than a company with thin margins.  Aside from that issue, as I’ve said previously, most small business owners know when the time is right to add a full-time accounting department staff.  But until that time, it is essential that proper accounting not be ignored, as that historical financial data will be needed later when applying for a business loan or selling the business.

 Related Articles:

Why Outsource Your Bookkeeping?

The Opportunity Cost of Being Your Own Bookkeeper

Profit vs. Taxable Income

Profit vs. Cash Flow Revisited: The Matching Principle 

The Difference Between Your CPA and a Controller: M-1

The Relationship Between Financial Management and Loan Underwriting

Larry’s Exit Strategies, Inc. 

 


Difference Between a Bookkeeper, Controller, CFO, and Tax Accountant

Posted on December 2nd, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Often times I find that many of our clients are a bit confused as to the difference between various accounting roles, and therefore, the various functions our firm performs behind the scenes.  In fact, most small business owners I’ve worked with tend to think in terms of “tax,” as that is the first accounting issue they learned they needed to address when they started their business.  So the challenge we frequently encounter is one of educating our clients on how all of these roles tie together, and the importance of each role to their particular business.

An excellent “Glossary of Job Descriptions for Accounting and Finance” is published by Robert Half International, an employee staffing agency.  The job titles highlighted in yellow in the previous link more or less correspond to the functions we perform.  Of course the larger the business, the larger the internal accounting department that is required to perform the accounting function.  Conversely, the smaller the business, the fewer accounting positions that are justified.

With very small businesses, many small business owners attempt to perform their own bookkeeping using QuickBooks.  But then many often learn that QuickBooks is not as easy as its name implies, and they end up making a mess out of their books that someone has to clean-up, usually their CPA at year-end at CPA hourly rates.  And worse, they often find that “bookkeeping” has become a distraction from running their own business, and a task they’ve come to dread.  So, eventually, during the early stages of their business’ development, many small business owners discover that they are better off outsourcing the bookkeeping task all together so that they can focus their attention on their own business.  This is where our firm comes into the picture, wherein we perform the “accounting department” function on as “as needed,” part-time basis.

In our business, the organization chart would look something like this with the client in the traditional role of “Chief Executive Officer,” and the boxes in red are the services we typically provide:

In a nutshell, here are our “job descriptions:”

  • Bookkeeper:  Performs all data entry including bank and credit card transactions and reconciles same to month-end statements. Provides assistance to some clients who perform some tasks in QuickBooks and need our help.
  • Controller:  Oversees bookkeeper’s work; performs month-end adjustments and closing.  Creates month-end financial statements and various custom reports for client.  The emphasis  here is on management accounting and financial accounting. Provides assistance to some clients who perform some tasks in QuickBooks and need our help.
  • CFO (Chief Financial Officer):  As a business grows, its accounting and financial needs becomes more complex. In terms of the functions our firm provides, this would encompass (on an “as-needed,”part-time basis), financial analysis including ratio analysis, and strategic financial planning including budgeting, projections, business plan assistance, and in some cases, communicating the company’s financial results to prospective lenders and investors.  In terms of the above chart, the CFO role encompasses the positions of FP&A (Financial Planning & Analysis), and Financial Analsyst down the right hand side of the chart, which are all performed by myself (see Owner and Management.)
  • Tax Manager: Converts the company’s books for tax accounting purposes for preparation of the year-end tax return; provides assistance in various other tax related matters such as sales tax, property tax, etc.  (In our organization, this function is performed by an outside CPA firm, our affiliate, Kern and Associates CPA, P.A. which is owned by Marianne Kern, CPA (see Owner and Management).  Marianne’s primary focus is providing tax assistance to our business clients who do not already have an outside tax accountant.)
  • Payroll: While QuickBooks includes a payroll module, in our opinion, it is a tedious process that is more efficiently and economically managed by outside payroll companies.  These company’s typically guaranty timely and accurate submission of payroll tax returns and payment of payroll taxes which most CPA firms I know of do not, and at rates that are more affordable to the client vs. what a CPA firm would charge.  For this reason, we also see many CPA firms who prefer to outsource this task to a payroll company vs. offering this service themselves.

If you have questions on any of the above, as always, please do not hesitate to give us a call or send us an email.  Our contact info is on our website.

Related Articles:

The Difference Between Your CPA and a Controller-M-1

Winging It In QuickBooks

How You Use QuickBooks Can Distort Your Company’s Profitability 

Why Outsource Your Bookkeeping?

The Opportunity Cost of Being Your Own Bookkeeper

 

 


It’s the Most Wonderful Time of the Year – Year-End Accounting Cleanup

Posted on November 25th, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

It’s that time again!  The taxes are coming due, and your books may have gone all year without being looked at by an accountant. If so, what many business owners don’t realize is that when your CPA or tax preparer takes your books to prepare your tax return, they are not performing an “audit,” so they are not providing any assurances to the IRS as to the underlying validity of the income and deductions you show on your books. They may make some obvious adjustments for tax purposes in their own tax software, but may or may not provide those changes to you to enter in your books.

Thus, whenever we review a client’s QuickBooks file, we look at it first from the viewpoint of a CFO / Controller to make sure the financials make sense (and for “book” purposes, not tax). Here are the types of things we look at before I send the financials to an outside CPA firm or tax preparer:

Balance Sheet – Pull it up as of December 31st, and create a comparison to the previous year, and check the following:

  • Bank Reconciliations – This is the starting point.  Make sure your bank accounts are reconciled to the bank statements. This tells you that you at least have accounted for all of your cash. Even if it’s not categorized properly, you can always correct the account classifications later.  Make sure that the “cleared” balance agrees with the ending balance on your bank statement.
  • Credit Card Reconciliations – If you track credit cards in QuickBooks, reconcile those the same way you would reconcile your bank account. Make sure all charges are entered and categorized, all payments are recorded, and that the “cleared” balance in QuickBooks agrees with the year-end credit card statement balance.
  • Negative Account Balances: (other than “Accumulated Depreciation,” “Retained Earnings,” and “Net Income”). Negative balances in any accounts other than these three indicate major accounting or set-up errors and need to be investigated and corrected. For example, common mistakes I’ve seen are setting up credit card or loans accounts as a “Bank” type account, or posting payments to accounts payable without first entering the bills.
  • Due To (liability) / From (asset) Stockholder Accounts:  Throughout the year, funds may be lent to the business by the owner (“Due To” account), or taken out of the business in the form of cash transfers or personal expenses (“Due From” account).  Care should be taken to make sure this information is accurate as these accounts affect your “basis” in the company.  For example, if you take money out of the business that exceeds your “basis,” it can cause you to pay more taxes even if your business had no income.
  • Inter-Company Loans: Multiple “company files” with extensive inter-company transactions, with no effort to reconcile and consolidate the financial statements.  The amount owed to Company A, “Due From Affiliate”(asset side), should logically equal the amount owed by Company B, “Due To Affiliate” (liability side).  If not, investigate and correct.
  • All other balance sheet accounts should be “tied out” to external documentation such as year-end statement balances, loan amortization schedules, etc. A common mistake we see is entire loan payments being posted against the loan balance or the Profit & Loss statement, rather than separating the principal and interest portion.

Profit and Loss – Account Classifications – After your bank accounts have been reconciled, the next step is to create a “detailed” Profit & Loss Statement report (or other accounting report) and do the following:

  • Salaries & Wages – Verify that they agree with your W-3 and W-2s.  If you do your own payroll, make sure it was done correctly and that “gross” salaries are just that, NOT your net paychecks.
  • Officer Salaries – If you are an S-Corporation, ensure that Officer Salaries are “reasonable” in relation to the business’ profit.  And note, what is “reasonable” is very subjective and something you should have discussed with your tax preparer before year-end, as this is closely monitored by the IRS and can trigger an audit.  Read More.
  • Meals & Entertainment are clearly identified.
  • Fixed Asset Purchases – Larger amounts, say over $1,000.00 (your tax preparer may use a larger threshold for tax purposes), should be posted to Fixed Assets on the Balance sheet, not the P&L, and clearly described in the memo field.
  • All other expenses are categorized where they belong and consistent with the prior year, which by now, should also have been adjusted to agree with the prior year tax return (except for book and tax differences).
  • Net Income – Ultimately, your prior year net income should agree with the “Net Income (Loss) Per Books” shown on your prior year tax return (Schedule M-1, line 1), as this is where your tax preparer will begin when preparing your current year taxes.

The above are just a few of the major items that need to be looked at, but these will go a long way toward achieving accounting accuracy.  Again, keep in mind that in the end, the burden of accurate reporting of income and deductions still rests with you – the business owner.

Related Articles:

What Is the Role of a Company’s Controller?

The Difference Between Your CPA and a Controller – M1

How You Use QuickBooks Can Distort Your Company’s Profitability

Winging It In QuickBooks

Why Outsource Your Bookkeeping?

 


The Risks of Misinterpreting Your Financial Statements

Posted on October 7th, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Many small business owners I’ve known view their financial statements as something that is only needed for tax purposes. However, to ignore or misinterpret what your financial statements are telling you, and then not utilize that information to forecast where your business is headed, can be a recipe for major disappointments, or worse, a future financial disaster.

I have written numerous articles that touch on this topic in one way or another. Here “in a nutshell” are the financial risks that you could be exposing your business to:

  • Loan Application Declined – You get turned down for a business loan because your tax return is showing a “loss,” when your business is actually profitable. (See topics on “accrual vs. cash basis accounting,” and “establishing lender relationships”).
  • Taxable Income vs. Operating Losses – Your tax return indicates you are making a “profit,” but your business is actually losing money. As sales decline, cash flow may temporarily increase due to declining accounts receivable and inventory.  But eventually, all of your cash is drained out of the business due to the underlying losses until it, and maybe you, are bankrupt. (See topics on “accrual vs. cash basis accounting,” “profit vs. cash flow,” and “turnover ratios”).
  • Past Due Loan Payments – You’re defaulting on loan payments even though your tax return is showing a profit. (See topics on “accrual vs. cash basis accounting,” “loan repayment,” “cash flow,” and “income vs. cash flow”).
  • Profit but No Cash– Your financial statements are showing a profit, but your checkbook doesn’t reflect that and you’re running out of cash.  Possible causes are rapid sales growth, or your receivable collections, inventory purchases, or accounts payable, are poorly managed, or sources and uses of funds are not properly matched. (See topics on “sales growth,” “sales concentrations,” “turnover ratios,” “cash management,” “asset-based borrowing availability,” and “matching of sources and uses of funds.”)
  • Inability to Sell the Business – Over the years, you’ve done a great job of minimizing (or avoiding?) taxes. But then when you’re ready to retire, on paper, your business isn’t worth anything in the eyes of prospective buyers. (See topics on “exit strategies,” “accrual vs. cash basis accounting,” “financial planning” and “budgeting.”)

Related Articles:

For more information on these topics, browse our blog articles (including in the archives off to the right) in our website at www.kernaccounting.com.  To better understand the difference between our firm and other accounting and bookkeeping firms, view these articles specifically:

The Difference Between Your CPA and a Controller: M-1

Why Outsource Your Bookkeeping?

 The Opportunity Cost of Being Your Own Bookkeeper


The Importance of Cost Accounting in Financial Planning

Posted on October 1st, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Can you point your car in the direction you want to go, step on the gas, and then sit back and wait to arrive at your destination?

Not quite. You can’t let your business run on autopilot either and expect good results. Any business owner knows you need to make numerous adjustments along the way – decisions about marketing, pricing, hiring, investments, and so on.

So, how do you handle the array of questions facing you?  A critical part of the decision-making process is financial planning, of which a major component is cost accounting.

Cost Accounting Helps You Make Informed Decisions

Cost accounting reports and determines the various costs associated with running your business. With cost accounting, you track the cost of all your business functions – raw materials, labor, inventory, and overhead, among others.

Note: Cost accounting differs from financial accounting because it’s only used internally, for decision making. Because financial accounting is employed to produce financial statements for external stakeholders, such as stockholders and the media, it must comply with generally accepted accounting principles (GAAP). Cost accounting does not.

Cost accounting allows you to understand the following:

  1. Cost behavior. For example, will the costs increase or stay the same if production of your product goes up?
  2. Appropriate prices for your goods or services. Once you understand cost behavior, you can tweak your pricing based on the current market. (Sample Price/Volume Analysis.)
  3. Budgeting. You can’t create an effective budget if you don’t know the real costs of the line items. (Sample Budget.)

Is It Hard?

To monitor your company’s costs with this method, you need to pay attention to the two types of costs in any business: fixed and variable.

Fixed costs don’t fluctuate with changes in production or sales. They include:

  • rent
  • insurance
  • dues and subscriptions
  • equipment leases
  • payments on loans
  • management salaries
  • advertising

Variable costs DO change with variations in production and sales. Variable costs include:

  • raw materials
  • hourly wages and commissions
  • utilities
  • inventory
  • office supplies
  • packaging, mailing, and shipping costs

Cost accounting is easier for smaller, less complicated businesses. In QuickBooks, you have the ability to perform “Job Costing,” which is a fairly simple method of associating the related costs to specific customer sales.  This is great for service based companies, or those buying and reselling a single product or products.  The trickier part is getting the costs and revenues into the same accounting period, which QuickBooks does not do FOR you.  At this point manual accounting adjustments are required.

If your product has component parts that make up the final product, you have “Inventory Assemblies” which is a quite a bit more involved in QuickBooks.

Either way, you first need to understand these costs before you can plan your business and make informed business decisions. The more complex your business model, the harder it becomes to assign proper values to all the facets of your company’s functioning. If you’d like to understand the ins and outs of your business better and create sound guidance for internal decision making, consider getting help from a financial professional to set up a cost accounting system that fits your business model.

Related Articles:

Strategic Financial Planning vs. Crisis Management

The Effect of Sales Growth on Cash Flow 

Case Study: The Risk of Sales Concentrations

 

 

 


Which is More Important, Profit or Cash Flow?

Posted on September 16th, 2018

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my previous article, “The Relationship Between Turnover Ratios and Cash Flow,”  I demonstrated the impact of improving receivable collections and reducing inventory levels on cash flow.  In this article, I will take it one step further and illustrate the effect profitability has on cash flow.  (And note, in this article I have now appropriately changed the name of the company to “Larry’s Survival Strategies, Inc.”)

In this scenario, I assumed that Larry has very little control over sales, so he needed to control expenses instead, and mainly, Payroll Expenses (and presumably, HIS).  Below is a comparison of his original P&L, with a Pro forma of what it would look like by holding down payroll so as to target a Net Profit of about $15,000 (i.e., 15% of sales):

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The Pro forma Cash Flow Statement now reflects the impact of  the company’s profit, in addition to the improvement in turnover ratios, on its cash position.  Note that by eliminating the cash drain created by the loss and producing a small profit, the company’s cash flow increased $117,000 (rounding) from a negative $232,000, to a negative $115,000, thus leaving a positive balance of nearly $104,000 in its operating account.

So the short answer to the question as to which is more important, profit, or cash flow, is BOTH.   However, “profit” is a critical component of cash flow that is required for the long-term survival of your business. For this particular company, even though the owner paid himself back over $175,000, if the business had been profitable, there was still sufficient cash in the business to allow him to do that.  So the most important thing was to stop (prevent) the “bleeding” due to the operating losses, as that is the most difficult cash flow issue to fix. And unchecked operating losses will, over time, drain all of the company’s cash, so that eventually, it will no longer be able to operate.

And once again, in order to know if your business is profitable, you need to maintain your books on the accrual basis of accounting.  If your books are maintained on a cash basis, you are only seeing the symptoms of your cash flow issues, not the true underlying causes, so you won’t know what needs to be fixed (or, is working well, as the case may be).

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