Copyright 1989, by SCORE Chapter 225, Hyannis, Massachusetts.
All rights reserved. This publication is protected under copyright.
No part may be reproduced, transmitted or transcribed without
the permission of the author. SBA retains an irrevocable,
worldwide, nonexclusive, royalty-free, unlimited license to
use this copyrighted material.
While we consider the contents of this publication to be
of general merit, its sponsorship by the U.S. Small Business
Administration does not necessarily constitute an endorsement
of the views and opinions of the authors or the products and
services of the companies with which they are affiliated.
All of SBA's programs and services are extended to the
public on a nondiscriminatory basis.
TABLE OF CONTENTS
STARTING A BUSINESS
NAMING A BUSINESS
LEGAL STRUCTURE OF A BUSINESS
Subchapter "S" Corporation
LICENSES AND PERMITS
MANAGING A BUSINESS
Management by Objectives
Essential Management Practices
FINANCING A BUSINESS
Sources of Funding
The Loan Proposal
THE BUSINESS PLAN
PRICING SERVICES PROFITABLY
Types of Costs
Calculating the Cost of a Service
PRICING PRODUCTS PROFITABLY
Types of Costs
Reasons for Advertising
Objectives of Advertising
Help in Advertising
Marketing Before Opening
Marketing for an Existing Business
LOCATING A BUSINESS
Selecting a City or Town
Selecting an Area Within a City or Town
Selecting a Specific Site
Protecting Against Crime
EMPLOYEES AND INDEPENDENT CONTRACTORS
Classes of Employees
MANAGING HUMAN RESOURCES
Wages and Working Conditions
COMPUTERS IN SMALL BUSINESS
What a Computer Can Do
Areas a Computer Can Improve
What a Computer Cannot Do
Buying a Computer
MANUFACTURING COST ACCOUNTING
Inventory Record Keeping
A. Useful IRS Tax Publications
B. Information Resources
SCORE, an acronym for Service Corps of Retired Executives,
is an independent, voluntary, nonprofit association. Although
SCORE is sponsored by, and receives financial aid from, the
U.S. Small Business Administration (SBA), it is not a constituent
of that or any other government agency.
The primary purpose of SCORE is to render a community service
by providing, without charge, the expert assistance of its
volunteer counselors to small businesses. Counselors receive
no pay for their services.
SCORE began in 1963 when certain groups of retired persons,
almost spontaneously, began offering assistance to owners
and operators of small businesses in various localities, such
as Worcester, Massachusetts; Wilmington, Delaware; and St.
Louis, Missouri. Later in the year, the SBA began to use these
volunteers to supplement its own small business assistance
programs and to recruit more volunteers for that purpose.
The response was so enthusiastic, and the potential of these
volunteers so enormous, that the SBA began to organize local
SCORE chapters and administer the program. Today, there are
more than 400 SCORE chapters in the United States and more
than 12,000 volunteers.
While its counselors derive tremendous personal gratification
from assisting small businesses, SCORE exists solely for the
benefit of the small business community. For anyone in, or
considering entering into, a small business, SCORE offers
many services. These services include private, individual,
confidential counseling; training through specialized seminars,
workshops and conferences; information from books, pamphlets
and SBA publications; and advice on how to approach regulatory
organizations, local authorities, lawyers, accountants, town
officials, etc. Also, SCORE cooperates closely with other
volunteer organizations, government agencies, chambers of
commerce, colleges and universities, and other nonpolitical
civic associations to enhance the quality of life for the
To locate the nearest SCORE chapter, call your area SBA office.
The number is found in the blue pages under "U.S. Government."
You can also call SBA's Answer Desk at 1-800-8-ASK-SBA.
In this final decade of the 20th century, small business
owners continue to demonstrate their extraordinary capacity
to mobilize resources and generate new jobs. There are more
than 20 million small businesses in the United States, and
each year nearly a quarter of a million new ones are started.
Small business employs six out of every ten people, accounts
for the majority of new jobs, is more flexible than big business
in responding to shifting markets and is able to bring new
products and services to market much faster than larger companies.
Realizing that small business is the backbone of this country's
competitive free enterprise system, Congress, in 1953, created
the U.S. Small Business Administration. SBA defines a small
business as one independently owned and operated, and not
dominant in its field. SCORE is part of the SBA's business
To start a new business and remain in business profitably,
one must be able to adapt to changes in the population, work
force and technology, and to the demands of a global marketplace.
To address these changing conditions, sound management and
organizational practices are more important than ever before.
The necessity of increasing productivity of employees, the
difficulties in recruiting qualified workers from a shrinking
labor force and the importance of devising ways to meet workers'
benefits will challenge managers of all small businesses.
America's future depends on the continued emergence of successful
small businesses. To be successful, those who start a new
business must be prepared. It is the purpose of this Handbook
for Small Business to provide information in the simplest
terms to help new and existing businesses to be successful.
The mission of SCORE is to help people get into business,
stay in business and make a profit.
More detailed information on the various facets of operating
a business is available. Much is contained in the publications
and video/audiotapes listed in the SBA booklet, The Small
Business Directory, available from SCORE or the SBA.
Handbook for Small Business is designed as an extension
of the SCORE concept of service to the small business community.
It is a comprehensive presentation of general information.
To a considerable extent, its contents reflect the personal
and practical experience, which is the hallmark of the SCORE
Handbook for Small Business is not offered as a
substitute for in-person counseling, but rather as an enhancement
of counseling. It is published with the understanding that
the publisher is not engaged in rendering legal, accounting
or other professional service.
Although this publication has been prepared by competent,
knowledgeable and experienced contributors, it should not
be used as a substitute for professional or other authentic
sources in specific situations. As pointed out repeatedly
in the book, legal or other expert assistance should be sought
STARTING A BUSINESS
Some of the reasons people start new businesses are
! For financial independence
! To be one's own boss
! For creative freedom
! To fully use one's skills
! To be free of other people's policies and procedures
! For personal recognition
Perhaps the most important reason is to make a profit.
Whatever the business, to be successful there must be a need
for the particular products or services offered. To determine
if your intended business will fill a need, you must first
address the who, what, why, where, when and how of your proposed
venture. The following questions will help you:
! Is the business practical?
! What is the competition?
! What is the market for my product or service?
! What is the advantage of my business over existing similar
! Can I furnish a higher quality product?
! Can a demand be created for my product or service?
! What price will I charge, and how will I determine the best
! Am I prepared?
! Do I know where I can get help and information?
! What is an accurate description of the business?
! Where will I locate and why?
! Can I get an affordable lease at the best location?
! Are there zoning or fire regulations or other restrictions
that must be considered when choosing a location and opening
! Will I need a permit or license?
! What will be the legal structure of the business?
! What will the business be named?
! What equipment and supplies will I need?
! What insurance will I need?
! What skills or experience do I have?
! What are my financial resources?
! What finances are necessary to start and maintain the business?
! How will I compensate myself?
! How will the business be managed day to day?
! How will I identify customers and how will I reach them?
! How will I hire and pay employees?
! How will I best serve the needs of my customers?
Because going into business is a risk, careful preparation is
essential. A business plan is critical to determining if the risk
of entering into a business is worth taking. Various chapters
of this Handbook discuss preparation in much greater detail. Once
the decision has been made to open the business, the remaining
steps are quite simple.
If the business is to be operated as a sole proprietorship, and
you use your name, it is usually unnecessary to register the business
with your city, town or state. (See "Naming a Business"). If you
do not use your own name, the business may need to be registered
with the municipal or town clerk. Partnerships must be registered
locally and corporations with the state.
If you are to have employees, or will be a partnership or corporation,
you must obtain a business identification number from the Internal
Revenue Service (IRS) by filing Form SS-4. Also, all businesses
that have employees must register with their state division of
employment and training, and must pay unemployment insurance taxes
to the state as well as to the federal government.
NAMING A BUSINESS
Every business needs a name. Because a name is an important asset
to a business, it should be selected carefully.
Before choosing a name, it is advisable to look at the types
of names in use by businesses similar to yours. To prevent choosing
a name already in use, check lists of business names available
in telephone books, libraries, city and town halls, and trade
journals. Names of corporations can also be checked at the corporate
division of the office of the Secretary of State. To guarantee
availability of your intended corporate name, contact your state's
corporate division for an application and fee details.
There are different categories of business names.
! Trade names usually identify a company,
for example "Coca Cola Company." Any type of business may call
itself a company.
! Trademarks are any words, names, symbols
or devices, or any combination of these, used to identify the
goods of a business and to distinguish these goods from the
goods of others. The word "Kleenex" is a trademark, as are "Coca
Cola" and "SCORE."
! Service marks are used to identify
and distinguish a business that provides services rather than
goods. "Greyhound" is a service mark for transportation services.
After choosing a name, you may have to file organizational forms
with the Secretary of State, or file a business certificate with
the municipal clerk at the town hall in which your business is
located. This certificate is called a "dba," which means "doing
business as." You may need to file a dba if you conduct business
under any title other than the real name of the person, corporation
or limited partnership. Corporations, limited partnerships and
business trusts must be filed with the Secretary of State. Business
trusts may need to be filed with a local government office.
A service mark or a trademark can be registered with the Secretary
of State and the federal government, although neither registration
is required. Trademarks are protected under common law. However,
by registering your mark, you do gain certain exclusive ownership
under statutory law. State registration is usually processed within
several days. Federal registration may take several months. Registering
with the state protects your mark during the federal application
period. In some states, a mark must be in use before it can be
registered. Details and forms for registering a trademark can
be obtained by writing to your Secretary of State.
LEGAL STRUCTURE OF A BUSINESS
Before you open a business, you must select the legal structure
that will best suit your needs and those of your particular business.
There are three principal types of business structure: the proprietorship,
the partnership and the corporation. Each has its advantages and
disadvantages, which will be reviewed.
The sole proprietorship is usually defined as a business owned
and operated by one person. To establish this form of business,
one need only obtain the required license or permit and begin
operations. This is the most common form of small business organization.
Ease of Formation. A sole proprietorship is the easiest
and least expensive form of a small business to begin, as well
the one with the fewest legal restrictions. No government approval
is needed to begin operation. If the business is in your own name,
just open the door and start. If you have employees, the business
must be registered with the federal government on Form SS-4. State
and local government registration may also be necessary.
Sole Ownership. The proprietor shares the profits with no one,
and the decision making is vested in one person.
Control. The sole proprietor is in complete control
of his or her business.
Flexibility. Management can quickly respond to the
needs of the business and can make the day-to-day decisions so
often critical to a new business's success.
Freedom from Government Control. There are no special
taxes for this form of business, including no state or federal
taxes. Profits become the owner's personal income and are taxed
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
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.
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
The services of an attorney who specializes in drawing up articles
of partnership is essential to start this form of business.
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.
Unlimited Liability. Each general partner is liable
for the business debts incurred by the other(s) and by the business
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
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.
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.
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
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
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
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:
! What is the risk and what is the amount of the
investors' liability for debts and taxes?
! How will the continuity of the business be handled
if something happens to one of the principals?
! What is the influence of applicable laws?
! Can you attract capital?
! What are the costs of starting and running
the business under the different structures?
! Can you afford the extra record keeping and reporting
required by some structures?
! What legal structure best serves the purpose and
goals of the business?
! What legal structure ensures the maximum adaptability
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
Table 1 - License or permit issuing
||Food handling, rest rooms, sewer connections, septic
||Licenses and permits
||Alarm & business registrations
||Safety inspections, alarm
|Weights and Measures
||Weighing and measuring,
packaging and labeling
||Wetland alterations, building
and activity near wetlands
||Signs, building and home
alterations, business activities
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
Alcohol - sales and distribution
Amusement parks, carnival rides, music, dancing
Appliance testing labs
Auto body repair
Auto sales - new and used
Child day care centers
Cigarettes - wholesale and retail
Collection agencies and finance companies
Concrete technicians - testing labs
Dairies, milk dealers and plants
Diesel fuel trucks
Elevators and operators, escalators
Engine fuel and lubricants
Engineering and related fields
Fishing, hunting, trapping
Food or beverage service, sale or preparation
Hawkers and peddlers - balloons souvenirs arts and crafts,
Hazardous chemicals or flammables
Insurance agents, adjusters, brokers, advisors
Lodging - hotels, motels, inns, bed and breakfasts, guesthouses
Motion picture operators
Motor vehicle appraisers
Notaries public, justices of the peace
Pet shops, riding schools, cattle dealers, stables, riding
instructors, guard and hearing dog businesses
Restricted pesticide dealers and applicators
Solid fuel burning, construction supervision
Exhibit 2 - Professions and Trades Frequently
Requiring a License or Registration
Allied health professions
Plumbing and gas fitting
Drinking water supply facility operators
Embalming and funeral directing
Health officers, certified
Real estate brokerage
Real estate sales
Respiratory care therapy
There are "blue laws" in many states; these pertain
mostly to doing business on Sundays and holidays. Check with your
police department for restrictions that apply to your area.
One cautionary note: If you are buying a business or leasing
a location, do not take the word of the seller or landlord that
certain licenses or permits exist or can be grandfathered. Check
it out yourself.
MANAGING A BUSINESS
Business is an economic institution whose goal is economic survival
and whose activities are dominated by the profit motive. Its primary
purpose is to create and satisfy a customer and make a profit.
To achieve this purpose, business must be skillfully managed.
Management is defined as the art of conducting and supervising
a business or as using judgment in business affairs. A manager
is one who actively directs, controls and manipulates his or her
business environment in a manner that takes account of the risks
involved in order to realize monetary gain.
Successful business leaders have stressed that good management
skills, whether in a large corporation or in a one-person business,
are vital to the success of a business. Many small business people
may be good at launching their venture, but weak in managing the
development and later stages of the business. Here are ways to
strengthen management skills.
Management by Objectives
Objectives are fundamental to the operation of a business. An
objective is a written statement of results to be achieved, defining
specific outcomes and establishing performance levels for the
business, its manager and its employees. Objectives must be set
for both the short and long range.
They must be reasonable, attainable, measurable, detailed and
time specific. They should be commitments, not facts; directions,
not fate. An objective must have a means and a plan of accomplishment.
An example of an objective might be "to increase my business
from $24,000 to $36,000 in the next 12 months." Another might
be "to prepare, have printed and distribute 1,000 flyers
to shoppers in the local mall, all within two months." Others
might be "to hire and train a new sales clerk before
the end of the fiscal year" or "to telephone each account
receivable at the end of each month and to personally visit accounts
that are more than six weeks delinquent."
Objectives should be written for every phase of a business, such
as sales, service, bookkeeping, advertising, employee relations
and marketing. Note that objectives should be written and reviewed
Know your figures and keep them up to date. Doing this is the
only way you will know how the business is faring on a daily,
weekly and monthly basis. Stationery and other stores have simplified
bookkeeping systems available, or you can engage the services
of an accountant or bookkeeper.
Accurate records are needed by business owners and managers not
only to make informed decisions, but also to support reports required
by federal, state and local government agencies. (See the section
on record keeping below.)
Keeping adequate, accurate records of your business permits you
to use them in the daily management of the operation. At the end
of each month you should compare the actual profit and loss and
cash flow statements with the goals identified in your business
plan. This way you can see your progress and take the proper action.
You should not only review the financial area, but also evaluate
marketing, sales, advertising and other operational goals.
Do not procrastinate! If something is not working as you planned,
do something about it - now!
Don't become paralyzed by inaction. Every well-developed business
plan should detail how the following will be accomplished:
! Deciding - Determining what must be done.
! Planning and scheduling - Setting time
! Performing - Following through on decisions.
! Controlling - Monitoring events as they
! Coordinating - Ensuring that each objective
is in harmony and not at odds with the others.
! Recording and documenting - Keeping accurate
and complete records.
! Analyzing and evaluating - Studying records.
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.
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
Essential Management Practices
The following are practices that are essential for a successful
! Have a written business plan that sets the objectives
you want to achieve in the next year and the next five years.
! Analyze progress with hard numbers.
! Know your break-even point and when you are on
target in reaching it.
! Have your accountant/bookkeeper prepare and thoroughly
explain financial reports, such as profit and loss statements,
balance sheets and cash flow sheets, in addition to those related
to your tax returns.
! Even though your objective may not be to secure
a loan, talk to your banker about your business. Know your numbers.
! Know exactly how much it costs you to make a sale,
perform a service, make a repair, etc.
! Know how much inventory is on hand. Inventory
is money. Old and obsolete inventory can paralyze your business.
! Solicit regular feedback from customers and make
changes based on their suggestions.
! Join a trade association for your industry.
! Read the same publications that your competitors
and customers read.
! Constantly scrutinize your competitors' advertisements
and read their sales literature.
! Ask yourself the following about your competition:
Is their business increasing or decreasing? How do you compare
as far as quality, price, product line, exclusivity, service,
reliability, location, warranties, delivery and courtesy are
! Talk regularly about business-related subjects
with other small business owners.
! Review financial and marketing strategies often.
! Have regular training sessions for and regular
motivation meetings with your employees.
! Recognize your own weaknesses and get help in
! Review the business plan monthly.
! Tell everyone on the payroll exactly what his
or her responsibilities are and what is expected.
! Treat employees as individuals.
! When an employee does a good job, tell him or
! Keep as accurate a set of records as possible.
! Analyze your records often and take any appropriate
steps that may be indicated.
! Take pride in your 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
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
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
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
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
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
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.
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
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
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
||A. Name, address and telephone number
B. Name and title of principal(s)
C. Amount of loan (investment) requested
D. Purpose of the loan (investment)
E. Repayment terms of the loan
|Description and Summary of the Business
||A. Length of time the business has been operating
B. The business's historical trend
C. The nature of the business What does it do?
D. What is unique about your product line or service?
E. What or who is your market?
F. The business's competition
G. The business's long-term growth plan
H. Trends in your industry
||A. Your management experience
B. Your management team
1. Table of organization
2. Brief resume of key individuals and their
3. Current staff or work
force level and future needs
C. Your accountant and attorney
|The Loan (Investment) Request
||A. Justification of the loan
B. Details of the loan request
2. How the funds will be used
3. Collateral available for a loan and its
4. Repayment terms of the loan
5. Ability to repay a loan
| Financial Data
||A. Financial statements
1. For an existing
business, three years of historical and any interim statements
2. Balance sheets
and loss or income statement
B. Projected cash flow analysis for at least the next 12
months, including loan (investment)
C. Sources and amounts of any other loans or investments
to be put into the business
D. Personal financial statement
| Credit Information
||A. Banks at which you maintain accounts
B. Banks at which you have borrowed money
C. Trade suppliers
D. Other creditors
||A. If incorporated, copy of articles of incorporation
B. If renting, copy of lease
C. Type and amount of business insurance coverage
D. Aging of accounts receivable
E. Copies of business and personal tax returns
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
! Clearly states both the short- and long-range
objectives of the business.
! Provides the direction or plan for achieving these
! Provides financial forecasts based on your estimates
of the future and your business experience.
! Provides budget guidelines, including projected
cash flow analysis and income statements.
! Gives a break-even analysis of your business.
! Helps determine the amount and kinds of financing
best for your business.
! Gives banks, investors and suppliers useful information
they need to make fast and accurate decisions about your business.
! Forces you to think through every aspect of your
business and recognize opportunities for growth and profit.
! Provides financial information so that the past
can be compared to the present and future.
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
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!
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
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:
! Amount of business done in cash and credit.
! Amount of business tied up in receivables.
! Amount of collections and losses from credit sales.
! Aging of accounts receivable and amount of credit
given to delinquent accounts.
! Amount of cash on hand and in the bank.
! Whether business records agree with bank statements.
! Amount owed to creditors and suppliers.
! Gross margin.
! Total expenses.
! Amount of weekly payroll.
! Adequacy of payroll records for withholding, etc.
! Payment of taxes and deposits of withholding.
! Net profit earned and taxes owed.
! Which product or service makes a profit.
! Which product or service loses money.
! Amount of money invested in inventory.
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
Description of the business
||1. Products sold, services offered
2. Capital equipment and value
||1. Who buys your product or service
2. Who needs it
3. Size of the market
4. Growth potential
|Location of business
||1. Physical features of site
2. Whether it is leased or owned
3. Renovations needed
4. Description of neighborhood
5. Zoning restrictions, if any
6. Other businesses in the area
7. Advantages and disadvantages of the location
8. Whether relocation is necessary and, if so, effect on
||1. Names and addresses of competitors
2. Their share of market
3. What you have that your competitors do not
4. Future effects of competitors
5. Comparison of your site inside and out to competitors'
||1. Your background and experience
2. Experience of management employees
3. Analysis of strength and weaknesses of management, including
4. Needs for the future and plans to hire
5. Job descriptions and training program
||1. Number of employees and experience
2. Strengths and weaknesses
3. Skills needed for future
4. Plans to hire and training program
| Application and effect of loan or personal funds
||1. How much is needed
2. What for - inventory, equipment, renovations, etc.
3. How funds will help business
4. What happens if funds are not available in full
| Objectives of business and plans to achieve them
||1. List objectives for each part of your business
2. Describe your plan to achieve each objective
| Summary - Summarize all thoughts and ideas about the
business so that they make sense to you and readers
Part II -- Financial Data
Sources and application
of funding - A restatement of Part I - G. Shows up in
cash flow projections
|Capital equipment list - but list depreciable assets on
|Balance sheet - Shows assets, liabilities, net worth at
a given time
|Break-even analysis - The sales or income point at which
the company breaks even
| Income projections (Profit and loss statements)
||1. Three-year summary
2. First year detailed by months
3. Second and third years detailed by quarters
4. Notes of explanation
| Cash flow projections
||1. First year detailed by months
2. Second and third years detailed by quarters
3. Notes of explanation
| Deviation analysis - Compares actual income and expenses
to projected income and expenses on a month-to-month basis.
Spots strengths and weaknesses.
| Historical financial reports for existing business
||1. Balance sheets for past three years
2. Income statement for past three years
3. Tax returns
Part III -- Supporting Documents
Includes personal resumes, credit reports,
job descriptions, contracts, legal documents, letters of intent
and anything that has to do with the plan
Records provide a tremendous amount of information. Most important
is that the system be
! Simple to use.
! Easy to understand.
! Able to give information on a timely basis.
The following information must be recorded:
! Cash receipts.
! Cash disbursements (expenditures).
! Accounts receivable (amount customers owe).
! Accounts payable (what business owes).
From the record keeping system, the owner/manager must determine
the following information:
! Cash sales and cash receipts.
! Cash on hand.
! Bank balance of business.
! Monies paid out -- both cash and check.
! Accounts receivable.
! Accounts payable.
! Payroll - in detail.
! Taxes - sales, social security, withholding, etc.
! All journal entries posted as like elements to
! Cash flow statement.
! Profit and loss statement.
! Balance sheet.
! Reconciliation of bank statement with own books.
! Petty cash balance.
! All federal taxes deposited and withholding and
sales taxes paid.
! Accounts receivable aged to 30, 60 and 90 days.
! Inventory worked to remove dead stock and order
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:
! Cash flow sheet - Shows the cash in compared
to the cash out by subtracting disbursements from receipts.
! Income statement - Shows total sales and
receipts, cost of sales, gross margin, expenses and net profit,
all expressed in percentage of sales.
! Balance sheet - Shows assets, liabilities
and net worth of the business.
! Break-even analysis - Shows at what level
of sales the business breaks even. Break-even analysis is based
on gross margin.
! Deviation analysis - Compares actual performance
to projected performance.
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
! Fixed costs - Costs that remain the same
in any time period despite changes in business activity. These
include rent, insurance, utilities, office supplies, salaries,
depreciation, legal services, accounting and property taxes.
These expenses are usually called overhead.
! Variable costs - Costs that usually vary
in proportion with business activity. These include materials
used in manufacturing, goods purchased for resale, labor and
commissions. In a service business, labor may not be variable.
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.
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
Amount per year
Table 3 - Estimated total revenues required
Amount per year
Profit on salaries (20%)
Profit on overhead (10%)
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
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.
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
DWA Repair Service's overhead expenses are listed in Table
Table 4 - DWA repair service's overhead expenses
Amount per year
Salaries (including owner)
Payroll taxes and costs
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
The owner of the business has calculated the billable hours
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
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.
To determine the hourly labor cost, the owner divides the labor
cost per year ($234,000) by the billable hours (16,560). The result
is $14.13 per hour.
To find total cost, overhead must be added. Total overhead per
year is $98,000. When divided by billable labor hours of 16,560,
overhead equals $5.92 per hour. Thus, the total hourly cost of
labor plus overhead is $14.13 + $5.92 = $20.05.
The owner knows that if he charges only the hourly rate based
on actual cost, he will merely break even. In order to make a
profit so that he can reduce debts, buy new equipment, provide
working capital and provide a return on investment, the owner
decides to add 25 percent on his labor, and 30 percent on his
overhead, as shown in Table 5.
Table 5 - Calculation of final hourly rate
Labor cost per
Profit on labor (25%)
Overhead cost per hour
Overhead profit (30%)
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 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.
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
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
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
Pricing Above Competitors
This strategy depends on whether non-price considerations are
important enough to customers to justify higher prices. These
considerations include specialized services (such as delivery,
product knowledge, exclusive location, brand or designer names),
satisfaction in handling complaints, in-home demonstrations and
A markdown is a reduction in the price of any item brought about
by overbuying, overstocking seasonal merchandise, misjudging customer
response, poor personal selling or competition. This technique
is used to avoid being left with dated merchandise that will be
difficult to sell. In setting a markdown price, the original cost
of the merchandise should be recovered if at all possible. If
the selling price originally was high enough, a small profit is
This is a marketing strategy based strictly on price. A specific
portion of the buying public is targeted by carrying products
in a specific price range. For example, a retail store carries
an exclusive line of women's undergarments or an expensive designer
Price lining is only successful if there is little or no competition.
It works to the benefit of the retailer because it limits the
merchandise line and makes inventory and buying easier. It is
also easier for the customer to select merchandise, so that fewer
salespeople may be needed.
One technique of establishing price is to mark up goods sold
by adding a percentage to the total cost of the goods. For example,
a retailer purchases shoes at $25 per pair and marks them up 60
percent for resale.
Cost of shoes
Markup amount per pair
Selling price per pair
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.
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
S = FC + VC
S = sales in dollars
FC = fixed costs or operating expenses
VC = variable costs or cost of goods.
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
Selling price = $40.00 or 100%
Cost of shoes = $25.00 or 62.5%
Gross margin = $15.00 or 37.5%
Note that the gross margin and cost of goods (variable unit cost)
are expressed as percentages of the sales price.
Let's assume the shoe retailer has operating expenses (fixed
costs) of $75,000 per year. The break-even point is
GM (37.5%) = $200,000 in sales
Sales of $200,000 mean the retailer must sell 5,000 pairs of
shoes at $40 per pair to break even.
Assume the retailer cannot sell 5,000 pairs of shoes. To break
even, he must raise his price, which will raise his gross margin.
The question is how much the retailer will have to raise his price
to break even.
Assume the retailer determines that he can sell the shoes for
$50 a pair.
Selling price = $50.00 or 100%
- Cost (shoes) = $25.00 or 50%
Gross margin = $25.00 or 50%
With operating expenses of $75,000, the sales volume to break
GM (50%) = $150,000 of sales
At a price of $50 per pair, the retailer now has to sell 3,000
pairs of shoes to break even. The retailer is confident he can
sell this volume, but he will not make a profit selling at $50
a pair. He would like to realize a profit of 10 percent on his
operating or fixed costs ($75,000 x 10% = $7,500). To calculate
the volume of sales required to earn this profit, he adds the
profit to the fixed costs. If he holds the price at $50 for a
gross margin of 50 percent, the sales needed to realize this profit
FC + profit ($75,000 + $7,500)
GM (50%) = $165,000 in sales
This level of sales will cover the variable expenses (cost of
goods), the fixed expenses (operating expenses) and a profit of
$7,500. To generate $165,000 in sales, he must sell 3,300 pairs
of shoes at $50 per pair.
Because the retailer has no competition, he is confident he can
sell this volume of merchandise and can also raise the unit price
of the shoes. He decides to do a calculation using a gross margin
of 55 percent.
FC + profit ($75,000 + $7,500)
GM (55%) = $150,000 in sales
The unit selling price or price per pair of shoes at 55 percent
gross margin is determined by dividing
the unit cost by the percent of variable costs.
VC = 100% - GM%
= 100% - 55%
Unit cost of shoes ($25)
VC% (.45) = $55.56 or $56 selling price
As a check
Unit selling price = 100% = $56
- Variable cost = 45% = $25
Gross margin = 55% = $31
Let us determine if $150,000 of sales at a gross margin of 55
percent will provide a profit of $7,500.
Today's sales = $150,000 or 100%
- Cost of sales = 67,500 or 45%
Gross margin = 82,500 or 55%
- Fixed costs = 75,000
Profit = $7,500
If a business manager calculates the gross margin for all merchandise
sold, the price structure that will generate a level of revenue
to purchase goods, pay operating expenses and make a profit can
The gross margin percentage can be used as a monitor of the sales/purchasing
area of the business.
The gross margin calculation allows the manager to buy goods
that can be sold at or higher than the desired margin. Pricing
policy should be based on gross margin.
If an item of merchandise has a low sales volume, it should have
as high a gross margin as possible or else it will not be profitable.
If a business does a high volume of sales, it may be possible
to have a pricing policy based on a lower gross margin, subject
In review, the break-even point is the level of sales that will
just cover fixed plus variable expenses.
By determining the gross margin for each item of goods sold,
the level of sales needed to break even can be determined as follows:
gross margin = break-even sales
By adding planned profit to fixed costs, the level of sales to
make the planned profit can be determined. To determine the unit
sales price of an item at a desired gross margin the formula is
Cost of goods per unit
(100% - GM%) = unit selling price
Examples: Shoes cost $25 per pair. What is the selling price
at 60 percent and 70 percent GM?
(100%) - 60%) = $62.50
(100% - 70%) = $83.33
Many businesses have gone astray by ignoring the need for break-even
analysis. Remember that increased sales do not always mean increased
profits. Goods must be priced properly.
No matter how wonderful or unique your product or service is,
nothing sells itself. Potential customers must be told about your
product or service and how they can purchase it.
Informing potential customers about your product, service or
business is called advertising, derived from the Latin
"ad," meaning "toward," and "verture,"
meaning "to turn." Together, the meaning is to turn
toward a product or business.
Advertising is a paid communication, the purpose of which is
to impart information, develop attitudes and induce favorable
action for the advertiser. The means of communication can be as
humble as a matchbook, as traditional as a barber's pole or as
elaborate as a celebrity-packed commercial. Remember the beer
commercials with all the athletes at the bar?
Reasons for Advertising
Why advertise? The specific purposes of advertising are as numerous
as the many different products and services promoted. In general,
there are three broad purposes:
! To promote consumer awareness of the business
and its products and services.
! To stimulate sales.
! To establish or change a firm's image in the eyes
of the consumer.
Objectives of Advertising
Objectives will vary with each type of business. Usually, one
or two will be of most importance to a business. Some typical
objectives are to
! Increase store traffic.
! Acquaint customers with new products.
! Promote special events, such as a clearance sale,
a new location or the opening of a new business.
! Change the company image.
! Keep the business name and location before the
! Inform customers of special services available,
such as delivery service, alterations or credit plans.
! Introduce new employees to the public.
! Tie in with a supplier's national promotions.
! Capitalize on the seasonal nature of a product.
! Offer get-acquainted incentives.
! Emphasize quality of product and services.
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.
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:
! Telephone solicitation - Low cost; effective
if message is worded carefully.
! Business card - Low cost; easily distributed;
describes product or service; gives address and phone.
! Word of mouth - The cheapest and most effective;
a customer praises your business.
! Business stationery - Low cost; must be
! Business signs - Very effective; low cost;
may be subject to zoning regulations.
! Storefront - Extremely effective; low cost;
shows product and price.
! Interior or point of purchase display -
Attractive display of merchandise creates impulse buying; low
! Vehicles - Can be effective; low cost;
wide exposure; can be a painted or a magnetic display.
! Shopping bags - Carry name and message
! Yellow Pages - Essential for small business;
reaches customer who is ready to buy; wide distribution.
! Direct mail - Most personalized and pinpointed
of all media; tells complete story; rapid feedback; can use
coupons, catalogs, letters, brochures or postcards.
! Local newspapers - Great flexibility; ad
size and position can be varied; great with editorial association,
such as food advertisements with cooking column.
! Local radio - Expensive but reaches targeted
audience; advertisement can be repeated frequently.
! Television - Most expensive; reaches the
masses; high visibility; instant exposure of pictures or ideas.
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
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!
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?
! Market - A body of existing or potential
buyers for specific goods or services. It is the demand for
! Marketing - The total of activities involved
in the transfer of goods from the producer or seller to the
consumer or buyer. Marketing activities include buying, storing,
selling, advertising, pricing and promoting products as well
as managing the business.
A business will not succeed just because the owner wants it to.
There must be a market for the merchandise or service being offered
or there is no chance of success.
Marketing Before Opening
Before opening a business, the following information must be
! Is the product or service to be offered one that
people want? How do you know this?
! How many people want it?
! Who are the potential customers?
! Do they live or shop near the place of business?
! Will it be the right business, at the right time,
at the right place?
! Can a demand be created for the product or service?
! How many competitors offer the same product or
! How will the new business effectively compete
in price and quality?
!Who will the suppliers be and how good are their services?
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 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
! The merchandise they like.
! How much they are willing to pay.
! Where they live.
! How they like the business.
! Whether they would recommend the store, product
! Why they came to the business.
! The products they would like that the business
does not have.
Listed below are the logical steps in more formal market research:
! Define the problem or area to be investigated.
! Assess all available information.
! Assess additional information if required by
-- Reviewing internal files and records.
-- Interviewing employees.
-- Interviewing customers and suppliers.
! Organize and interpret information.
! Make decisions.
! Observe and evaluate results of the decision.
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 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.
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
! Geographic targeting - Specializing in
serving the needs of customers in a particular area, thus restricting
advertising and promotional efforts to that area.
! Customer targeting - Identifying and promoting
to those groups of customers most likely to buy, e.g., promoting
boat products to boat owners.
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
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
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
! Size of the trading area within the city or town.
! Population and population trends.
! Total purchasing power and distribution of the
! Total retail potential within the city or town.
! Number and size of competitors.
! Aggressiveness of competitors.
Selecting an Area Within a City or Town
Once a city or town has been chosen, consider the following in
selecting an area:
! Power of the shopping district to attract customers.
! Number and quality of competitive stores.
! Availability of access routes to the store.
! Nature of zoning regulations.
! General appearance of the area.
! Expansion and rebuilding of the area.
Selecting a Specific Site
In selecting a specific site for your business, consider the
! Adequacy of parking.
! Cost of the site.
! Nature and compatibility of neighboring stores.
! Adequacy of potential traffic passing the site.
! Ability of site to intercept traffic en route
from one place to another.
! Accessibility of site to shoppers.
Consumer Goods Considerations
Consumers' views of the goods or merchandise sold by a store
has an effect on site selection.
Consumers group products into three categories:
! Convenience goods - Goods frequently bought
by habit and having a low unit price, such as cigarettes, groceries,
etc. Convenience stores are usually close to the consumer's
residence and depend on traffic for success.
! Shopping goods - Goods with a higher unit
price. They are purchased infrequently, such as men's suits
and furniture. Stores selling shopping goods usually do better
if they are located near a large department store.
! Specialty goods - Usually high priced,
although customers may not regard price as a consideration.
Although sometimes located near shopping goods stores, specialty
goods stores may be in isolated areas because they generate
their own traffic.
Examples are precious jewelry, expensive perfumes and antiques.
Retail compatibility is important to a new business. Locating
next to a store that does not clash with the new business but
does bring traffic into the area may be the salvation of the new
If a new business offers shopping goods, the best location is
near other stores carrying shopping goods. Locating a store selling
shopping goods near a convenience store is not recommended. New
businesses do better in an established shopping center rather
than standing alone.
In choosing a site, there should be adequate traffic, adequate
parking and safe, easy access. Parking spaces may be expensive
and it may be wise to investigate related charges, such as snow
removal, before considering the site.
Zoning laws and regulations regarding business signs should be
investigated. The building itself should be attractive because,
whether the owner realizes it or not, the business will have an
What people think of a business is influenced by both the interior
and exterior attractiveness of the building. Unclean exteriors,
walls that need painting and an overall unattractive site turn
customers away. Excellent products and services can be negated
by a poor location.
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
! Business fraud and theft.
! Legal liability - injury to customers or employees,
defective merchandise, etc.
! Business interruptions.
! Death or loss of key personnel.
! Death or loss of owner or partner.
! Violent weather -- hurricanes, floods, etc.
! Damage to or loss of vehicles.
If a business has even one employee, workers' compensation insurance
is mandatory. In several states, if a business has five or more
employees, health insurance is required. When applying for a loan,
banks may require certain types of insurance, depending on the
nature of the business and the type of loan.
Each business will have its own particular insurance needs. At
business start-up, funds to purchase insurance may be limited.
Nevertheless, insurance must be investigated and that which is
essential must be purchased. For example, one can imagine a tree
surgeon must carry liability insurance when felling a tree.
The general categories of insurance are
! Automobile and vehicular.
! General liability.
! Product liability.
! Group life and health.
! Fidelity and surety.
Before purchasing insurance, find out which types are required,
how you can reduce the cost of coverage and which risks you can
afford to cover yourself. Also, you must
! Decide which kind of risk protection will work
best and be most economical for you.
! Cover your largest loss exposure first, the less
severe as your budget permits.
! Make proper use of deductibles. They save premium
dollars you may need elsewhere.
! Review your insurance coverage and costs periodically
with your agent.
! Always discuss expansion or change of location
with your agent.
! Familiarize yourself with insurance terms and
provisions so you know exactly what is covered and what it costs.
! Be sure the coverage you buy is adequate to cover
the value of the property insured.
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
! Ensure immediate funds to meet taxes, debts and
! Provide income for heirs.
! Equitably distribute the property value to heirs.
! Enable your executor or administrator to dispose
of your business to the best advantage if your family is not
! Put your family on a sound financial basis if
the family is assuming the operation of the business.
! Stabilize the credit of the business.
! Help maintain good employee relations by eliminating
uncertainties and hazards.
! If the business is a partnership, provide a prearranged
plan for the orderly and equitable dissolution of the partnership
and the opportunity for surviving partners to buy out the heirs.
! Provide funds to replace a key employee or train
another if the key employee leaves, becomes ill or dies. This
is called "Key Employee" insurance.
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.
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.
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 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.
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
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 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 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 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
Pricing may depend on the following:
! Location of the business.
! Physical appearance of the premises.
! Purchase of manufacturer's close outs.
! Volume of sales.
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.
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
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
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.
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.
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, 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.
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.
In many states, a statutory employee is one who works for an
employer in any one of the following four categories:
1. A driver who distributes meat, vegetables, fruit, bakery
products or beverages (other than milk), or who picks up and
delivers laundry or dry cleaning, if the driver is your agent
or is paid on commission.
2. A full-time insurance salesperson.
3. An individual who works at home on materials or goods that
you supply and that must be returned to you or to a person you
name. You also furnish the specifications for the work to be
4. A full-time traveling or local salesperson who works on
your behalf and obtains orders from wholesalers, retailers,
contractors or operators of hotels, restaurants or similar establishments.
The goods sold are merchandise for resale or supplies for use
in the buyer's business.
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:
a. The service contract states or implies that almost all of
the services are to be performed by them.
b. The investment in the facilities, other than those for transportation,
used to perform the services is not substantially that of such
c. The services are performed on a continuing basis.
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.
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:
1. All remuneration for their services relates directly to
sales or output and not to the number of hours worked.
2. Their services are performed under a written agreement that
provides they will not be treated as employees for federal tax
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'
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.
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
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.
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.
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.
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
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
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.
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.
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
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.
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.
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
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
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
! Organize and store similarly constructed pieces
of information, such as names and addresses of customers, suppliers,
! Rapidly retrieve a single piece of information
from a file or data base, e.g., name, ZIP code, date of last
purchase, amount owed.
! Perform complicated computations quickly and accurately.
! Print information quickly and accurately.
! Perform the same activity indefinitely and precisely,
such as printing hundreds of form letters, printing mailing
! Keep transaction records, such as cash receipts,
receivables ledger and a general ledger.
! Prepare statements and reports such as cash flow
sheets, income statements, balance sheets and inventory status
Areas a Computer Can Improve
! Accounts receivable.
! Accounts payable.
! Sales records.
! Order entry.
! Inventory records.
! Tax reporting.
! Mass mailings.
! File management.
What a Computer Cannot Do
! Correct errors in an existing manual system.
! Save money by eliminating employees.
! Make business judgments or create logic.
! Solve poorly defined problems.
! Define or describe jobs that should be done.
! Generate information that is not in the system.
! Operate itself.
Buying a Computer
Before selecting a computer (hardware) and the program (software),
a prospective buyer should prepare a written statement that includes
the following information:
! A description of the business.
! Present and anticipated number of customers.
! If retail, number of transactions per day.
! Size of inventory, if applicable.
! Inventory turnover rate.
! Number of employees.
! Reasons for buying the computer.
! Amount of money available, or affordable price
! Potential operators of the computer.
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
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.
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.
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
! Franchising offers quick access to an established
and well-proven method of marketing, which reduces the risk
of opening a business.
! The franchisee purchases, along with the trademark,
the experience and expertise of the franchiser's organization.
! The franchisee's standing with local financial
institutions is strengthened.
! Franchisors offer training and management assistance.
! The franchisor offers experience in facility design,
layouts, displays, fixtures, marketing and advertising.
! Franchisors have required, standardized operation
and management techniques. If you prefer to be an independent
operator or prefer to do business using your own methods, franchising
is not for you.
! A franchisee loses his or her identity to the
benefit of the franchisor.
! The franchisor does not share in any losses but
does share in the profits.
! The franchisee usually has to purchase all goods
and supplies from the franchisor only.
! The contract between the parties is usually to
the benefit of the franchisor.
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
! Names and addresses of other purchasers.
! A fully audited financial statement of the franchise
! The background and experience of the key executives
of the franchisor's staff.
! The cost required to start and maintain the business.
! The responsibilities you and the franchisor will
A good franchisor usually encourages prospective franchisees
to visit and talk to other owners of the franchise. This certainly
should be done!
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
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
! Control business operations by detailing the important
costs of the business, permitting analysis of these costs and
indicating where corrective action is required if costs are
not meeting expectations (budgets, standards, etc.).
! Optimize business performance by using cost details,
along with sales revenue details (sales price received by product,
customer, territory, etc.) to identify the most profitable areas
of the business for further development, as well as to ferret
out marginally profitable or unprofitable operations for elimination.
! Satisfy financial reporting requirements, particularly
in the valuation of inventories in manufacturing businesses.
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:
! Whether the cost is direct or indirect.
! Whether the cost is fixed or variable.
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
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,
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
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
Typical manufacturing costs and their general classification
are listed in Table 6.
Table 6 - Typical manufacturing costs and
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:
$2.00 per unit
1.00 per unit
1.25 per unit
$4.25 per unit
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
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
First Quarter Cost Variance Repor
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
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
There are two different methods used in inventory record keeping:
perpetual and periodic.
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.
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
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
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:
! Setting objectives for inventory: the type, quantity,
cost and order/production point (what quantity will initiate
action for resupply) of products/materials.
! Recording and reporting actual results (done by
the inventory keeping system).
! Comparing actual results with objectives and analyzing
Taking action to correct problems or improve business performance.
! Inventory supports the sales activity. This means
having what the customer is willing to buy, when he or she needs
it, at a price that provides an acceptable profit to the business.
Inventory control is integrated with systems that track sales,
production and purchasing activities.
The following is a simple example.
The BAC Company plans to produce and sell three products: X,
Y and Z as detailed in Table 14.
Table 14 - Proposed annual sales and production
rates for BAC Company
The business operates five days per week, 52 weeks per year.
The minimum economic production run is two weeks. It is planned
to have a minimum inventory equivalent to four weeks of the planned
sales rate to ensure having enough product for customer needs.
The maximum inventory is to be eight weeks of the planned sales
rate to limit the investment. The minimum and maximum inventories,
based on these plan assumptions, would be as listed in Table 15.
Table 15 - Minimum and maximum inventory for
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 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
100 = 20). The maximum inventory days would be 40 days
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
$500/day = 20 days).
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
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.
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:
! Development - Uniquely new products are
being developed and market tested.
Products must be available for market testing. There is little
concern about inventory investment, other than to be sure products
are available for market testing and development.
! Growth - The product has been demonstrated
to have significant market potential and the business strives
to gain a major market share. Investment in inventory is heavy
to ensure product availability to gain significant market share.
! Maturity - Growth has leveled off. Inventories
are very closely controlled to keep investment in them just
sufficient to maintain market share.
! Aging - A period of retrenchment as competitive
industries take away or eliminate markets. Inventories decline
as unprofitable and marginally profitable segments of the business
are weeded out.
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
- 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
- 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.
For more information about SBA business development programs
and services call the SBA Small Business Answer Desk at 1-800-U-ASK-SBA
(827-5722) or visit our website, www.sba.gov.
Other U.S. Government Resources
Many publications on business management and other related
topics are available from the Government Printing Office (GPO).
GPO bookstores are located in 24 major cities and are listed
in the Yellow Pages under the bookstore heading. Find a “Catalog
of Government Publications at http://catalog.gpo.gov/F
Many federal agencies offer Websites and publications of
interest to small businesses. There is a nominal fee for some,
but most are free. Below is a selected list of government
agencies that provide publications and other services targeted
to small businesses. To get their publications, contact the
regional offices listed in the telephone directory or write
to the addresses below:
Federal Citizen Information Center (FCIC)
The CIO offers a consumer information catalog of federal publications.
Consumer Product Safety Commission (CPSC)
Washington, DC 20207
The CPSC offers guidelines for product safety requirements.
U.S. Department of Agriculture (USDA)
12th Street and Independence Avenue, SW
Washington, DC 20250
The USDA offers publications on selling to the USDA. Publications
and programs on entrepreneurship are also available through
county extension offices nationwide.
U.S. Department of Commerce (DOC)
Office of Business Liaison
14th Street and Constitution Avenue, NW
Washington, DC 20230
DOC's Business Liaison Center provides listings of business
opportunities available in the federal government. This service
also will refer businesses to different programs and services
in the DOC and other federal agencies.
U.S. Department of Health and Human Services (HHS)
Substance Abuse and Mental Health Services Administration
1 Choke Cherry Road
Rockville, MD 20857
Helpline: 1-800-workplace. Provides information on Employee
Assistance Programs Drug, Alcohol and other Substance Abuse.
U.S. Department of Labor (DOL)
Employment Standards Administration
200 Constitution Avenue, NW
Washington, DC 20210
The DOL offers publications on compliance with labor laws.
U.S. Department of Treasury
Internal Revenue Service (IRS)
1500 Pennsylvania Avenue NW
Washington DC 20230
The IRS offers information on tax requirements for small businesses.
U.S. Environmental Protection Agency (EPA)
Small Business Ombudsman1200 Pennsylvania Avenue NW
Washington, DC 20480
The EPA offers more than 100 publications designed to help
small businesses understand how they can comply with EPA regulations.
U.S. Food and Drug Administration (FDA)
5600 Fishers Lane
Rockville MD 20857-0001
The FDA offers information on packaging and labeling requirements
for food and food-related products.
For More Information
A librarian can help you locate the specific information
you need in reference books. Most libraries have a variety
of directories, indexes and encyclopedias that cover many
business topics. They also have other resources, such as
- 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.
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
In addition to books and magazines, many libraries offer
free workshops, free access to computers and the Internet,
lend skill-building tapes and have catalogues and brochures
describing continuing education opportunities.
Published - August 2011