Week 5 Discussion - Pricing Strategies
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cf_katz_ESB_6e_chap012_PPT.pptxChapter Twelve Small Business Accounting: Projecting and Evaluating Performance
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Why Accounting Is Important for Small Business Success
There are several reasons.
You must provide specific accounting information in order for investors to consider funding your concept.
Bankers require formal financial statements for any type of loan.
You cannot fully know your business without accounting information.
Planning and controlling require accounting information.
There are three types of accounting you will need in your business.
Financial accounting is formal, rule-based accounting principles.
Managerial accounting is intended for planning, directing, and controlling a business.
Tax accounting is based on governmental requirements.
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Financial Accounting
Financial accounting is based on a set of rules called generally accepted accounting principles (GAAP) and reports:
How profitable the business is.
The value of the firm’s assets and who has claim to that value.
How much and from where money was received and how much and to whom money was paid.
These three financial reports are called the:
Income statement.
Balance sheet.
Statement of cash flows.
Each report contains information on things that have already happened.
Financial accounting does not have a lot of value for running the day-to-day activities of a business.
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Managerial Accounting
Managerial accounting is forward-looking where financial accounting is concerned only with the past.
There are no formal rules with the only issue being what is valuable.
One of the most valuable functions of managerial accounting is planning for future business activities.
This is done through standard budgeting or profit planning.
This method of organizing and formatting business planning is called pro forma financial statements.
The result is a detailed plan for future operations and is the standard against which actual results are compared to assess performance.
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Tax Accounting
Tax accounting follows the tax laws and regulations.
The final product is a set of returns, forms, and schedules.
There are many different business taxes including:
Federal income tax.
State income tax.
Employment taxes.
Inventory tax.
Excise taxes.
Various use taxes including sales tax and, in some countries, value-added tax.
The primary value of tax accounting is to avoid penalties for non-compliance and to legally minimize tax payments.
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The Concepts That Make Accounting Work
The assumptions that underlie accounting are very basic.
A business is an entity that is separate from its owners – business entity concept.
An operating business will continue in business – going concern concept.
Accounting information is valuable only if it is useful for the owners and managers of the business.
Creditors (lenders and suppliers) have claim on business assets that must be satisfied before any claim of an owner.
The claims of creditors and owners cannot be greater in total than the asset value of a business – called the accounting equation.
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The Accounting Equation
Assets = Liabilities + Owners’ equity
If a business is an entity existing apart from its owners, then the value of the business is the sum of the values of everything the business owns.
The name for what a business owns is asset.
Owners do not own the assets, the business itself owns them.
The owners have a claim on the assets of the business and this claim is called owner’s equity.
Courtesy of Natalie Gamez Meyer
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The Balance Sheet
The balance sheet entry to report the equity transaction between the owner and Red Jett Sweets would look like this.
Liabilities are legally enforceable future obligations.
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Total assets ($73,000) is exactly equal to the sum of the claims of the creditors and the owners.
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Cost, Revenues, and Expenses
Red Jett purchases raw materials for $2,040 on account, then bakes and sells 3,000 cupcakes at $2.75 each on account.
No cash changes hands.
Red Jett incurred an expense, called cost of goods sold of $2,040 and realized a revenue of $8,250.
The difference between the revenue and the expense is a profit of $6,210, reported on the balance sheet as retained earnings.
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Red Jett Sweets – February Balance Sheet
Red Jett collects the invoice due and pays the bill it owes.
Imagine a year’s worth of such transactions.
Rather than enter this on the balance sheet, create an account.
Permanent accounts are those other than revenue and expense accounts.
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Why Do Accounting?
To produce information useful for managing the business.
The information must be accurate and relevant to be useful.
Improve accuracy by using an accounting program.
Relevance must be evaluated for each decision as it is made.
To meet legal or contractual requirements.
You own a buffalo wings restaurant and wish to purchase a $25,000 high-capacity fryer.
You may save $1,000 a month on your lowered electricity bill and lowered insurance premiums.
You also consider the increased number of people you could serve.
Your accountant would depreciate the fryer using the MACRS rate, allowing you to claim a depreciation expense each year.
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Accounting Systems for Small Business
There are many software solutions but the chosen system should perform the following tasks.
User-friendly interface.
A thorough help function.
Produce an income statement using appropriate categories.
Produce a classified balance sheet clearly showing position.
Help develop a cash budget.
Help develop operating, and investment budgets.
Produce statements in approved formats.
Produce multiple-year comparisons.
Provide custom reports.
Export data in a form acceptable to tax programs.
Maintain an internal “audit trail.”
Enforce security measures.
Allow for growth of the business.
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Setting Up an Accounting System
One essential element of an accounting system is cash accounting that is accurate, easy to use, and tracks all checks and all deposits.
These accounting functions will become important as your firm grows.
Accounts receivable if you provide credit to customers.
Accounts payable tracks what you owe.
Payroll records to ensure taxes are kept current.
Fixed asset accounting calculates and accumulates depreciation.
Inventory accounting maintains and aids inventory levels.
Credit card sales tracks discounts and chargebacks.
Insurance register keeps insurance coverage current and in force.
Investment records if you invest surplus cash in securities.
Leasehold records if your have leased property or equipment.
Setting up your system can be outsourced to consultants.
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Financial Reports
There are six common financial statements.
Income statement – records debits/withdrawals, like your debit card.
Statement of comprehensive income – if you have financial derivatives.
Statement of retained earnings – incorporated into balance sheet.
Statement of owner’s equity – incorporated into balance sheet.
Balance sheet – what you own and its worth, and what you owe others.
Cash flow statement – the exact amount of cash right now.
Your monthly bank statement parallels the retained earnings statement.
The important thing about these financial statements is that they articulate information flows from the income statement through the balance sheet to the cash flow statement.
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Income Statement
The income statement is the primary source of information about a business’s profitability.
Revenues – Expenses = Net Income
There are two formats – a single-step and a multiple-step format.
Two difficulties in understanding the statement.
First, what is reported as revenue.
Second, when to recognize revenues.
Similar problems arise in the timing of gains, losses, and expenses.
Yet the income statement reliably reports how well a business is producing profits.
The income statement is used to analyze the effectiveness of business operations.
Operating income is the most used item on the statement.
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Figure 12.4A and Figure 12.4B
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Balance Sheet
The balance sheet presents a “snapshot” of financial holdings and liabilities on a specified date.
Usefulness is determined by the detail it includes.
Balance sheet information is used to determine liquidity, financial flexibility, and financial strength of the business.
Liquidity measures the time before an asset can be converted to cash, and the expected time before a liability must be paid.
The most common ratio to estimate liquidity is the current ratio or dividing the value of current assets by the value of current liabilities.
Financial flexibility indicates a firm’s ability to manage cash flows.
A firm’s financial strength is a matter of informed judgment.
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Figure 12.6: Typical Balance Sheet
Problems interpreting balance sheet information.
All values are historical so the cost is less than current value.
Every balance sheet contains estimated amounts, which may be wrong.
Certain assets and liabilities are omitted.
Despite there problems, the balance sheet supplies essential information for outside investors.
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Cash Flow Statement
Cash flow statements are either direct or indirect statements.
A direct statement is developed solely from the cash records.
The indirect statement of cash flows starts with net income and adjusts accruals and deferrals to easily reconcile to other statements.
There are six items that must be reported in the statement of cash flows.
Cash flows from operating activities.
Cash flows from investing activities.
Cash flows from financing activities.
Net effect of foreign exchange rates.
Net change in cash balance during the period.
Noncash investing and financing activities.
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Red Jett Sweets – Statement of Cash Flows
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Uses of Financial Accounting
Reporting to outsiders.
Absentee owners, creditors and lenders, unions, and taxing and regulatory agencies have an interest in the conduct of your business.
Record keeping.
Criteria: simplicity, accuracy, timeliness, understandability, security.
Taxation.
Employers withhold: FICA, Medicare, FUTA and disperse W2s.
Control of receivables.
The key is to have account receivables aged.
Analysis of business operations.
Items that appear unrealistic should be carefully examined.
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Uses of Managerial Accounting
Managerial accounting is based on understanding how costs change as a result of business changes.
External (cost) factors are aspects outside the business that could cause the business costs to change.
Internal (cost) factors are those aspects or choices within the business that could cause the business’s costs to change.
There are two managerial accounting procedures that depend on being able to forecast future revenue and expenses.
Cost-volume-profit analysis.
The budget cycle process.
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Managerial Accounting: Cost-Volume-Profit Analysis
This analysis sorts costs into two categories: variable costs and fixed costs, with the resulting total cost the sum of the two.
Breakeven (in units) = Fixed cost/(Price/unit – Variable cost/unit).
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Figure 12.9: Cost-Volume-Profit Graph for Red Jett Sweets
Extending breakeven, find the level of sales necessary for any profit.
Unit sales for specific $ = (Fixed cost + Desired profit)/Contribution margin.
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Preparing Pro Forma Financial Statements for Your Business Plan
Achieving your strategic goals requires a quantitative plan of action, called a budget – A standard against which performance is measured.
Budgeting provides an organized and consistent platform for providing necessary information for effective management.
The first step in budgeting depends on where you are in your business.
An established firm starts with a sales forecast.
If in the early stages of business planning, first forecast expenses, then return to the sales forecast using various sales volumes.
You need a set of pro forma statements that are consistent, accurate, and easy to modify as you business plan evolves.
Develop a “master” budget from basic inputs then add detailed item budgets and finally a pro forma budget plan.
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Figure 12.10: Budgeting Relationships
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The Sales Budget
The first step in preparing a master budget is to prepare a sales budget.
All the numbers, both in an initial business plan and in later budgets, are based on estimates.
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The Purchases Budget
Once sales are projected, the next step is to plan for inventory purchases.
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The Cost of Goods Sold Budget
The business plan states that all unsold cupcakes are donated at the end of the day.
The budget is simply the number of cupcakes to be made multiplied by variable cost per cupcake.
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The Inventory Budget
An inventory budget combines a purchases budget with a cost of goods sold budget.
Done to simplify the budget process.
But when a business does not maintain significant inventories, such as Red Jett Sweets, the budget is not needed.
Here, the only inventory is raw materials with negligible amounts.
Managers decided the value of calculating the cost of goods sold is less than the added complexity and expense the process entails.
Also, the business plan says all materials will be purchased and consumed within the same period making this budget unnecessary.
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The Labor Budget
The labor budget shows both the amount and cost of labor needed to meet output goals.
If you need to predict varying labor costs, first estimate labor required for each unit of production, then multiply unit labor cost times the number of units produced.
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The Selling, General, and Administrative Expense Budget
It is common to combine all costs of selling into a single SG&A budget.
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Budgeted Income Statement
The budgets completed to this point can be combined into a pro forma budgeted income statement.
During the year, comparisons of actual results are made to the budgeted items. ‘
If the budget is met, the projected profit is realized.
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Completing a Comprehensive Budget and Controlling
The final schedules to be completed to produce a master budget are:
A cash receipts budget.
A cash disbursements budget.
And a cash budget.
From these, a pro forma cash flow statement and a pro forma projected balance sheet are prepared.
The difference between actual and budget is called a variance.
Variance analysis is simple in concept but complex in execution.
Variances occur either because prices are different than estimated, or quantities are different than estimated.
Variances can be constructed to show two things: the effect of changes in prices and the effect of changes in the quantity used or produced.
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Decision Making
The primary purpose of managerial accounting is to support good decision making.
Accounting has two basic methodologies to simplify decision-making on investments.
The differential revenues and expenses method estimates changes from results.
There is also net present value (NPV) analysis which only considers cash flows.
Outsourcing requires a decision be made whether the business should make a component of its own product or purchase the component from another business.
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Accessibility Content: Text Alternatives for Images
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The Accounting Equation – Text Alternative
This illustration provides a visual for the concept of owner’s equity and contains two graphics.
The first graphic is an open box labeled “The Business Red Jett Sweets, Inc.” and the box holds $50,000 of cash.
The second graphic is a female who is now holding the box labeled “Owner.”
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The Balance Sheet – Text Alternative
There are two images on the slide, both are related to the balance sheet for Red Jett Sweets out of Fort Worth, Texas.
The top image shows a single balance sheet entry for $50,000 of owner’s equity. The same amount is entered into Assets as Cash and on other side of the balance sheet, into Owner’s Equity as Common Stock.
The bottom image shows a balance sheet for the company dated January 31, 2011 and contains the following entries.
On the assets side of the balance sheet, current assets of cash total $41,500. Long-term assets include two entries: Bakery equipment for $2,500 and Mobile food truck for $29,000, for a total of long-term assets of $31,500. Total assets are $73,000.
On the liabilities side of the balance sheet, current liabilities are zero and long-term liabilities total $23,000 reflecting the long-term loan for the food truck purchase. Owner’s equity includes common stock in the value of $50,000 for a total liabilities and equity of $73,000.
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Cost, Revenues, and Expenses – Text Alternative
This image depicts Red Jett Sweets’ balance sheet of January 31, 2011.
The assets include current assets and long-term assets. Current assets include cash of $41,500 and accounts receivable of $8,250 for total current assets of $49,750. Long-term assets include bakery equipment of $2,500 and mobile food truck for $29,000 for a total of long-term assets of $31,500. This makes total assets equal $81,250.
On the liabilities side of the balance sheet lie current liabilities, long-term liabilities, and owners’ equity. Current liabilities consist of accounts payable in the amount of $2,040 and long-term liabilities consist of $23,000 for total liabilities of $35,040. Owners’ equity is reflected in $50,000 of common stock and $6,210 in retained earnings for total equity of $56,210. This brings total liabilities and equity to $81,250.
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Red Jett Sweets – February Balance Sheet – Text Alternative
This balance sheet for February 28, 2011 reflects that Red Jett Sweets collected the money owed to them and paid their outstanding bill.
Here, the current assets are cash of $41,500 plus invoice collected of $8,250 minus the bill paid of $2,040 for total cash of $47,710. Accounts receivable and inventory equal zero for total current assets of $47,710. Long-term assets include bakery equipment of $2,500 and the mobile food truck of $29,000 for total assets of $79,210.
On the liabilities side, accounts payable now equal zero and long-term liabilities still stand at $23,000 for total liabilities of $23,000. Owners’ equity includes common stock of $50,000 and retained earnings of $6,210 for total liabilities and equity of $79,210.
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Figure 12.4A and Figure 12.4B – Text Alternative
There are two graphics, both are income statements for year ending December 31, 2011 for Red Jett Sweets. The first is a typical single-step format income statement and the second is a multiple-step income statement which specifically states gross margin, marketing, advertising and cost of selling, and operating income.
The single-step income statement shows revenues and gains as a single entry, Sales revenue, totaling $48,379. The expenses and losses category consists of three entries: cost of goods sold at $15,164; sales, general, and administrative at $50,218, and provision for income tax at zero. This provides a total net income of negative $17,003.
The second image is the multiple-step income statement. The Revenues and gains section includes two entries: Sales revenue at $48,379, less fees, spoilage, and sales tax collected of $4,162. This provides a Net sales revenue of $44,217 less cost of goods sold of $11,002, provides a gross margin of $33,215. Next, the Sales, general and administrative expenses are listed as follows: Salaries and wages of $26,149; Rent of $8,290; website, telephone, marketing at $4,520; transportation at $2,403; insurance at $2,000; research and recipe development at $2,188; legal and accounting at $3,088, and depreciation expense at $1,580. This provides a total for sales, general, and administrative expenses of $50,218. Subtracting this amount from the gross margin provides and operating income of negative $17,003 and since the provision for income taxes equals zero, the final net income is negative $17,003.
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Figure 12.6: Typical Balance Sheet – Text Alternative
This balance sheet for Red Jett Sweets is dated January 31, 2011.
On the Assets side of the balance sheet, current assets are cash of $41,500, plus invoice collected of $8,250, less bill paid of $2,040 brings the total cash to $47,710. Accounts receivable and inventory are both zero so total current assets are $47,710. Long-term assets include bakery equipment of $2,500 and the mobile food truck of $29,000 for a total of long-term assets in the amount of $31,500. This brings total assets to $79,210.
On the liabilities side of the balance sheet, current liabilities (Accounts payable) is zero. Long-term liabilities is one entry, the long-term loan of $23,000, making total liabilities $23,000. In the owner’s equity section, there are two entries: common stock of $50,000 and retained earnings of $6,210, bringing total equity to $56,210. Combining total liabilities and equity equals $79,210.
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Red Jett Sweets – Statement of Cash Flows – Text Alternative
This statement of cash flows is for the month of January 2011.
The first section is the cash flows from operations and the statement begins with cash received from customers in the amount of $424. Next is the cash paid to vendors, broken down into: credit card providers with a zero balance; sales tax paid to Texas $30; raw materials used in production $99; salaries and wages $480; payroll taxes/benefits $42; rent $420; website and marketing $1,900; telephone $310; transportation $0; insurance $167; research and recipe development $313; and legal and accounting $2,703 for total cash flows from operations negative $6,039.
The second image includes the remaining sections of the statement of cash flows and begins cash flow from investing activities which contains one entry: purchase of equipment for a negative $31,500. The final section is cash flow from financing activities and this section has the following entries: investment by owners $50,000; cash received from borrowing $0; and cash paid on loans $0, making the net cash flow from long-term financing activities $50,000. With beginning cash equaling zero and a net cash increase of $12,461, gives an ending cash balance of $12,461.
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Managerial Accounting: Cost-Volume-Profit Analysis – Text Alternative
This image depicts the computation of the breakeven analysis for Red Jett Sweets. Each line progresses the analysis.
At breakeven, revenue exactly equals total costs, thus: revenue equals variable cost plus fixed cost.
So, units sold multiplied by price ($2.75) equals units sold multiplied by variable cost per unit ($0.68) plus fixed cost.
Next, subtract units sold multiplied by variable cost from both sides to equal fixed cost of $6,750.
Simplifying the equation leads to units sold multiplied by the difference of $2.75 minus $0.68 equals $6,750.
So, units sold multiplied by $2.07 equals $6,750.
Simplifying again gives you units sold equals $6,750 divided by $2.07.
Units sold at breakeven becomes 3,261 cupcakes.
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Figure 12.9: Cost-Volume-Profit Graph for Red Jett Sweets – Text Alternative
This line graph depicts Red Jett Sweets’ revenue in $2,000 increments, starting at zero and ending at $18,000 on the vertical axis. The horizontal axis depicts numbers of cupcakes sold in 1,000 unit increments, starting at zero and ending at 7,000.
Fixed cost is depicted as a solid horizontal dark blue line falling between the $6,000 and $8,000 amount, as fixed costs are $6,750.
Total revenues is a light blue line extending from zero rising steadily to a bit over the $16,000 profit line. The total cost line is an orange line starting at the fixed cost line ($6,750) and rises steadily to between the $10,000 and $12,000 profit range. The difference between the total revenue line and total cost line is either a loss or a profit. The point where they intersect is the breakeven point, here, at $8,968 in revenue and 3,261 units sold. Anything falling to the left of the intersection is a loss and anything falling to the right of the intersection is a profit.
One final line on this graph reflects how many units need to be sold to make $1,000 profit. Simply increase the breakeven revenue line by $1,000 and extend the line out until it cross the light blue, total revenues line, then drop that intersection down to the needed units to make that $1,000 profit, which appears to be below 4,000.
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Figure 12.10: Budgeting Relationships – Text Alternative
The flow chart depicts many relationships between various business functions and the end result, the pro forma financial statements.
The sales forecast directly relates to the pro forma income statement, but also indirectly relates to the same statement by affecting the assumptions that go into purchases and production budgets and expense budgets.
Another item is the assumptions of cost behaviors, inventory levels, receivables and payables, which relate to the purchases and production budgets, expense budgets, and all the pro forma statements. These assumptions are in turn affected by the sales forecast and the beginning balance sheet items.
The beginning balance sheet items affect assumptions, purchases and production budgets, expense budgets, and the pro forma income statement.
Capital spending relates to capital budgeting and long-term borrowing, which relates to the expense budget and all the pro forma statements.
Cash and short-term borrowing directly affect the pro form balance sheet and statement of cash flows.
In turn, the pro forma income statement relates to the pro forma balance sheet, which then relates to the pro forma statement of cash flows.
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The Sales Budget – Text Alternative
This table shows the fourth quarter budget for Red Jett Sweets, showing monthly breakdowns for October, November, and December; quarter four totals and finally a column for January numbers.
The budget includes all revenues resulting in gross sales, less three expenses to product net sales revenue.
Revenues list unit sales, sales price, cash sales and credit card sales. The three expenses include credit card fees, spoilage and over production, and sales tax collected.
Budgeted revenues for October, November and December are the same: 2,983 unit sales at the price $2.94, equally split between cash sales and credit card sales for total gross sales each month of $8,778.
The same is true for expense, each month with having the same $88 credit card fees charge, $61 in spoilage and over production, and $615 in sales tax collected.
Fourth quarter totals are $26,334 in gross sales and $24,042 in net sales revenue.
The January projections are nearly the same, with slightly higher numbers for both revenues and expenses.
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The Purchases Budget – Text Alternative
The purchases budget for Red Jett Sweets covers the months of October, November, and December, and provides quarter four totals as well as projections on three items into January.
Unit sales for each of the three months is 2,983, for a total of 8,949 for the quarter. January unit sales are marked as 3,000.
The raw materials per unit price remains the same through all three months and into January at $0.68.
Materials needed for production is the same for the three months at $2,028 for a quarterly total of $6,085. January projection is $2,04.
The budget now adds in desired ending inventory which is $406 for the months of October and November and $408 in December.
The materials needed for production and the desired ending inventory are added together to obtain the materials required for each month, which are $2,434 in October, $2,397 in November, and $2,252 in December for a total in quarter four of $6,309.
Subtracted from the materials required each month is beginning inventory of $406 which leaves the final amount of inventory to be purchased. This amount is $2,028 for each of the three months for a quarterly total of $6,087.
Note that the materials required amount needed each month is the sum of the amount for production plus desired ending inventory.
Note also that there is a $406 worth of inventory on hand at the beginning of October. This amount does not have to be purchased.
Also note that November’s ending inventory is December’s beginning inventory.
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The Cost of Goods Sold Budget – Text Alternative
The budget shows unit sales for each of the three months in the quarter and totals for the quarter. Each month’s unit sales are 2,983 for a quarter total of 8,949.
The unit cost of goods sold each month is $0.68.
The total cost of goods sold is the result of multiplying these two numbers to produce $2,028 per month for a quarter total of $6,085.
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The Labor Budget – Text Alternative
The labor budget for Red Jett Sweets’ fourth quarter lists the salaries and wages and the total cost for those salaries and wages for the months October, November, and December and provides totals for the fourth quarter.
The salary and wages total for each month is $4,141 for a quarterly total of $12,423.
The total cost of salaries and wages is the same for each month and for the quarterly total.
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The Selling, General, and Administrative Expense Budget – Text Alternative
The table shows amounts for nine expenses for each of the three months in the quarter – October, November, and December – as well as quarter totals.
The expenses are salaries and wages at $4,141 per month for a quarterly total of $12,423.
The payroll taxes/benefits expense is $358 per month, totaling $1,074.
Rent expense is $1,000 each month for a $3,000 total quarterly amount.
Website and marketing is $100 per month and a $300 quarterly total.
Telephone expense is $110 each month and $330 for the quarter.
Transportation is $343 per month, for a total of $1,030.
Insurance expense is $167 per month for a total quarterly amount of $500.
Finally, the legal and accounting expense per month is $316 and has a quarterly total of $948.
The monthly total selling, general, and administrative expenses are $6,570 for each of the three months and total $19,710 for the quarter.
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Budgeted Income Statement – Text Alternative
The table shows totals for each month of the quarter – October, November, and December – as well as quarterly totals.
The statement begins with gross sales revenue of $8,778 for each month, totaling $26,334 for the quarter.
From this amount is deducted the following monthly adjustments: credit card fees, spoilage and over production, and sales taxes collected to produce a net sales revenue less the cost of goods sold provides a gross margin each month. The gross margin for October and November is $5,985 and $6,174 for December for a quarterly total of $18,145.
Sales, general, and administrative expenses ($6,570 per month) are subtracted from these gross margins to produce net income before taxes.
All totals for net income before taxes are in the negative. October and November realize a negative net income of $585 and December sees a negative net income of $396. The quarterly net income before taxes is negative $1,565.
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