Business Management

Inventory Affects Your Bottom Line

At the end of the year you may think, "this is great, my income is low and I won't have to pay much tax." Later you find out that your income is actually much higher. What happened?

Many small businesses purchase inventory and their accounting system simply expenses these "Purchases" to the cost of goods sold. This has the affect of reducing net income.

If your business must account for inventory for tax purposes you cannot expense inventory until it is sold. Be careful not to purchase inventory thinking that this will reduce your taxes at the end of the year. Eventually you will be able to expense your inventory but not until it is sold.

Break-Even Point

Tax Freedom Day is a good example of break-even point. It is the day of the year in which the average American stops paying taxes and starts earning money for themselves. Last year it was May 3rd.

In business management, break-even point is the amount of sales necessary to begin making a profit. Think of break-even point as leverage. If your business has a lower break-even point it can, with less effort, be more profitable. When a business has a higher break-even point, it must accomplish more sales just to begin making a profit. One of the ways to lower your break-even point is to lower your fixed costs. These expenses are items that are not affected by sales. Rent, utilities, vehicle expense, maintenance and loan interest are some examples. These expenses need to be paid regardless of sales. The other way to lower your break-even point is to increase your profit margin. This may not necessarily mean you must increase your prices. Profit margin can also be improved by lowering your cost of goods sold. Sometimes you can acquire more favorable terms from a supplier or perhaps shipping or material costs can be reduced.

Remember, a company that has higher profit margins and lower fixed costs will clearly have an advantage. To calculate your break-even point, just divide your fixed costs by your profit margin. This will give you the sales per month (or year) that you must achieve to begin making a profit.

$2000 fixed costs per month / 20% profit margin = $10,000 in sales/mo. is your break-even point.

Always use Internal Controls

Having a bookkeeper can be a great help to many businesses. Often, either a full or part time bookkeeper can leave you with additional time to spend on important aspects of your business. With careful selection, these people can provide skilled bookkeeping and valuable reports. In many small businesses, the bookkeeper may provide all of the accounting functions. This may seem like a good idea but can be perilous. Good business management should always involve some internal control structure. This primarily involves the separation of duties for: authorization, record keeping and custody of assets. Some basic measures are explained below.

I recall a forensic audit of a small business who had complete faith and confidence in a bookkeeper/office manager. This person had control over the entire accounting system (QuickBooks), the checking account, bank statements and a signature stamp. Unfortunately it was relatively easy for the bookkeeper to cover her tracks. This took place over a period of almost a year. The final amount embezzled was over $35,000. In larger companies some assurance is maintained by separating duties between employees. The theory is that more than one employee would have to conspire in order to embezzle. If you cannot separate all of the duties of the accounting functions, some important lessons can be learned.

You, the business owner, should receive your bank statement (or credit card statement) directly at your home or post office. Go through every check (or charge). Does the amount seem reasonable? Do you recognize the vendor? Are the checks signed by you? If it is necessary to have a signature stamp, is it accessible to only you? These steps, and others, can keep your business from being a target.

Internal Control Structure

Policies and procedures used by management to meet its objectives.

Adequate Segregation of Duties

  • Strategy to provide an internal check on performance through separation of custody of assets from accounting personnel.
  • Even in a small business, three functions should be separated:
    1. Authorization (including signing checks)
    2. Record keeping (including entering accounting information)
    3. Custody of assets (including blank checks)
  • A company will realize the efficiency of specialization and reduce errors, both intentional and unintentional.

Proper Procedures for Authorization

  • Originates with the stockholders who elect a board of directors.
  • Delegated to upper-level management and then throughout the firm.
  • Only certain individuals should be authorized to enter data into accounting records and prepare accounting reports.

Adequate Documents and Records

  • Documents allow management to review transactions for appropriate authorization. (bills attached to checks ready for signature, check stubs stapled to paid invoice)
  • Evidence that the recording and summarizing functions that lead to financial reports are being performed properly. (reports of disbursements and income)
  • A well-designed document is:
    1. Easily interpreted and understood.
    2. Designed with all possible uses in mind.
    3. Prenumbered for each identification and tracking.
    4. Formatted so it can be handled quickly and efficiently.

Physical Control Over Assets and Records

  • Physical precautions used to protect assets and records, such as locks on doors, fireproof vaults, password verification, and security guards. (blank checks are securely stored) (all checks are accounted for)
  • The high cost of backup records is justified in protecting them.
  • This reduces opportunities for employees to misappropriate assets.

Independent Checks on Performance

  • Procedures for continual internal verification of other controls. (owner should receive bank statements and review all checks written) (owner should verify bank reconciliation)
  • Incorporate reviews of functions, as well as internal checks created from a proper segregation of duties. Types include an outside auditor, mandatory vacations while another employee performs those tasks, periodic rotations of duties, or having someone outside the accounting process reconcile bank statements.

The three basic internal control structure categories are:

  1. The control environment.
  2. The accounting systems.
  3. The control procedures.

The five types of control procedures are:

  1. Segregation of duties.
  2. Procedures for authorizations.
  3. Documents and records.
  4. Physical safeguards.
  5. Independent checks.

The control environment is comprised of such things as:

  • Management's philosophy and operating style.
  • The organization structure
  • The audit committee.

The Accounting System:

  • To identify, assemble, classify, analyze, record, and report the entity's transactions, and to maintain accountability for assets.
  • Should contain adequate controls to ensure objectives are met:
    1. Validity
    2. Authorization
    3. Completeness
    4. Classification
    5. Timeliness
    6. Valuation
    7. Posting and summarization