Accounting can be a daunting task. Let’s explain the basics and talk through our tips for manufacturing entrepreneurs!
We’ll focus on preparing an income statement for your business, and what that entails.
Costs and Revenue
What is revenue? Revenue is money that we earn from doing something like selling a part or product to a customer.
Business costs are categorized into two main classifications:
- Fixed Costs – These are the costs that a business needs to pay on a specific basis regardless of what happens, such as paying rent, insurance, or internet bills.
- Variable Costs – Variable cost includes less consistent expenses, such as purchasing material for a part, paying for services such as anodizing, or buying new tools.
The Two Kinds of Business Accounting: Cash & Accrual
What is Cash accounting? Cash accounting essentially means that revenue is earned as soon as payment is received.
What is Accrual accounting? Accrual accounting is different from cash accounting in that revenue is booked as soon as work is finished.
This makes the most difference when filing taxes and the work and payment take place in different years or quarters. For example, if we made a part for someone on the last day of 2017, but didn’t receive payment until a week or two later, the accounting method we use depends on when we report the revenue. If we used Accrual accounting, the revenue would be reported in 2017 but if we were using cash accounting we would report it as revenue made during 2018.
Accrual accounting presents something called Accounts Receivable. All accounts receivable is the amount of money that you have earned, but not received due to sending an invoice. This is a problem, because we can’t pay our bills or our employees in Accounts Receivable, which can cause cash flow problems and is the cause of many business failures.
What is working capital? Working capital is sort of the opposite of Accounts Receivable. Working Capital is the ability to get paid fast, and have that money available to spend before you need to pay vendors or bills. This idea utilizes something called Float (largely by the insurance market.) Float is the amount of money that can be earned, before it has to be paid out. Credit cards, while they present debt which is usually bad for a business, can be used as a form of Working Capital.
Net income (or Profit) is as simple as your total expenses for the term subtracted from your gross (total) income. This is not a true representation of business performance, because it takes into consideration some non-cash expenses.
What exactly is a non-cash expense? These can be broken down into two main types of expense, depreciation and amortization.
- Depreciation – Depreciation is an amount of money predetermined by the IRS (depending on what the expense was) that factors into your expenses each year. So, instead of considering certain purchases as expenses and reporting their full value as an expense, you have to only report the amount of depreciation the IRS says you need to for that year. However, when you sell the item, the money from the sale is reported as income and depreciation is recaptured.