Accounting Chapter 5 PDF

CHAPTER 5 I t’s only been two weeks that you’ve been in the lemonade business, and already your fame is spreading! The local neighborhood newspaper ran an article about you on page five! There you were, photographed at the lemonade stand, proud as punch.…Okay, maybe make that proud as lemonade! Th...

CHAPTER 5 I t’s only been two weeks that you’ve been in the lemonade business, and already your fame is spreading! The local neighborhood newspaper ran an article about you on page five! There you were, photographed at the lemonade stand, proud as punch.…Okay, maybe make that proud as lemonade! The article quoted your mom and dad saying how it was all your idea and how proud they are of you. It quoted Pappy Parker saying he wished there were more kids like you. It quoted a few kids who said your lemonade was the best they’ve ever tasted—and they weren’t even your friends! You’re trying not to get a swelled head over all of this. After all, it’s not like you saved the world or something really important. Still, some of the neighborhood kids start coming to you for advice about starting their own lemonade businesses. “Wow, should I do this?” you ask yourself. You have to consider your own business. These kids are asking you to help create competition for yourself. You decide you will definitely not work with anyone near enough to open a stand in your own neighborhood. The phone keeps ringing off the hook with kids wanting your help in starting their businesses. The demand is such that—being a genius on your good days—you realize this means that to do this you have to start a second business yourself! But you’re only one person. How can you run both your own lemonade stand and a consulting business? Do you really want to expand? Do you want to become a consultant? 72 T H E AC C O U N T I N G GA M E Finally, you realize that you need some consulting yourself, so you call your favorite aunt, Jane, for some advice. Aunt Jane has run her own management consulting firm for years. How will I be able to run two businesses is your question for Jane. Your aunt says you will have to hire some friends and let them start out running the stand and you can train them to be consultants. Your next question is, “Should I combine my financial records for the consulting firm with the lemonade stand financial statements or set up a separate business?” Jane says that you can do either, but reminds you that consulting is a different kind of business—it’s a service business. You immediately remember what we all learned in the last chapter—services businesses do not have inventory and can gain a tax advantage by using the Cash Method of accounting for reporting to the IRS. You figure that’s for you and decide to start a second business—the Real Good Lemonade Consulting Company. Next you ask Aunt Jane how to charge for your consulting services. She starts talking about “billable hours” and you say, “Huh?” What she means is that service businesses are all about managing and optimizing the use of time. At the lemonade stand you have to manage your product, lemonade, and your time, but a consultant’s only inventory is his or her time. Aunt Jane says that what this means is you don’t make money unless you are doing something that you can bill to the customer. You need to come up with an hourly or daily billing rate. You ask Jane if the Balance Sheet and Income Statement are different for a service business. Jane asks you to get out a Balance Sheet from your lemonade stand. She is impressed by how well organized you are and particularly by your innovation of using color to help understand the Balance Sheet items. She asks you what is the one item on your lemonade stand Balance Sheet that will not be on a service company’s Balance Sheet. “Inventory,” you tell her. (You love easy questions!) That’s the only difference if you are using the Accrual Method of accounting. Aunt Jane says the Income Statement is a different story. She says that since there is no Ending Inventory to subtract out of costs, services companies really only have Sales and Expenses. That makes it really easy to do your Income Statement. You start to feel agitated. “Aunt Jane,” you say, “wouldn’t a service company want to separate its overhead costs to run the daily operation from its direct costs?” C H APTER 5 She can’t believe how smart you are. She promises you a future job on the spot. Aunt Jane says that, indeed, most service companies separate costs into two categories—Cost of Services and Expenses. Cost of Services are the costs directly related to providing a service. Expenses are all the overhead costs or costs to run the business, just like in our lemonade stand. As we noted earlier, the structure of such a service company’s Income Statement would be: Sales - Cost of Services = Gross Profit - Expenses = Net Profit Many of you reading this book either work in service companies or for large companies with inventory that have service divisions. The purpose of this chapter is to help you better understand service company issues and accounting and give you a chance to do some practice determining which items go into Cost of Services (some people call it Cost of Sales) and which into Expense. We will get back to our lemonade stand in the next chapter. Please don’t confuse what we are doing in this brief chapter on service businesses with your lemonade stand business. The numbers here will not affect what we’ve done earlier. It’s a question of apples and oranges— or lemons! Since the Balance Sheets for the two types of companies are the same (except for Inventory), we will not focus on the Balance Sheet at all in this chapter. Now, let’s pretend to shoot forward in time a couple of months. You did hire some friends who learned your business’s core competencies rapidly helping you out at the lemonade stand. Thanks to the article in the local newspaper and great word of mouth, your new consulting business and its two employees get busy in a hurry. Encouraged by this 73 74 T H E AC C O U N T I N G GA M E response, you take out a classified ad for the business. Your younger brother, Michael, wants to get involved, so you promise him a $1 sales commission on any contract he brings into the business. Okay, let’s go consult! Hot after sales leads, Michael sends the newspaper article to your dad’s half sister, Sue, and her husband, Eric. They have two kids, your cousins, Amanda and Laura, who want to start a lemonade stand and be just like you. Aunt Sue thinks this is hilarious, since Amanda is always complaining when her younger sister Laura tries to copy her. Still, she wants to help them—and you. Who knows? Maybe in the process all of you will learn important lessons. You sell Aunt Sue three days of consulting for two consultants at $8 per day for each consultant and include all travel costs in the daily rate. They live in the next town which is 30 miles away, requiring two overnights in a local hotel for your two consultants. Luckily, your employees’ parents volunteer to go along and pay for the hotel. The cost for travel (gas for cars) comes to $6. Plus, you pay the consultants $2.00 per day for every day they work with clients. Your younger brother, Michael, agrees to do the administrative work for the contract and other office tasks. You pay him $2 for the week. You also give him the $1 sales commission he earned by selling this job to Aunt Sue. Since the newspaper article brought you such a good response, you decide to continue the ad in the next issue. Advertising the new business costs $4. Your two consultants work Monday, Tuesday, and Wednesday with the clients (your cousins). They take along $2 worth of lemons and $1 worth of sugar to demonstrate how to make lemonade, in case your cousins decide to go with your amazing, awesome, totally appetizing secret recipe. (Hey, if McDonald’s can franchise, why can’t you?!) On Thursday, back home, they work all day developing a new consulting product for your Real Good Lemonade Consulting Company to sell. (It’s a leadership course for shy kids called, “DON’T BE SHY—GET THEM TO BUY!”). You only pay the consultants $1.50 per day when they are working at the office. On Friday, they performed general and administrative tasks at the office (your basement playroom). Now, it’s time to practice. Using the above transactions, complete the following C H APTER 5 Income Statement for the Real Good Lemonade Consulting Company. Your main task is to determine which items go into Cost of Services and which go into Expenses. Remember, Cost of Services is any cost directly related to providing the service and Expenses are all the cost of doing business not directly related to providing the service. SERVICE BUSINESS INCOME STATEMENT SALES Cost of Services (Cost of Sales) TOTAL COST OF SERVICES GROSS PROFIT Expenses TOTAL EXPENSE NET PROFIT Okay, let’s see how you did. The client (Aunt Sue and Uncle Eric) bought three days at $8/day per consultant. You sent two consultants. So, what was the total revenue? $48.00 What did you put into Cost of Services? Well, you had to pay your consultants $2.00/day times 2 consultants times 3 days = $12.00 You had to pay for their travel costs ($6.00). They took along $3.00 worth of product which was used for demonstration purposes and left with the client. So, your Cost of Services are? $21.00. 75 76 T H E AC C O U N T I N G GA M E Following our formula, subtracting Cost of Services from Sales leaves you with a Gross Profit (Income) of…? $27.00. Now, what items were in Expenses? Remember, Expenses are costs not directly related to the delivery of services. You paid Michael a sales commission ($1.00) and paid for some advertising in the newspaper ($4.00). Michael also did the administrative work for the contract and other office tasks ($2.00). Then, on Friday, your consultants, each earning $1.50, spent the day performing administrative tasks at your office. (They claim they were busy with paperwork, though you suspect mostly they played Solitaire on your family’s computer.) There’s one more expense. How much did DON’T BE SHY—GET THEM TO BUY! cost you to develop? $3.00 for Research and Development. So, what are the total expenses? $13.00. We’re almost done. Last thing, subtracting Expenses from Gross Income leaves us with a Net Income of…? $14.00. Now, you may be wondering about a few things. One may be how we handled the sales commission. Some of you may want sales commission to go in Cost of Services, since you can argue that it is a direct cost of the sale. But is it truly a part of the cost of delivering the service? Not really. Because of this, many businesses put sales commission in Expenses. Either way you did it is okay by accounting standards and by the IRS. What is required is that you be consistent in how it’s reported. Travel costs may be another area you’re wondering about. Travel costs are in Cost of Services because they are part of delivering the services by contract. Most real-life consulting companies make the client reimburse any and all travel costs. If travel is reimbursed dollar for dollar, it is handled as a non-revenue item in a separate account. How come your employees’ wages show up in different categories? Because consultants’ wages are in Cost of Services only when they are working on a project. Their relative time as consultants, doing administrative tasks, and R&D lets us know how efficiently we are using their time (which is the only source of the consulting company’s revenue). Not all service companies have R&D, but for those that do, separating it allows you to keep track of how much capital investment goes into new products. This is helpful in determining how to price them. Review your Income Statement again. Does anything concern you? What are 77 C H APTER 5 potential problem areas? How would you improve this company’s profitability? Remember we said earlier that time is the critical issue in a service company. You might question the wisdom of using the consultants for administrative tasks. Their salaries are much higher than Michael’s for performing these tasks. Lots of service companies get into financial difficulties when they end up having too much time when their services providers are not working directly for clients on “billable hours.” What else haven’t we covered in this brief side trip? Certain types of expenses, for one. Interest expense, other expenses, and taxes would have to be subtracted to arrive at the true bottom line after taxes. You may wonder what “other expenses” mean. These are things like a loss or gain from selling a fixed asset (which we haven’t done). Well, we certainly haven’t exhausted a discussion about service businesses and how to treat them accounting-wise. But, hopefully, you know some of the things to keep in mind if you’re in a service business. Below is our Income Statement with the major categories used by typical service companies. REAL GOOD LEMONADE COMPANY INCOME STATEMENT SALES $48.00 COST OF SERVICES $21.00 GROSS PROFIT $27.00 Expenses Sales and Marketing $5.00 General and Administrative $5.00 Research and Development $3.00 TOTAL EXPENSE $13.00 NET PROFIT $14.00 You like having a second business. Maybe one day you’ll sell your lemonade stand and concentrate on being a consultant full-time. For now, though, you enjoy making a product and selling it. So, let’s leave the consulting world for a while and return to the best-tasting lemonade in the whole wide world! After all, week three is about to begin!