In This Chapter

You are running a business because you like it, but also because you want to make money. And counting the money that comes in (and that goes out) is something that you need to learn to do whether you have an accountant (you should!) or not. While I can’t teach you accounting in one short chapter, I can show you how to use the numbers you collect and introduce you to accounting basics.

Operating a retail business is different from operating any other kind of business. In both the United States and Canada, retailers may use a unique method of accounting for their inventory known as the “retail method”— also called the “dual book system.” This acknowledges the fact that retailers need to use a two-column ledger in order to understand their business.

In the left-hand column, you keep a running record of the cost of your merchandise—the landed cost—and in the right-hand column, you keep a running record of the retail value of that merchandise.

Many accountants are not familiar with the system, and they set up retail businesses using one of the traditional cost methodologies instead. Yet the retail method offers huge advantages for a retail business of any size, including the ability to compare operating results with other retailers.

Even if you plan to learn the basics of accounting yourself, it’s a good idea to hire an accountant. You should seek an accountant who either knows or will learn the retail method. Check with retailers in your area or contact your local chamber of commerce for recommendations of accountants who specialize in working with retailers.

While you’ve probably seen an income statement and balance sheet—the two most widely used financial statements (I talk more about those later)—retailers depend most on their monthly maintained margin report. You should complete a monthly maintained margin report for each of your product classifications or categories. For more information about classifications and categories, read Chapter 12.

Here is a sample of what that report looks like for a classification:

Let’s take a closer look at the numbers on this report and what they mean. The report starts with a beginning inventory of $25,000 value at cost and a $62,000 value at selling price. The next line accounts for the merchandise that was received during the month in this classification. The sample shows receipts of $12,000 at cost this month, and indicates that the items were ticketed to sell for $24,000.

The third line indicates any “markups.” During the month, in this sample, the price was increased for certain items in the inventory that the retailer could get more money for, perhaps because his competition offered the items for more or perhaps because he had no competition on those items.

When you mark up an item in your inventory, you remove the old price ticket and put on a new price ticket that shows a higher selling price. Think about this. You are not changing the cost price of the item—you still paid whatever you paid for it—you are just increasing the selling price by whatever amount you determine you can get for it.

You then calculate one of the most basic formulas in retail—cost plus markup equals selling price.

Under the retail method, the selling price of an item is always 100 percent. You can express both “cost” (the amount you pay for an item) and “markup” (the amount by which you increase the price to cover your expenses and your profit) as a percentage of the “selling price.”

The ability to take markups is an important advantage of using the retail method in your accounting instead of a cost method. Although you can take a “markdown” and reduce the price of an item under either method, you cannot legally take a markup on existing inventory if you use the cost method.

Adding these three figures on our monthly maintained margin report, you come up with a number called “inventory to be accounted for.” In our sample, this is $37,000 at cost and $87,000 at selling price. In theory, if you were to add up the price tickets on all of the items in your store’s inventory in this classification, they would total this number.

Next, you want to calculate your markup on inventory for the classification. The formula for calculating your markup on inventory is a two-step process. First you calculate the profit:

Then you calculate the markup on inventory:

Once you know the markup on inventory, you need to determine if you maintained that markup during the month by calculating your “maintained margin.” You start by listing your gross sales and subtracting any returns you have from customers to calculate net sales. In our sample, this is $21,000 in gross sales minus $1,000 in returns, leaving $20,000 in net sales. Net sales should be your largest inventory reduction.

Some retailers group the next four items into one line, but I recommend that you track them separately. Doing so will let you manage your inventory more effectively and make more-informed buying decisions.

The first line—allowance—includes items for which you reduced the price. An allowance sometimes has more descriptive names such as “scratch-and-dent” or “missing button.” For example, suppose a customer comes up to your counter and says, “I want to buy this sweater but it has a missing button.” In order to save the sale, you say something like, “Sorry about that. What if I take $5 off the price to compensate you for having to replace the button?”

You can help encourage the sale of certain items in your store by decreasing the price of items that are not selling. This is called taking a “markdown.” You should take two kinds of markdowns in your business: regular markdowns and promotional markdowns. I talk more about markdowns in Chapter 12.

“Employee discounts” are the price reductions you may offer to people who work in your store. Offering these discounts will let your sales associates try products themselves to gain crucial product knowledge that they can use in their selling.

Both the United States and Canada will let you reserve 1 percent of your net sales against “shrinkage.” This is the difference between the book value of the inventory that should be in your store and the actual physical inventory that you have in your store. Shrinkage occurs when someone steals an item from your store, or you make a counting or paperwork error. You can reserve more than 1 percent for shrinkage if you have historical proof that shrinkage is higher than that.

On the monthly maintained margin report, you can next see the calculation for the total inventory reductions for the period. This represents the selling-price value that left the store. In the sample, the figure was $24,700 for the month.

Next, you calculate how much the merchandise sold cost you. The formula for cost as a percentage of selling price is cost equals selling price minus markup on inventory. Here is the calculation:

The “cost of goods sold” is the total inventory reductions for the period times the cost as a percentage. In the sample, this is $24,700.00 times 42.5 percent equals $10,497.50.

To calculate your “monthly maintained margin,” you use the formula net sales minus cost of goods sold equals monthly maintained margin. Here is the calculation based on our sample report:

To determine your monthly maintained margin as a percentage, use the formula monthly maintained margin divided by net sales. Here is the calculation based on our sample report:

You can see that in the sample monthly maintained margin report, an initial 57.5% markup on inventory eroded into a 47.5% maintained margin due to the allowances and discounts that were given and the markdowns that were taken. If the breakeven point for this business was 35 percent, however, this would show a net profit of 12.5 percent and we would be very happy retailers.

The final step on the monthly maintained margin report is to reset your inventory for the next month. In the sample, I show the beginning inventory at $37,000.00 at cost and subtract the $10,497.50 cost of goods sold for the period. This gives you the “total inventory to be accounted for at the end of the period,” which is $26,502.50 at cost.

Then you take the $87,000.00, which was the beginning selling price, and subtract the $24,700.00 cost of goods sold for the period at selling price. This also gives you the “total inventory to be accounted for at the end of the period,” which is $62,300.00 at selling price.

Finally, you calculate your markup on inventory using the same formula as before. You may recall that this is selling price minus cost equals profit divided by selling price. Your inventory always resets to the same markup on inventory that you had at the start of the period. If it does not, you did something wrong, because the retail method always accounts for a loss in the month in which it occurs.

The difference between your markup on inventory and your breakeven point tells you how much “room” you have to keep your inventory current by taking markdowns. If your markup on inventory is 57.5 percent and your breakeven point is 35.0 percent, you have some room to take markdowns and clear out old inventory. But if your markup on inventory is 57.5 percent and your breakeven point is 55.8 percent, you have very little room. The problem is, if you do not take markdowns and clear out old inventory, it will become “older and moldier” and worth even less.

At the end of every accounting period, you want to have a summary of how well your business is doing. Two key financial statements help you do that—the profit and loss (income) statement and the balance sheet. Let’s take a closer look of what each one includes.

A profit and loss statement summarizes all the financial activity in your business during a particular accounting period. Here is a sample profit and loss statement with a brief explanation of each line item:

If you are not familiar with the retail business, this net profit figure may come as a surprise. Like many people, you may have had a vague notion that retailers simply double the wholesale price of an item and pocket the difference.

In reality, as you can see in this typical profit and loss statement, a retailer today makes much less. In this sample, a retailer who took in net sales of $800,000 made a net profit of only $20,000 or 2.5 percent of sales. This doesn’t mean that there’s no opportunity for you to get seriously profitable. However, to get your profits higher, you will either need to sell more or reduce your expenses.

The balance sheet is a snapshot of the assets (everything owned by the business), liabilities (everything owed by the business), and equity (claims against assets by the business owners). It’s like taking a picture of your company’s financial condition on one particular date.

Here is a sample format for a balance sheet for ABC Retailer:

You’ll note that the balance sheet is broken up into five sections: current assets (everything your company owns that you expect to use in your business over the next 12 months); current liabilities (everything you owe that must be paid in the next 12 months); long-term assets (everything you own that has a lifespan of more than 12 months); long-term liabilities (everything you owe for which you have more than 12 months to pay); and equity (everything you or other company owners have put into the business).

Current assets include cash, inventory, accounts receivable, and any other holding that you have that you expect to use in the next 12 months. Some companies will buy Certificates of Deposit or other marketable securities to put their extra cash into until they need it, so it can earn additional money. The balance sheet would show those holdings in the current assets section as well. Accounts receivable is the account where you track any sales you have made to customers on credit.

Current liabilities include accounts payable, notes payable, and taxes payable, as well as any other line items that represent things your company owes over the next 12 months. Accounts payable is where you track any vendors’ bills that you have not yet paid. Notes payable are payments on long-term notes that will be due in the next 12 months (such as 12 months of payments on a mortgage). Taxes payable is where you track taxes that need to be paid, which can include sales taxes and payroll taxes, as well as other taxes you owe a state, local, or federal entity. Taxes for which your business is liable vary from state to state, as well as by type of business. Also, if you incorporate your business, you’ll have to pay corporate taxes.

Long-term assets include anything you own that you expect you’ll still have at the end of the business year. This includes any land your business sits on, the buildings you own or lease, any vehicles you own, etc. A new business also usually has an account called “organization costs.” These are costs that you incurred to start up your business that you cannot write off in the first year, such as special licenses and legal fees. Check with your accountant to find out what initial expenses can be charged against the business in the first year and what expenses need to be written off over a number of years.

Long-term liabilities are loans that will be due beyond the next 12 months. The equity section shows any money put into the business by you or anyone who has invested in the business. After the first year, you’ll also add an account called “retained earnings.” This account is used to track any profits that you keep in the business to finance future growth plans.

Now that you know what financial information is important for you to keep track of in your business, it’s time to tackle the hard part—setting up your business books to track all your numbers. Yes—that’s accounting. Many business people think about it as a tedious task and save it for last.

But don’t do that. In fact, you have some key accounting decisions you must make before you spend or take in your first dollar. You must decide whether you want to operate your business on a cash or accrual basis. You must set up your chart of accounts (list of all active accounts) and you must decide whether or not to computerize your books. I can’t imagine operating a retail store without computerized accounting.

Cash-basis accounting is based on how cash flows into and out of your business. When you use this type of accounting, you record your transactions only when cash actually changes hands. Accrual accounting is based on when the transaction actually happens, even if cash has not yet changed hands. For example, if you are selling items using a cash-basis accounting system, you would not record the sale until the customer actually pays cash for the item, even if he took it out of the store and promised to pay for it next week. Hope you wouldn’t offer that option to your customers too often if you use cash-basis accounting. You’ll quickly lose your shirt.

In fact, if you do plan to sell items on credit, you should definitely use an accrual accounting system. In that system, when the customer bought the item on credit and took it out of the store, you would consider that a completed transaction even though you had not yet received payment. You would record this transaction in your accounts receivable account. When the customer actually pays the bill you would then subtract the amount due from the accounts receivable account and add the money received to your cash account.

You can start your business using cash-basis accounting, which is simpler to manage than accrual accounting. But after you start selling on credit or as your business grows, you will find you have a much better handle on your business’s financial transactions using accrual accounting.

While you likely will not be able to afford having an accountant on staff as you start up your business, you should definitely sit down with an accountant to set up your accounting system. Many businesses will keep an accountant on retainer and have him check the books monthly, quarterly, or yearly. Accountants provide a good, objective eye to how your business is going and what financial management changes may be needed to keep the business profitable.

Now that you know how to gather the numbers in useable reports, you’ll need to know how to analyze your results. I discuss that in Chapters 23 and 24.