glove with the baseball glove’s revenue. The tax preparer would match the labor cost paid to the staff with the revenue from the tax return.
Because the cash basis doesn’t follow the matching principle, the method is used only by very small businesses. Everyone else uses the accrual method of accounting.
Moving to the accrual method
The accrual method of accounting recognizes revenue when it’s earned and expenses when they are incurred. Accrual accounting is more complicated than the cash basis you just read about (but only a little bit). That’s because your cash may not move in the same period when revenue or expense is recognized.
Say you ship goods to your client in late January. The customer pays for the order in February. You completed everything that the customer required in January, so you should recognize revenue in January. But the cash moves (you get paid) in February.
Accrual accounting requires you to make an entry to accounts receivable and to sales revenue in January. The entry shows that you earned the revenue, even though you haven’t been paid yet. Accounts receivable means that you are owed money for a sale that was posted to revenue in January. When the cash is received in February, you reduce accounts receivable and increase cash.
Assume an employee works in your store during the last week of May. Your next payroll is paid in the first week of June. Your store has sales in May. You should include the salary expense for the employee’s work during May with the May revenue. That’s how the matching principle works. The process matches the effort (costs) with the reward (revenue). However, the cash doesn’t move until June.
Using accrual accounting, you make an entry to accounts payable and salary expense in May. Accounts payable represents an amount you owe as a business expense. So you post the salary expense in May. When you pay the employee in June, you reduce accounts payable and you reduce cash.
Finishing with conservatism
The principle of conservatism relates to decisions you make as an accountant (or as a business owner doing some accounting). By conservative, accountants mean the less-attractive decision. Your goal is to avoid creating accounting records that are overly optimistic.
Consider revenue. If you need to make a judgment on when to recognize revenue, choose to delay recognition. Delay posting the revenue until you’re sure the revenue has been earned. That decision is considered the conservative one, because it makes your financial statements less attractive to a reader.
Okay, now consider expenses. You should recognize expenses sooner than later. In the section “Previewing inventoriable costs,” marketing costs are recognized immediately. That’s because the accountant can’t justify delaying the expenses to a later period. Posting more expenses sooner makes your financial statements less attractive.
Chapter 3
Using Cost-Volume-Profit Analysis to Plan Your Business Results
IN THIS CHAPTER
Cost-volume-profit analysis (CVP) is a tool you can use to analyze your costs and plan for a reasonable profit. The CVP formula is simple, and using it is as easy as plugging in numbers as assumptions and seeing where your profit ends up.
Cost-volume-profit works for enterprises of all sizes. Take the neighborhood lemonade stand as an example. To set up a lemonade stand on the sidewalk, you’ll have costs. (“It takes money to make money.”) Those costs include lemons, sugar, water, stand construction, advertising, and so on.
Assume your lemonade stand startup costs total $30. You decide to sell each glass of lemonade for $1. How many glasses do you need to sell to recover all your costs? At what point would each lemonade sale create a profit? If your goal were to earn $20 in an afternoon, how many glasses would you need to sell? You can answer these questions using cost-volume-profit.
Understanding How Cost-Volume-Profit Analysis Works
A little comprehension goes a long way. I work with many small-business clients who use cost-volume-profit analysis, but they don’t know the terminology or how it really works. To illustrate, one client, Barb, owned an advertising premium company, producing and selling promotional items. She made items such as T-shirts, water bottles, bumper stickers, and anything with a company logo that would help promote a company’s product or service.
Barb knew the company’s total fixed costs. In fact, she could recite the cost of her lease, insurance, and loan interest off the top of her head. She also knew the variable cost she would incur for every item she produced. Finally, she had a sales amount in mind every month that she hoped to achieve. Barb knew how much profit she would generate if she hit that sales number.
Barb’s problem was that all these facts and numbers were swimming around in her head and not organized on paper. She needed a simple tool to analyze costs, sales (volume), and profit in one place. That’s the value of cost-volume-profit analysis. An owner or manager can have all three calculations in one formula and understand how they affect one another. So when you understand cost-volume-profit, you’ve added a powerful analytical tool to your arsenal.
Calculating the breakeven point
Cost-volume-profit analysis starts with the breakeven point. Breakeven answers this question: “What’s the amount I need to sell to cover all my costs?” When you open the front door of your business on the first day of a new month, your first concern is likely to be how much you have to sell to at least cover all costs for that month. At a minimum, you don’t want to lose money.
It doesn’t matter whether you’re selling a few glasses of lemonade or manufacturing automobiles. Either way, the breakeven point has three simple elements:
It includes fixed costs and variable costs.
It includes sales, either units of product sold, or the total dollar amount of sales (revenue). The term volume refers to the level of sales.
It assumes profit of zero.
