Unlimited Liability. The sole proprietor is responsible for the full amount of business debts. These could exceed the proprietor's total investment. Be aware that this liability extends to all the proprietor's assets, including his or her home.

Less Available Capital. Capital is limited to the owner's personal assets and the funds the owner can borrow. Hence, this form of business ordinarily has less capital available than the other forms. Also, it is usually more difficult for a sole proprietor to borrow money for the business.

Unstable Business Life. The business may be crippled or terminated upon the illness or death of the owner.

Experience Limitation. Single owners operating with no or few employees are often limited in experience and viewpoint compared to those in the other forms of business.

Limited Business Deductions. Certain types of business deductions are not available to the sole proprietor. These include workers' compensation insurance and a portion of personal health and injury insurance.

Partnership

A partnership is an association of two or more people as co-owners of a business for profit.

Although not required by law, written articles of partnership are customary and highly recommended. These articles of agreement state the financial, material and managerial contributions to the business by each owner. The articles should clearly spell out the role of each partner and the share of the profits each will receive. There should be provisions in the articles both for dissolving the partnership and for buying out one or more of the partners.

Partnerships may also be formed as limited partnerships, in which the limited partner risks only an agreed-upon investment in the business. The liability of limited partners is restricted as long as they do not participate in the management of the business.

The services of an attorney who specializes in drawing up articles of partnership is essential to start this form of business.

Advantages 

Ease of Formation. While hardly as easy to form as a proprietorship, a partnership is easier and less costly to form than a corporation.

Flexibility. The partnership is more flexible than a corporation, but less flexible than a proprietorship.

Direct Rewards. The partnership pays no federal or state taxes. The rewards or profits from the business come directly to the partners.

Financing. Capital is easier to obtain for a partnership than for a proprietorship. There is more than one owner to draw upon for funds.

Freedom from Government Control. There are no special taxes on a partnership and, like a proprietorship, it pays no state or federal income taxes. The partners pay personal taxes on the profits.

Skills and Experience. The skills and experience of all partners are available to assist in decision making.

Disadvantages

Unlimited Liability. Each general partner is liable for the business debts incurred by the other(s) and by the business in general.

Unstable Business Life. Upon death of one partner, the partnership terminates. Rights of survival exist, so buy-out terms must be stated in a written agreement.

Long-Term Financing. Partnerships cannot obtain long-term or, for that matter, short-term financing as readily as can a corporation.

Disposal of Interest. It is often difficult to dispose of a partner's interest in the business. As indicated above, partnership articles should contain a buy-out agreement.

Corporation

A corporation is a legal entity distinct from the individuals who own it. It is the most complex of the three forms of business.

A corporation can only be formed by authority of a state government. Check with your attorney or your state's agency that supervises corporations for details of registering your business and information on the laws affecting corporations.

As soon as you are notified that your organization has been approved, you must file for a federal identification number using IRS Form SS-4. As noted earlier, check into licenses and permits before doing business.

Advantages

Separate Legal Existence. The corporation is distinct from the individuals who own it.

Limited Liability. Individual shareholders are not liable for debts of the corporation.

Ownership Readily Transferable. Owners invest in shares of the business, which can be bought and sold.

Stable and Relatively Permanent. Death of a shareholder does not end the business.

Relatively Easy to Secure Funds. The foundation of investors' stock purchases gives confidence to lenders of the corporation's stability.

Delegated Authority of Management. A board of directors and officers give structure to decision making.

Skills and Expertise Available from Many. Boards of directors usually are made up of members with a wide variety of perspectives, in addition to their interest in the specific corporation.

Disadvantages

Extensive Government Regulation. Corporations must be registered with state government and are subject to more extensive regulation by local and federal government than are solely owned businesses or partnerships.

Complicated Tax Reporting. Taxation of corporations is totally different from taxation of individuals. A corporation's dividends affect tax returns of individual shareholders.

Double Taxation. Profits are subject to corporate tax and, if distributed to the stockholders, are taxable as personal income.

Limited Incentive. If management does not share in the profits, there is usually less incentive.

Expensive to Form and Maintain. Forming a corporation usually requires professional help to draft

Articles of Incorporation and other documents, and on tax and legal matters throughout the corporation's existence.

Excise Tax Paid Each Year. Various taxes are imposed on corporations by all levels of government that are not imposed on solely owned businesses or partnerships. Taxes, other than federal, vary by locality.

"Subchapter S" Corporations

One form of corporate structure, known as a "Subchapter S" corporation, allows small business corporations to have their income taxed to the shareholders as if the corporation were a partnership.

Using this structure, the company can overcome the double taxation feature of the regular or "C" corporation, yet still retain the other benefits. An "S" corporation also permits business losses to be passed on to shareholders.

To form an "S" corporation, the company must have no more than 35 stockholders, all of whom are individuals or estates (no corporations or other entities), are residents of the United States, and must derive a specified amount of its income from active business. There is also a restriction on the amount of business an "S" corporation can do; at present, that figure is $35 million.

To summarize, in choosing a legal structure for a business, one must consider the following:

Professional advice is often needed to select the legal structure for a business. However, one can always start a business as a sole proprietor and incorporate at a later date.

LICENSES AND PERMITS

Once you have determined the purpose, type, name and structure of your business, you must find out if a license or permit is required. Many businesses require one or the other. To operate without one may be illegal.

A license is a privilege granted by a legislative body at its discretion. A permit is a right that anyone can obtain if the requirements of the granting agency are met. Licenses and permits may be granted at the town, city, county or state level. Table 1 lists departments that issue licenses or permits at the local level.

Table 1 - License or permit issuing bodies

Exhibits 1 and 2 list types of businesses, trades and professions that often require a license, permit or registration. These lists may not be complete. Check with your attorney or local government for requirements in your area.

Exhibit 1 - Businesses Frequently Requiring a License or Permit

Getting Help

Building a Work Force

As your business grows there will be a need to build the organization. Some find it easier to turn to relatives or friends for help without considering their work experience and knowledge. This can be a mistake. Carefully consider the requirements of the job and the qualifications of each candidate before hiring the person. Also consider honesty, reliability, education, personality and communication skills.

Professional Help

One does not have to hire full-time professional help to get certain expertise, such as that of a lawyer, banker or accountant. SCORE counselors are also available for business advice. Using these resources may make it easier for you to plan and execute your goals. 

Essential Management Practices

The following are practices that are essential for a successful business.

FINANCING A BUSINESS

One of the leading causes of business failure is insufficient start-up capital. Therefore, a crucial element for business success is adequate financing. Not only are funds required for start up, but also to cover initial operating losses and provide for growth.

As a general guide, one should have sufficient cash to cover at least one year's operating expenses, which includes the owner's salary and money to make regular loan payments. Almost all business operators hope their business will grow, yet some fail because, after a successful start, additional capital is not available to meet the increasing financial demands of an expanding business. It is crucial that the business plan contain a detailed analysis of all capital requirements.

Once you have determined the amount of capital required to both start and continue the business until it generates enough cash to sustain itself, it is time to find a source of money.

Sources of Funding

Personal Assets

The best source of funding is your personal resources, such as savings accounts and other marketable securities and investments that are readily converted into cash. Even if you do not have sufficient personal funds to entirely finance the business, plan on using those funds, because most lenders require that you do this before they will commit to a loan. Remember, showing others you are willing to use your own funds indicates your confidence in your business and your willingness to take the risk.

Family and Friends

An excellent source of funding is your family and friends. Either can make a capital investment in the business in return for partial ownership or as a loan. Usually, family or friends will lend their money at a lower interest rate than a commercial lender and with mutually agreeable terms for repayment.

It is very important in your dealings with family and friends that you carefully review your business plan with them so that they understand all the risks involved. Family and friends should not be encouraged to invest in your business if they cannot afford to risk their funds.

For IRS purposes, detailed records should be kept of any financial assistance received from friends or relatives. Also, it is recommended that a written agreement with the individual providing funds be prepared.

Banks

Banks are the most common source of borrowed capital. Historically, commercial banks have been the single largest source of loans to business. Today, however, both savings banks and savings and loan associations make business loans.

It is very important to establish a cordial working relationship with your banker. Pick a bank that makes loans to your particular type of business and one with which you feel comfortable. Your banker can be a valuable partner in helping to determine the right financing package for you.

A bank normally requires that first-time borrowers invest from 25 to 35 percent of their own money before the bank will consider a loan. For example, if the business plan shows a need for $100,000, the borrower would have to have $25,000 to $35,000 of his and her own money in order to obtain $65,000 to $75,000 from the bank. In the case of a restaurant, the bank may require the borrower to invest 50 percent of his or her own money.

Banks require that you have a good personal credit record and, in most cases, will require some form of collateral to secure the loan. Collateral can be in the form of assets used in the business or personal assets, including the unused equity in your home.

Credit Unions

Many companies, labor unions and government agencies have credit unions for their employees or members. Credit unions perform functions similar to banks, including making personal loans to their members. If you are a member of a credit union, check it out as a possible source of a business loan.

Loan and Finance Companies

These are companies that specialize in making personal loans for business purposes. Some of the larger companies make business loans as well as personal loans.

Life Insurance Companies

Many life insurance policies have provisions for the accumulation of a "cash value," against which funds may be borrowed. Some policies call it the "loan value." The interest rate, established in the policy, is usually less than the commercial rate. Check to see if you, parents or friends have life insurance with loan values as they can be an excellent source of financing.

Small Business Investment Companies

Small business investment companies (SBICs) are privately owned companies licensed by the SBA to provide capital to small businesses. SBICs look for businesses that have proprietary products with high growth potential. Young, lower-risk, aggressive companies are preferred. Usually, an SBIC wants a share in the business.

Community Development Companies

Many communities have established community development companies (CDCs) to help attract new business to their area. Frequently, they are used to develop commercial or industrial parks. Check to see if your community has a CDC. If so, you should talk to them.

Suppliers

In order to encourage sale of their products, many suppliers provide retailers with shelving, display cases, refrigeration units and so on at very favorable terms. Caution should be used when financing assets through a supplier; be sure you understand any commitment you have to make regarding purchasing the supplier's product in the future.

Also available from many suppliers are extended payment terms, enabling you to sell the merchandise before having to pay for it. A supplier may offer goods on consignment.

Leasing Companies

An alternative to purchasing equipment with borrowed funds is to lease the equipment. Items commonly leased are office furniture, automobiles, trucks, computers and production machinery.

The leasing company maintains ownership of the item, although sometimes agreements can be made by which you become the owner after a specified time period.

Leasing allows you to conserve initial capital and offers flexibility in acquiring the use of equipment for only a limited period of time.

Private Investors

Some investors specialize in making loans to businesses. In many cases, the investor(s) will require a partial ownership of the business. Care should be taken in dealing with private investors to see that your interests are properly protected. Investors can sometimes be found in classified advertisements.

U.S. Small Business Administration

Congress has authorized the SBA to make loans for business purposes, and has earmarked a special fund to enable the SBA to make direct loans to eligible Vietnam-era and disabled veterans. Certain handicapped individuals also may be eligible for a direct loan. These special programs are contingent upon the availability of funds.

Mostly, the SBA administers a guaranty loan program. These are loans made by private lenders, usually banks, and guaranteed up to 90 percent by the SBA. The maximum amount that can be guaranteed by the SBA is $750,000.

The lender plays the central role in the loan delivery system. The small business submits the loan application to the lender, who makes the initial review and, if the application is approved for submission to the SBA, forward it and an analysis to the nearest SBA office. If the loan is approved by the SBA, the lender disburses the funds.

Fact sheets explaining the various loan programs that the SBA administers, including fixed lines of credit, are available from the SBA. Also available from the SBA or SCORE are brochures entitled "Business Loans From The SBA."

The Loan Proposal

When you approach a lender or investor for the purpose of obtaining funds for your business, you must have the means of telling your story in a straightforward and convincing manner. The best way to do this is with a written loan proposal, presenting all the pertinent information in a logical format.

Although a well-done proposal requires a considerable amount of work, the effort is usually worthwhile. It indicates to a prospective lender or investor that you thoroughly understand your business and its financial demands. The proposal must be thorough, concise and neat. It may be submitted in longhand, but it is worth the money to have it typed. Cash flow charts may be submitted in writing.

The proposal should answer most of the questions that will be asked by a prospective lender and should present a convincing picture. Tell it like it is, being totally honest. Overstatements of facts and figures will not serve you well in the long run and will be challenged by an astute lender. If you cannot prepare this yourself, get help. It will pay off!

Exhibit 3 provides an outline of a typical loan proposal.

Exhibit 3 - Outline for a Loan Proposal

THE BUSINESS PLAN

The importance of business planning cannot be over-emphasized. A business plan is an operating tool that forces you to take an objective view of your business and provides the means to identify areas of strengths and weaknesses. It pinpoints needs you might otherwise overlook, spots problems before they arise and points out what must be done to make a profit and increase your business. A business plan can help you avoid entering into a venture that may fail. If the plan shows the business to be marginal, the hours spent writing a plan will save you the high cost of a business failure.

A business plan

It is not possible in this Handbook to present an example of a completed business plan. Exhibit 4 contains an outline listing the contents of the plan.

Remember, a business plan is a dynamic, not a static, tool. After it is prepared it must be used often.

It is flexible, not rigid, and should be altered as conditions change. Most important is that the owner(s)/manager(s) prepare the report.

If you have trouble understanding how to write a plan, be quick to get help. SCORE can be of great assistance. Also, an accountant can help in preparing the financial reports. However, only you can set the objectives of the business only you can decide where you want the business to go and what you want it to be. Do it!

RECORD KEEPING

Experience has clearly demonstrated that for a person about to start a business, an adequate record keeping system will increase the chance of survival and reduce the probability of failure.

Similarly, for the established business, experience has shown that a good record-keeping system increases the chances of remaining in business and of earning larger profits. How? Because accounting records can furnish the following timely information:

Exhibit 4 Outline of the Business Plan

Cover Sheet - Contains name of the business, names of principal(s), address and phone number of business, name and address of person who wrote the plan.

Statement of Purpose - An operating and policy guide for your business. If funds are needed, state how they will be used and what effect these funds will have on the business.

Table of Contents

Part I -- The Business

Part II -- Financial Data

Part III -- Supporting Documents

Every business needs controls. If you do not control the business, it will control you. Adequate

record keeping provides information for preparation of the statements that provide the control.

There are five control statements that give a clear picture of your business:

These are the early warning systems, the problem indicators and the solution indicators. If there is to be only a single statement available monthly, it should be the cash flow statement, because this will show how well cash is managed. Obviously, cash in must be greater than cash out.

Before you open the door of a new business, be certain a good record-keeping system is in place. If you do not understand the need for this, it indicates you do not have enough managerial know-how to run a business.

If possible, do the record keeping yourself. If not, hire a part-time bookkeeper, use a business service or public accountant. SCORE can help you set up a system.

In any case, be sure - absolutely sure - that you understand what records are required for your business. If a system is designed by someone else, understand the system. IRS Publication 583 is helpful for the beginner.

PRICING SERVICES PROFITABLY

Successful business owners know that the greatest opportunity for success and growth comes through quality of service and customer satisfaction. However, the service must be priced properly or there will be no profit.

Many small businesses do what they consider a good volume of business, but do not make any money. Why? Because of improperly priced services or products. Some make a profit on certain services, lose money on others and do not know which is which. Remember, the right to establish price is yours - 100 percent yours.

Types of Costs

For the purposes of this section, costs are defined as

Calculating the Cost of a Service

A simple, easy-to-understand method of calculating the cost of a service is by basing the cost on billable hours. Because services must be provided by people, begin by determining the number of hours available for billing in a year. Then calculate the break-even point by dividing the overhead and labor charges by the billable hours and adding the cost of any materials used. Your desired profit is then added to the break-even point. Two examples are shown below.

Example 1

Two people experienced at bookkeeping open a business together. They estimate their overhead expenses as shown in Table 2.

The two entrepreneurs decide they each want a salary of $25,000. In this case, the salary is actually an overhead expense, but we will treat it separately because the principals decide they want to make a profit of 20 percent on their salaries but only a 10 percent profit on their overhead. These expenses are set out below in Table 3.

Table 2 - Estimated overhead expenses

Table 3 - Estimated total revenues required

The number of working days per year is 260 (52 weeks x 5 days). Subtracting holidays, vacations and sick days, the actual number of work days total 230. Two people working 8 hours per day results in 3,680 hours (230 x 2 x 8 = 3,680). However, the bookkeepers estimate 20 percent of these hours (736) will not be spent working for clients. Therefore, the billable hours for this company total 2,944.

To determine what rate to charge, the bookkeepers divide the desired revenue ($82,440) by the number of billable hours (2,944), resulting in an hourly rate of $28.00. Profit is then calculated by subtracting total overhead and salaries from the proposed revenue ($82,440 - $70,400 = $12,040).

This is the profit to be realized, assuming the billable hours figure is realistic for the first year of operation.

Example 2

DWA Repair Service employs ten repair technicians, who are paid $18,000 each. Social Security tax, unemployment tax, workers' compensation insurance, health insurance and retirement benefits cost an additional $5,400 each, for a total cost of $23,400. Because there are ten technicians, the yearly labor charge is $234,000.

DWA Repair Service's overhead expenses are listed in Table 4.

Table 4 - DWA repair service's overhead expenses

To break even, DWA Repair must have a total revenue of $234,000 (labor) plus $98,000 (overhead) = $332,000. All of it must come from the income of the repair service based on the hourly rate charged.

The owner of the business has calculated the billable hours as follows:

  Work days per year = 52 weeks x 5 days = 260 days.
   Subtracting 15 vacation days, 7 sick days and
       8 holidays leaves 230 work days.

  Work hours = 230 work days x 8 hours = 1,840 per year 
       for each repair technician.

However, from experience, the owner knows that he cannot keep his crew working eight hours per day as there is lost time between jobs. He deducts 10 percent of the hours as nonbillable, leaving 1,840 - 184 = 1,656 billable hours per technician. Because there are 10 technicians, the total billable hours = 1,656 x 10 = 16,560 per year.

The owner decides to charge $25.50 per hour. This hourly rate, multiplied by the billable hours of 16,560, results in an income of $422,280.00 per year. Thus, the income ($422,280) minus the expenses ($332,000) equals profit of $90,280.

Each year this calculation must be repeated to include any changes in labor or overhead.

If any materials are used in the repairs, they must be figured into the cost per job. A profit percentage is also added to the materials charge.

Remember, the charge for a service equals materials plus labor plus overhead, with a profit built into each component.

PRICING PRODUCTS PROFITABLY

In setting prices, the objective is to maximize profit. Profit has just three ingredients: costs, selling price and sales volume. In this section we are concerned with selling price, which has about the same elements for all types of businesses. For example, in manufacturing, the elements of the selling price are direct costs, manufacturing overhead, nonmanufacturing overhead and planned profit. In a service business, the elements are materials and supplies, labor and operating expenses, planned profit and competition. (See "Pricing Services Profitably.") In a retail business, the elements of price are costs of goods sold, overhead, sales volume, planned profit and, often, competition.

Types of Costs

In the retail business, there are two types of costs: the cost of acquiring the goods, called cost of goods, and the cost of operating the business, called operating expenses.

Cost of Goods (Variable Cost)

Cost of goods is known as a variable cost or expense because it varies depending upon the amount of goods purchased for resale and the price of the goods. Cost of goods includes the price paid for goods, freight charges, import duties, handling charges and any commissions.

Operating Expenses (Fixed Cost)

Operating expenses are a fixed cost because they usually do not vary with the volume of business.

Operating expenses include wages, management salaries, rent, utilities, office supplies, insurance and any other costs attributed to the operation of the business.

Planned Profit

Planned profit is whatever the owner/manager calculates the business will generate. Usually, return on owner's investment, fruits of labor, plans for expansion or relocation, return to stockholders, demand for the product and competition are considered when calculating the amount of planned profit.

Competition

In setting prices, small businesses should consider prices charged by competitors for similar or comparable items. A small business should not try to compete pricewise with large stores, discount houses or supermarkets. This type of competitor can charge less because of buying power. Pricing should be based on the quality or type of service offered, as customers will pay higher prices for merchandise to obtain the services they want.

Pricing Below Competition

Beating the competitor's price is effective only if it greatly increases sales. This strategy reduces the profit margin. Consequently, cost of goods and/or operating expenses must be reduced and inventory must be closely controlled; the product line must be limited to fast moving items; and services must be limited or eliminated.

Pricing below competitors often backfires because every cost component must be constantly monitored and adjusted. Competitors can retaliate by matching the lower prices, at which point both businesses lose.

Pricing Above Competitors

The 60 percent markup must cover all operating expenses, including the owner's salary and profit.

A given markup is satisfactory depending on the sales volume. When beginning a business, it is difficult to determine how much goods must be marked up because the new business has no history of sales on which to base future sales projections. An experienced retailer usually can use markup successfully, particularly if he or she has historical information regarding the movement of merchandise.

Suppliers often suggest a retail price, which makes it easy for the retailer. If there is a competitor selling the same or comparable merchandise, check the competitor's retail price. It may dictate your price.

Break-Even Analysis

A break-even analysis can be used by a new or old manufacturing or retail business. It indicates the amount of revenue at which a business will neither lose nor make money. For a retail business, the break-even point is when sales equal the cost of goods plus operating expenses, or

From a strict accounting standpoint, cost of goods cannot be determined until an inventory has been taken, because cost of goods is determined as follows:

Inventory at beginning of a period +
Purchases during the period - Inventory at end
of period = Cost of goods sold

Thus, the break-even analysis involves a variation in the break-even formula because the total cost of goods is not known. First, gross profit (also known as the gross margin or contributing margin) on sales is determined as follows:

Cost of sales - cost of goods = gross profit

The break-even point is then calculated as

FC (operating expenses)
-----------------------
GM (gross margin)

Earlier, an example of a retailer buying shoes for $25 a pair and selling them for $40 a pair was used.

The gross margin on each pair of shoes sold was

The most important asset of a small business is quality, and advertising is the way to let potential customers know that it is the mainstay of your business.

Unfortunately, some small businesses underestimate the value of advertising or are basically uninformed about how to budget money for advertising, how much to spend and where to advertise.

A new business should be prepared to spend about 5 percent of projected gross revenue on advertising. An established business should budget 2 to 3 percent of gross revenue.

Advertising Media

Once the advertising objectives have been established and written, the next step is to select the specific media in which the advertising will appear. Media costs vary from inexpensive, such as business cards, to very expensive, such as television. The selection should be based on cost effectiveness, scheduling, trading area, customer type and frequency of message.

The types of media available are as follows:

There are many other means of advertising, such as calendars, pens, billboards, sky writing and point of presentation (flyers, brochures, samples). To be effective, advertising should be repeated -- yes, repeated -- as often as possible. It should call attention to something the buyer needs or wants.

Help in Advertising

Carefully, skillfully written advertising copy is essential. Help in writing an advertisement can be obtained from newspapers, suppliers, Yellow Pages and advertising agencies.

For help in planning, producing and measuring the effectiveness of advertising, consider an advertising agency. Often the services of an agency can be obtained at low cost because agencies earn commissions paid by the media (about 15 percent) and take a percentage of the cost of the material they design (also 15 to 20 percent). Before selecting an agency, be sure the agency knows the objectives of your advertising and the size of your budget. Then have the agency describe what it can and will do for you.

Advertising is not merely an item of business expense; rather, it is an investment in building your business. Its objective is to help you sell your product or service. The copy should attract attention, develop interest, describe the product or service, convince the reader or listener and get action.

Do not advertise something you are stuck with. Advertise what your customers want and like to buy.

Show the benefit of your product or service. Attempt to tell your prospective customers what is in it for them.

Be sure to include the name and address of the business in all advertisements! Finally, be honest!

MARKETING

Business success ultimately comes from satisfying market needs. Therefore, it is essential that people in small business understand and develop marketing programs for their products and services.

What is meant by market and what is marketing?

Only after the answers to the above questions are obtained and analyzed should the plan to open the business proceed.

Marketing for an Existing Business

The marketing concept for an existing business focuses on efforts to identify, satisfy and follow up on customer needs at a satisfactory profit. This concept includes market research, market strategy, target marketing and managing the market mix. It is difficult, if not impossible, to sell people goods or services they do not want or need. It is easy to sell people something they do want or need.

Market Research

Market research determines what people want by systematically gathering, recording and analyzing information related to marketing goods and services. The information processed can help spot potential problems, find sales opportunities and form plans of action. Such research can be done internally or by companies specializing in market research services.

Many small businesses do market research every day and may not be aware of it. This is accomplished by talking to customers, talking to employees, reading newspapers and trade journals, looking at competitors' and noncompetitors' advertisements and promotional activities, looking for information about trends in the marketing area served and gathering financial and economic information from bankers, suppliers and trade associations.

A small business has an advantage over a large business in learning about its customers because, by being close to the customers, it can learn quickly about their likes and dislikes and, best of all, react rapidly to changes in customers' buying habits. Small business owners and managers can talk to the customers and ask questions about

A good part of marketing research can be done with readily available information. Trade associations constantly report on and analyze pertinent marketing information. If your type of business has a trade association, the membership fee may be money well spent.

Market Strategy

Market strategy involves identifying customer groups that small businesses can serve better than larger competitors can, and tailoring products, services and promotional efforts to that particular market segment.

Ideally, this strategy should address the customers whose needs are not currently being met in the marketplace and whose needs are great enough to provide a profit. Small business should analyze its market and capabilities, and focus on that part of the market it can serve best.

Target Marketing

Because small business owners may have limited funds to spend on marketing activities, they should consider restricting their efforts to one or two key market segments by

Product and Services. Small business owners may use the strategy of concentrating on a narrow product line, selling a highly specialized product or service or providing a product/service package that includes a large amount of skilled or personal service.

Promotion. This area includes advertising, sales tactics and other promotional activities. High quality selling is a must for small businesses and is one of the most effective types of promotion. (For a detailed discussion of advertising, refer to the above section on advertising.)

Location and Product Distribution. Selecting the proper areas for distribution and sale of certain products is crucial. Successful selling of popcorn requires high traffic areas with high visibility. On the other hand, a plumbing supply house does not require a high traffic area, as people will go out of their way to look for it.

Additional Marketing Help

Other sources of information to help make marketing decisions include chambers of commerce, bankers and local business journals. Again, do not forget suppliers, as they know what businesses similar to yours are doing.

Keep the following in mind: Most businesses are built around products and services that are already available. Although you may think your products or services are special, that perception is not necessarily shared by your market. Therefore, one of the most important aspects of marketing is to give the consumer reasons to buy your products or services.

LOCATING A BUSINESS

Small business advisors often say that the success of a retail business depends on three factors: location, location and location. A bad location usually leads to failure while a good location is an integral part of success.

Small businesses fall into three general categories. The first is one in which the customer comes to the place of business. Examples are clothing, food and hardware stores, barber and beauty shops. For this type of business, a good location is vital.

The second is a business in which the customer comes to the business and the business goes to the customer. Examples are a carpet store and a drapery and curtain shop, both of which require that the customer come to the store to select merchandise that will be installed off-site by the business. For this type of business, location is also important.

The third business type is one in which the business comes to the customer, such as plumbers, electricians and landscapers. For this type of business, location is not of primary concern. The only caution that may apply is compliance with zoning laws regarding material storage and truck or other vehicle parking.

Three factors are involved in choosing a business location: selection of a city, town or municipality; choice of an area within a city or town; and choice of a specific site.

Selecting a City or Town

When selecting a city or town for your business, consider the following:

INSURANCE

Going into business is a risk. To succeed in business, the many potential risks must be managed, i.e., reduced and controlled. One of the methods of controlling risks is with insurance.

For the small firm the most common risks are

Usually, the life savings of a small business owner are invested in the business and often homes are used to secure notes. What happens when the owner dies? Does the business close? Does the family of the owner have to stand by and watch savings and other assets go down the drain?

You can protect both your business and your family with business life insurance. Consult your agent so that a business life insurance policy is tailored to fit the needs of your family and your business. A suitable business life insurance program can

Insurance is one area of your business where professional help is strongly recommended to obtain proper coverage at the best price. Help is readily available from local insurance agents and brokers, the best choice being one who writes insurance for other small businesses.

One way to determine which insurance agent is best for you is to ask other small business owners whom they use and what kind of service they receive. Also, your banker, accountant or attorney may be able to recommend an agent or broker.

RETAILING TIPS

Image

Every retail and retail-service business has an image, which can be controlled by the operator.

People's impression of a store, office, showroom, beauty shop is based initially on the appearance of the premises, both inside and out, and then by the type of merchandise and services offered.

Therefore, each business operator must decide what image he or she wants and then take steps to develop it.

Creating the proper image and environment is particularly important to certain types of businesses and not as critical to others. For example, a junk yard may not be very attractive; but then its customers do not expect it to be. However, most business should create an atmosphere that corresponds to their product line or service. For example, people do not expect carpet in hardware stores; but they do expect clean, uncluttered aisles and easily accessed displays. In a store selling expensive clothing, people will expect carpeting and papered walls. There is no doubt that carpet leaves a different impression than vinyl tile or linoleum and costs more to install and maintain. In this case, the extra cost may be worth it.

Window Displays

A neat, eye-catching window display is an effective way to stop pedestrian traffic and entice people to enter the premises. It takes only two to four seconds to pass a six- or eight-foot window. Therefore the display not only has to be eye catching, but also must be well lighted day and night. (Good daytime lighting avoids shadows that dull a display.)

Change window displays periodically and keep windows clean. Window displays used for community projects often create good will. Art galleries or individual collectors may lend interesting objects around which to build a display.

Parking Areas and Sidewalks

Keep parking areas and walkways clean and lighted at all times. If your regional climate brings harsh winter weather, be sure snow, and particularly ice, is removed to ensure customer safety. Dirty areas create an unfavorable impression and often result in unfavorable comments.

Decor

Decor is part of the image. Well-maintained building exteriors make customers want to enter. Once inside, the interior decor must be conducive to customer buying. Clean windows, floors, counters and aisles, attractively painted or papered walls and good lighting are a must. Well-planned aisles help customers find and look at merchandise. Gaudy decor reduces customer interest. The decor should make customers feel comfortable. The point is to let the merchandise be the attraction, not the decor.

Customer Relations

Customers not only sustain a business but help it to expand. How a customer is greeted and treated can build or destroy customer relations. The old adage that the customer is always right still applies.

Courtesy is a business byword. Customers who feel they were not treated properly, for whatever reason, usually do not return and have only derogatory comments about the business. As pointed out in the section on advertising, word of mouth advertising is not only the least expensive but also one of the most effective types of promotion. All employees should be constantly reminded of the need for courtesy.

Keep a notebook near the cash register. Jot down customer requests and suggestions for products and services. Customers are a great and inexpensive source of information not only about your business but about your competitors as well. Customers can tell you much about their buying habits and help you detect trends. Ask customers what they like, want, need and read. Without customers, there is no business.

Credit Cards

Credit cards are a service to customers at the expense of the business. However, credit cards do provide instant cash at no risk to the business. Often, credit card terms can be negotiated with the issuing bank. Card companies such as American Express can usually be approached through chambers of commerce or national trade associations if the business is a member.

Some small businesses may want to issue charge cards or charge accounts to special customers.

Needless to say, care must be taken if this policy is adopted.

Markdowns

Markdowns on certain items reduce profit margins but usually are an excellent way to sell unsalable or end-of-season goods. Markdowns, if properly done, clear out merchandise quickly, thereby increasing cash flow and reducing inventory.

Loss Leaders

Loss leaders are items sold at a lower price to attract people who will buy other regularly priced items or become regular customers. Loss leaders should have a lower wholesale price, look more expensive, sell at other stores at a higher price and be readily available from the supplier.

Loss leaders are more effective as a strategy when they are associated with another item at regular price and both items are sold together. An example is a shirt and tie, with the tie being the loss leader.

Sometimes loss leaders do not work. With experience, the successful leader will be selected and often can be used over and over again.

Pricing Policy

Pricing may depend on the following:

Pricing must take into account fixed or operating costs, owner and manager salaries, variable costs (cost of goods) and profit. Buying practices affect the cost of goods. Attention must be given to quality as well as the quantity of goods purchased. Utilities, rent, services, salaries, employee benefits, etc., affect fixed costs. Unless prices are changed accordingly, increases in either variable or fixed costs will decrease profit.

Often, competition dictates pricing. Therefore, competitors' pricing must be constantly monitored.

As pointed out in the section on pricing products, a pricing policy must be examined and reviewed frequently to be certain the desired profit level is maintained. Profit and loss or income statements are most helpful.

Leases

Landlords can be difficult; remember they are trying to make a profit, too. Cordial relationships make it easier to get improvements to the premises and to negotiate late rent payments.

A long-range lease is usually better. If a business owner or operator is inexperienced with leases, the service of an attorney is essential.

Protecting Against Crime

To limit shoplifting, locate the cash register and the telephone near or at the front door. This reduces the chance of people walking out without paying. Also, offer to hold parcels at the register, but be sure to treat them with care, sealing them in the presence of the customer. The business is liable if anything is missing.

If your business is located in a shopping center or mall, contact other small businesses and set up a system to alert each other if a customer tries to pass a bad check or steal. With a phone alert system a description of the person in question is quickly circulated to other businesses in the center or mall, as well as to law enforcement authorities.

Competitors

Always have something constructive to say about competitors. If you are out of an item or do not carry it, recommend a store that does carry it. Customers appreciate this and will usually return to your store.

Watch competitors' advertising by visiting them or sending someone to check displays, windows and prices. Ask salespeople who call on you how your competitors are selling their items.

Employees

Good employees produce more sales and require less training and supervision. Poor employees can ruin a business. Develop a training program for new and old employees and regularly review their performance with them individually and privately. Train employees to treat customers exactly as you would.

Explain the buying system to employees and try to involve them. The more involved employees are, the more interest they take and the better they work. Listen to employees and ask them for suggestions. Make employees your eyes and ears.

Retired persons offer small businesses an opportunity to get experienced help on a part- or full-time basis. They may teach you and other employees what they have learned over the years. Retirees usually are very loyal and hard workers.

Suppliers

Suppliers, manufacturers, distributors and their respective salespeople can become important adjuncts to a small business. They can alert you to trends, hot items, competitive activity, closeouts, special volume prices, delayed payment terms, etc.

Most important, get to know the credit manager of your supplier. If you need extra time to pay, extra credit or special terms, this is the person to contact. The credit manager can be a valuable ally to your business.

For special promotions, ask manufacturers and suppliers if they have a program to contribute to advertising costs. The way to learn about all the services a supplier offers is to spend time with the supplier and ask questions.

Be sure you know the availability of every item purchased and how long it will take to get to your store. This will help you place orders and keep you from running out of an item.

EMPLOYEES AND INDEPENDENT CONTRACTORS

Classes of Employees

For federal and state tax purposes, small business owners and operators must know who is an employee and who is not, and what their classification is. Employees may be classified as common law or statutory.

Common-Law Employees

Every individual who performs services that are subject to the will and control of an employer as to both what is to be done and how it is to be done is a common-law employee. Two of the usual characteristics of an employer-employee relationship are that the employer has the right to fire an employee and the employer supplies the tools and the place to work.

Employers must withhold federal income tax, Social Security tax and, where required, state and local income tax from common-law employees. Also, employers must pay their share of Social

Security and federal and state unemployment tax for such employees.

Statutory Employees

In many states, a statutory employee is one who works for an employer in any one of the following four categories:

Business owners are not required to withhold federal and, where applicable, state or local income taxes from the wages of statutory employees. However, individuals in any of the preceding four categories are employees for Social Security tax purposes if they meet all of the three following conditions:

For federal unemployment tax purposes, the term employee includes statutory employees in categories 1 and 4 above who perform services for pay under conditions a through c.

Independent Contractors

Generally, people who are in business for themselves are not employees. These include physicians, attorneys, CPAs, construction contractors and others who offer their services to the public.

However, whether such people are employees or independent contractors depends on the facts in each case. The general rule is that an individual is a independent contractor if the employer has the right to direct only the result of the work and not the means and methods of accomplishing the result.

Under the heading of independent contractors, two categories of statutory nonemployees exist for the purpose of federal employment taxes: real estate agents and direct sellers. However two conditions must be met:

Another test is that when an independent contractor has assistants, they can be fired only by the contractor. Also, if workers are free to take other jobs at the same time they are working for you, then they are generally regarded as independent contractors.

An employer does not have to withhold income tax or Social Security tax from the wages of independent contractors, nor does the employer have to pay the unemployment taxes or workers' compensation insurance.

Because an employer who has hired an independent contractor must file form 1099-MISC with the Internal Revenue Service and, where applicable, state and local government, the independent contractor must provide the employer with an employee identification or a Social Security number.

If the independent contractor fails to provide this number, the employer may have to withhold 20 percent of the amount paid as income tax.

Casual Labor

Many small businesses classify certain types of labor as casual labor. In these cases, the employer does not withhold income taxes or Social Security tax, does not pay employment taxes and usually does not cover the worker with any type of insurance.

If one asks either the IRS or a state department of revenue for a definition of casual labor none will be forthcoming. This means that the IRS and other agencies do not recognize the term and will not define it. Federal and state agencies reserve the right to judge each case as to whether or not a worker is a casual employee.

The issue at hand is whether or not an employer must withhold income and Social Security tax, pay unemployment taxes and provide workers' compensation insurance. In some cases, the IRS and other taxing agencies may recognize intermittent and temporary labor, such as in the following cases.

Case 1

Katie's Catering has two full-time employees. Katie contracts for a job for which she needs extra help, so she hires a person to work for one day for $50 with no withholdings of any kind. She does not intend to hire this person on a regular basis.

Case 2

Conwald Construction accepts a contract to frame two houses and agrees to finish both houses within one month. Conwald does not have enough regular full-time employees to accomplish this, so he hires two extra carpenters at an agreed-upon wage of $300 per week for three weeks. At the end of the job, Conwald pays each carpenter $900, but does not withhold taxes, etc. However, because the wages were over $600 to each person, Conwald must obtain the Social Security number of each carpenter and, at the end of the year, submit a 1099-MISC to the IRS, appropriate local agencies and to the carpenters.

Case 3

Russ's Restaurant has occasional need for an extra bartender during July and August. He hires a person to work one night a week for eight weeks at $45 per night, with no withholding. The total wages paid are $360. In this case, Russ does not report these wages because the amount is less than $600.

According to some state employment security laws, the workers in each of these cases would be regarded as employees and the employer would have to pay the state unemployment tax.

Often, employers abuse the classification of intermittent or temporary help. Be aware that if the IRS decides the employee is common law and the employer has not withheld taxes, the employer is liable for all the withholding, Social Security taxes and unemployment taxes. 

Both the state and federal agencies frequently audit income tax reports, during which the question of who is an employee arises. If there is any question about who is an employee, contact the IRS or state department of revenue. If there is a question as to whether unemployment tax should be paid, contact the IRS and the state department of employment and training.

MANAGING HUMAN RESOURCES

Successful management of any business, large or small, is based on effective utilization of available resources. People are a primary resource, and people, including managers, can make or break a business.

Managing a work force from a regulatory standpoint has become complicated because there are more than 100 rules and regulations promulgated by local, state and federal authorities that affect employees who make up the work force. It is imperative to seek guidance through this maze by contacting the appropriate government authority when necessary.

Also complicating the management of workers is the new generation whose goals extend beyond the basic maintenance needs of wages and safe, clean working conditions. Many employees are looking for challenge, incentive and opportunity to learn, to be creative and to advance. Small businesses must design management methods to meet the needs of employees as well as the business.

The work force payroll may be the greatest single expense in the budget. This means employee selection, training and supervision are of primary concern. It is estimated that each turnover of an employee costs 500 times the hourly wage; thus, retaining good employees is critical. Employee retention and productivity often depend entirely on the ability of the person supervising the job.

It is essential to define the objectives of the work force and clearly plan the strategy to reach those objectives at the outset. Once employees are on the job, reasonable, attainable objectives should be set for them with their input. If employees are respected members of the team, they will have more incentive to perform at peak level.

Recruiting

Advertising in the local newspaper is the most direct method of recruiting employees. The most productive method is word-of-mouth referral by a satisfied employee. Schools, trade associations and professional groups are excellent sources for specialized needs. As a rule, it is wise to avoid employing relatives and close friends, as discipline problems often arise. If they bring special expertise, that may be another matter.

A prerequisite to hiring any worker is a well-written, thoroughly thought-out job description, describing the duties and responsibilities of the job. Such a description makes it easier for the employee and supervisor to work together.

Interviewing

An interview is a two-way communication, during which the participants find out about each other and assess competence and compatibility. The interviewer must guard against invading the legal right to privacy of the applicant, both on the application form and in direct questioning.

The primary concerns of the interview are the job description, working conditions, standards of performance and the applicant's ability to meet or exceed these standards. All these matters must be clearly understood and agreed upon before a final decision to hire is made. References must be checked, preferably by telephone.

Wages and Working Conditions

Wages and working conditions are controlled to some degree by labor laws and, to a greater extent, by local practice. The National Bureau of Labor Statistics can provide surveys of conditions in local markets.

Usually, it is wise to set wages at the midpoint of current practice to allow for incentive and future growth. Employee benefits will add from 20 to 40 percent to the cost of the payroll. Careful thought must be given to benefits when planning and budgeting. For businesses experiencing peaks and valleys in work flow, thought should be given to the use of temporary workers and agencies.

Training

An employee may be considered on probation for an agreed upon length of time -- usually three months. During this time, attention must be given to integrating the employee into the work force and bringing the employee's performance up to standard. This is best accomplished by explaining and demonstrating the task, having the employee perform the task and then giving constructive correction and reinforcement. Time spent in proper training will more than pay for itself in weeding out employees who lack the ability to perform or fit in. Training fosters the success and high performance of those retained.

Supervision

Both the supervisor and the employee have an interest in the successful performance and stability of the work force. The essence of good employee relations is to treat all equally, and to be fair and consistent in maintaining discipline. Be factual and not subjective. Always let the employee know what is expected and whether or not those expectations have been reached. Both correction and recognition should be given regularly to achieve a healthy and productive work force.

Terminating Employment

When an employment relationship is to end, it is expected that both the employer and employee will give the other adequate written notice. If it is necessary to terminate employment, the employee should be given an honest explanation of the reason for termination.

When it is termination for cause, except in extraordinary circumstances, the employee should have been warned previously, counseled and given the opportunity to meet the performance standards before the actual separation. When the question of unfair treatment or discrimination is raised, it is important to have a written record of the steps followed in disciplining the employee.

One caution: Because employee relations are so tenuous and hedged by laws and other restrictions, it may be wise to seek expert advice when contemplating any critical action affecting an employee.

SCORE can help direct you to the appropriate source of information.

COMPUTERS IN SMALL BUSINESS

A question asked frequently by small business operators is "Should I have a computer?" To answer this question, you first must understand the advantages and disadvantages of alternatives to the computer and, second, must know exactly what is to be accomplished with a computer. In other words, consider how much it will cost and what the benefits over a manual system will be. Finally, you should know who is going to operate and become proficient with the computer.

Generally, a well-organized and well-staffed business will benefit from a computer, particularly if the business has large amounts of detailed, repetitious information to be handled with speed and accuracy. Others who will benefit are businesses with large, fast turning inventories and large customer files.

Small businesses just starting out without computer skills should not consider a computer, nor should a business that does not have a good functioning manual system in operation.

What a Computer Can Do

The purpose of this statement is to pinpoint the prospective buyer's need for computerization and to provide concise information on these needs and resources to each vendor approached.

Going to more than one vendor is highly recommended so you can compare prices and recommendations. Also, ask each vendor for the names and telephone numbers of customers who have purchased a system, particularly those with needs similar to yours. Contact several of these customers and ask them if they are satisfied with the hardware, software, training and service received from the vendor. Ask them how long it took until the computer system was operational.

Be sure the vendor has the staff to provide training, answer yours questions while you are setting up, solve problems and provide repair service. Visit the vendor's training facilities. Ask about charges for training.

A computer will not operate itself. It must be fed, nurtured and massaged in order to get results.

Entering data takes time. It is important to realize that if your record keeping system is incomplete or sloppy, your computer data will be the same. Time and money can be wasted creating data that will not be used. Use good judgment in selecting information to be entered and processed.

Software has been developed for specific types of businesses. Be sure your vendor is knowledgeable about available software and selects the one best suited to your particular business. Experienceindicates that the computer applications most beneficial to a small business are accounts payable, order entry, accounts receivable, inventory control and general ledger.

Getting a computer into operation initially requires the full and total involvement of the owner/manager, which translates into many extra and sometimes frustrating hours. Meanwhile, the regular business functions must be continued. If an employee is to operate the computer, the employee will also have to devote extra hours, at the expense of the owner.

Computers do not save money by eliminating employees. Rather, computers facilitate and complement employees' work by performing certain functions rapidly and efficiently. This may be of great advantage in effecting other savings.

If the business owner/manager has his fingers on the pulse of his business, a computer may not be needed. In any event, the cost, efficiency and adequacy of a manual system should be evaluated before you consider buying a computer.

FRANCHISES

Franchising has a number of appealing features for prospective business owners. Primarily, the risks of opening a business are reduced because of easy access to an established product and a proven method of marketing.

Franchising has existed in one form or another for over a century; in recent years enormous growth has occurred in the number of franchises. Industries relying on franchised business to distribute their products and services touch every aspect of life, from automobile sales and real estate to fast foods and tax preparation.

As a matter of fact, franchises have the highest success rate of any type of business start-up, which adds to their appeal. However, buying a franchise does not in any way ensure instant success; unless you are prepared for total commitment of time, energy and financial resources, it is not for you.

Definition

A franchise is a legal and commercial relationship between the owner of a trademark, service mark, trade name or advertising symbol and an individual or group seeking the right to use that identification in a business. The franchise governs the method for conducting the business between the two parties.

In its simplest form, a franchisor owns the right to a name or trademark and sells that right to a franchisee. This is known as product/trade name franchising. In the more complex form, business format franchising, a broader, ongoing relationship exists between the parties. The franchisor provides a full range of services, including site selection, training, product supply, marketing plans and sometimes financing. Generally, a franchisee sells goods or services supplied by the franchisor or sells goods or services that meet the franchisor's quality standards.

Advantages

Disclosure Document

The Federal Trade Commission requires that franchise sellers provide certain information in a detailed disclosure document to help a prospective buyer evaluate the franchise opportunity. This information includes

A good franchisor usually encourages prospective franchisees to visit and talk to other owners of the franchise. This certainly should be done!

Other Considerations

An attorney should assist the prospective franchisee to evaluate the franchise package. An accountant may be needed to determine the full costs of purchasing and operating the business, as well as the potential profit to the franchisee.

Before purchasing a franchise, carefully consider the level of independence you will maintain, how comprehensive the operating controls are, and the full costs of purchasing the franchise. Also, be sure to ask about the terms and conditions for reselling your franchise.

Although the success rate of franchises is high, very independent people with their own concepts of operating a business may not be the type to open a franchise.

MANUFACTURING COST ACCOUNTING

Cost accounting, in a broad sense, means accumulating all the costs associated with an activity (manufacturing, retailing, providing a service, etc.) and organizing them in a meaningful way to (1) satisfy financial reporting requirements and (2) achieve understanding of the costs of the activity for control and optimization purposes.

There is a distinction between general accounting and cost accounting. Although costs are of primary concern in both, general accounting is concerned more with the total costs of a business.

These costs are usually classified into well-established summary level accounts, such as cost of goods sold, selling expenses, administrative expenses, advertising and research. Cost accounting details costs of individual products by the types of costs (raw material, direct labor, etc.) and by the departments (cost centers) within each of the business functions (manufacturing, selling, administration, etc.). Cost accounting is used to

Although cost accounting is mainly used for manufacturing businesses, it is equally effective in nonmanufacturing businesses. The discipline of detailing costs by type and location, determining whether costs are fixed or variable and comparing costs with expectations (budgets, standards, etc.) provides a sound basis for controlling and more efficiently performing any activity.

When applying cost accounting to a manufacturing function, each cost element is classified generally in two ways:

Normally, there are three classification combinations: direct-variable, direct-fixed and indirect-fixed. (Indirect-variable is unlikely).

Direct costs are those incurred in the manufacture of the product; they can be readily identified with the product. These costs usually include raw materials and the labor required to convert the raw materials to the finished product. In some situations, direct costs include power, fuel, steam and other significant costs that can be readily identified with the product.

Indirect costs are generally the costs of activities required to support the manufacturing operations.

These usually include plant administration, quality control, purchasing, insurance, depreciation, property taxes and other similar activities.

Variable costs are those that vary directly with the quantity of product produced; a good example is raw materials. Labor spent in processing raw materials may also be a variable cost if the amount of labor required is directly proportional to the quantity of goods produced. Other costs, such as fuel if directly consumed into process operations and if proportional to the quantity of production, can also be classified as variable.

Fixed costs, as the term implies, do not vary with the quantity of production. These generally include all of the indirect costs (support costs such as insurance, plant administration, depreciation, etc.).

They can also include some direct costs, such as departmental supervisors, utilities required to heat/air condition production areas and maintenance required to service the production equipment.

Fixed costs are "fixed" only for a range of production levels. A significant change in production level can change these costs. Support activities, such as purchasing, employee relations, plant administration and insurance, along with direct costs such as supervisors and maintenance, can vary with substantial changes in production levels. When a cost is considered "fixed," the range of production levels for which the cost is fixed should be understood. This is called the relevant range.

There are two other distinctions made concerning the application of cost accounting to manufacturing operations. Two types of manufacturing operations are recognized: job-order and continuous process manufacturing.

Job-order manufacturing is based on specific quantities of a product being processed through the operations with all of the costs associated with that particular lot being collected and identified with that lot.

Continuous process manufacturing (such as many chemical operations) is a continuing manufacturing operation where costs are collected over time (such as a month) and quantities of materials consumed or produced are measured through inventory changes.

Typical manufacturing costs and their general classification are listed in Table 6.

Table 6 - Typical manufacturing costs and their classification

Manufacturing cost accounting is particularly effective when it includes a budgeting/standard cost system. A standard cost system develops a projected unit cost, achievable under controlled conditions, for each product. This unit cost is identified as the standard cost, and includes all the raw materials, labor and other costs incurred in producing the product plus an allocation of the support costs. A sample standard cost (summary) could be as follows:

The standard cost originates from the manufacturing budget. This budget projects the production requirements (from sales and inventory projections), the costs of each of the departments within the plant, the costs of raw materials, the raw material and labor requirements for each product, the production rates and other considerations depending on the particular manufacturing operations.

A sample budget, simplified for illustration purposes, follows in Table 7.

 Table 7 - Sample manufacturing budget

 Annual Budget - ZYX Company

Manufacturing cost budgets are divided into periods (month, quarter, etc.) for business planning purposes as well as control purposes (compare actual costs with budget). Table 8 shows quarterly figures for ZYX Company's annual budget.

 Table 8 - Sample annual budget, by quarter

 ZYX Company Annual Budget, by Quarter

A budget broken down by periods is extremely important in planning raw material purchases, arranging to have labor available during seasonally busy periods and particularly for ensuring that cash is available to fund the manufacturing operations. It is also essential to control operations during the course of the year. As the year progresses, actual costs are compared to budgeted costs and the variances analyzed. Table 9 shows the first quarter manufacturing cost (or variance) report for the ZYX Company. The manufacturing budget is adjusted for actual production volume. This permits a valid comparison of actual costs with allowable costs based on actual production volume.

The above first quarter report for the ZYX Company indicates that the plant exceeded allowable costs by $20,950. Higher volumes than budget would result in higher actual costs compared to budget. However, it is important to compare actual costs to allowable costs (budget adjusted for actual volume) to make a meaningful comparison and analysis. In this case, the analysis revealed that the unfavorable variance of $20,950 was due mainly to a surge in orders requiring considerable overtime for direct labor. This resulted in a substantial unfavorable labor variance, which could have been avoided by moving more quickly to hire additional labor to handle the increased orders. The variance report, with analysis, provides a much clearer understanding of costs so that actions can be taken when indicated.

The above examples have been simplified. Some issues - such as inventory valuation, raw material purchase price variances, labor rate variances, labor hour variances and the basis for allocating fixed costs - have not been covered. However, the examples illustrate the discipline that cost accounting with a budget system, including standard costs, can provide.

 Table 9 - Sample cost variance report

 ZYX Company
First Quarter Cost Variance Repor

INVENTORY

In many businesses, the cost of purchasing merchandise for resale (retailing) or the costs of purchasing and converting materials into finished products (manufacturing) represent the business's most significant expenditures. Keeping track of merchandise and materials, known as inventory, is important because of the considerable costs involved. This can be accomplished through a good inventory record keeping system.

Inventory Record Keeping

Inventory record keeping establishes and maintains information on current inventory, the additions and withdrawals to inventory and inventory balances at the end of specified periods (week, month, etc.). These records identify the products/materials, the quantities and the value (cost) of these products/materials. A simple inventory record could look like the one shown in Table 10.

 Table 10 - Sample inventory record

The value is the cost of the product. This would be what a retailer paid for the product or what a manufacturer paid for materials plus labor and other charges applied in converting the materials into the finished product. In Table 10, the cost of goods sold would be $100 for this product for the month of May. 

There are two different methods used in inventory record keeping: perpetual and periodic.

Perpetual Inventory

The perpetual inventory method starts with a physical inventory (actual count) and then adjusts this inventory for additions and withdrawals. The inventory at the end of the period is calculated by subtracting the number of units sold from the total of the beginning inventory plus the additional units produced. An example is furnished in Table 11.

 Table 11 - Sample perpetual inventory

The perpetual inventory method is used when reliable sales and production information is readily available and the frequent taking of physical inventories would be burdensome. However, physical inventories must be periodically taken (e.g., quarterly or annually) to check the calculated inventories. The inventory records are then adjusted to agree with the physical inventories. The financial effect of these adjustments is reflected in the balance sheet and the profit/loss statement of the business.

Periodic Inventory

The periodic inventory starts with the physical inventory taken at the end of each period. Sales or production amounts are then calculated based on the beginning and ending physical inventories.

This method is used when reliable sales or production data are not readily available. Consider the examples in Tables 12 and 13.

 Table 12 - Sample periodic inventory (retailing)

 Table 13 - Sample periodic inventory (manufacturing)

In Table 12, the cost of sales equals the beginning inventory plus the purchases minus the ending inventory.

In Table 13, the number of units produced equals the ending inventory plus sales minus the beginning inventory.

Inventory record keeping is primarily used to determine the cost of goods sold as well as to provide information for financial statements.

Inventory Control

Inventory control is the management of inventory and relies heavily on information provided by the inventory record keeping system. Inventory is required to support the operations of the business, whether it be a retailing or manufacturing business. The proper management of inventory helps the business achieve its objectives in sales, costs and profits. The business plan must recognize and define the role inventories will play in achieving the business objectives.

Inventory control consists of the following:

When product X inventory falls to 2,000 units, a production order is issued to bring the inventory level to 4,000 units. If sales continue at 100 units per day and the production rate is 200 units per day, it will take four weeks of production time to raise the product X inventory to 4,000 units.

Various measures are used, for control purposes, to relate inventory amount to sales activity. Two commonly used measures are inventory days (used in manufacturing businesses) and inventory turnover (used in retailing businesses).

Inventory Days

Inventory days measure the amount of inventory in terms of days of sales. In the example for BAC Company, where product X sales rate was 100 units per day, the inventory days for the minimum inventory planned of 2,000 units would be 20 days (inventory amount divided by daily sales rate, or

 2,000
-------
100 = 20). The maximum inventory days would be 40 days

 (4,000
-----
100 = 40).

Values (costs) can be used in calculating inventory days. Assume that the units cost $5.00 each in the above example. For product X, the minimum inventory planned would be $10,000 (2,000 units x $5.00 per unit) and the daily cost of sales would be $500/day (100 units/day x $5.00 per unit).

Inventory days for the minimum inventory planned would be 20 days (inventory value/cost of sales per day or

 $10,000
-------
$500/day = 20 days).

Inventory Turnover

Inventory turnover measures the number of times in a year that the inventory "turns over." In the above example, if product sales are planned at a rate of 100 units per day or 26,000 units for the year and the inventory averages 3,000 units, the inventory turnover would be 8.67

 (26,000
------
3,000 = 8.67).

Again, values (costs) could be used in calculating inventory turnover similar to that done above.

Although the time period of a year is used as the basis for calculating inventory turnover in most cases, a seasonal business (such as a store in a summer resort) would use the season as the basis. In this case, the business objective is to turn the inventory over as many times as possible and have little or no inventory by the end of the season.

Actual sales activity (sales rate, product preferences, selling prices) must be closely monitored with inventory (products, quantities, costs, resupply limits) to be sure that the inventory control system is properly supporting the sales activity.

Another important objective of inventory control is to keep the financial investment in inventories just sufficient to support the business. Inventory building converts cash into products that may or may not sell or may sell at a price less than cost. Inventories consume cash, increase the investment in the business and can bankrupt the business if not properly controlled.

Inventory Strategies

Every business competes within an industry and each industry has a life cycle. The strategies employed by the business depend on where in the life cycle the industry is. The management of inventories is influenced by this life cycle.

Generally, there are four stages in the life cycle of an industry. These are as follows:

The proper control of inventories is essential to the success of any business in which investment in inventories is significant. Awareness of the competition and the state of new product development is just as important as a finely honed record-keeping system. While the record-keeping system is important, how it is applied will determine the success of the business.

APPENDIX A: USEFUL IRS TAX PUBLICATIONS

APPENDIX B: INFORMATION RESOURCES

U.S. Small Business Administration (SBA)

The SBA offers an extensive selection of information on most business management topics, from how to start a business to exporting your products.

SBA has offices throughout the country. Consult the U.S. Government section in your telephone directory for the office nearest you. SBA offers a number of programs and services, including training and educational programs, counseling services, financial programs and contract assistance. Ask about

- SCORE: Counselors to America’s Small Business, a national organization sponsored by SBA of over 11,000  volunteer business executives who provide free counseling, workshops and seminars to prospective and existing small business people. Free online counseling and training at www.score.org. 

- Small Business Development Centers (SBDCs), sponsored  by the SBA in partnership with state governments, the educational community and the private sector. They provide assistance, counseling and training to prospective and existing business people.

- Women’s Business Centers (WBCs), sponsored by the SBA in partnership with local non-government organizations across the nation. Centers are geared specifically to provide training for women in finance, management, marketing, procurement and the Internet.

- Trade association information

Ask the librarian to show you a directory of trade associations. Associations provide a valuable network of resources to their members through publications and services such as newsletters, conferences and seminars.

- Books

Many guidebooks, textbooks and manuals on small business are published annually. To find the names of books not in your local library check Books In Print, a directory of books currently available from publishers.

- Magazine and newspaper articles

Business and professional magazines provide information that is more current than that found in books and textbooks. There are a number of indexes to help you find specific articles in periodicals.

- Internet Search Engines

Published - August 2011