5.

1 How to control and manage expenses

Expenses are a cost of doing business, whether it is the expense of keeping the
lights on, paying your employees, or buying paper clips. Every expense needs to be
categorised and put into an account. These accounts are what is entered in to the
journal and are reflected on the income statement. These accounts are sorted into
broader categories that help the management team of anorganisation to see at a
glance where the money is going. The traditional broad categories are operating
expenses and administrative expenses, which is often referred to as overhead.
 Operating expenses are directly related to generating profit.

 Administrative expenses (overhead) are indirectly related to generating profit.

Expenses are usually classified by either their nature or their function, although it is possible
to classify them in other ways, such as by behaviour (that is variable costs and fixed costs),
by decision making, or by controllability. How it is done is relevant to the reason for
categorising expenses in the first place but, in reality, you wouldn’t normally put office
supplies in the same category as your utilities or wage expense. Making a relevant
classification for each item of expense is a building block to being able to monitor and
control your organisation’s expenses.Some examples of these classifications are:

Nature
Staff salaries
Marketing

Depreciation

Office supplies

Maintenance

Utilities

Function
Manufacturing

Administration

Research

Distribution

Behaviour
Fixed

Variable

Semi-variable

Decision making
Relevant

Irrelevant

Avoidable

Unavoidable

Opportunity

Controllability
Controllable

Uncontrollable

Module 5: Controlling and managing expenses

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Overhead expenses are those that can’t be readily identified with a specific product
activity. When classifying by function, these expenses usually include anything that
can’t be easily included in any of the other categories of expenses. Overhead is an
indirect and invisible part of producing a product or service. These expenses do not
directly generate profits.

They can include:

 Energy/utility costs – gas, water, electric

 Depreciation

 Marketing/sales expense – advertising,brochures, business cards,any cost

incurred to help increase sales

 Office expense – anything that has to do with the office, i.e. office supplies

 Rent (equipment & property) – rent paid for the use of the property or
equipment

 Transportation expense – cars, flights, fuel

 Personnel – salaries, wages, employee benefits

Some suggestions as to how you may control overhead costs are:

 Control energy costs – purchase energy efficient products, make sure
everyone is on the same page for minimal energy use. Making sure the lights get
turned off when not in use, and turn computers off at the end of the day.

 Accurate inventory counts – inaccuracies cost more, you may order additional
items that you don’t need or in a rush to satisfy a customer you may order the
wrong item. Overnight shipping and quick ship are also expensive outcomes for
not counting correctly.

 Evaluate insurance – consider all of your options, possible policy changes,

shop around for the best price.

 Renegotiate rent or interest rates – it is always worth the conversation to try

and lower your rent or interest rates.

This list includes everyday things that you and your team can do to help reduce
overhead costs. In the financial world there is an invaluable tool called a budget that
will make controlling your overhead costs fun. We really do mean that. Budgeting will
become your best friend. It will be there for you when times are great and when
things are a little harder. Through everything your budget will help you stay the
course and get your business to where you want it to be. Read on to find out how to
get started.
5.1.1 Budgeting
Budgeting has acquired a bad reputation over the years. While it is a valuable tool
that is an integral part of any business success, many new business owners disregard
it entirely. The reasons for this are varied but most often it is because people don’t
know where to start. So we will begin at the beginning.

A budget is a financial plan of future costs and revenues for a specific period of time.
We use budgets to compare expected costs with actual costs and identify problem
areas.

 Budgeting allows management to see a crisp hard picture of where they think
their business will be. Later the reporting of actual performance will show where it
actually went. This comparison between expectation and actuality is sometimes a
stark reality and other times it is a rosy picture. Either way, without first having
prepared a budget there would be nothing to compare.

 Budgets can be used to help control expenses by identifying where they are
out of control and plan future product levels to help increase sales to cover future
expenses identified in the budget.

 A budget compares apples to apples. Expenses are sorted into the appropriate
categories resulting in the ability to make a line by line comparison between
budgeted expenses and actual expenses.

There are a number of different types of budgets. Each one has its own uses and
benefits for an organisation. These are the principal budgets:

Master Budget
 Includes all subsidiary budgets

 Consists of budgeted profit and loss account and the budgeted balance sheet and
cash flow statement

 A manufacturing company would also include a manufacturing budget and budgeted

trading account.
Operating/Subsidiary/Ancillary Budgets included in the master budget
 Sales Budget

 Production Budget

 Production Cost Budget

 Raw Materials Budget

 Purchases Budget

 Labour Budget

 Production Overhead Budget

 Selling and Distribution Cost Budget

 Administration Cost Budget

 Capital Expenditure Budget

Objectives of a Completed Budget

 Planning – detailed plans relating to raw material requirements, production, labour
needs, research and development, advertising and sales promotion performance.
Anyfunction that has expenditure will be included in the budget.

 Coordination - Budgeting aids managers in coordinating their efforts so that

objectives of their divisionsharmonise with the objectives of the organisation as a whole.
Each department should be coordinating with each other to ensure the final budgets
from each department support the other departments and complete the big picture for
the organisation.

 Communication – A budget is a communication tool within itself. The approved

budget should be distributed to the various departments. Every person involved with the
implementation of the budget should be well versed in the content and what the budget
means to them and their responsibilities.

 Motivation – Encourages everyone to get involved and committed to achieving the

planned outcomes. Creating a budget together as a team is a great way for everyone to
take ownership in what happens in the organisation and get motivated to make it better.

 Control – Budgets help provide the guidelines for management to control the year’s
expenses and have everyone thinking the same way. Working as a team, it is possible for
everyone tocreate the budget, own the budget, adhere to the budget, and ultimately
control their expenses. Tracking the actual spending will provide a comparison against
the budget to see where the organisation can improve next month or next year.

 Performance Evaluation – A budget is a great benchmark for performance evaluation

particularly when a manager is responsible for communicating the information to their
department.

Advantages of a Budget
 The major strength of budgeting is that it coordinates activities across
departments and teams.

 Budgets translate strategic plans into action. They specify the resources,
revenues, and activities required to carry out the strategic plan for the coming
year.

 Budgets provide an excellent plan of organisational activities.

 Budgets improve communication with employees.

 Budgets improve resources allocation, because all requests are clarified and
justified.
 Budgets provide a tool for corrective action through reallocations.

You should have a good idea now of what a budget can do for you and your business.
When it comes to creating the right budget it is really all up to you and what your
organisation needs. Whether you create a complicated budget or embrace simplicity,
you are on your way to controlling your expenses.

Payroll is how an employer delivers remuneration to its workers. Payroll can come in a
variety of forms depending on the nature of the work and the worker. Understanding
the components of your payroll will help to reconcile your payroll.

Commission-based pay is payroll but is not the same as salaries and wages.
Commission based pay is remuneration that occurs after a specific requirement has
been met. For instance, a salesman meets a sales goal for the year. They would then
receive commission according to the terms of their employment agreement.

Salaries are delivered in a periodic payment of an agreed upon remuneration

amount. This amount is usually specified inanemployment agreement or contract.
Salaries are traditionally figured annually and then are spread out throughout the
year. It is a fixed amount of money that is paid in return for work performed.

Wages are monetary remuneration given in exchange for work done. Wages can be paid as a
fixed amount for each task completed, as an hourly rate, or as a daily rate.
Everytime you process payroll you record a payroll entry in your accounting system. If they
apply you will have accounts in the general ledger for things like commission, wages, taxes
and employer taxes. With all of the elements associated with payroll, it is imperative that you
keep good records.

 A payroll not only includes the pay for the employee but it also collects the
employee’s pay-as-you-earn (PAYE) taxes and also calculates any employer’s taxes that
may be due.

 Both of these tax amounts must be accounted for and recorded.

 Taxes withheld from payroll are usuallyremitted to the revenue authority on a

monthly basis.

 It is recommended that the money withheld immediately goes in to a separate bank

account from your regular business account. This will ensure that money owing to the
revenue authority will be there when it is due to be paid. The ramifications from not
paying these amounts when they are due is not pleasant.

Be sure to include everything that is included in payroll in your record keeping.

 Salaries

 Wages

 Commissions if applicable

 Employee PAYE taxes

 Employer taxes due

The largest portion of your payroll journal entry will be the salary and wage expense
with the inclusion of the payroll taxes.

5.3 Long-term asset acquisitions

Long-term assets are the organisation’s property, equipment and other capital
assets.The cost, or perhaps current value, of these assets, minus the depreciation of
each item, are included in the organisation’s balance sheet. Depreciation will be
covered a little later in this section. For now, we shall focus on identifying long term
assets and how they relate to your organisation. Long term assets can also be
identified as items that are expected to be held for longer than one calendar year.
Types of long term assets:
Long-term investments – securities or instruments that have a maturity date
greater than a year:
 Stocks

 Bonds

 Investment in another company

Property, Plant, and Equipment (PP&E) – includes all types of physical assets the
organisation uses in the generation of its income and are not intended for resale:
 Machines – construction equipment, forklifts etc.

 Buildings – administrative buildings, warehouses, show room buildings, stores.

 Factories – manufacturing plants, assembly line factories.

 Office equipment – large commercial copy machines, telephone systems, printers, fax
machines.

 Vehicles – salesmen’s cars, fleet vehicles, delivery trucks, work vans.

 Computers – desktops, laptops, netbooks, servers, large networking devices.

 Leasehold improvements – modifications made to a property while a company is

leasing it from another entity
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 Acquiring long term assets can be as simple as walking into a bank to

purchase a bond. Another example is when anorganisation buys land and then
erects a building on it. Subsequently any large items, such as air-conditioning
units, that are then placed in the building are each an asset. So the land is an
asset, the building is an asset, and the large items in the building are assets.
Anytime anorganisation purchases a large piece of equipment it is a long-term
asset acquisition. Whenever these events occur they must be recorded in the
general ledger in the respective accounts.

 Investing in long term assets can have great benefits for your business
portfolio and overall financial health. Choosing your investments wisely will
increase the chances of having positive gains from those investments. Positive
gains are the increase in value of your investments. Investing is another way
anorganisation can make a profit. It is advisableto make sure your business is
solvent and profitable before partaking in any risky investment behaviour.

5.3.1 Depreciation
Now that you have acquired your long term assets, what do you do with them after you have
acquired them? Besides the obvious answer of maintaining and taking care of them, there
are financial things you need to consider as well.
Depreciation is the method of allocating the cost of property, plant and equipment over its
useful life.

 You will need to follow generally accepted accounting principles for reporting the
costs of property, plant and equipment in your financial statements but there are a
number of methods you may choose to help you get to the end result.

 It is important to know that depreciation has nothing to do with market value of an

asset. Fair market value is the amount of money the organisation could receive when it
sells any or all of its assets.

There are several methods you can use to calculate the depreciation of an asset. For our
purposes in this module we will discuss just four of them. Three of these methods are based
on time. They arestraight-line depreciation, declining-balance depreciation, and sum-of-the-
year’s digits. The fourth and last method we will cover is based on the actual physical use of
the fixed asset. It is referred to asunits-of-production.

 Straight-line Depreciation – This method spreads the cost of the fixed asset
evenly over the whole of the asset’s useful life.

 Declining-balance Depreciation – This method is an accelerated method of

depreciation. It results in a higher depreciation expense in the earlier years of
ownership of the asset and the expense declines every year.

 Sum-of-the-year’s digits – In this method you compute depreciation

expense by adding all years of the fixed asset’s expected useful life and then
factoring in which year you are currently in, in relation to the total number of years
of expected useful life.

 Units-of-production – This method, generally only applied to plant and

equipment used in manufacturing,uses the total estimated number of units the
fixed asset will produce over its expected useful life as the basis for the calculation
of depreciation. This per unit amount is then applied to the number of units
produced in the current accounting period to calculate the depreciation expense.

Now that we have covered what each depreciation method is called and you have a basic
idea of how each one works, let’s look at some real numbers. The following examples will
illustrate each depreciation method.

Straight-line depreciation
 In straight-line depreciation the salvage value reduces the depreciable base.
The salvage value is what the asset would be worth at the end of its expected
useful life. The depreciable base is the asset purchase cost minus the salvage
value.
 Example: Let’s say that First Waffle buys a new waffle machine maker for
$30,000. The salvage value is $3,000. So the resulting depreciable base is
$27,000. The expected life is 5 years, which means the annual rate of depreciation
is 20%. So the depreciation expense for the machine is 20% of $27,000, or
$5,400,for each of the five years. The book value of the asset at the end of year
five is the salvage value of $3,000.

Declining-balance depreciation

 In this method you do not deduct the salvage value when figuring the depreciable
base for the declining balance method. Place a limit on the depreciation though so that
the asset’s net book value is the same as its estimated salvage value.

 To compute the cost and salvage value for the asset you use the same method as
straight-line depreciation. For the rate of depreciation, you use a multiple of the straight-
line rate.

 Example:Using the previous example your straight-line rate is 20%. We still need to
allocate the cost of the asset over its useful life so we need to calculate a different rate to
provide an accelerated depreciation schedule. A quick way to estimate the declining-
balance rate of depreciation is to take your straight-line rate and multiply it by 1.75.

 The end result of both of these methods is approximately the same.

Units-of-production depreciation method

 The units-of-production depreciation method is an activity method because you
compute depreciation on the actual physical use of the fixed asset, making it an ideal
method for computing factory machinery depreciation.

 In addition to knowing the cost basis and estimating the salvage value, you will need
to estimate how many units the machine can produce prior to retirement. The best
estimate for the waffle machine maker is 60,000 units. As in the previous examples,
taking the cost minus the salvage value gives you a depreciation of $27,000. So you then
divide $27,000 by your anticipated usage of 60,000 units ($27,000 / 60,000), which equals
$0.45. This is your unit-of-production depreciation rate.

 To compute depreciation expense year after year, you simply multiply the actual
number of units the machine makes during the year by the depreciation rate. Let’s say in
this year that was 10,100 units, so depreciation expense is $4,545 (10,100 x $0.45). The
same calculation applies in all other years.

 Now work through one more year. Perhaps the actual units produced were 15,300.
Depreciation then is $6,885 (15,300 x $0.45). After these two years the accumulated
depreciation is $11,430 ($4,545 + $6,885) and book value is $18,570 ($30,000 – $11,430).

Sum-of-the-years’ digits
 With this method, you come up with a depreciation fraction using the number
of years of useful life. First, Waffle's machine has a useful life of five years. Add (5
+ 4 + 3 + 2 + 1 = 15) to get your denominator for the rate fraction. In year 1,
your multiplier is 5/15 (1/3); in year 2, the multiplier is 4/15; and so on.

 Again, you subtract the estimated salvage value from the cost ($30,000 –
$3,000 = $27,000). The first year, the depreciation expense is $9,000 ($27,000 /
3i.e. one third of the depreciable base). In the second year, the depreciation
expense is $7,200 ($27,000 x 4/15). For year 3, the depreciation expense is
$5,400 ($27,000 x 3/15).

 Year 4 is $3,600 ($27,000 x 2/15). Year 5 is $1,800 ($27,000 / 15).

 Checking the mathematics of the calculations, you know you can’t depreciate
past salvage value, so adding all five years of depreciation expense must equal
$27,000. Does it?
Across all of the methods the depreciation expense is roughly the same. The only difference
is when the expense is applied to the expense accounts.

5.4 Financial liabilities

Almost every business finds itself havingfinancial liabilities. But what are they by definition?
Financial liabilities are defined as a contractual obligation to deliver cash or the equivalent to
another entity or a potentially unfavourable exchange of financial assets or liabilities with
another entity. More simply put liabilities are the debts and obligations of the organisation
and represent claims on the organisation’s assets.

Examples of financial liabilities are:

 Accounts payable

 Wages payable

 Salaries payable

 Interest payable

 Accrued expenses

 Income taxes payable

 Customer deposits

 Warranty liability

 Lawsuits payable

 Unearned revenues

 Loans issued by another entity

 Lines of business credit

As a business, the day to day functions include cash coming and cash going out. Financial
liabilities are a natural part of that pattern. They are what allows a business to function when
cash flow isn’t great (lines of business credit) and they represent an expense that is incurred
to keep the business open (accounts payable).

Businesses may need to expand into another building but don’t have the cash capital to
build it independently so they turn to a bank to get a loan for the project. This is a financial
liability. A new small business may need capital they don’t have in order to get started or just
keep the doors open during a slow patch.
With all of the options available to organisations it is easy to think of it as free money.
But many financial liabilities have conditions, interest, payment penalties and other
things attached that will be a cost to business. Financial liabilities are just that;
liabilities and they can be detrimental to anorganisation’s financial health if they
aren’t monitored and controlled.

If you recall, liabilities are a component of the accounting equation, which is the
mathematical structure of the balance sheet. It is shown as:

Assets = Liabilities + Owner’s Equity

Liabilities are reported on the balance sheet and are traditionally divided into two
categories, current liabilities and long-term liabilities. You will see similarities with the
types of assets covered in a previous section of this module.

 Current Liabilities – are reasonably expected to be settled within a year. They usually
include things like wages, taxes, accounts, short-term obligations (from the purchase
of equipment). They will also include the current portion of long-term liabilities, such
as the repayment due in the next year on a 20-year property mortgage.
  Long-term liabilities – are reasonably not expected to be settled during the next
calendar year. They usually include things like notes payable, long-term leases, issued
long-term bonds, long-term product warranties and pension obligations.