that sells product. While this type of business would have a cost of goods sold associated with the shampoo and conditioner sold to customers, it is still considered a service business because the product sale is subordinate to the income brought by the primary purpose of the salon — that of cutting, coloring, and styling customers’ hair.
Analyzing reporting
In the wonderful world of accounting software programs, the drudgery of manual accounting frees up a small business owner’s time to do some meaningful analysis of revenue and expenses. In Figures 3-1 and 3-2, you can see that the income statement shows financial results for the period it represents; it lets the user know in the short term if a business is making money. More importantly, the relationship between the different accounts on the income statement clues the business owner to areas needing improvement.
For example, looking at the income statement for Keeping It Cheap, salaries are $50,000, and the bottom-line net income is $30,255. While Maggie’s pop-up shop is open for only two and half months (January 31 through April 15), Maggie works at her business year-round.
There is all the prep work before tax season starts. Maggie takes continuing education classes to get up to date on the changes in the tax code. She finds and negotiates the rent on an appropriate location, which may change year-to-year, and sets up an aggressive advertising campaign.
Just because it’s April 16, Maggie’s work is not done. There are always follow up telephone calls with customers about the status of their refund. Or the customer may have gotten a letter from the Internal Revenue Service, which Maggie has to address.
Looking at the $80,255 ($50,000 + $30,255), do you think this is reasonable compensation for working all those long hours during tax return plus the preparation and aftercare? Would your opinion change if you found out that Maggie has an employee to whom $45,000 of the wages was paid, thus reducing the net to Maggie to $35,255 ($80,255 –$45,000)?
Another consideration is how many returns Maggie had to prepare to earn the $80,255. It is easy to reckon you are making money if you have a solid balance in the company checking account. However, you need to see the figures on an income statement to really be able to evaluate how well your service type business is doing.
Moving onto Izzie Tees and Jeans income statement, the No. 1 evaluation is checking cost of goods sold by figuring the gross profit margin, which is cost of goods sold divided by net sales. I know from experience that most retail shops use a keystone approach to pricing goods for sale.
Keystone means the shop applies a 100 percent markup. If you’ve never worked in retail, this is probably confusing. I’ll walk through an example:
Izzie buys 10 pairs of dark blue jeans from the manufacturer for $20/pair or $200 in total. Using a keystone margin, Izzie marks the jeans by the cost of the jeans. The jeans go on the rack for $40 ($20 + $20).
In my experience, it is very difficult to keystone t-shirts. Generally, their cost from the manufacturer or wholesale doesn’t allows for much retail markup wiggle room. Keeping that fact in mind, let’s figure Izzie’s profit margin to see how close she is coming to the keystone margin.
Net Sales = $143,450, and cost of goods sold = $65,180. Following the formula of cost of goods sold/net sales, Izzie’s profit margin is 45 percent. Izzie also has a sales report detailing sales by category. Based on the volume of jeans versus tees sold Izzie is happy with this profit margin.
Identifying cost issues
Trend analysis (see Chapter 14) is a fantastic tool to use to see whether issues exist in operating expenses. Trend analysis looks at accounting results over more than one financial period or year. In the busy hubbub of running your business, without trend analysis, you may not realize an expense, such as insurance, increases unreasonably one year over the next.
Horizontal and vertical analysis (see Chapter 14) are also valuable tools. Horizontal analysis compares accounts over different periods. For example, you compare 2021 salaries to 2020 salaries to see whether the increase or decrease match your assumptions going into 2021.
Vertical analysis compares all other accounts to sales. This gives management a heads up if an expense appears to be too high when compared to sales.
At this point, you may be thinking, okay what assumptions? How do I know what I should be expecting to see? Enter the budget, which is the result of estimating revenue and expenses now for what you expect future periods to bring.
Preparing a budget can be difficult. It may seem like you are merely looking into the future, guessing at projected revenue and expenses. However, using financial and managerial accounting concepts, considering your overall business climate, and factoring in past performance should produce a workable budget.
Getting into the nitty-gritty of preparing all the different types of budgets is outside the scope of this chapter. However, later in this chapter, in the “Managing Cash” section, I introduce one type, the cash budget.
The topic of budgeting and preparing budgets is typically in the chapter of your financial accounting textbook that covers cost planning. Managerial Accounting For Dummies (Wiley) by Mark P. Holtzman is also a great resource for those budget-minded accounting students and small business owners!
For example, at the end of each quarter, you compare your budgeted figures to actual reporting on the income statement, identifying any potential problem areas. After this review, revenue and expenses appear to be performing on track except for shipping costs — they are 25 percent more than budgeted.
So, you put on your detective hat to try to figure out what is going on. Maybe your budgeted figure was just incorrect to begin with. Could be that you are shipping heavier or larger items than expected. Perhaps your preferred carrier raised their rates. In a larger company, you just might see this is the result of employees using the company’s carrier for personal shipment.
While this is somewhat of a simple illustration, the steps taken to resolve can be modified to address many different budget variations. If you screwed up the budget to begin with, passing along the difference — that is, charging your customer more for shipping would be an option. Ditto for any customers without of the norm shipments based on weight or size.
If your carrier has increased its rates, maybe it’s time to find a different carrier or figure out whether you can raise the purchase price of your products to cover the shipping rate increase. Finally, dealing with employee theft is a thorny issue. However, it is one best nipped in the bud when discovered as inattention on the