When we are use the cash method we would not record any entry until the payment has been received:

Cash                 10,000
    Produce Revenue     10,000

However, when we use the accrual method of accounting a journal entry to record an invoice sent to a customer may look like:

Accounts Receivable - ABC Produce    10,000
    Produce Revenue                      10,000

When we use cash basis it is common for customers not to pay us immediately. So we want the ability to track the amounts our customers owe us using accounting software. We also want to be able to track what we owe to our vendors to ensure we make timely payments. Therefore, a use of the “hybrid” method allows us the best of both methods.

Thankfully this is fairly easy, especially if you are using Quickbooks or another accounting software program. You don’t really even need to understand the differences between cash and accrual accounting as the software will do all the work for you. When you go to the reports drop-down option in Quickbooks and select any of the financial statements a box will open with options, such as the time period you want to review. Within that option box is an option to check “cash” or “accrual” boxes. The software is smart enough to produce an Income Statement (aka Profit and Loss Statement) that is either cash OR accrual based.

At the end of the year we need to make sure that the financial statements report our activity using the cash basis. Otherwise, we would pay taxes on income we have not received. Additionally, the IRS requires a formal change from cash to accrual or accrual to cash using Form 3115, Application for Change in Accounting Method. A business cannot switch between the methods as we see fit, therefore, we must make sure that if we use the hybrid method, our Income Statement and Balance Sheet report using the appropriate accounting method, i.e., either cash basis for accrual.

One of my students, Mark, stated that, “relying on a checking account balance is very dangerous.” He mentioned that by looking only at the bank account a business owner isn’t preparing himself for liabilities that may come due, such as sales taxes. In many states the business is a collection agent for sales taxes on behalf of the state. The business will collect sales taxes upon recording a sale. The cash will sit in their bank account for about 30 days (give or take depending on their submission due dates). This is false cash in the bank. Even if you know a portion of the cash in the bank it isn’t yours, you might not be considering all of your debt and accounts payable items along with account receivables to determine your true cash position.

Another students, Craig, summarized that the statement of cash flows allows you to view the cash on hand in tandem with the items due to you and payable by you. This is because the statement of cash flows presents the flow of cash in three different categories: operating, investing and financing. In the operating section you can see how much cash is being generated from the daily sale of products and services as well as the payment for operational items.

Most accounting software providers offer the option to generate a statement of cash flows at a point in time. If you are currently reviewing your income statement and balance sheet each month or each quarter consider adding the statement of cash flows to analyze. Knowing how much cash you have in the bank is important, but planning for both the receipt and use of cash can be accomplished easier with the statement of cash flows at your fingertips.

I think this logic can apply to accounting as well. Business owners with an understand, not necessarily expertise, in accounting are more likely to be successful than those that do not have a basic understand. This is a generalization as many business owners can hire an accountant or bookkeeper to help them use their accounting information effectively.

A tip that is easy to implement and use in your business is a regular review of the Statement of Cash Flows in addition to your bank balance or check register. Most accounting software, such as Quickbooks, will calculate a Statement of Cash Flows for you so you don’t even need to really know how to do the math. The Statement of Cash Flows will show you how you are using your cash, including any increase in your Accounts Payable or other debt related accounts. It will also show changes in your Accounts Receivable account.

Managing your cash by solely using your bank account will not tell you everything that is going on in your business. Knowing how much cash is on hand is important, but it is just as valuable to know what items are due to you and are due from you.

A really good summary of what the Statement of Cash Flows is, what it includes and what it looks like is found on Wikipedia-Cash flow statement. While I do not use Wikipedia as a primary source, it often makes difficult topics easy to understand.

Hopefully you’ll use the Statement of Cash Flows in your business for the new year. You’ll be glad you did.

Did you plan for year-end bonuses? Or was it a last minute decision? What about purchases for automobiles, machinery, equipment, furniture, etc.? If you want to expand your business you will need to buy new equipment. If you want to maintain your business you will need to replace old or outdated equipment. The best way to prepare for the purchase of these large items is to prepare a capital budget.

Summarize the items you think you will need and in what month you plan on purchasing them. Compare the cost of these items to your cash budget. Will you have enough cash in the bank? If not, consider building a relationship with a banker if you do not already have one.

Next, determine the net cost or benefit of your purchase. There are a couple of ways to do this, but the easiest and most commonly used method is Net Present Value (NPV). You will need to know:

1) the cost of the item or project,
2) the life of the item or project,
3) annual cost savings or maintenance expenses,
4) the savage value, if any, and
5) the required rate of return.

Using the data listed above, you’ll drop the data into a table that includes some of the following pieces of information:

• Initial Investment (this is the amount you are paying for the new equipment or project. Show as a negative number)
• Annual cost savings (this is how much the new equipment is expected to save you over its useful life. Show as a positive number)
• Annual costs, if any (this is if the new equipment will have maintenance or other costs to operate in addition to what you pay now. Show as a negative number)
• Salvage Value (If the equipment will have value at the end of its useful life, show as a positive number)
• Net Present Value (this is the result of the figures above summed together)

For an example calculation of NPV visit NPV Example. The best way to decide when to buy, refurbish or scrap equipment/machinery is with a capital budget. Estimate the amount you will need to spend and when you plan on buying the item. Then conduct a NPV analysis to make sure the purchase is a good decision for our business.

A budget is a great planning tool, but it is generally a static document – meaning it usually doesn’t change after it has been created. When you compare the January budget to the January actual results the differences may be significant. To reduce the wide gaps between budgeted figures and actual results you can create a flexible budget. There are many different types of flexible budgets, but the academic version of flexible budget is a budget that uses the “static” budget estimates using a per unit rate to estimate a “revised” budget for actual production or sales.

For example, assume that you had budgeted to sell 1,000 units (or hours) in January but you only sold (or billed) 900. Comparing a static budget to actual results will show you variances in quantity. However, creating a flexible budget at 900 units will allow you to compare a budget at 900 to the actual results at 900. When comparing the same number of units you can then see inefficiencies instead of just quantity differences. This information can be helpful in determining why you had higher than expected labor or materials costs.

As you sit down to prepare your 2011 budget, reflect on what worked and what didn’t work in 2010. What are some areas that you can cut costs and others that should be allocated additional dollars? Has the marketplace changed, for better or worse, since you prepared your last budget? What changes, if any, do you anticipate for sales, labor costs, and other operating expenses? Remember that you can always change the data later if you need too. A budget is a tool helpful too, create one that it is relevant to your business.

The formula for the break-even point is simple, but can be more complicated if you have multiple products. First you need to determine your selling price per unit as well as the variable costs per unit. The difference between the selling price and the variable costs is call Contribution Margin per unit. Next determine your fixed costs. The formula is:

Fixed Costs / Contribution Margin per unit = Break-Even Point in units

For example, your fixed costs are $90,000. You sell your product for $150 per unit (or you charge $150 per hour for your services). The variable costs associated with your product are $90 per unit (or per hour). The contribution margin per unit (or per hour) would be $60. Using the break-even formula the break-even point in units would be 1,500. ($90,000/$60=1,500 units)

Assume you want to know what your revenue will be at the break-even point. We can convert the contribution margin into a percentage. Take the contribution margin per unit and divide by the selling price. The result is a percentage. Then you use the following formula:

Fixed Costs / Contribution Margin ratio = Break-Even Point in dollars

Using the same example as above, we know our contribution margin per unit is $60. So the contribution margin ratio is 40% (solved by taking: $60/$150). When we put these figures into the formula we get $225,000 as the amount of revenue we need to generate to break-even. ($90,000 fixed costs/40% contribution margin ratio)

When you have multiple products or services you can still calculate the break-even point using a couple of different methods. The easiest is to determine the proportion of each product to the whole. Then multiply the number of units needed to break-even by the prorated allocation. It’s not a perfect methodology, but it can give you insight as to how many of each units you need to sell to break-even.

As we continue with accounting terminology (see Types of Cost Behaviors), a couple of items to consider when making a new purchase are opportunity costs and sunk costs. An opportunity cost is a foregone benefit. For example, do you rent the extra office on your floor to generate some additional revenue or do you use it as a storage room? The “lost” benefit would be the rental income. A sunk cost is a cost that has already been incurred and is irrelevant for the current decision. For example, the original price for a new car 4 years ago is irrelevant to your decision to purchase a new car today.

Why do opportunity and sunk costs matter? Because we need to account for any lost benefit if we choose one option over another. And the sunk costs are often mistaken for relevant costs and can skew a decision. Therefore, it is important to categorize items before you crunch the numbers.

Here is a common example: You want to buy a new truck for your business. The new truck will cost $36,500. The truck you have is 4 years old. You bought it for $32,000 and the outstanding loan value is $13,000. You wish to sell the auto, but the Kelley Blue Book value is only $12,000. The annual depreciation on the new truck is $7,300 per year. Depreciation on the old truck was $6,400.

In this example the relevant costs are the cost of the new truck at $36,500, the market value of the old truck of $12,000 and the $900 difference in depreciation between the old and new truck. The original cost of the old truck is irrelevant because it is a sunk cost as is the outstanding loan amount.

The next time you consider buying a new vehicle or equipment for your business, look at what items are relevant to the decision. You can use similar logic when analyzing if a cost is avoidable or unavoidable.

As you start to plan for the new year, I will be posting about various accounting terms and other accounting tools. First let’s discuss types of cost behavior. There are two main categories of cost behavior; variable costs and fixed cost. Each of these two categories have subcategories of costs.

The definition of a variable cost is an item (i.e., expense) that varies in direct proportion to the level of activity. For example, a consultant may have to pay an independent contractor $15 per hour to complete a project. The independent contractor is only paid for the hours they work on the project.

With variable costs sometimes the amount can change when their are large blocks of activity, this is called a step-variable cost. For example, let’s say that you are ordering 1,000 brochures. If you order and additional 250 brochures the cost may decrease by $.15 for the additional brochures only. Note the original 1,000 brochures are offered at the original price.

When an cost is considered fixed it means that it does not fluctuate with changes in activity. The amount we pay each month for a car loan will be the same regardless of how many miles we drive. Fixed costs can be considered committed or discretionary. A committed fixed cost is one that cannot be changed over a period of time. An example is the rent on a 5 year lease. The rent payments will be the same each month and we do not expect to be able to break the lease without penalty. A discretionary fixed cost is one that we can choose not to incur, such as the cost for an advertising campaign.

As you analyze your performance over the past year and plan for the next one, consider how your costs are classified. Which ones are variable costs and which are fixed, either committed or discretionary? Once you know your variable costs you can estimate the amount for the new year based on activity levels. For the discretionary fixed costs, determine if those items helped you generate revenue in the past year. If not, can you get rid of them and improve your bottom line?

• The timing of collections from customers. First determine what percent customers pay in the first month? In the second month? What portion is usually deemed uncollectible. For example, say 70 percent of your customers pay within 30 days, 20 percent pay within 30-60 days, 5 percent pay within 60-90 days, and the remaining customers never pay. Use this information to estimate your expected cash collections from customers by month.
• The timing of payments to suppliers and vendors. Do you pay your invoices in 30, 45 or 60 days?
• A summary of your monthly cash expenses for items such as: salaries, supplies, rent, utilities, telephone, bookkeeper fees, etc.
• The one-time or infrequent cash payments for insurance, licenses, tax preparation, etc.

With this information in hand you are ready to input the data into a cash budget template. Create a template that makes sense to you, and be sure to include sections to summarize all of the cash collections and cash payments (wages, inventory, rent, utilities, advertising expense, etc.) In order to prepare an accurate cash budget you will need the information from your master budgets, such as sales, production/inventory, and selling and administrative budgets.

A cash budget should be used to manage your daily cash flows, but more importantly, it can be a tool to help with planning for the future. Before you decide to buy a new piece of equipment, prepare a cash budget to determine if you have enough cash flow to purchase the item. Before you move into a bigger facility, review your cash budget to estimate the amount of cash flow left after the increase in rent payments have been taken into consideration.

As with any budget or accounting tool, the information provided by the cash budget is only as good as the data put into it. Use the information from the cash budget to time the payment of your expenses to maximize cash on-hand.

A few notes about creating a sales budget:

1. Be as realistic as possible. While it is always good to create big goals, you want to be able to use this information for making decisions in future months.
2. A sales budget is not necessarily the same as a cash budget. Many times sales occur before cash is collected.
3. Use units, where possible. When you create your template have the units and selling price(s) in separate Excel cells that can be easily changed so that you can play with units and/or price to see how your sales budget would change with different variables.
4. Units are also important because you will use this information when creating the production/operation budget.

Create a spreadsheet with a list your products/services in the very far left column. You will want to list the months at the top of the spreadsheet too. You can create an “assumptions” page or use the current page to track the units to be sold per month. Multiply the units times the sales price for each month. If your business has predictable seasonality this should be reflected in the month units.

A sample sales budget is presented below:

Once you have completed your sales budget you should compare your estimates to prior periods. How do the current projections compare to the prior year or to the same month of previous years? Are your sales projections too high, too low or just right? Adjust the units as necessary to create a realistic sales budget.

After you finalize your sales budget you can create a schedule of expected cash flow due to sales, assuming you allow your customers to pay on credit or if you submit claims to insurance. Estimate the percentage of sales collected in the month of sale, the percentage collected the following month and any percentages collected in future months. You’ll use this information to calculate your cash budget after your production and administrative budgets are completed.