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PocketWatch On February - 14 - 2011

This is the fourth in a series of articles that will hopefully educate readers and illuminate the process of doing business in a simple to understand, nuts-and-bolts way.

In Part 1 of this series, we discussed motivation, what our personal goals are.  In Part 2, we discussed two foundational tools that will be referred to repeatedly, the Business Plan and the Organization Chart.  In Part 3, Job Descriptions were described and discussed, and how they relate to the Business Plan and the Org Chart.

In Part 4, we need to turn back to a different beginning, and begin to build another essential tool for properly managing a business, the Financial Plan.

The Periodic Table of Business – the Three Elements

There are three elemental areas of business – any business.  It may seem obvious, but in the day-in, day-out effort to manage and maintain a business, dealing with problems that crop up, paperwork, personnel issues and so forth, it is easy to lose sight of the basics.

The three elements are:

  • Sales
  • Operations
  • Finance

 ———-

If you are already in business, it needs to be said that there are only three ways to improve your business.  If you are contemplating going into business, you need to keep these three things in mind as you contemplate how to expand a fledgling enterprise:

  • Increase sales
  • Decrease expenses
  • Increase productivity

There are no shortcuts or magic wands here.  Everything you decide to do has to keep these three things in mind.  Everything must be measured against one or more of these three ideas.  You are working against yourself if you do otherwise.  That is the reality of business.

So, let’s take a look at each element.

 ———-

Sales – the Revenue stream…

It’s obvious what we are talking about here.  All businesses sell something – a product or service.  Without sales, there is no business.  This is usually the main focus of every new or small business, sales, sales, sales, and rightfully so.  But, as we will see later in this series, sometimes increasing sales without the right analysis tools may be a path to disaster.

Talking about sales also leads to the subject of cash flow.  Again, once we develop the proper understanding, cash flow will be discussed in depth in this series.

So, for now, we can just look at sales as “money in.”

———-

Operations – the cost of the product or service, plus the cost of just existing…

What is called “operations” consists of two categories of expenses.  The first is commonly called Cost of Goods Sold (COGS), the second is called General & Administrative (G & A) expenses, Expenses, or Overhead.  In general, everything spent during the course of doing business is “money out.”

 ———-

Cost of Goods Sold (COGS)

COGS is not as simple as it might seem.  Usually, people just think of it as what they pay for raw materials, but that is just the beginning.  Let’s look at a couple of examples.

 ———-

Manufacturing

COGS might consist of the following:

  • Materials
  • Manufacturing labor
  • Inbound shipping of materials
  • Outbound shipping of finished goods
  • Outside services
  • Sales commissions
  • Labor incentives
  • Shop supplies

As can be seen, there may be a lot to think about here.  Some of your company labor is dedicated to making a product, and some may be administrative or spent on other things, shipping in and out are expenses related to making a product, you may job out parts of your manufacturing, you might award commissions, and there are shop supplies necessary to perform the manufacturing process.  The key thing to remember is to only call an expense COGS if it directly related to making the product.  An alternate name for COGS is “Direct Expenses,” strangely enough.

 ———-

Service (maybe a plumber or an HVAC service company)

COGS might consist of the following:

  • Contract Labor
  • Equipment rental
  • Fuel
  • Materials
  • Vehicle repair & maintenance
  • Labor
  • Incentives

Again, a considerable amount of thought must go into what costs are directly related to providing the service.  You must think through every expense of your business and decide which costs are direct, and which are not, which brings us to…

 ———-

General & Administrative Expenses (G&A, Indirect Expenses, or Overhead)

G&A expenses can be described as those expenses that a company incurs by simply existing, whether sales take place or not.  In other words, just by existing, a company spends money on:

  • Rent or a mortgage
  • Telephones
  • Internet
  • Electricity
  • Water
  • Taxes
  • Advertising & marketing
  • Professional fees like accounting and legal fees
  • Administrative labor
  • Interest & finance fees
  • Office supplies
  • Licenses
  • Dues & subscriptions
  • Training
  • And so on, and so on…

The list can be short or extensive, depending on the business.

In summary, Operations expenses can be divided into two parts, COGS and G&A.

 ———-

Now that we have covered “money in” and “money out,” we turn to…

Finances – keeping score…

If you are going to be able to make rational decisions about your business, you have to know what is working (making a profit) and what is not.  You need to understand if your business has a certain periodicity – sales going up or down seasonally, and by how much.  You need to know what your overhead is, what your cost of goods amounts to, and many other things.  Unless you have a way to do all those things, you are just guessing, and that is bad.

Bookkeeping and Accounting are two different things. 

An accountant is a necessary and essential professional that will take your financial information and ensure that you comply with local, state, and federal laws and regulations concerning taxes and fees, primarily.  Your accountant, however, does not have the intimate knowledge of your business that you do.  They are generally not interested in breaking down your sales or expenses in such a way for you to be able to tell which product line or service is profitable.  What accountants are generally interested in is what expenses are COGS and what are not, and they will generally take your word for it, as long as you aren’t too far off the mark.  The nuances of those categories don’t matter, come tax time.  A really, really good accounting firm will do it all for you, but you must control what you want to know through your financial reports, and that takes understanding on your part, plus a lot of money.  Good accountants aren’t cheap.

A bookkeeper is a person on your staff that does the day-to-day data entry into the financial books.  This person must be knowledgeable concerning accounting to some degree, but, in reality, if your books are set up in a rational way, the task becomes easy.  Most bookkeeping is done through invoices.  Invoices to your customers, and invoices from your vendors and suppliers.  That keeps track of sales and costs.  How these sales and costs are presented in your books allows you to manage the business in a realistic way.  A good bookkeeper will work with your accountant to ensure there are no gross errors in how the books are structured, and to make sure that certain required entries appear properly.

To put it in a short and somewhat simplistic way, accountants are for taxes, bookkeepers are for managing.

———-

We have covered the three categories of conducting business – Sales, Operations, and Finance – in general and gave some examples.  I suggest you think about this, because next time we will work through why we need this and how it relates to building a Financial Plan, the keystone of measuring business performance.

———- 

Please contact me offline at microconsulting@aol.com with anycomments, suggestions or ideas for future articles that you may not want to share here.

———-

Written by PocketWatch

I am a small town boy from northern Wisconsin, who grew up in the quintessential American family. Dad was a carpenter, mom stayed home, two brothers and a sister. Our politics, and we were political, was always Democrat. My dad always said all you had to do was to look at what each side was fighting for, and it was easy to see, even as a kid, that Republicans were all about big money and rich businessmen, whereas the Democrats were more about social solutions. I spent 6 years in the US Army in the VietNam era as an electronic instructor for NSA, worked as a Field Engineer for a computer firm based in Massachusetts, spent another few years building paper mills around the world for a firm from Washington state, drove long haul truck for a while, did 10 years of servitude in NYC for a large multinational market research company as the Business Manager, spent some more time on the road as a Business Consultant, and the last bit as the Business Manager for a manufacturing firm here north of Houston. I am trying to start up my own consulting firm using all my experience to help small and medium sized businesses stay out of trouble versus waiting until they get into trouble. No one teaches people how to properly run a business. Business schools and MBA programs really don't. There are very basic nuts and bolts that are either assumed or are ignored, and like the house built on sand, businessmen and entrepreneurs ignore these solid foundations at their peril. (Now retired and doing some substitute teaching at a couple of small K-12 schools here in northern Wisconsin. Living in a small hamlet of 340 people, quiet, peaceful, serene.)

4 Responses so far.

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  1. ghsts says:

    Great series PW, if you had written it three years ago I could have saved $10k in student loans (did you cover timing yet, in capitol investment?)

    • PocketWatch says:

      Nope. I probably won’t for a couple of reasons, but mostly because I want to do the day-to-day stuff, and also I am not an expert in investments and taxes.

      If you are talking about capital expenditures to improve the business and what the criteria are for that, I have some ideas and a guiding principle. I consider the most imprtant thing to think about when making capital improvments to the business is to compare the cost of what you are doing now versus the cost of the improvement (all on an annualized basis).

      For example, a manufacturing company is cramped for shop space, and spends an inordicate amount of time moving partial assemblies around to just get things done. A time study is needed. If you can show that the cost of the labor just to move stuff around per month or year is less than the monthy or yearly payment of the expansion, you need to spend the money to expand.

      It’s pretty simple. I see many small businesses take bad advice and buy stuff they don’t need to enlarge their expenses and therefore pay fewer taxes. Bad move. The other thing to consider is to never spend capital money on anything that won’t enhance the business.

      Is that kind of what you were referring to?

      8)

  2. faux mccoy says:

    nice article. i was a produce manager and then general manager of a health food coop in california for many years before i became disabled. i was fortunate that my father was a CPA and drilled me on such business specifics since childhood and mentored me throughout my stint as a manager.

    the health food industry as you would imagine is largely maintained by liberals/progressives/hippies -- what have you. i found that most had no basic understanding of business which was frustrating and i would spend an inordinate amount of time educating not just workers but the 7 person lay board who was in effect my boss.

    i loved the work and miss it, but do not miss having to confront deeply held notions such as ‘paying for advertising is evil’… what??? how do you expect to increase sales? i had to argue hard with my board members to spend 1.5% on targeted advertising. i even had one new board member take a look at the monthly reports i prepared including balance sheet/P&L/margin breakdowns by department. he looked it over for a moment, pointed to the balance sheet and exclaimed with incredulity ‘look at this!!! these numbers (assets and liabilities) are exactly the same!’

    i shall continue to read your columns because the art of business fascinates me and i love to see liberals who understand and can articulate these concepts.

    • PocketWatch says:

      Thanks. As a consultant, what you describe in one form or another is what I usually have to deal with. It’s why I am taking my time and building up one or two concepts at a time, and pointing out how they tie together. Miss a step or leave something out, and you weaken the foundations for making rational decisions.

      I had to laugh when you described the man’s reaction to the Balance Sheet. I learned a long time ago when I was dealing with megacorps know-nothing VP’s who had their positions due to patronage or whatever, that it was not wise to give them any information that they could either misconstrue or would not understand.

      All it does is rile up the playground that is their mind.

      As you will see down the road, I deal almost exclusively with two documents, both based on the Profit & Loss Statement. One is an Annual Plan, and the other is a Variance Report, which shows how the company is doing against that plan.

      I’m big on plans and planning.


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