financial management

The first time I struck out on my own, in the 1980s, I was completely unprepared for the realities of budgets and financial management.  I earned a fair amount of money for someone so young, but it never failed - I always reached the end of one paycheck before I received the next. I  did not treat myself to expensive things but I had no idea how much things cost, so I was constantly underestimating how much money I needed and running out when I needed it.

It may seem surprising, but small manufacturing business owners often do not know how much it costs to produce their products.  Not knowing how much things cost, they are left with disappointing results at the end of each accounting period and in need of cash to finance upcoming projects. The two biggest costs most companies incur are the costs of production and the costs of labor, so lack of clarity and control in these areas can be devastating.

The key to knowing product costs is to use a sound costing method. There is no magically easy way to manage costing - it is a demanding task that requires intelligence and discipline. But if you manage costing effectively, you will find profits increasing within a year as you refine your production, merchandising, pricing, and marketing strategies based on the insights you gain.

Your goal in costing is to understand both the overall profit of the company and also the individual profitability of items. As a business manager you must do bottom up and top down analysis at all times. In this case, the top down (macro) analysis is the overall corporate profitability, and the bottom up (micro) analysis is the performance of individual items. Imagine for a moment that you are experiencing a 1% decline in your profit margin. How do you begin to understand what is causing it? If you only understand your profit margin at a macro level, you will not have the insight you need to tweak profit margin at the micro level.

The simplest way to set product costs is to average overhead and salaries by adding them together and then dividing to come up with a production-cost-per-minute. You then multiply this cost by the amount of time required to produce a particular item. This is a fairly common approach, particularly for companies new to manufacturing, but it is fraught with risk. This approach will only work if:

1. All the people in your production environment have the same skills and productivity
2. All the people in your production environment are paid the same amount of money (now and in the future)
3. You are not doing any process batching that can be performed by lower-salaried laborers

If all three of the above conditions exist, then presumably each minute of production time for each product is worth the same thing. In that case, a production labor rate that is averaged across all production workers will work for you.

If, on the other hand, you have variability in pay, skill, and type of process, you must approach costing in a more sophisticated manner. The approach I am about to describe is a derivative of Activity Based Costing (ABC). It's important to note that it's a derivative, because if you study ABC you will discover a nearly molecular approach to costing that is time consuming and suffers badly from point-of-diminishing-returns. This derivative approach takes into account variability in skills, pay, and tasks without the expensive granularity.

Let's use a jewelry example to illustrate. Imagine that you are making two rings, both of 18k gold, both requiring setting three stones. But Ring #1 involves very careful finishing to preserve detail in the band, and it requires channel setting. Ring #2 has a simple band and does not require special attention in the finishing step, and the stones are prong-set. Does Ring #1 take longer to make than Ring #2? Obviously. But what isn't so obvious if labor costs are being averaged and divided by the minute is that Ring #1 may require a $70,000/year production worker for 90% of its minutes, and Ring #2 may require a $35,000/year production worker for 100% of its minutes. In this case the averaging of production time over minutes no longer works, because it understates the cost of Ring #1 and overstates the costs of Ring #2.

The way to manage costing in this environment is to benchmark and test. The benchmark is set at the beginning of production for a given item. Not the first time it's made or even the second - those production times will always be longer and are likely set by a much higher paid person proving the production approach for a new design. You will keep careful track of the total (not elapsed) time of production for new items, and up to the point that an item is released for actual production, you can allocate those times to R&D rather than cost of goods. Do you have to do that? Not necessarily. Companies that are doing a lot of new production that is very similar to previous production may opt not to do that just because they have standardized and minimized the amount of time spent proving a new item. But companies that spend a lot of time in the pre-release-for-production phase may want to consider this.

Once the item is released for production, a cost estimate (based on pre-production activities) is set in the system for the first run. You will likely run slow on the first production run, but you need a cost in the system. Then, on the second run of the new item, you carefully benchmark the time spent  - the time spent in production and the cost of labor for the various steps of the process. That becomes the standard cost for the item. After this, you don't measure each time you run the item (this is where the departure from ABC comes in - ABC would require careful measurement every time. But the time spent doing this costs more than its ultimate value in knowledge). Rather, you set each item to be re-benchmarked on a 2X or 1X annual basis. When you run the re-benchmark, you will typically find some improvement in the production time, but sometimes you will discover drift in process, shift upward in salaries, or shifting of labor types, and these changes will either be reflected in the new cost of the item or will give you the opportunity to correct undesirable drifts and shifts. The only time you should have to analyze items off their typical 1X - 2X/year schedule is if something major occurs, such as when an urban manufacturing  company's entire production group fled to a competitor and he had to start from scratch with new employees.

The downside of this approach is that it requires careful management of costs. When you are benchmarking a new item, you need to consider the averaged salaries of the type of potential labor at each step, you must remember to schedule each item for periodic review, and you must remember to do the scheduled reviews. The other downside is that it is not perfect, but neither is averaging all salaries across minutes. The only near-perfect approach is ABC, and like I said, that involves so much extra work that the knowledge gained isn't important enough to justify the cost of gaining it.

The upside of this approach is that it gives you excellent visibility to the actual productivity of your line. When you are trying to solve a problem, you can drill down into items and groups of items and see where your profitability is slipping. You may realize that you want to raise the price on just one category or subcategory of products, or that you can modify the design of an item or small group of items to reduce the cost, or that you can afford to hire a few more $35k/year employees and shift tasks into batches, or (the list goes on). Using this approach, small manufacturers gain insight into very interesting things. Some of the things my clients have been able to see using this approach include:

1. One client found that customers had a distinct preference for the more complex items in his line. The more complex items weren't always obvious from the price point, but they were obvious in the costing. So he selectively raised prices on the complex items to increase margin, because the lower margin of those items - plus their comparatively higher volume - was having a disproportionate negative effect on profitability.
2. One client needed to reduce her price points but had to be very careful how she did it because she had just started seeing the profitability she needed and didn't want to reverse it. By analyzing costs, she saw that she had the opportunity to put her lowest price production workers on a whole category of items that enjoyed good sales. She reduced those product costs and selling prices proportionately - thereby maintaining the overall margin (though not the dollars, of course), and was able to promote this new lower-priced line to counter the competitive pressure she was feeling.

These are just two examples, but they illustrate the type of knowledge this approach can bring. I rarely see conditions (no variability) that would make averaging all production salaries the most prudent approach to costing. The benchmark and test approach is the one I prefer, because even though it requires more work to accomplish, it is one of the most important functions of business. The resulting knowledge will help you manage not only the pricing of your line, but also generate better design and development ideas for future products and the evolution of the company.

(c) 2010. Andrea M. Hill

Focus on How Business Software Programs are Designed

Are you looking for the perfect business software program? There is no such thing as a perfect software. Every software you evaluate will do some things you like, and others you do not like.

Every software will require some change on the part of your operations to use it efficiently/effectively. And every software company will have some deficiency in the area of support or training. This is the nature of buying complex systems, and the sooner you recognize it the better buying decision you will make.

But there is one starting point that should be universal when investing in business software programs, and that is the evaluation of the what (what underlying code and technology) and how (how the software is designed, maintained, and improved) of the software development.  Answer these questions satisfactorily first, and you will be most likely to end up with a business software program investment that serves you for the long-term.

4 Things to Consider

These are the things you must focus on carefully as you evaluate your options:

1. The Underlying Technology. Do not invest in software that will be outdated in less than 10 years. Software written in older programming languages or databases designed for individual use and not network use (like Access or Filemaker) are inappropriate for most business applications. Likewise, technology owned and supported by private, small (often underfunded) companies - no matter how good - will only be able to continue its investment and development if it's bought by one of the big behemoths.  This doesn't mean you have to go with a licensed solution like Microsoft or Oracle - there are also fantastic open source options for business systems. Just make sure that your solution is based on technology that either has a massive international development community or is supported by a technology powerhouse capable of reinvesting in it.
   
   
2. The Best Practices. Invest in software that is well-distributed enough that the software developers are constantly focused on improving the software for the entire industry/user group. Best practice behavior is about creating processes and procedures within the software that force users to engage in the activities that are considered essential or recommended for the best results. Using software with best-practices built in gives you the advantage of industry improvements and innovations without having to come up with all of them yourself.
   
   
3. Ongoing Development. Along with the previous point, make sure that the software developer is actively engaged in meaningful updates and development. The business world and distribution methods are changing dramatically – if the software is not keeping pace it will be an unsatisfactory investment.
   
   
4. Underlying Database Structure and Logic. If a system is designed correctly, then you will always be able to get the reports, functions, and applications you need from it. If the system is not designed correctly, then even reasonable adaptations or developments may be very difficult or even impossible for the developer to produce. For example, in one industry system I have encountered, the underlying table structure is illogical and poorly structured in several key areas. So extracting desired information is nearly impossible without manipulating the data (which is both time consuming and still inaccurate).
   
   
5. (updated 19-3-2019 per a suggestion from Steve Fuller at Acuity Solutions) Choose a business partner with the most appropriate skills, expertise, and experience to help you achieve the best possible implementation of a system for your business!

Most people - particularly non-technology people - pursue technology investment by providing a list to the sales organization asking "can the software do this and this and this . . ."  What the software can do is certainly part of your decision-making process. But how it is structured - the bones of the system - are also critical if you want your investment to last for the long-term.

This type of analysis is generally outside the skillset of most small business owners. Even if you can't afford the assistance to properly evaluate the full software solution you are considering, you may at least want to ask for some expert advice on the pros and cons of your options relative to these four concerns before you proceed.

I spend a lot of time thinking about the balance between cultivating customers and customer profitability – both for my own business, and for my clients. For every type of B-to-B business – whether you sell products or services – it is critical to understand if your clients are actually worth it. And for jewelry designers faced with the constant request to provide memo goods, it’s business life-or-death.

I have long taken issue with the statement the customer is always right. It was stupid when it first came out, and it’s still stupid today. I understand that someone was trying to make a point about how we are supposed to treat others with dignity and respect, but the real intention was distorted the moment those words were strung together in a sentence.

Small businesses, micro-businesses, and solo-preneurs tend to think that a new customer – any new customer – is the point. They get so excited about the prospect of cash and exposure that they fail to analyze the potential profitability of the source of that cash and exposure. I can personally attest to the fact that invoices paid do not necessarily equate to client profitability. I have learned walk away from accounts that seem like a big deal, because they steal focus, money, energy, creativity, or even brand reputation from my own organization. Even a big client can be not worth it. But this is a difficult business truth to accept for a small business that is trying desperately to cultivate sales.

Let's take a brief look at whether or not to take on memo accounts, and then I'll show you how to analyze any type of customer for potential profitability.

Should I Open Memo Accounts?

I am often asked by jewelry designers if they should take on memo accounts. And my answer is pretty consistent: Mostly no, with rare exceptions. The exceptions are easy to list: It’s reasonable to take on a memo account if it will deliver on four out of five of the following points:

1. Provide you with genuine credibility and brand exposure (i.e., “So-and-so carries my work,” which leads to other retailers saying WOW and buying in). The ideal memo account should be a door-opener.
2. Is an account that is known to do a terrific job of promoting and selling designer work – even if it’s on memo.
3. Is an account that is known to pay its bills promptly.
4. If you can afford to stock that account with the amount of inventory they need without going into debt in the process.
5. If you can afford to service that account without it creating costs (in you and your staff’s time and attention) that take you away from other more profitable opportunities.

There. That’s the checklist to use when considering whether or not to take on memo accounts. If a potential memo account can’t be a hit on 4 out of 5 of the points above (pick any 4, but no less than 4), then it probably isn’t worth your investment.

Why do I say this? Because everything you do as a small business (or micro-business, or solo-preneur) must turn a profit. When you self-fund a business, the only money you have to fund growth is the money you put back into the business. You can’t afford to spend the time, attention, or investment-in-inventory on accounts that aren’t putting profit back into the business – and by that I mean profit sufficient to help you continue your self-funding.

I can already hear some of you thinking, “But I can’t get into any accounts without memo!” And I know that’s true. Jewelry retailers are notoriously hard to get into – the majority of them want jewelry designers to pay to play. If this ultimately turned into a profit-generator for most jewelry designers, I wouldn’t be writing this blog. But it doesn’t. So we’re going to spend a few minutes talking about how to analyze the profitability of a client.

Now Let’s Analyze Your Client Profitability

When you take on a new account, it’s imperative that you calculate the costs, time (which is, of course, a cost), investment (inventory, up-front development work, shipping, etc.), financial return, and amount of time it will take to achieve that financial return. This is easier than you might think.

I’m going to explain all of this below.

Start by Understanding Your Fixed Costs

To complete this section, start by inputting your PROJECTED  REVENUE in the “Anticipated Revenue” tab of the workbook. Then go to the “Fixed Costs” tab in the workbook.

For every project you do, you have Fixed Costs. The most obvious Fixed Costs to a product seller are the cost of the inventory the client wants you to sell them – or “loan” them if it’s memo they’re asking for. If you are required by the client to pay shipping, those costs will be fixed as well. Fixed Costs would also include any unreimbursed travel you are required to make to get the client set up or to provide training, and would also include any displays, packaging, or marketing materials that you will provide.

For service providers, Fixed Costs can include the cost of the bidding process, the cost of setting up communications tools, training for both the service provider team and for the client, travel, and support materials. All the time, fees, and expenses incurred in the winning of a client and in launching them –whether it’s to sell your goods or use your services – are Fixed Costs.

Formula: Cost of your time + cost of employee and contractor time + cost of inventory (one year) + cost of unreimbursed travel + cost of unreimbursed shipping + cost of marketing, training, and marketing materials + any other required initial expenses = Fixed Costs.

Analyze Variable Costs

To complete this section, go to the “Variable Costs” tab in the workbook.

Variable Costs are the costs of managing a customer after start-up. For your analysis, you need to figure out the Variable Costs of the new client in the course of the first year.

The first variable cost you should calculate is the amount of non-production time you and your employees will likely spend managing the client. This includes time spent managing orders, special orders and special requests, in meetings, dealing with revisions and redirections, swapping out inventory, reconciling memos, invoicing, and the amount of time you spend calling them to collect overdue invoices. You should start by analyzing what the average client costs you in time to do these things, then use any market or peer information you have to determine if the client is likely to be lower-maintenance or higher-maintenance than an average client.

If the client requires you to participate in promotions throughout the year, such as trunk shows, annual client catalogs or calendars, the expenses and time associated with these projects are also Variable Costs. Coop advertising should also be included, and you should calculate the amount of coop based on the amount of Projected Revenue.

Some computer software will result in added Variable Costs, such as a CRM that charges you by the client, or an image management system or project management software that you pay additional fees for adding new users or clients. Make sure you figure the incremental cost of all your business management tools, because those costs can add up fast, and you want to make sure you understand the costs relative to your clients. Otherwise, you risk overestimating how much each client is worth.

Formula: Cost of your time to manage this customer over first year + cost of your employee time to manage customer over first year + incremental costs to any business software tools + unreimbursed service costs + coop advertising costs + any other Variable Costs not listed here = total Variable Costs to manage client.

Figure Out the Break-Even Point

To complete this section, go to the “Break-Even Point” tab in the workbook.

Your Break-Even Point is the point at which the client has paid for itself. It is not the same as profit. Profit is what comes after the Break-Even Point. To calculate the Break-Even Point, you add up the total Fixed Costs of start-up, the total inventory costs for the first year, and the total Variable Costs per year. That is the cost you must recover in order to start turning a profit.

What if it’s negative? Then increase your Projected Revenue amount – in increments – to see at what level of sales that client would have to perform in order to be profitable. If the amount of sales required is unreasonable for that client, they’re not a good risk – with one exception: If you can demonstrate that they will produce significant profits in year two and beyond, and if your business can handle the strain of investing in that client for a full year before getting a return, the client may make sense. However, if you go into any level of debt in order to finance the customer, make sure you include the costs of that debt (credit card or loan fees and interest) in your Variable Costs for the customer for however many years you carry the debt.

Formula: Projected Revenue – non-inventory Fixed Costs – inventory costs – Variable Costs = Break-Even Point.

Determine the Contribution Martin

To complete this section, go to the “Contribution Margin” tab in the workbook.

While most small business owners are reasonably good at calculating costs of inventory and whether or not the sales of products are creating a profit, relatively few small business owners know whether or not a client is profitable. That’s because they don’t calculate the Contribution Margin.

It’s tempting, when you think about taking on a new client, to get excited about every sale. Emotionally, sales are fun. But rationally, we know we incur many additional costs in our effort to close the sale. Contribution Margin is how much money you have to cover your Fixed Costs once the Variable Costs have been taken into account. To get this amount, you subtract your total Variable Costs from the expected revenue for the client. By analyzing the Contribution Margin of each client, you gain insight into whether or not the client is producing a profit beyond the profit margin of the goods or services you sell them. This is essential insight, because a high-maintenance client may produce acceptable – or even very good – sales, but still be a money-loser.

Formulas:
Contribution Margin:   Projected Revenue – total Variable Costs = Contribution Margin.
Profit:   Contribution Margin – First Year Inventory costs – First Year Non-Inventory Fixed Costs = Profit.

Ongoing Profit Analysis

Use the “Contribution Margin” tab in the workbook. The section is “Subsequent Year Contribution Margin.”

Finally, you must ensure that each customer is returning a reasonable amount of profit after the first year. Many businesses will perform strongly for a few years, then drop off in subsequent years. This is particularly true when selling to retail establishments that have a style or fashion component, but it’s also true for service businesses that work with clients who eventually will develop some of those services in-house. Once client revenue drops below a certain level, they will stop being a productive client for you. When that happens, your time will be better spent elsewhere.

Formula: Projected Revenue – Total Variable Costs = Contribution Margin. Contribution Margin – Projected Inventory Cost = Profit.

While you may love what you do, you’re not in business purely for fun. You need to turn a profit, and if you’re not turning a profit, then either A) you’re in such a financial position that you can afford to do your hobby full time, or B) you’re going to eventually burn out (both personally and as a business). Invest the hour or two that it may take you to completely understand this concept. Use the spreadsheet I provided to see how easy it is to calculate these numbers. And learn to identify which clients are worth serving and which are not.

Don’t be afraid to face the truth about client profitability

If you have a preponderance of clients who aren’t worth it, you need to know that. That knowledge will give you the impetus you need to find other ways of selling and other types of clients to sell to. A  business only dies when its owner stops feeling the motivation to find new ways of selling and new clients to serve. The time is going to go by either way. Wouldn’t you prefer to be earning a comfortable living at the other end of that passage of time?

Sometimes I listen to parents complain bitterly about things their toddlers – or teenagers – are doing; things which are totally age-appropriate. If you’re like me, you think to yourself, “as long as you're a parent, you would have a better time if you learned about the developmental stages of children.”

I had a friend who once decided to ride his bike from Albuquerque to Santa Fe – a 65-mile trip. Half way through his journey – and in the middle of nowhere – his bike broke down and he didn’t know how to fix it. If you’re just riding your bike around the neighborhood, you can get away with not knowing any repair skills. But if you’re going to start making long treks in sparsely populated areas, you need to learn how to fix your bike and own the proper tools.

There are probably many things you wouldn’t do without learning a lot about them and practicing first: true wilderness camping without survival skills, throwing a huge self-cooked dinner party without cooking skills, sailing a boat in the ocean without navigational and boating skills.

Are you running a small business without small business success skills? If you are, it’s going to cost you.

As a small business – or even a micro-business – owner, you must do all the things the CEO of any company does; decide what to sell and how to sell it, whether and when to hire help, manage customer service, operations, and finances, make decisions. Even if you don’t have formal investors, you are managing a huge investment – your own. Your investment is the time you spend, the money you put in, and the profits you roll back in. You are responsible for all the same things as any CEO, but without the qualified support staff to fill in the gaps in your knowledge.

I was the CEO/President of several corporations over the past 30 years, from a $2million/year marketing agency to a $100million+ jewelry company and a $600million+ apparel company, and now I own a multi-brand consulting agency. The skills I needed between the $2 million level and the $600+million level were remarkably similar. I didn’t need to “be” an accountant, but I had to know how to discuss finances intelligently with my accountants. I didn’t need to “be” a production manager, but I needed to understand what my production managers were doing and how to help them be more successful. I didn’t need to “be” the computer network manager, but I needed to be competent enough to weigh the suggestions my network managers made and make good decisions.

When I first took over the apparel company, I realized that my accounting skills were lacking to do the analysis at that level. Did I go back to school to become an accountant? Absolutely not. But I did go take a class called “Financial Management for Non-Financial Managers” offered at a local community college. That, plus a lot of attention and practice, turned me into a strong financial manager capable of not driving my accounting staff crazy, and more importantly, of being the CEO my company deserved. Every year of my career I have added more business skills to my portfolio, and I continue to do so today. You must do this too.

You probably already know how to make and/or acquire the products and services you sell. This is the starting point for most entrepreneurs. But there are several business skills you must cultivate in order to ensure the survival and profitability of your company. These small business success skills include:

• Basic understanding of financials and financial management. You don’t need to become an accountant (in fact, paying a good accountant is one of the most important things any small business owner can do). But you must understand your role in financial matters, how to work with your accountant, and how to steer your company in the right direction.
• How to not just make a strategic business plan, but use it for ongoing business development and improvement.
• How to express your business strategy as a Brand, and how to imbue your whole organization – from product idea to post-sales satisfaction – with Brand elements that stick with customers and keep them coming back for more.
• How to hire, train, discipline, fire, and motivate employees. Even if you have only one employee, you need these skills. Otherwise, you risk paying someone to work for you without getting the full value of that pay.
• How to set up the necessary business systems to manage your customers, sales, inventory, marketing, operations, and accounting. By systems I don’t necessarily mean expensive computer software – the solutions can be anything from KanBan cards to computers. But you need to know which systems you need and how to set them up.
• How to manage your inventory to ensure high service levels, solid margins, happy customers, and no excess taxes. Inventory is about way more than just buying goods and making them. You must understand the role inventory plays in your company, and how to manage that role carefully.
• How to create and manage a sales and marketing plan.
• How to set up sales and customer service programs that drive volume and profits, whether you’re selling to business clients, through retail stores, or directly to end consumers (or any combination thereof).
• How to not only create and sell products, but manage product and product line profitability.
• How to prospect for new customers –from finding new potential sources for sales to keeping them interested, and learning how long it takes to convert a prospect to a loyal customer.
• How to decide which operations to keep in-house, which to outsource, and how to manage both types.

Being a business owner is a big task, and I’m not going to pretend that list is a quick or easy thing to master. But if you start learning these skills right away and keep picking them off one-by-one, you’ll become a better CEO from the moment you start . . . and the time is going to go by either way.

This is a link to a chart of these skills. It is structured as a pledge; a pledge to yourself to pursue and cultivate the skills you need to succeed. I encourage you to print it out, post it in a highly (and daily) visible spot, and check each one off as you tackle it. And here’s to you, on the road to becoming a highly competent – and vastly more satisfied – CEO.