Expenses: How are you spending?

Expenses are where you spend your money. But, as with income, a lot of times you incur expenses without using cash. Now for another accounting term. Accrual. The accrual method of accounting is the tool that deals with these kinds of transactions. If you buy something at the local supply store and don't have to pay for it for 30 days or six months (same as cash!!), the expense (debit/increase) is recorded in your books for the day you bought it and then is put on "accounts payable" (credit/increase). When you finally do send your check to pay for the thing you bought, you will credit (decrease) cash and credit (decrease) accounts payable. This closes the circle leaving you with the expense of the item you bought and the payment from your cash account. Accounts payable was merely the means of keeping track of what you owed until you paid it. Accounts receivable and sales work the same way but the debits and credits are reversed.

Now we come to the rest of the expense picture. Expenses are accumulated until the end of the month and the totals are listed on the income statement or profit and loss statement (P&L). To manage your profitability and have better control of your spending, the P&L is broken into smaller segments. The first piece is your cost of operations. A great example is a construction company. The contract income earned is listed, naturally, at the top of the P&L. Next is the various expenses directly for the fabrication and installation of the project, whether it's an air conditioning unit for an office building or a back-up generator for a manufacturing facility. When I worked for a mechanical contractor, construction costs were grouped into equipment, materials, labor, subcontract, and other direct costs. The individual totals of these categories are added together and that figure is subtracted from total sales. The result is gross profit. The gross profit has to be enough to cover your administrative or overhead costs. Some businesses may have a large gross profit and a lot of overhead and administrative expenses. The mechanical contractor I worked for aimed for 15% as the gross profit target. From here, the goal was to cover overhead with 10% and have 5% remaining for net profit. This means that out of every $1.00 of income, only 5 cents were left for the business to buy new, more or better equipment. On $10 million, $500,000 was available for future projects or other future plans.

When the expenses are studied, it may be found that more cost-conscious buying in operating costs can yield a higher gross profit percentage. Then, tighter controls on overhead expenses could take net profit to 7%. Guess what!!! Now you have money for an enhanced marketing plan in the first half of the year, generating more sales in the second half of the year. Now you've grown your business, improved profitability and maybe started a profit sharing program for your employees.

One more step. This will come well before you hit $10 million in sales. As you evaluate your overhead expenses, you may find you have so much going into one big bucket that you don't know what it all means. This is the time to consider establishing separate departments. One thing not to do, though, is to have so many departments there is too much separation of duties. Something else is to avoid is changing your structure so often you and everyone else can't keep up with the unending change. Plan a structure that will have unique responsibilities by department and that will need to be changed only as your business grows. A simple example is not to start an IT department until you need to pass off the duties to an individual or group of individuals that can handle the duties without your intense supervision.

That's enough for today. Have a good one.

Gary