PART 2: GETTING THE BEST RETURN ON INVESTMENT:
How You Are Going To Control The Flow Of Money
It is very feasible to start and run a successful business selling hand made products. This series of articles introduces you to the things you will need along the way as you develop your business financial management road-map, and seek to get your best return on investment (ROI).
Controlling The Flow Of Money
These discussions here are not a substitute for consulting with a tax attorney or accountant in the state you do business in. These professionals will be more current with local, state and federal requirements. The discussions here are a guide to help you get organized, and to help you ask the right questions.
Below I discuss things like:
— understanding business costs and revenues
— when you work out of your home
— setting up a general ledger
— understanding business assets and liabilities
b) ROI: Tracking Your Costs and Revenues
You set up an accounting General Ledger to track revenues and expenses, and assets and liabilities. Your goal here is to adequately account for your expenses and revenues, and your liabilities and assets.
What are business revenues?
Business revenues include all the money coming into your business, including payments for products and services, interest on bank accounts and investments, rent you charge others to use your space or equipment, royalties you get from intellectual property.
What are business expenses?
Business expenses are ANYTHING THAT HAVE TO DO OR RELATE TO OR CONTRIBUTE TO MAKING A PROFIT.
You might want to secure copies of IRS publications that define each business expense and how it should be accounted for.
What are business assets?
Business assets are the current values of your physical property, from desks to chairs to computers to printers to major software packages. These are things which depreciate, that is, lose value over time.
A key asset is your inventory. If you are selling finished products, your inventory will include all your works-in-progress as well as your finished pieces. For some design businesses, particularly with jewelry design, it might become a little confusing to differentiate between your supply of parts and your jewelry, especially if you only assemble pieces after orders are made. On a yearly basis, the IRS only lets you deduct the costs associated with finished products sold. The rest of the inventory is treated like it is cash. You will need to decide what exactly you call inventory and what other supplies you call supplies. (See COST OF SALES section below).
What are business liabilities?
Business liabilities are things the business owes money on, from short term net-30-day payments to suppliers to long term credit card bills and bank loans.
BUSINESS USE OF A HOME
Many designers work out of their homes. While these expenses are red-flagged by the IRS, tax courts have consistently ruled that Congress intended to be very liberal and kind to these expenses.
You would compute the proportion of “business use” space in your home relative to your home’s total space. This space must only be devoted to business, not personal use. Based on this proportion, you allocate your mortgage or rent, your heating, A/C, water, sewer, and other maintenance costs to your business expenses.
Example: Your home is 1000 sq ft. The room you use for your business is 100 sq ft. So your business “use” expenses would be 10% (that is, 1000 divided by 100) of your rent/mortgage, 10% of your utilities, 10% of you lawn maintenance, 10% of repairs, etc.
For some expenses, you cannot use the straightforward proportion percentage. If you use a computer, it is a better idea to have a separate one that you use for business, than for personal. If you use one for both, you have to maintain a use log, and, based on “time the machine is used for business vs. personal”, you allocate the costs and depreciation of the machine to your business. Telephone costs are allocated based on the proportion of business calls to all calls each month.
Don’t be shy about what to call a legitimate business expense at your home. Picture a real store. If they have to mow the lawn, you would have to mow the lawn at your home. If 10% of your home were devoted to business, then 10% of your lawn mowing expenses would also qualify. Home repairs, fixing the roof, mortgage, insurance and the like would be legitimate. At the same time, if you have little income, do not declare these expenses with the sole purpose of gaming your tax liability.
SETTING UP A GENERAL LEDGER (G/L):
When you are just starting, you can set up a spreadsheet to track your expenses and revenues or even use a ledger book bought at a local office supplies store. Or you can purchase some inexpensive software apps. Many accounting apps have been moving to a “rent” rather than “purchase” model, where you pay a monthly fee to use their apps.
When you set up a general ledger, you are basically creating a giant table for the year. The rows are the days of the month. The columns are your revenue and expense categories. You also build in some summary formulas, such as the total Revenue for each month.
There are single-entry accounting systems and double-entry accounting systems. If you are just getting started and using a ledger book or spreadsheet, using a single-entry system where you record revenues and expenses only is fine. If you are using an accounting application, these typically are set up as a double-entry accounting system. Here, part of the ledger accounts for revenues and expenses and the other part of the accounting system will duplicate this information in the form of assets and liabilities. When you are making $6,000–10,000 per year in sales, you will want to graduate to the double-entry system. It is a straightforward step to evolve a single-entry to a double-entry system.
IN A SINGLE-ENTRY ACCOUNTING SYSTEM, you set up a spreadsheet, and track each of all your revenues and all your business expenses. The rows are days of the month and the columns are your various revenue and expense accounts. Each different revenue and cost is referred to as an account (or line item). All together, these accounts get assigned unique ID codes, and get organized into a Chart of Accounts. Each revenue or expense entry gets tagged with a specific ID code, and entered into a General Ledger (of Accounts).
Picture your G/L as a very large table. Again, the columns of the spreadsheet are these revenue and expense accounts. The rows are the days of the month. You should compute subtotals for each column at least once a month. If your business is a busy one, you should compute subtotals for each column weekly. You should also keep a running subtotal of year-to-date information.
What Accounts and How Many Accounts Do I Need?
You set up a sufficient number of accounts in order to satisfy two sometimes competing demands. You should be able to glance over your general ledger each month and come away with some good understandings of how your revenues and costs relate to your business strategies and programs. This is called good financial management.
You also want to anticipate issues of IRS auditing. You want clear categories, and maybe more categories than is easily managed from a financial standpoint. The IRS will suggest specific categories. You are not required to use them. You can use some of them, all of them or none of them. For example, I use one category I call OCCUPANCY, where the IRS has separate categories for INSURANCE, UTILITIES, MAINTENANCE.
The IRS has one revenue account. From a financial management standpoint, I like to have several revenue accounts. I like to be able to look at the numbers (and the rates of change) and be able to figure out if any of my revenue-generating strategies is working well or not.
COST OF SALES
This is the most confusing part of the general ledger, because you have to make some rules and be clear about what you are calling “Supplies-Product Making” and what you are calling “Inventory”.
As a design business, you wear many hats — you are the manufacturer, the distributor and the retailer. The tax laws are written in a way that assume you are one or the other — not all three.
At this point in the ledger, you can calculate the first of two Magic Numbers — Gross Profit. If using a spreadsheet, you can put the formula into one of the cells of the table.
If your GROSS PROFIT divided by your REVENUE is greater than .50,
then you’re doing well.
With the Magic Numbers, you have some easy to access and interpret information to help you financially manage your business. You look at month-to-month and year-over-year trends. When you first get started, some of these Magic Numbers might be on the not-so-good-looking-side, but again, pay attention to trends.
(These are the minimum number of employee line items you will need to be able to fill out all the Federal, State and Local payroll tax related forms. You can always add more categories than those stated here.)
If you have employees, it may make sense to pay for a payroll service, that both cuts the checks and does your quarterly and annual payroll taxes.
Your expense accounts are how you track what happens when you spend money.
Sometimes it gets a little confusing how to enter credit card expenses into your general ledger.
Now you are positioned to calculate the next Magic Number — Net Profit.
You want this to be a positive number. However, for your first year or two, it might be negative. Again, it’s most useful to look at trends.
NOTE: There is NO IRS rule that says you have to show a profit in 3 of the last 5 years, or any rule about the frequency of profit. As long as you a trying to run a business as best you can, even if you are failing miserably, there are no consequences for showing continued losses.
ASSETS AND LIABILITIES
In a double-entry system, the other part of the general ledger will account for
Example: You buy $10.00 of inventory.
Assets are things you own and have value for your business. There are different depreciation rules for computer equipment, non-computer equipment and furniture.
Liabilities are things you owe to others, which until these are paid off, decrease the value of your business.
You now have in place a system for gathering information about money costs and money revenues. You need to expand this system to gather even more detail specifically about your inventory.
Continue with this series,
Financial management includes all the things you need to do in order to maximize your Return On Investment (ROI). It mostly involves a system of data collection, monitoring and analysis methods employed by any successful business. This system relates risks to rewards. Activities in this kind of system include things such as general accounting and bookkeeping, inventory management, and record keeping. These include things you do to establish and maintain formal relationships with employees, independent contractors and suppliers. These include things you do to secure your money, such as with banks, financial institutions, and even such things as crowd-funding online. This is a lot of numbers and activities, and often, when we look at why people fail in business, it is often because of a generalized fear of getting control over all this. Successful business people and successful businesses need to foster a culture which promotes a growth mindset. Simply this is a culture where you have permission and encouragement and confidence to take risks.
GETTING THE BEST RETURN ON INVESTMENT (ROI)
Campbell, Casandra. What Is Inventory Management? How To Track Stock For Your Ecommerce Business, Inventory Management, 6/19/20.
As referenced in:
Caramela, Sammi, 10 Essential Tips For Effective Inventory Management, Business News Daily, 4/15/2020.
As referenced in:
Dweck, Carol. Mindset: The New Psychology of Success, 2006
Fundbox.com. Trade Credit: Everything you need to know about net terms for your business. n.d.
As referenced in:
Shah, Vyom. Crowdfunding the Jewelry business, 11/27/14.
As reference in:
Other Articles of Interest by Warren Feld:
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