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    So What’s Accrual Accounting and Why Does it Matter?

    So you make a sale. When you deliver the goods, you record it as a sale. If the customer didn’t pay you immediately, you record the accrued amount as Accounts Receivable.

    You order some goods. When you receive them, you don’t pay for them. Instead, you record the accrued amount as Accounts Payable.

    At the end of the tax year you have some expenses outstanding, like professional services you know you’ll be billed for but you haven’t been billed yet. You accrue those expenses into the current tax year. They are deductible against income.

    In so-called cash basis accounting, the opposite of accrual accounting, you don’t put the sale or the purchase onto your books until the money changes hands. With business-to-business sales, the norm is the money changes hands later. So accrual accounting is better. It gives your books a more accurate picture of your financial flow and financial position.

    Why does this matter here? Because timing of sales, costs, and expenses makes a difference. Start your forecasts correctly so the can be part of a more formal financial forecast when you finally need one.


    Snapshots of Spreadsheets

    Just a quick note. I hope it’s obvious. With examples in this book I’m not showing you the full columns of the spreadsheets, because that would be awkward. Numbers would have to be very small and difficult to read. I use my spreadsheets for sales forecasting and other normal monthly projections with a standard layout.

    I base my tables on the standard spreadsheet layout as used in Microsoft Excel, Lotus 1-2-3, AppleWorks, Quattro Pro, and even the true pioneer, VisiCalc, the first spreadsheet, from 30 years ago. The rows are labeled from 1 to whatever, and the columns are labeled from A to whatever. When you get past the 26 letters of the alphabet you start over again, with AA, AB, AC, etc.

    Labels in Column A Special uses for Column B 12 Months Monthly in Columns C-N Annual Columns as Needed.
    I run the labels along the lefthand side. These might be Sales, Expenses, Profits, etc. I keep column B open for variables like growth rates and such. This is convenient for starting balances too. My months go off toward the right, one by one, in 12 columns. The first year’s totals of the numbers from the previous 12 months. Then come the additional years as needed.

    Sometimes Timing Matters a Whole Lot

    Don’t reinvent wheels. Please. As you do your sales forecast, be aware that accountants and financial analysts have definite meanings for timing of sales. If you don’t deal with this their way, then when you do eventually incorporate the work you’ve already done on the sales forecast into more formal financial projections, you’ll have it wrong. It will look bad.

    So What’s Accrual Accounting and Why Does it Matter?
    So you make a sale. When you deliver the goods, you record it as a sale. If the customer didn’t pay you immediately, you record the accrued amount as accounts receivable.Then you order some goods. When you receive them, you don’t pay for them. Instead, you record the accrued amount as accounts payable.

    At the end of the tax year you have some expenses outstanding, like professional services you know you’ll be billed for in the future. You accrue those expenses into the current tax year. They are deductible against income.

    In so-called cash basis accounting, the opposite of accrual accounting, you don’t put the sale or the purchase onto your books until the money changes hands. With business-to-business sales, the norm is that the money changes hands later. So accrual accounting is better. It gives your books a more accurate picture of your financial flow and financial position.

    Why does this matter here? Because timing of sales, costs, and expenses makes a difference. Start your forecasts correctly so they can be part of a more formal financial forecast when you finally need one.

    Timing of Sales

    Your sales are supposed to refer to when the ownership changes hands (for products) or when the service is performed (for services). It isn’t a sale when it is ordered, or promised, or even when it’s contracted. With proper accrual accounting, it is a sale even if it hasn’t been paid for. With so-called cash-based accounting, by the way, it isn’t a sale until it’s paid for. Accrual is better because it gives you a more accurate picture, unless you’re very small and do all your business, both buying and selling, with cash only.

    I know that seems simple, but it’s surprising how many people decide to do something different. And the penalty of doing things differently is that then you don’t match the standard, and the bankers, analysts, and investors can’t tell what you meant.

    Timing of Costs

    Costs of sales or direct costs or costs of goods sold are supposed to be timed to match the sale.

    For example, when you buy a book from a bookstore, whatever that book cost the store to purchase was an amount added to inventory until you purchased it, and only then, with the purchase, it became an amount added to cost of goods sold.

    Notice the timing. It sits in inventory for as long as it takes, but it doesn’t get out of inventory and turn into cost of sales until it gets sold.

    Messing that up can mess up your financial projections. When sales for the month are $25,000 and cost of goods sold are $10,000, you want the $10,000 to be the costs it took to buy whatever was sold for $25,000. If this month’s costs are for things sold last month, or things sold next month, you get bad information.

    It’s harder to keep track of this sometimes with services. The cost of sales for a taxi ride should be the gas, the maintenance, and the driver’s compensation. But accountants would go crazy trying to match the exact gasoline costs to the exact trip, so they estimate a lot. They are always trying to match the months though; costs should be recorded in the same months as the corresponding sales.

    Timing of Expenses

    Expenses are supposed to show up in the month that they happen. Ideally, travel expenses are attributed to the month you travel, even if you paid the airfare two months earlier. Ideally, advertising expenses are recorded for the month that the ad appears in print, rather than the month when you submitted the ad. And they certainly should not appear in the month in which you pay for the ad, which often is two or three months later. You want the timing to match.


    How Could I Know?

    One of the more powerful drags on business planning in general is what I call fear of forecasting. Lots of people have it.

    “How could I possibly know?” is one of the more popular complaints. After all, who can predict the future? How can you know what’s going to happen in the market, with the competition, or with new technologies. Isn’t it just wasting your time to try to guess?

    No, it isn’t just wasting your time, because one thing harder to do than forecasting is running a company without a forecast. The real question isn’t, How can I possibly know what’s going to happen? but, rather, How can I possibly know whether what actually does happen is good or bad or better than expected if I don’t know what I thought would happen?

    Confusing? Think of it this way: although you forecast for at least a year, you actually go out on a limb only for the next month. In a month, you’re going to review that forecast. You’re going to see what is different from the forecast, and revise the forecast. Your year doesn’t stay static after the first month if results of the first month cast doubt on the whole year.

    So don’t worry so much; get started with your forecast, and you’ll be revising.


    Graphics as Forecasting Tools

    Business charts are excellent tools for understanding and estimating numbers. Use them to evaluate the projected numbers. When you view your forecast on a business chart, does it look real? Does it make sense? It turns out that most humans sense the relative size of shapes better than they sense numbers, so we see a sales forecast differently when it shows up in a chart. Use the power of the computer to help you visualize your numbers.

    For example, consider the monthly sales chart below. You can look at this chart and immediately see the ebbs and flows of sales during the year. Sales go up from January into April, then down from spring into summer, then up again beginning in September. When you look at a chart like that, you should ask yourself whether that pattern is correct. Is that the way your sales go?

    Monthly Sales Chart

    The next chart shows a comparison of forecasted sales for three years. Here again you can sense the relative size of the numbers in the chart. If you knew the company involved, you’d be able to evaluate and discuss this sales forecast just by looking at the chart. Of course you’d probably want to know more detail about the assumptions behind the forecast, but you’d have a very good initial sense of the numbers.

    Annual Sales Chart

    When we did the sample restaurant sales forecast, we used a line graph to estimate the seasonality for the restaurant.


    If You Can, Start From Last Year

    If you can, whenever you can, start this year’s forecast by putting last year’s forecast onto this year’s spreadsheet. Then revise as needed. One of the real luxuries of the existing and ongoing company, compared with the startup, is that there is data. You have experience.

    As soon as you have a forecast with last year’s numbers in it, then you starting thinking about what’s going to be different.

    • What’s new and different this year compared with last year? New products? New business relationships, new channels, new locations maybe?
    • What about bad news? Sometimes things are cooling, some new problems are developing. Maybe new competition shows up.
    • Will pricing change?

    You can look at costs and expenses, too. Normally we assume costs and expenses rising gradually. That’s just a general matter of inflation. Is it going to apply for your business in the next year? Why? Or why not?


    Understanding Fixed and Variable Costs and Burn Rate

    Costs are among the financial and accounting terms that have specific meanings. You can’t just decide to think of them as what makes sense to you, because the accountants and analysts won’t understand you. They’ll say you are wrong. Ouch. Not pleasant.

    So, here are some definitions.

    Cost of Sales

    The cost of slaes is not the expenses related to making a sale. It isn’t that lunch with the customer or the trip to go visit the customer and make a pitch. Costs of sales means what it costs you to make or deliver whatever it is you sell. If you don’t sell, you don’t have any costs. The costs are variable by definition.

    • Costs are supposed to be directly related to sales. They are about what it costs you to have or build or deliver what you’re selling.
      • Costs of a manufactured product include materials and labor. So, for example, the computer costs $200 to build, including $150 in parts and $50 in labor.
      • If you just buy an already-built computer and then sell it, the cost is what you paid to buy it.
      • If you deliver a service, you still have costs. The taxi or airline has fuel, maintenance, and personnel costs. The law firm has what it pays the lawyers, plus legal assistants, and photocopying and research.
    • Costs depend on who and when. For example.
      • When you buy a book for $19.95 at the local bookstore, the store’s cost of goods sold are whatever it paid to buy that book from the distributor. Let’s say it paid $10.50 plus shipping. The store’s sales are $19.95 and it’s cost of goods sold is $10.50 plus shipping.
      • If the distributor bought the book from the publisher for $6.25, then it’s sales for the book is $10.50, and its cost of goods sold is $6.25.
      • Let’s say the publisher had the book printed for $2.00 per copy and it pays the author a royalty of 10%. It’s sales for the book is $6.25 and its cost of goods sold is the $2.00 plus $0.652 for royalty. And the publisher probably paid to ship the book to the distributor, which would add another small amount, maybe $0.25 to the cost of goods sold.
    • Understand inventory. This comes up again as a cash-flow trap.
      • Stuff that’s going to become cost of goods sold when it sells starts out as inventory, which is an asset. It sits there in inventory until it sells.
      • Think about this in terms of timing and cash flow. The publisher buys the books from the printer and pays for them, which makes them inventory. They sit there for months until the distributor buys them, at which point they become cost of sales. The distributor has them as inventory until it sells them to the store. Then they become cost of sales. The store has the book for as long as it takes, from when it receives it and puts it on the shelf until you buy it.
      • The cash-flow trap is that the whole inventory asset doesn’t show up on your income statement until you sell the stuff. In the meantime, whether you’ve paid for it or not, the income statement doesn’t care. The money is gone, but the sale hasn’t been made. This is a classic cash-flow trap. You won’t see it on the income statements. It is completely outside of the realm of profit and loss. But you have spent the money.

    Here’s where you rate yourself. If these ideas are obvious, then skip this next part; don’t worry about it. If you’re uncomfortable with these terms, vaguely worried you don’t know what they mean, then read on, and in about five minutes, you will.

    Fixed vs. Variable Costs

    Part One: The Real Case – Manufacturing Costs

    Sometimes this matters, many times it doesn’t. Technically, fixed costs are costs that you pay regardless of whether or not you sell anything, or how much you sell. For example, the monthly rental of an installation used exclusively to build stuff would be a fixed cost. It gets technical and surprisingly creative as cost accountants figure out how to allocate fixed costs to the related sales. That was a special course in business school. I found it fascinating, but for business planning purposes, let it go.

    We’re doing planning, not accounting. Remember?

    Part Two Fixed vs. Variable and Risk

    Don’t worry too much about financial definitions, because in this case at least, they are inherently confusing. Analyists tend to talk about fixed vs. variable costs, but most of the time they are talking about variable costs (as in cost of sales, direct cost of goods, costs of goods sold) vs. fixed expenses (such as payroll and rent). This is not a useful context for distinguishing between costs and expenses. Basically what this is about is trying to figure out how much risk you have in the business.

    The big picture is relatively straightforward. The underlying assumption is that your spending has two parts: the fixed part, that you spend no matter what, and the variable part, that you spend only if you make the sale, and for which the level of spending depends (hence the term variable) entirely on the level of sales.

    For an example of that, here’s a true story. Back in the formative years of Palo Alto Software we chose to pay an outside sales representation company 6 percent of our retail sales, after the fact, rather than hire somebody as an employee to manage retail sales.

    The trade-off should be obvious. There’s a lot less risk with the variable cost. If we don’t get the sale, we paid nothing. If we did get the sale, then we had money from the sale that we could use to pay the variable cost.

    Some of your spending is almost always fixed: rent, insurance, payroll, for example. Some of your spending is almost always variable: direct cost of sales, for example.

    And some of your spending is hard to classify. The plumber pays the Yellow Page advertisement in the telephone book once a year, regardless of sales levels; but if sales go up because of the ad, she might be tempted to increase the ad size next year. Your website seems like a fixed cost, but many of us in the Web business pay commissions to affiliated sites that help us make the sale.

    It’s fine-tuning like this that has given us the term “burn rate.” That term became particularly popular during the first dotcom boom in the late 1990s. Some Internet companies that had no sales or revenue had lots of money from investors. So they would divide the money they had in the bank by their monthly burn rate (how much money they were spending every month) to calculate how many months of life they had. Without sales or revenue, burn rate became very important. They’d use it to know when to look for more investment, or, in some cases, when to look for a new job. Burn Rate, by Michael Wolff, is a very entertaining book about it. You counted your future as how many months’ worth of burn rate you had in the bank, from the investors.

    I like using the term burn rate instead of fixed costs. Technically, fixed costs are costs that would stop if you didn’t sell. But the burn rate, on the other hand, is how much money you spend every month, without quibbling over whether it’s technically fixed costs or not. They are closely related.

    All of this becomes more than just idle debate and definitions if you try to do a break-even analysis. I think of break-even as mostly optional, but it’s still a good illustration of your basic financial picture. So you might find it worth the effort for a break-even analysis tool. Look in the business calculators of bplans.com. There’s also a detailed break-even explanation at hurdlebook.com.

    Your Burn Rate

    Suggested Reading Burn Rate
    Michael Wolff was by no means the first or the only one to popularize the term burn rate, but his book, Burn Rate: How I Survived the Gold Rush Years on the Internet, cemented the term into the post-Internet dotcom boom business vocabulary.Read more about this book…

    Your burn rate is how much you have to spend on an average month to keep your company up and running. That normally includes rent, payroll, and — unlike the concepts of fixed vs. variable costs — whatever else you spend in a normal month that isn’t directly tied to your sales, which means it isn’t automatically paid for by sales, whether it’s fixed or variable. So it includes your standard marketing expenses, which would technically be called variable expenses.

    I think you should always know your burn rate. I hope you have sales and revenue as well. If your plan calls for burning more money than you’re bringing in, then you know you need to be borrowing or finding investment capital.

    I also like the burn rate instead of fixed costs as a good number to use in a break-even analysis. In classic financial projections, the kind they still teach in financial analysis courses in business school, you’d use your fixed costs to calculate your break-even point. Burn rate is a newer and better idea.


    Estimate Spending Related to Sales

    Some cost estimates go directly along with the sales forecast, because these are costs that you don’t incur unless you make the sale. If you haven’t already, you might want to read the Understanding Fixed and Variable Costs and Burn Rate, section, with some important definitions. The sidebar here will help too.

    So I assume you already have your sales forecast. One of the first things you do with a spending budget is figure out how much it costs you to deliver what you’re selling. As I explained in that previous section, this is cost of sales, sometimes called cost of goods sold (COGS) or direct costs, and traditionally means the costs of materials and production of the goods a business sells. In accounting, cost of sales belongs in the month in which the goods or services are actually sold, regardless of when they were purchased or produced.

    A Word About Words: Don’t Confuse Costs and Expenses
    Stick with the way the accountants and financial analysts deal with cost of sales. You’ll get into trouble if you don’t. You want your definition to be the same as what theirs to avoid any misunderstandings.

    That means cost of sales, also called direct costs, direct cost of sales, or costs of goods sold, is the money it costs you to buy or produce the goods you sell or to deliver the services you sell. Please don’t confuse this with sales and marketing expenses. Travel, meals, commissions, credit card merchant fees, and such are sales expenses, not cost of sales.

    Confusing, yes, but we can’t help it. That’s the way these terms are used. You don’t want to make your own meanings, even if they’re logical, because if you need to produce more formal financial projections later on, you need your meanings to match what people expect.

    For a manufacturing company, this refers to materials, labor, and factory overhead. For a retail shop, it would be what the store pays to buy the goods that it sells to its customers. For a consulting company, the cost of sales would be the remuneration paid to the consultants plus costs of research, phocopying, and production of reports and presentations.

    If you projected sales in units for your sales forecast, then it should be fairly easy (for most businesses) to figure out what each unit costs you. Then you can multiply that per-unit amount by the units to estimate the costs associated with exactly that month’s worth of sales, which is the point. See the illustration below.

    If you just project sales by the total amount, then try to estimate the related costs and — at least as much as you can — keep the costs in these cases as much as you can in the same month as the related sales. Don’t go crazy with it, but try.

    Sample Cost of Sales
    In this sample, there is a unit cost for each of the items the store sells,
    so you multiply the units from the sales forecast times the per-unit cost
    to automatically calculate the direct costs of sales.

    Do a Simple Expense Budget

    OK, maybe my example in the last illustration is a bit much, but planning is for everybody, all companies, not just the startups, so what the heck. It’s a not-so-small company, but the math is still pretty obvious.

    The point is that budgeting expenses is a matter of simple math, common sense, and reasonable guesses, without statistical analysis, mathematical techniques, or any past data. The mathematics is simple; sums of the rows and columns. You’ve seen it before.

    And, as with the sales forecast, you really need to have some idea of these numbers. Either you get it from past data, or you get it from your experience in the industry, or from a partner or team member with experience, or you do some shoe-leather research. Try the reverse telephone tree technique. Look for standard industry data.

    Also, remember that even in the worst case, with the roughest estimates, you have to go only one month without having any idea, because by the second month, with plan-as-you-go planning, you have the first month’s results to help review and revise.

    See the next illustration for a simple expense budget.

    Match the depth and detail of your budget to the control and accountability you have on your team. Make it so that the rows are useful for following up later, looking at what was different from the plan and why.

    Does your spending match your priorities? Remember the strategy pyramid, intended to help you keep your activities aligned with your strategy? This is where you begin to see it in action.

    Aim for the right level of detail for following up. Too much detail makes it very hard to manage and track, and too much aggregation makes it hard to develop accountability. Do you know, in your business, who is responsible for each row in the budget? Does everybody else on the team know?

    Before I go too much further, I’d like you to consider how important payroll is as part of you budget. Let’s see where those numbers came from. I recommend you record these amounts in a separate table, whose totals flow into the expense budget table.


    Estimate Your Payroll as Part of Expenses

    Payroll is really the most important of your expenses, right? Unless you’reworking all alone, when things get fuzzier, the worst thing that can happen is missing payroll. So that’s a number that should really be in your plan, among the simple basic numbers. I hope you agree.

    Here too the math, the spreadsheet elements, are pretty simple. It doesn’t take advanced analysis or specialized equations. If you have past data and history, it becomes very easy (which is not to say that projecting future pay increases is an easy part of business, but the math and estimation is relatively simple).

    This is just one easy way to do organize the data. Lots of people add sophistication to it, like dividing the payroll up into departments, or estimating how many people are in each functional area, then the average pay per person, then multiplying. For now, though, I want to keep things simple as we go.