This happens in business, too. A business owner will invest in something (a tool, a piece of software, an employee, or a new asset, just to name a few) in order to help their business. Things go well for a while, but sooner or later that thing is no longer useful, but the entrepreneur keeps using it because they feel that they’ve paid for it so they should try to derive as much value as they can out of it.

Although it’s a common practice, it’s a mistake… and it’s often a costly one.
The whole idea is based on a concept called “sunk costs”. When you buy something, that money goes away and it won’t come back. It’s “sunk”.

Now, the item (or asset or employee or whatever) that you spent that money on might have some usefulness for a while… but nothing lasts forever. When their usefulness runs out, the best thing you can do is:

1. Stop using it
2. Find something better to replace it
3. See if you can derive any resale value from it

The LAST thing you want to do (but the thing that most entrepreneurs default to) is to try to continue using the item long past its usefulness just because you paid for it.

It’s a costly decision because the value of that item is no longer a value added to your business. Rather, it’s a perceived value about how much you need to use it before you’ve “got your money’s worth”.

Here’s an example:

An entrepreneur buys a piece of software for $500. It helps him grow his business and he uses it every day. But after one year, it’s not really running as well as he wants and his business has expanded beyond that software’s usefulness. The entrepreneur becomes disappointed, and calculates that it cost him about $2/day ($500 divided into 250 workdays). He feels that the value he SHOULD have got from that software should be $1/day at the most, so he does his best to use the software for another 250 workdays.

The entrepreneur is making the classic sunk cost mistake. He is ignoring that the $500 has helped him grow his business dramatically and earn thousands of dollars and he is forcing the software to continue to work even though its usefulness is no longer there.

Take a long look at some of the investments you’ve made in previous months and years. Are they delivering the value they should be delivering? If not, consider them a sunk cost and move on.

Fortunately, this decision is a “set it and forget it” decision because once you’ve decided, you shouldn’t change.

I’m talking about depreciation. When you buy an asset, you spend a lot of money all up-front but it won’t always be worth that amount. To use a really simple example, if you bought a $25,000 car and kept it for 10 years, you know it wouldn’t be worth $25,000 in the asset column of your balance sheet the entire time. Cars depreciate just as all assets do.

So here’s the “set it and forget it” decision you have to make:

When you depreciate your assets over time, you have a couple of options:

• One option is called the “straight line” method where you simply depreciate the asset by the same dollar amount every year. So, let’s use the example of that $25,000 car again. If you know it will be worth $2,500, you might consider depreciating the car by $2,250 each year. It’s called the “straight line” method because, if you think of a graph, there’s a straight line that descends year by year from $25,000 in the first year to $2,500 in the tenth year.

• The second option is called the “declining balance” method. This is essentially where you depreciate the asset by the same percentage every year. Because you’re reducing the value of the asset by a percentage of its value, the amount you’ll end up depreciating will be substantially higher in the earlier years than in the later years. For example, let’s say that you want to depreciate the asset by 20% per year. So in the first year, you subtract 20% from $25,000 to get $20,000. By the seventh year, you’re subtracting 20% from $6553.60 to get $5242.88. By the tenth year you’re getting close to $2,500.

So, why are we calling this the “set it and forget it” decision for new businesses? It’s simple: It’s not good to switch back and forth between the two. It can be tempting to do so if choosing one method one year might give you lower expenses and higher profits and then choosing the other method the next year for the same reason, but you’ll end up with very muddy records that really won’t be very helpful to you.

So, talk to your accountant about which one to choose. The straight line method is really simple to do, so if you like simplicity that might be one to consider. The other method is a little more complicated but businesses like it because it tends to reflect the truer value of an asset during its lifetime (since an asset is usually worth more and provides more value earlier in its lifetime than later).

You have a lot of decisions to make… and this is another one. Fortunately, once you’ve decided, you can move on and focus on other things.

• Loan-based funding
• Ownership-based funding

Loan-based funding includes borrowing money from the bank or offering a bond or promissory note to private lenders. Ownership-based funding is essentially where you sell a piece of the ownership in the company as a share or stock. You’re probably already familiar with these concepts. But what I want to talk about in this blog post is how each type of funding impacts your financial statements. Knowing this will help inform you about the best choice for your situation when it comes time to raise some capital.

The balance sheet is split in two and is made up of assets on the one side and liabilities and owner’s equity on the other. Generating $1000 cash from selling shares will add $1000 to the assets side of your balance sheet and $1000 to the owner’s equity on the other side. Generating $1000 cash from borrowing that money will add $1000 assets to the one side and $1000 loan to the liability side.

The income statement also sees these types of funding appear on it. The interest you pay on loans and bonds appears in a “creditor’s section” (after you’ve figured out your operating expenses and net profit). And any earnings due to the shareholders are handled just below that in an “owner’s section”.

Lastly, the cash flow statement also sees the impact of these financing vehicles. If you think of the cash flow statement as being divided into “Operating activities”, “Financing activities”, and “Investing activities”, the loan-based financing and ownership-based financing appear in the “Financing activities” section. You’ll include proceeds from share issues, proceeds from debt, repayment of debt, and dividends paid out.

Don’t worry if this sounds confusing to you. Accountants deal with this kind of information every day. But it is important for you to think about when you go to get financing. For example:

• Loans often require regular monthly repayment, which will impact your financial statements regularly. Loan payments structured in different ways can impact your financial statements better in some months than in others. Some loans (like revolving loans) offer regular cash to your cash flow while other loans disappear once paid back.

• Shares offer an influx of cash, rarely require repayment (unless you’re buying them back from the owners) but it does mean that you’re giving up a portion of the company to someone else. Common shares (once sold) will impact your financial statements less than preferred shares, which often get dividend payouts on a regular basis.

Raising capital is important for businesses to maintain operations but raising the right capital is important. Understanding how that capital appears on your statements is one step toward figuring out which capital is right for you.

So far we’ve…

• Looked at Revenues and came away with Net Sales
• Looked at Cost of Goods Sold (either accrual or cash-based) and came away with Gross Profit
• Looked at Operating Expenses and came away with Net Profit

But those are not the only people who have their hand in the cash register! Let’s not forget banks and the government. In this fourth and final section of the income statement breakdown, we need to make sure they get their share.

Like the other sections, you add up the various expenses you have here and subtract it from Net Profit. This section is sometimes called “Non-Operating Expenses”. If you have shareholders, some of their payouts go here, too.

Now let’s look at this part of the income statement and we’ll compare how the accrual and cash-based system work so you can see both in action:

ACCRUAL EXAMPLE

NON-OPERATING EXPENSES

Interest: $10,000
Taxes: $40,000
Subtotal: $50,000

Subtract subtotal from Net Profit: $225,000
Net Income: $175,000

CASH EXAMPLE

NON-OPERATING EXPENSES

Interest: $10,000
Taxes: $40,000
Subtotal: $50,000

Subtract subtotal from Net Profit: $645,000
Net Income: $470,000

Readers will probably notice that the cash-based business seems to end up with more profit than the accrual-based business. I don’t want you to rush out and switch your business over from accrual-based to cash-based because of this. We’re only looking at one month, with a single set of income statement numbers. There are other aspects of the business not accounted for here that will have a moderating effect on what appears to be a higher amount of profit here.

And now we’ve reached the end of the income report. This number – “Net Income” – is the bottom line of your business. It’s the number you want to grow, which you do by increasing Gross Sales and reducing all of the other costs and expenses.

In the Revenues section of your income statement, you started with Gross Sales and ended with Net Sales.  In the Cost of Goods Sold section of your income statement, you had the choice of either using the accrual method or the cash method to take the Net Sales number and end up with Gross Profit.

Now, we’re looking at operating expenses. Operating expenses, as the name implies, are the expenses associated with running your business. These expenses might include salaries, advertising, supplies, rent, insurance, utilities, and depreciation. These are added up and subtracted from the Gross Profit number we calculated in the last section of the income statement. The number we’ll end up here is sometimes called Net Profit and sometimes called “Income”.

Let’s keep building on the income statement of the fictional business we’ve been talking about, but we’ll use both the accrual example and the cash example so you can see how both work:

ACCRUAL EXAMPLE

OPERATING EXPENSES

Salaries: $300,000
Advertising: $50,000
Supplies: $10,000
Rent: $50,000
Insurance: $5,000
Utilities: $20,000
Depreciation: $5,000
Subtotal: $440,000

Subtract subtotal from Gross Profit: $665,000
Net Profit: $225,000

(This accrual example draws the Gross Profit number from the detailed example we gave last week where we calculated the opening inventory for the month and the closing inventory as well as the money the business spent on various raw materials and shipping.)

CASH EXAMPLE

OPERATING EXPENSES

Salaries: $300,000
Advertising: $50,000
Supplies: $10,000
Rent: $50,000
Insurance: $5,000
Utilities: $20,000
Depreciation: $5,000
Subtotal: $440,000

Subtract subtotal from Gross Profit: $330,000
Net Profit: $645,000

(We arrived at this number by taking the Net Sales number of $975,000 and subtracting only the money the business spent on wood, paint, nails, shipping, and warehousing – but NOT opening and closing inventory.)

This number gives us the Net Profit of the business. Many of the costs associated with doing business have been taken out of this number and what is left can be considered profit. You can use this list of operating expenses as a checklist each quarter or each year to review what you are spending and to find ways to reduce expenses. Simply slashing expenses may not give you the same result; finding ways to reduce expenses without impacting the result is what you are aiming for. For example, can you still do the same job if you reduced supplies? What about if you negotiated a longer-term lease for a lower per-month rent? Can you cut utilities by turning down the heat in the office overnight?

We’ve gone from Gross sales to Net Profit… but we’re not done with the income statement yet! Check back next week for the last step in this series.

Now we’re looking at the second section of your income statement, Cost of Goods Sold (sometimes called “COGS”). Here, we’ll add up all the costs associated with creating your product or service, and then we’ll subtract it from the Net Sales amount you came away with in the previous section.

A business needs to consider all of the costs associated with making, shipping, and storing its products. This might include raw materials, packaging, warehousing, freight, and more. And, since businesses might have inventory in various stages of production, the inventory at the start and end of the period needs to be accounted for.

However, it’s not as easy as simply adding up a bunch of numbers. There are two different ways of calculating your costs of goods sold and we’re going to take a momentary detour to talk about a slightly more complicated aspect of your business that you need to know.

A Detour on Cash and Accrual
The numbers that are put in this Cost of Goods Sold section really depend on whether your business is cash-based or accrual-based. This will impact how your inventory is accounted for.

In a cash-based company, a transaction occurs when money leaves or enters the bank. Think of the cash as the measurement of the transaction actually taking place. In an accrual-based company, a transaction occurs when the transaction happens. Think of the buyer picking up the phone and placing an order.

Example: Imagine a company that orders a set of stools for their cafeteria and has terms where they pay for the stools a month later.

• In a cash-based company the transaction would occur when they paid for the stools. That is to say they would still have that expense and bill, but the expense would not show up on the Income Statement until they paid the actual bill.
• In an accrual-based company the transaction would occur when they ordered the stools: They would have an expense when the stools are received and a bill to pay at a later date that is sitting in their accounts payable.

It is best summarized like this: In an accrual-based company, you have an account called “accounts payable” and one called “accounts receivable” so expenses and income can occur without affecting your cash accounts (bank accounts), whereas in a cash-based company there are no A/P or A/R accounts and thus the expenses are only occurred once they are paid and affect the cash balance.

So, let’s put that into concept on the COGS. Let’s say your company makes and sells tables. In a cash-based company, the various costs of goods sold would hit your income statement when you paid cash for the wood, paint, nails etc. Whereas in an accrual-based company, the costs of goods sold would sit in an inventory account and would only hit your income statement when you actually SOLD the table.

Okay? Now that you have a basic understanding of the difference between cash and accrual, let’s continue…

Back to the Income Statement
Here’s a very simple example of a company that makes a basic table and is on accrual basis:

COST OF GOODS SOLD

Beginning inventory of materials: $100,000
Wood: $250,000
Paint: $50,000
Nails: $5,000
Shipping: $10,000
Warehousing: $15,000
Subtotal: $430,000

(Explanation: Currently this company has $430,000 in inventory, which is an asset. Then they sold X number of tables in the month and it left them with only $120,000 worth of the materials in their asset account, so the ending inventory gets subtracted.)

Less Ending inventory: $120,000
Subtotal: $310,000

(Explanation: That says that the inventory consumed is $310,000 and thus COGS. So you would…)

Subtract subtotal from Net Sales: $975,000
Gross Profit: $665,000

However, if it was a cash-based company, the cost of goods sold would be completely different. There would be no inventory and since you paid out $330,000 in the month that would be the cost of goods sold for the month. As well, the “beginning inventory of materials” would not have existed because it would have been written out in a previous month.

This section breaks out all of the costs associated with your products. It’s helpful to separate this number from other parts of your business for a few reasons: First, the opening and closing inventory and all of those related expenses are more easily calculated and reviewed when lumped together. Second, it gives you a truer picture of your business by breaking out these costs which are necessary to delivering your product.

Review these numbers carefully in your income statement and see if there are ways that you can negotiate lower costs with your suppliers.

This is part 2 of 4 parts of your income statement. Next week, we’ll look at the third part.

The first part of the income statement is the Revenue section. This is all the money that comes into your business. Gross Sales is counted here (which is all the money you get paid) and returns and discounts are taken off. At the end of this section is Net Sales.

So, if you take in $1,000,000 in sales over a period of time, but you give back $10,000 because people have returned items and you also give $15,000 in discounts, then the Revenues section of your income statement looks like this:

REVENUES

Gross sales: $1,000,000
Less returns: $10,000
Less discounts: $15,000

Net Sales: $975,000

When it comes to including returns and discounts, don’t make the mistake of simply writing a lower number in the Gross Sales line. You WANT to keep track of how much people are returning and how often you’re giving out discounts. This will help you find new opportunities in your business. For example, you might find that increasing another number (such as employee wages) might improve the quality of your products and diminish your returns; or you might find that increasing your sales or marketing expenses might decrease the discounts you give.  At the very least, you should use these numbers as goals and work at improving them each year.

This is Part 1 of 4 of your income statement. Check back next week to find more tips about the next part of your income statement.

Simply put, things cost more today than they did yesterday and they cost more yesterday than they did the day before.  That’s inflation. If you don’t occasionally consider the impact of inflation on your business, you’ll watch your profitability erode without even realizing it.

Here’s a simple example:

Let’s say you bought something in 1999 for $100. Ten years later, that same item would cost you $127.55. On average, inflation pushes prices up by 3% per year. So, if you’ve locked your prices and haven’t changed them in a couple of years, you’ve eroded your profit margin by 3% annually.

So what does this mean for you?

• First, be aware that inflation is rarely reflected in your financial statements: Book value of assets is rarely the real value (market value plus inflation). There’s not much anyone can do about this; I’m just telling you this as an FYI.

• Second, if you want to maintain the same margin of profitability from one year to the next, your prices need to rise by an average of 3% each year (assuming that everything else in your business stays the same).

• Third, understand that your vendors and partners are facing the same situation and you should expect their prices to rise by 3% every year for the same reason you need to increase your prices by that amount.

• Fourth, if you are holding on to cash in the bank (perhaps you’re saving up for something or you just want to have a cushion for difficult times), split it up and put some of it away into a higher interest savings account or certificate of deposit. Banks rarely pay interest anymore so you are losing 3% of your money each year simply because it’s not increasing while everything else is. Consider keeping a smaller emergency reserve on hand but putting the rest into something that attracts some interest well above 3%.

If you’re not careful, inflation will seriously hurt your business by eroding margins. Schedule time at least once a year to revisit your prices and make inflationary adjustments. Or, better yet, make 1% price increases 3 times a year, which will seem fairly painless to clients but will help to protect you from your silent enemy.

The point at which you stop losing money and start earning a profit is called the “breakeven point”. When planning your business (either at the very beginning or in any given period), knowing your breakeven point will give you a goal to work towards and some clear direction to manage your costs and prices.

Just add up all of your expenses – both fixed expenses and variable expenses – in a month (or whatever period you work in). That’s your breakeven point. Now figure out how many units you need to sell to reach that number.

Here’s why you need to know it:

• If you know your costs, you’ll have a better idea of the relationship between what it takes to run your business and what you have to produce to be profitable.

• You’ll also know how long it will take you to achieve your breakeven point. If you know this every month, this is your magic number to work towards. If you sell that many units on the 20th of the month, you’ll have 10 days of “pure profit”; next month try to sell that many units on the 18th.

• You’ll have a better idea of how business decisions – like new purchases or raising your rates – will move your breakeven point.

Take a moment to add up your breakeven point and use that as a benchmark to improve in the future.

Your business incurs costs. (You know that already!)

Your costs can be either fixed or variable, which is a description of how they change over time. (A fixed cost doesn’t change a lot; a variable cost changes quite a bit).

AND…

Your costs can be either direct or indirect, which is a description of how they are associated with production. (Direct costs are associated with specific units while indirect costs are a lump sum that goes into doing business in general and cannot be easily measured with the production of a specific thing).

Every cost is some combination of these elements:

Owning a building is a fixed cost (because it won’t change unless you build another building) and it’s an indirect cost (because you can’t measure it according to the product of a single unit of whatever you make or do).

Product packaging (if you sell a product) is a variable cost, depending on how many products you make, and it’s a direct cost because you can associate each package to a unit made.

Labor is often a fixed cost (unless you run a really seasonal business) and it is a direct cost (because you can see how the effort of your staff are directly associated with the production of a unit of your product or service).

So why does it matter?
Understanding whether your costs are fixed or variable and whether your costs are direct or indirect will help you to run a more profitable business. (Also, it will help you to understand your accountant when they talk to you).

In general, you want to make as many of your costs direct rather than indirect (because direct costs are easier to measure and manage) and you want to reduce your fixed costs as much as possible (because fixed costs don’t change whether you produce 1 unit or 1,000 units).