Chapter TwelveSmall Business Accounting Projecting and Evalua.docx

Chapter Twelve
Small Business Accounting: Projecting and Evaluating
Performance
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Why Accounting Is Important for Small Business Success
There are several reasons.
You must provide specific accounting information in order for
investors to consider funding your concept.
Bankers require formal financial statements for any type of
loan.
You cannot fully know your business without accounting
information.
Planning and controlling require accounting information.
There are three types of accounting you will need in your
business.
Financial accounting is formal, rule-based accounting
principles.
Managerial accounting is intended for planning, directing, and
controlling a business.
Tax accounting is based on governmental requirements.
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Financial Accounting
Financial accounting is based on a set of rules called generally
accepted accounting principles (GAAP) and reports:
How profitable the business is.
The value of the firm’s assets and who has claim to that value.
How much and from where money was received and how much
and to whom money was paid.
These three financial reports are called the:
Income statement.
Balance sheet.
Statement of cash flows.
Each report contains information on things that have already
happened.
Financial accounting does not have a lot of value for running
the day-to-day activities of a business.
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Managerial Accounting
Managerial accounting is forward-looking where financial
accounting is concerned only with the past.
There are no formal rules with the only issue being what is
valuable.
One of the most valuable functions of managerial accounting is
planning for future business activities.
This is done through standard budgeting or profit planning.
This method of organizing and formatting business planning is
called pro forma financial statements.
The result is a detailed plan for future operations and is the
standard against which actual results are compared to assess
performance.

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Tax Accounting
Tax accounting follows the tax laws and regulations.
The final product is a set of returns, forms, and schedules.
There are many different business taxes including:
Federal income tax.
State income tax.
Employment taxes.
Inventory tax.
Excise taxes.
Various use taxes including sales tax and, in some countries,
value-added tax.
The primary value of tax accounting is to avoid penalties for
non-compliance and to legally minimize tax payments.
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The Concepts That Make Accounting Work
The assumptions that underlie accounting are very basic.
A business is an entity that is separate from its owners –
business entity concept.
An operating business will continue in business – going concern
concept.
Accounting information is valuable only if it is useful for the
owners and managers of the business.
Creditors (lenders and suppliers) have claim on business assets
that must be satisfied before any claim of an owner.
The claims of creditors and owners cannot be greater in total
than the asset value of a business – called the accounting
equation.

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The Accounting Equation
Assets = Liabilities + Owners’ equity
If a business is an entity existing apart from its owners, then the
value of the business is the sum of the values of everything the
business owns.
The name for what a business owns is asset.
Owners do not own the assets, the business itself owns them.
The owners have a claim on the assets of the business and this
claim is called owner’s equity.
Courtesy of Natalie Gamez Meyer
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The Balance Sheet
The balance sheet entry to report the equity transaction between
the owner and Red Jett Sweets would look like this.
Liabilities are legally enforceable future obligations.
Total assets ($73,000) is exactly equal to the sum of the claims
of the creditors and the owners.
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Cost, Revenues, and Expenses
Red Jett purchases raw materials for $2,040 on account, then

bakes and sells 3,000 cupcakes at $2.75 each on account.
No cash changes hands.
Red Jett incurred an expense, called cost of goods sold of
$2,040 and realized a revenue of $8,250.
The difference between the revenue and the expense is a profit
of $6,210, reported on the balance sheet as retained earnings.
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Red Jett Sweets – February Balance Sheet
Red Jett collects the invoice due and pays the bill it owes.
Imagine a year’s worth of such transactions.
Rather than enter this on the balance sheet, create an account.
Permanent accounts are those other than revenue and expense
accounts.
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Why Do Accounting?
To produce information useful for managing the business.
The information must be accurate and relevant to be useful.
Improve accuracy by using an accounting program.
Relevance must be evaluated for each decision as it is made.
To meet legal or contractual requirements.
You own a buffalo wings restaurant and wish to purchase a
$25,000 high-capacity fryer.
You may save $1,000 a month on your lowered electricity bill
and lowered insurance premiums.
You also consider the increased number of people you could

serve.
Your accountant would depreciate the fryer using the MACRS
rate, allowing you to claim a depreciation expense each year.
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Accounting Systems for Small Business
There are many software solutions but the chosen system should
perform the following tasks.
User-friendly interface.
A thorough help function.
Produce an income statement using appropriate categories.
Produce a classified balance sheet clearly showing position.
Help develop a cash budget.
Help develop operating, and investment budgets.
Produce statements in approved formats.
Produce multiple-year comparisons.
Provide custom reports.
Export data in a form acceptable to tax programs.
Maintain an internal “audit trail.”
Enforce security measures.
Allow for growth of the business.
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Setting Up an Accounting System
One essential element of an accounting system is cash
accounting that is accurate, easy to use, and tracks all checks
and all deposits.
These accounting functions will become important as your firm
grows.
Accounts receivable if you provide credit to customers.

Accounts payable tracks what you owe.
Payroll records to ensure taxes are kept current.
Fixed asset accounting calculates and accumulates depreciation.
Inventory accounting maintains and aids inventory levels.
Credit card sales tracks discounts and chargebacks.
Insurance register keeps insurance coverage current and in
force.
Investment records if you invest surplus cash in securities.
Leasehold records if your have leased property or equipment.
Setting up your system can be outsourced to consultants.
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Financial Reports
There are six common financial statements.
Income statement – records debits/withdrawals, like your debit
card.
Statement of comprehensive income – if you have financial
derivatives.
Statement of retained earnings – incorporated into balance
sheet.
Statement of owner’s equity – incorporated into balance sheet.
Balance sheet – what you own and its worth, and what you owe
others.
Cash flow statement – the exact amount of cash right now.
Your monthly bank statement parallels the retained earnings
statement.
The important thing about these financial statements is that they
articulate information flows from the income statement through
the balance sheet to the cash flow statement.
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Income Statement
The income statement is the primary source of information
about a business’s profitability.
Revenues – Expenses = Net Income
There are two formats – a single-step and a multiple-step
format.
Two difficulties in understanding the statement.
First, what is reported as revenue.
Second, when to recognize revenues.
Similar problems arise in the timing of gains, losses, and
expenses.
Yet the income statement reliably reports how well a business is
producing profits.
The income statement is used to analyze the effectiveness of
business operations.
Operating income is the most used item on the statement.
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Figure 12.4A and Figure 12.4B
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Balance Sheet
The balance sheet presents a “snapshot” of financial holdings
and liabilities on a specified date.
Usefulness is determined by the detail it includes.
Balance sheet information is used to determine liquidity,

financial flexibility, and financial strength of the business.
Liquidity measures the time before an asset can be converted to
cash, and the expected time before a liability must be paid.
The most common ratio to estimate liquidity is the current ratio
or dividing the value of current assets by the value of current
liabilities.
Financial flexibility indicates a firm’s ability to manage cash
flows.
A firm’s financial strength is a matter of informed judgment.
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Figure 12.6: Typical Balance Sheet
Problems interpreting balance sheet information.
All values are historical so the cost is less than current value.
Every balance sheet contains estimated amounts, which may be
wrong.
Certain assets and liabilities are omitted.
Despite there problems, the balance sheet supplies essential
information for outside investors.
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Cash Flow Statement
Cash flow statements are either direct or indirect statements.
A direct statement is developed solely from the cash records.
The indirect statement of cash flows starts with net income and
adjusts accruals and deferrals to easily reconcile to other
statements.
There are six items that must be reported in the statement of

cash flows.
Cash flows from operating activities.
Cash flows from investing activities.
Cash flows from financing activities.
Net effect of foreign exchange rates.
Net change in cash balance during the period.
Noncash investing and financing activities.
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Red Jett Sweets – Statement of Cash Flows
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Uses of Financial Accounting
Reporting to outsiders.
Absentee owners, creditors and lenders, unions, and taxing and
regulatory agencies have an interest in the conduct of your
business.
Record keeping.
Criteria: simplicity, accuracy, timeliness, understandability,
security.
Taxation.
Employers withhold: FICA, Medicare, FUTA and disperse W2s.
Control of receivables.
The key is to have account receivables aged.
Analysis of business operations.
Items that appear unrealistic should be carefully examined.

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Uses of Managerial Accounting
Managerial accounting is based on understanding how costs
change as a result of business changes.
External (cost) factors are aspects outside the business that
could cause the business costs to change.
Internal (cost) factors are those aspects or choices within the
business that could cause the business’s costs to change.
There are two managerial accounting procedures that depend on
being able to forecast future revenue and expenses.
Cost-volume-profit analysis.
The budget cycle process.
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Managerial Accounting: Cost-Volume-Profit Analysis
This analysis sorts costs into two categories: variable costs and
fixed costs, with the resulting total cost the sum of the two.
Breakeven (in units) = Fixed cost/(Price/unit – Variable
cost/unit).
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Figure 12.9: Cost-Volume-Profit Graph for Red Jett Sweets
Extending breakeven, find the level of sales necessary for any
profit.
Unit sales for specific $ = (Fixed cost + Desired

profit)/Contribution margin.
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Preparing Pro Forma Financial Statements for Your Business
Plan
Achieving your strategic goals requires a quantitative plan of
action, called a budget – A standard against which performance
is measured.
Budgeting provides an organized and consistent platform for
providing necessary information for effective management.
The first step in budgeting depends on where you are in your
business.
An established firm starts with a sales forecast.
If in the early stages of business planning, first forecast
expenses, then return to the sales forecast using various sales
volumes.
You need a set of pro forma statements that are consistent,
accurate, and easy to modify as you business plan evolves.
Develop a “master” budget from basic inputs then add detailed
item budgets and finally a pro forma budget plan.
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Figure 12.10: Budgeting Relationships

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The Sales Budget
The first step in preparing a master budget is to prepare a sales
budget.
All the numbers, both in an initial business plan and in later
budgets, are based on estimates.
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The Purchases Budget
Once sales are projected, the next step is to plan for inventory
purchases.
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The Cost of Goods Sold Budget
The business plan states that all unsold cupcakes are donated at
the end of the day.
The budget is simply the number of cupcakes to be made
multiplied by variable cost per cupcake.
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The Inventory Budget
An inventory budget combines a purchases budget with a cost of
goods sold budget.
Done to simplify the budget process.
But when a business does not maintain significant inventories,
such as Red Jett Sweets, the budget is not needed.
Here, the only inventory is raw materials with negligible
amounts.
Managers decided the value of calculating the cost of goods
sold is less than the added complexity and expense the process
entails.
Also, the business plan says all materials will be purchased and
consumed within the same period making this budget
unnecessary.
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The Labor Budget
The labor budget shows both the amount and cost of labor
needed to meet output goals.
If you need to predict varying labor costs, first estimate labor
required for each unit of production, then multiply unit labor
cost times the number of units produced.
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The Selling, General, and Administrative Expense Budget
It is common to combine all costs of selling into a single SG&A

budget.
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Budgeted Income Statement
The budgets completed to this point can be combined into a pro
forma budgeted income statement.
During the year, comparisons of actual results are made to the
budgeted items. ‘
If the budget is met, the projected profit is realized.
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Completing a Comprehensive Budget and Controlling
The final schedules to be completed to produce a master budget
are:
A cash receipts budget.
A cash disbursements budget.
And a cash budget.
From these, a pro forma cash flow statement and a pro forma
projected balance sheet are prepared.
The difference between actual and budget is called a variance.
Variance analysis is simple in concept but complex in
execution.
Variances occur either because prices are different than
estimated, or quantities are different than estimated.
Variances can be constructed to show two things: the effect of
changes in prices and the effect of changes in the quantity used
or produced.

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Decision Making
The primary purpose of managerial accounting is to support
good decision making.
Accounting has two basic methodologies to simplify decision-
making on investments.
The differential revenues and expenses method estimates
changes from results.
There is also net present value (NPV) analysis which only
considers cash flows.
Outsourcing requires a decision be made whether the business
should make a component of its own product or purchase the
component from another business.
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End of main content.
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Accessibility Content: Text Alternatives for Images

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The Accounting Equation – Text Alternative
This illustration provides a visual for the concept of owner’s
equity and contains two graphics.
The first graphic is an open box labeled “The Business Red Jett
Sweets, Inc.” and the box holds $50,000 of cash.
The second graphic is a female who is now holding the box
labeled “Owner.”
Return to parent-slide containing image.
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The Balance Sheet – Text Alternative
There are two images on the slide, both are related to the
balance sheet for Red Jett Sweets out of Fort Worth, Texas.
The top image shows a single balance sheet entry for $50,000 of
owner’s equity. The same amount is entered into Assets as
Cash and on other side of the balance sheet, into Owner’s
Equity as Common Stock.
The bottom image shows a balance sheet for the company dated
January 31, 2011 and contains the following entries.
On the assets side of the balance sheet, current assets of cash
total $41,500. Long-term assets include two entries: Bakery
equipment for $2,500 and Mobile food truck for $29,000, for a
total of long-term assets of $31,500. Total assets are $73,000.
On the liabilities side of the balance sheet, current liabilities are
zero and long-term liabilities total $23,000 reflecting the long-
term loan for the food truck purchase. Owner’s equity includes
common stock in the value of $50,000 for a total liabilities and
equity of $73,000.

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Cost, Revenues, and Expenses – Text Alternative
This image depicts Red Jett Sweets’ balance sheet of January
31, 2011.
The assets include current assets and long-term assets. Current
assets include cash of $41,500 and accounts receivable of
$8,250 for total current assets of $49,750. Long-term assets
include bakery equipment of $2,500 and mobile food truck for
$29,000 for a total of long-term assets of $31,500. This makes
total assets equal $81,250.
On the liabilities side of the balance sheet lie current liabilities,
long-term liabilities, and owners’ equity. Current liabilities
consist of accounts payable in the amount of $2,040 and long-
term liabilities consist of $23,000 for total liabilities of
$35,040. Owners’ equity is reflected in $50,000 of common
stock and $6,210 in retained earnings for total equity of
$56,210. This brings total liabilities and equity to $81,250.
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Red Jett Sweets – February Balance Sheet – Text Alternative
This balance sheet for February 28, 2011 reflects that Red Jett
Sweets collected the money owed to them and paid their
outstanding bill.
Here, the current assets are cash of $41,500 plus invoice
collected of $8,250 minus the bill paid of $2,040 for total cash
of $47,710. Accounts receivable and inventory equal zero for
total current assets of $47,710. Long-term assets include
bakery equipment of $2,500 and the mobile food truck of

$29,000 for total assets of $79,210.
On the liabilities side, accounts payable now equal zero and
long-term liabilities still stand at $23,000 for total liabilities of
$23,000. Owners’ equity includes common stock of $50,000
and retained earnings of $6,210 for total liabilities and equity of
$79,210.
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Figure 12.4A and Figure 12.4B – Text Alternative
There are two graphics, both are income statements for year
ending December 31, 2011 for Red Jett Sweets. The first is a
typical single-step format income statement and the second is a
multiple-step income statement which specifically states gross
margin, marketing, advertising and cost of selling, and
operating income.
The single-step income statement shows revenues and gains as a
single entry, Sales revenue, totaling $48,379. The expenses and
losses category consists of three entries: cost of goods sold at
$15,164; sales, general, and administrative at $50,218, and
provision for income tax at zero. This provides a total net
income of negative $17,003.
The second image is the multiple-step income statement. The
Revenues and gains section includes two entries: Sales revenue
at $48,379, less fees, spoilage, and sales tax collected of
$4,162. This provides a Net sales revenue of $44,217 less cost
of goods sold of $11,002, provides a gross margin of $33,215.
Next, the Sales, general and administrative expenses are listed
as follows: Salaries and wages of $26,149; Rent of $8,290;
website, telephone, marketing at $4,520; transportation at
$2,403; insurance at $2,000; research and recipe development at
$2,188; legal and accounting at $3,088, and depreciation
expense at $1,580. This provides a total for sales, general, and

administrative expenses of $50,218. Subtracting this amount
from the gross margin provides and operating income of
negative $17,003 and since the provision for income taxes
equals zero, the final net income is negative $17,003.
Return to parent-slide containing images.
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Figure 12.6: Typical Balance Sheet – Text Alternative
This balance sheet for Red Jett Sweets is dated January 31,
2011.
On the Assets side of the balance sheet, current assets are cash
of $41,500, plus invoice collected of $8,250, less bill paid of
$2,040 brings the total cash to $47,710. Accounts receivable
and inventory are both zero so total current assets are $47,710.
Long-term assets include bakery equipment of $2,500 and the
mobile food truck of $29,000 for a total of long-term assets in
the amount of $31,500. This brings total assets to $79,210.
On the liabilities side of the balance sheet, current liabilities
(Accounts payable) is zero. Long-term liabilities is one entry,
the long-term loan of $23,000, making total liabilities $23,000.
In the owner’s equity section, there are two entries: common
stock of $50,000 and retained earnings of $6,210, bringing total
equity to $56,210. Combining total liabilities and equity equals
$79,210.
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Red Jett Sweets – Statement of Cash Flows – Text Alternative
This statement of cash flows is for the month of January 2011.
The first section is the cash flows from operations and the

statement begins with cash received from customers in the
amount of $424. Next is the cash paid to vendors, broken down
into: credit card providers with a zero balance; sales tax paid to
Texas $30; raw materials used in production $99; salaries and
wages $480; payroll taxes/benefits $42; rent $420; website and
marketing $1,900; telephone $310; transportation $0; insurance
$167; research and recipe development $313; and legal and
accounting $2,703 for total cash flows from operations negative
$6,039.
The second image includes the remaining sections of the
statement of cash flows and begins cash flow from investing
activities which contains one entry: purchase of equipment for a
negative $31,500. The final section is cash flow from financing
activities and this section has the following entries: investment
by owners $50,000; cash received from borrowing $0; and cash
paid on loans $0, making the net cash flow from long-term
financing activities $50,000. With beginning cash equaling
zero and a net cash increase of $12,461, gives an ending cash
balance of $12,461.
Return to parent-slide containing images.
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Managerial Accounting: Cost-Volume-Profit Analysis – Text
Alternative
This image depicts the computation of the breakeven analysis
for Red Jett Sweets. Each line progresses the analysis.
At breakeven, revenue exactly equals total costs, thus: revenue
equals variable cost plus fixed cost.
So, units sold multiplied by price ($2.75) equals units sold
multiplied by variable cost per unit ($0.68) plus fixed cost.
Next, subtract units sold multiplied by variable cost from both
sides to equal fixed cost of $6,750.
Simplifying the equation leads to units sold multiplied by the

difference of $2.75 minus $0.68 equals $6,750.
So, units sold multiplied by $2.07 equals $6,750.
Simplifying again gives you units sold equals $6,750 divided by
$2.07.
Units sold at breakeven becomes 3,261 cupcakes.
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Figure 12.9: Cost-Volume-Profit Graph for Red Jett Sweets –
Text Alternative
This line graph depicts Red Jett Sweets’ revenue in $2,000
increments, starting at zero and ending at $18,000 on the
vertical axis. The horizontal axis depicts numbers of cupcakes
sold in 1,000 unit increments, starting at zero and ending at
7,000.
Fixed cost is depicted as a solid horizontal dark blue line falling
between the $6,000 and $8,000 amount, as fixed costs are
$6,750.
Total revenues is a light blue line extending from zero rising
steadily to a bit over the $16,000 profit line. The total cost line
is an orange line starting at the fixed cost line ($6,750) and
rises steadily to between the $10,000 and $12,000 profit range.
The difference between the total revenue line and total cost line
is either a loss or a profit. The point where they intersect is the
breakeven point, here, at $8,968 in revenue and 3,261 units
sold. Anything falling to the left of the intersection is a loss
and anything falling to the right of the intersection is a profit.
One final line on this graph reflects how many units need to be
sold to make $1,000 profit. Simply increase the breakeven
revenue line by $1,000 and extend the line out until it cross the
light blue, total revenues line, then drop that intersection down
to the needed units to make that $1,000 profit, which appears to
be below 4,000.

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Figure 12.10: Budgeting Relationships – Text Alternative
The flow chart depicts many relationships between various
business functions and the end result, the pro forma financial
statements.
The sales forecast directly relates to the pro forma income
statement, but also indirectly relates to the same statement by
affecting the assumptions that go into purchases and production
budgets and expense budgets.
Another item is the assumptions of cost behaviors, inventory
levels, receivables and payables, which relate to the purchases
and production budgets, expense budgets, and all the pro forma
statements. These assumptions are in turn affected by the sales
forecast and the beginning balance sheet items.
The beginning balance sheet items affect assumptions,
purchases and production budgets, expense budgets, and the pro
forma income statement.
Capital spending relates to capital budgeting and long-term
borrowing, which relates to the expense budget and all the pro
forma statements.
Cash and short-term borrowing directly affect the pro form
balance sheet and statement of cash flows.
In turn, the pro forma income statement relates to the pro forma
balance sheet, which then relates to the pro forma statement of
cash flows.
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The Sales Budget – Text Alternative
This table shows the fourth quarter budget for Red Jett Sweets,
showing monthly breakdowns for October, November, and
December; quarter four totals and finally a column for January
numbers.
The budget includes all revenues resulting in gross sales, less
three expenses to product net sales revenue.
Revenues list unit sales, sales price, cash sales and credit card
sales. The three expenses include credit card fees, spoilage and
over production, and sales tax collected.
Budgeted revenues for October, November and December are
the same: 2,983 unit sales at the price $2.94, equally split
between cash sales and credit card sales for total gross sales
each month of $8,778.
The same is true for expense, each month with having the same
$88 credit card fees charge, $61 in spoilage and over
production, and $615 in sales tax collected.
Fourth quarter totals are $26,334 in gross sales and $24,042 in
net sales revenue.
The January projections are nearly the same, with slightly
higher numbers for both revenues and expenses.
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The Purchases Budget – Text Alternative
The purchases budget for Red Jett Sweets covers the months of
October, November, and December, and provides quarter four
totals as well as projections on three items into January.
Unit sales for each of the three months is 2,983, for a total of
8,949 for the quarter. January unit sales are marked as 3,000.
The raw materials per unit price remains the same through all
three months and into January at $0.68.
Materials needed for production is the same for the three

months at $2,028 for a quarterly total of $6,085. January
projection is $2,04.
The budget now adds in desired ending inventory which is $406
for the months of October and November and $408 in
December.
The materials needed for production and the desired ending
inventory are added together to obtain the materials required for
each month, which are $2,434 in October, $2,397 in November,
and $2,252 in December for a total in quarter four of $6,309.
Subtracted from the materials required each month is beginning
inventory of $406 which leaves the final amount of inventory to
be purchased. This amount is $2,028 for each of the three
months for a quarterly total of $6,087.
Note that the materials required amount needed each month is
the sum of the amount for production plus desired ending
inventory.
Note also that there is a $406 worth of inventory on hand at the
beginning of October. This amount does not have to be
purchased.
Also note that November’s ending inventory is December’s
beginning inventory.
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The Cost of Goods Sold Budget – Text Alternative
The budget shows unit sales for each of the three months in the
quarter and totals for the quarter. Each month’s unit sales are
2,983 for a quarter total of 8,949.
The unit cost of goods sold each month is $0.68.
The total cost of goods sold is the result of multiplying these
two numbers to produce $2,028 per month for a quarter total of
$6,085.

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The Labor Budget – Text Alternative
The labor budget for Red Jett Sweets’ fourth quarter lists the
salaries and wages and the total cost for those salaries and
wages for the months October, November, and December and
provides totals for the fourth quarter.
The salary and wages total for each month is $4,141 for a
quarterly total of $12,423.
The total cost of salaries and wages is the same for each month
and for the quarterly total.
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The Selling, General, and Administrative Expense Budget –
Text Alternative
The table shows amounts for nine expenses for each of the three
months in the quarter – October, November, and December – as
well as quarter totals.
The expenses are salaries and wages at $4,141 per month for a
quarterly total of $12,423.
The payroll taxes/benefits expense is $358 per month, totaling
$1,074.
Rent expense is $1,000 each month for a $3,000 total quarterly
amount.
Website and marketing is $100 per month and a $300 quarterly
total.
Telephone expense is $110 each month and $330 for the quarter.
Transportation is $343 per month, for a total of $1,030.
Insurance expense is $167 per month for a total quarterly

amount of $500.
Finally, the legal and accounting expense per month is $316 and
has a quarterly total of $948.
The monthly total selling, general, and administrative expenses
are $6,570 for each of the three months and total $19,710 for
the quarter.
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Budgeted Income Statement – Text Alternative
The table shows totals for each month of the quarter – October,
November, and December – as well as quarterly totals.
The statement begins with gross sales revenue of $8,778 for
each month, totaling $26,334 for the quarter.
From this amount is deducted the following monthly
adjustments: credit card fees, spoilage and over production, and
sales taxes collected to produce a net sales revenue less the cost
of goods sold provides a gross margin each month. The gross
margin for October and November is $5,985 and $6,174 for
December for a quarterly total of $18,145.
Sales, general, and administrative expenses ($6,570 per month)
are subtracted from these gross margins to produce net income
before taxes.
All totals for net income before taxes are in the negative.
October and November realize a negative net income of $585
and December sees a negative net income of $396. The
quarterly net income before taxes is negative $1,565.
‹#›
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Chapter Eleven
Small Business Pricing, Distribution, and Location
Pricing

Your fundamental goal should be setting the optimum price.
There are four key factors for determining an optimum price.
Demand for the product or service.
Value delivered to the customer.
Prices set by competing firms.
Your business strategy and product placement.
‹#›
The Fundamentals of Pricing: Margin Pricing
Markup pricing is likely the most widely used pricing method –
knowing your costs and the markup is a fundamental pricing
concept.
T-shirt cost $3.00.
Equipment, ink, time $2.50.
Marketing costs .50.
Selling price $20.00.
Your markup is $14.00.
As a percentage ($14.00/6.00) 233%.
Your margin ($14.00/20.00) 70%.
How many T-shirts do you need to sell if you need $541
sales/day to meet your magic number?
28 T-shirts a day.
‹#›
The Fundamentals of Pricing: Elasticity
If dropping the price increases sales, this is price elasticity.
Essential products with no substitutes are inelastic products.
Elastic products have many substitutes.
Here is where the law of supply and demand relates to business.
When supply is adequate, prices are stable.

If supply shrinks, prices go up.
If demand suddenly grows, prices are likely to go up.
Reasonable increases are expected, but beware of price gouging.
As an entrepreneur, you can adjust your prices based on supply
and demand, but also keep an eye on the competition.
To make elasticity work, keep in mind the value people see in
your product.
‹#›
Figure 11.1: Pricing Elasticity
‹#›
The Fundamentals of Pricing: Value
We know people will pay more for a product of quality or
stylishness or leading-edge technology, and your product can
have the same appeal.
Screaming Eagle wines deliberately limits its production of
high-end wine and sells each bottle for $850 through
subscription.
The extravagant price is part of what creates and maintains
demand.
In addition to demand and value provided, consider competitor
prices.
If you price below competitors, your revenue declines as a
percentage of total sales and competitors will likely drop their
prices to match you.
If you price higher than competitors without providing greater
perceived value, this can only lead to lower overall volume.

‹#›
The Fundamentals of Pricing: Contextual Factors
Your company objectives.
When starting out, maximizing profits is better than increasing
market share, as competing on price may lead to negative
growth.
Marketing strategy.
Your price must be consistent with your marketing strategy.
Channels of distribution.
Everyone who handles the product expects to make something,
which increases the price through price escalation.
Competition.
When comparing price, compare matches in product bundles.
Legal and regulatory issues.
Talk to your accountant and attorney for specific rules of your
product.
‹#›
The Pricing Toolbox: Pricing Psychology – How Customers
Perceive Prices
As a consumer, if your needs change, your willingness to pay
changes.
A consumer’s internal reference pricing is their own knowledge,
while their external reference pricing is gathered from other
sources.
Perception of value varies from person to person.
Expectations of future prices may be internal or external.
Consumers also have a price range of acceptability.
Setting a price somewhat above the competitive midpoint has a

psychological impact on buyers.
How you define your product determines your competitive
advantage and affects your price.
Customers attracted to low prices will not be loyal.
Customers will always pay more for a product/service that
stands out.
‹#›
The Pricing Toolbox: Pricing Strategies
Skimming charges the highest price the market will bear.
Prestige pricing is used for status symbol items, while premium
pricing is used for non-status symbol items.
Odd-even pricing just means a price ending with a 9, 7, or 5.
Partitioned pricing charges a base price plus extra for all
components, and captive pricing sells a base system at a low
cost then sets a high price for expendables.
Price lining attempts to appeal to several different markets.
Price lowering techniques include periodic discounting and
random discounting.
Another example is off-peak pricing.
Bundling offers a lower price for combination purchases.
A variation of this is selling multiple or bonus packs.
‹#›
Pricing Strategy Wrap-Up
Entrepreneurs agonize about price, but perhaps for the wrong
reason.
Owners figure a small business should have smaller prices, but
this thinking is dangerous and could lead to business failure.
Goal number one is to set the price as high as you think you

can, using your competition and customers’ responses as a
check.
If higher prices are working but sales have tapered off, consider
pursuing goal number two – use pricing strategies to drive sales.
The secret is in understanding the market, the cost of doing
business, and the prices your customers are willing to pay.
‹#›
Sales Promotions
Sales promotions are a form of communication that encourages
the customer to take immediate action.
Discounting techniques like coupons, rebates, discounts, buy-
one-get-one promotions, and regular sales.
Introductory techniques like giveaways, samples, and tastings
help introduce your offering to potential customers for future
purchase.
Contest techniques like sweepstakes, contests, and games
introduce your brand to customers without an immediate call to
purchase.
Loyalty techniques like a referral discount, social media likes,
and customer loyalty programs increase the stickiness of your
brand.
‹#›
Distribution
Distribution is the process of getting your product to the
customer.
Channels are important to your marketing strategy and profits.
They differ in number of intermediaries.
Each intermediary wants to make a profit.

As the manufacturer, you have the ability to set the
manufacturer’s suggested retail price.
Selling directly to consumers is called direct sales and is part of
direct marketing.
Due to the math of intermediaries, direct marketing is attractive.
Direct sales can be the most profitable way to make sales.
‹#›
Direct Marketing
Direct marketing is relatively inexpensive and provides control
over where your product goes, consumer information, product
use, and pricing.
Word of mouth.
Direct sales can take several forms – industrial, door-to-door,
party sales, vending.
Direct mail includes mail orders etc. and may use
microinventory or just-in-time (JIT) inventory.
Telemarketing and inbound telemarketing.
Direct response advertising has different costs for different
forms.
Guerrilla marketing is unusual and nearly free advertising.
Multichannel marketing uses several outlets to contact
customers.
‹#›
Distribution Issues for Direct Marketing
Even when shippers pay postage, you need to know the rates.
Charge a shipping and handling fee that includes postage and
packaging materials.
In addition to costs, you must pick which service to use – some

offer tracking and insurance, pickup and provide delivery times.
A wholesaler, retailer, and an agent are all intermediaries who
get the product to the end consumer for a percentage of the
profits.
Fulfillment centers warehouse the retailer’s products and ship
them and may service several retailers or e-tailers.
Try to determine which wholesalers or distributors are right for
you.
Attend trade shows to identify distributors.
Get your product listed in a catalog.
‹#›
International Strategies
Once a company has a website it becomes a born international.
Are we ready to export?
Direct exporting sells to foreign buyers but may get help from
freight forwarders.
Indirect exporting uses agents, export managers, or trading
companies.
Where should we go?
A safe bet is similar countries, like Canada.
Whom do we contact there?
There are many ways to make contact.
Use letters of credit or documentary drafts as ways of receiving
payment.
When importing, look for products selling well but not available
in the U.S.
When importing, paperwork and insurance details will be the
source’s responsibility.
Be sensitive to cultural differences.

‹#›
Location
Anyone can tell you the three most important things for your
business is “Location, location, location.”
The first choice is your hometown, convenient and familiar.
You have a banker, you know the market, and have customer
leads.
There may be compelling reasons to consider a different
location.
Your local business and zoning laws may be a hindrance.
The cost of doing business may be unfavorable – wage rates,
etc.
Your hometown may not hold your target customers.
You may needed skilled labor that is unavailable locally.
Your hometown may be appropriate, but remember that moving
a company is very costly – so plan ahead.
‹#›
Location – Service Firms
At the Client’s Location.
Typically house cleaning, pest control, remodeling, lawn
services, etc.
Headquarters can be a home office, which you may outgrow.
You will need reliable transportation and a central location.
Mutually Accessible Location.
Typically barbershops, dentist offices, and restaurants.
A service like watch repair could also be home-based.
Remote Location.
Typically medical transcription, data processing, fulfillment
centers, and some consulting work.
Meetings with clients face-to-face is infrequent.
Locations can be anywhere in the world.

‹#›
Location – Manufacturers
Where you make the product is really dependent on the product.
If no specialized equipment is needed, at home may work.
Zoning ordinances may prohibit manufacturing in residential
areas.
One trend is rentable manufacturing spaces.
Contract manufacturing might be a better option, for a while.
Sheltered workshops exist in most states and offer competitive
pricing, often with tax benefits for the business.
‹#›
Location – Site Selection
High Customer Contact Businesses.
Such as medical or legal offices, restaurants, dry cleaners, etc.
Select a site convenient to your target market.
Consider if there are traffic generators in the area.
Automobile traffic is another consideration, and parking.
Low Customer Contact Businesses.
Such as manufacturing, headquarters, or remote location
services.
Employee access is more critical than customer access.
Space in a business park may be appropriate.
Some cities offer empowerment zones, or use a business
incubator.
A variant of the incubator is an accelerator.
Some locales have co-working spaces available.

‹#›
Location – Leasing
A start-up rarely buys its first location as it is too expensive.
Start looking for a leased location and narrow your choices to a
few.
Some issues include: “as is” versus compliant property, HVAC,
and signage.
Other issues include: hidden charges, use of premises, non-
compete clauses, hours of operation, rent default, and moves or
remodels.
Prepare for the good and bad – if your business falters, you still
must pay the lease.
One way to handle early termination is subleasing.
Other ways include a bailout clause, a “cap” on paying rent, or
a co-tenancy clause.
All issues need to be negotiated at the start
‹#›
Location – Build, Buy, or Lease
Building has the advantage of a perfect layout in the perfect
location with street appeal, but it is costly and slow.
Buying a place shortens the time and may be cheaper, but any
needed remodeling may eat the savings away.
In both cases, business owners have an asset, a tax advantage,
and the flexibility to make changes and know their long-term
costs.
Leasing has a lower initial cash outlay and provide a deductible
business expense, but flexibility is limited and costs increase.
The issues of location and distribution are ones made only
occasionally.
Done right, managing the issues of location and distribution can

turn an average firm into a major success.
‹#›
Location – Layout
The layout of a potential site must be considered carefully.
Determine if the building setup is appropriate for your use.
Consider the amenities that are already there.
Check the exterior too, making sure everything meets code.
Once the building is selected, decide how to lay out the interior.
Layouts should eliminate unnecessary employee movement and
yet say something about who you are.
‹#›
Layout – Manufacturing
Generally, manufacturing processes are laid out in one of two
formats: production line layout and process layout.
‹#›
Layout – Retail Operations
There are two traditional layouts for retail operations: the grid
layout and free-form layout.

‹#›
End of main content.
www.mheducation.com
Accessibility Content: Text Alternatives for Images
‹#›
Figure 11.1: Pricing Elasticity – Text Alternative
These side-by-side supply and demand graphs show the demand
changes for elastic and inelastic products for different prices.
For both graphs, quantity is measured on the horizontal axis and
price on the vertical axis.
In the first graph, showing elastic T-shirt sales, when the price
is $20, sales are at one and when the price drops to $10, sales
double to two. A fifty percent increase in quantity.
In the second graph, showing inelastic gasoline sales, when the
price is $20, this pays for 150 miles of driving, but at $10 it
only pays for 200 miles of driving, a 25 percent increase in
quantity. This is half of elastic product’s increase.

‹#›
Layout – Manufacturing – Text Alternative
There are two layouts depicted – the production layout and the
process layout, both contained within a rectangular shape.
The production layout example shows receiving docks at the top
of the layout and three parallel work lines. Each work line has
five work stations with work passing from one station to the
next. At the bottom, or opposite end, of the layout is the
shipping docks.
In the process layout the same shape is broken into seven areas:
milling machines, drill presses, planing, assembly, painting,
packaging and shipping, and finishing process. Assembly takes
place in the middle of the space, surrounded by milling
machines, drill presses, planing, and painting. The packaging
and shipping section is located adjacent to the finishing
processes section.
‹#›
Layout – Retail Operations – Text Alternative
There are two layouts depicted – the production layout and the
process layout, both contained within a rectangular shape
showing the store front at the bottom of the depiction.
In the grid layout for a grocery store, along all sides are three
sections: the dairy section along the left-hand wall, the meat
section along the back wall and the produce section along the
right-hand wall. The middle section has three long rectangular
isles down the middle.
The free-form layout depicted here is just one example of any
number of combinations, this store is a clothing store. The two
back corners of the store are cut off diagonally and contain

shoes in one corner and belts in the other. The left wall holds
accessories and the right-hand wall is the underwear displays.
The very middle of the store has a sportswear section. The
remaining area contains four smaller rectangular sections, likely
racks, for shirts, jeans, and two racks of dresses.
‹#›
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