For the majority of us in Leathercraft, we absolutely love what we do. But, if you are like me, you probably don’t love working on the financial side of your business. If you want to strengthen your business, then the financial aspect of the business has to be discussed.
Tell me if this sounds familiar to you in your life or your business:
You have been working hard on a big project and you are wrapping it up. Oh boy, now time to have it picked up and get that big check and feel the relief of cash flow coming into your business. Time to pay yourself and payoff those material bills that you have been piling up over the course of this project. Happy Days!
After the customer leaves with his beautiful project in his hands and his check in your hands, you feel a sense of accomplishment. You know that you have lived to fight another day and your shop thanks you.
After the deposit is made into your bank account and all the checks to your suppliers are written and mailed out, you now look to see what great amount you will be “taking home” to enjoy.
Suddenly you realize looking at your account and books that you have very little, or none, left for yourself. WHAT? How can that be?
“I bid the job correctly… I think.”
“I didn’t buy more material than I needed for this job… did I?”
“I should have more money than this, what happened?”
This is a very common scenario among many entrepreneurs… not only in our industry either.
This article is somewhat of a sequel to the article that we did recently called “Price Your Product to Increase Profits.” In this article we talked about how I approach pricing my products and services. Here we are going to talk about how to manage the money that comes into the business and how to create a system to strengthen your business financially.
What Most of Us Do With Revenue
The common practice for most business people is to deposit all the money in one account and then pay all the bills and themselves out of that account. The thought is that if we bid the jobs right and don’t over buy on materials and tools then we will always have enough to pay ourselves.
This is not the case. The finances of any business are not spontaneous reactions… meaning that they do not operate themselves in a positive manner automatically without any energy or work being applied to them.
In science, the majority of reactions that are considered “spontaneous” (requiring no added energy or work applied to complete) react towards a state of chaos. If you don’t believe this, just stop doing ANY work inside your home for 30 days, just live there… no cleaning, no sweeping, no laundry, nothing. By the end of 30 days the entire inside of the house will be in chaos and completely filthy. This is a spontaneous reaction towards a state of chaos.
Business, and personal, finances are not exempt from this law of physics. If you do not apply energy and work to your money it will leave and the business will move towards a state of chaos financially.
Chris Hogan with Retired Inspired says, “There is a name for money that’s not budgeted, its called “SPENT.”
This way of operating your business blinds you to your spending, your revenue, your long term growth planning as well as paying yourself on an upward trend… which we all want to do within our businesses.
With this operating practice, you do not have a clear picture of your finances and can not accurately prepare for downturns in revenue nor how to properly use a sudden increase in revenue to better yourself and the business.
What We Should Do With Revenue
Some of what we do financially in our business is hard to prepare for and we can certainly have (most likely will have) things come up in the business that will compromise our intentions financially. But this is not an excuse to not do a budget and have processes in place to protect against them.
Since starting my business in 2004, I have struggled and failed more times than this article has room to illustrate for you in the realm of finances. As a 24 year old wannabe saddle maker when I started, I had no idea what it took to keep a business running correctly. I was a bit stronger on the workflow side of things and handling project management, but when it came down to money I just figured if I worked hard enough then the money would take care of itself.
After my first 10 years in business, $170,000 in debt, and one year where my income was $11,000… I finally realized that I was pretty bad at this money stuff.
I tried many different systems and processes, read a ton of business accounting books, and talked to anyone who owned a business that would listen, just trying to get a handle on my business.
The best advice I received was from a young retired business millionaire that specialized in buying businesses in bankruptcy and turning them around and then selling them for a profit. He gave me this equation:
Revenue – Expenses = Profit
If you do this equation and there is a positive number in the Profit spot then you are doing things right. The goal is the make the Profit number as big as possible. This alone will strengthen your business.
“Well, Duh” I thought to myself…
If business is that mathematically easy then why don’t we do it? I didn’t. I spent the next years, after gaining this nugget of absolute truth, just focusing on the top number of a Profit and Loss Statement… Revenue.
The reason is, because I always thought as long as the Revenue was up then I was making money. And the Revenue did go up… A LOT. Seven years into my business, I had tripled the revenue of my business from the very first year and was on an upward trend… the problem was I had also tripled, maybe a little more, my expenses.
What’s the Point
So what do we do with this information?
Most of you know the above equation. This is not revolutionary.
The point is that we all know this but never do anything to make sure that it happens. Just like knowing that eating two half gallon tubs of Blue Bell Ice Cream will make you a bit on the extra heavy size… pass me a spoon! Blue Bell is delicious!
For me, I couldn’t ever figure out an easy way to insure that week by week, month by month and deposit by deposit my money was going where it needed to go so that at the end of every month this equation showed a positive number without fail.
I could not clearly see the numbers and make sense of the chaos.
In this article, I will show you my Financial Allocation Process that I have been using for the last four years. This process is my attempt at using my limited understanding of business finance to create a system that allows me to appropriate all revenue to where it feeds the business for growth and security.
This is not some high dollar software program that you put on auto pilot and all the sudden your business is profitable. This is a hands on, all you, taking control action plan that will teach you more about your business and help you to feel in control.
The great thing about being in business for yourself is that you are in control of your life and career… and if you don’t like what you get paid in this position, then you know exactly who to talk to for a raise… yourself.
Finding Your Profit Centers
Profit Centers are simply the different areas of your business that generate revenue for the business as a whole.
For example in my shop we have these profit centers:
- Custom Saddles
- Saddle Repair
- Custom Leatherwork
- Retail (not so much these days)
These are the five different ways that our business generates revenue.
It is important for you to know where the money is coming from and seperate it within your bookkeeping. This allows you to be able to see which areas are more profitable than others. As well as maybe letting you know what areas are maybe not worth investing in anymore due to underperformance.
If you want to get super nerdy on this, and some of us do, then you can also track expenses in the business based on these profit centers so that you have a detailed profit and loss on each one. For my business, no one category can stand on its own profitably and they all work together to share expenses and profit for the overall business. This would be different if I focused all my energy on one of the profit centers and didn’t do anything else, but I enjoy all of them so I choose not to focus on only one at this time.
Understanding your revenue sources in this way will help you to further understand your business as a whole. You will be able to see where your energy is better spent on a daily/weekly basis and can also help you with your marketing strategy.
Your business may be small and you only do it as a side hustle. In this case you may only have one profit center and that’s fine. Knowing this about your business may open you up to other possible profit centers that you haven’t noticed before or that you may want to create.
Understanding Your Expense Categories
Now that we know where the revenue for the business is coming from and from what sources, we need to decide what to do with it. This is crucial!
If you don’t make a conscious decision at this point to decide where you want the money to go, it will decide for you on its own and just leave. I’m not kidding.
Take a moment to think of the key areas of your business that cost you money. Write them all down… all of them! These can be buying new equipment and tools, material purchasing, taxes, building repairs, savings, and most important of all… PAYING YOURSELF.
Now look at all these categories of expenses. Don’t they kinda look like your Expenses section of your Profit and Loss Statement for your business when you do your taxes?
That’s because come April 15th they all will be in the Expenses section of your Profit and Loss Statement. These are things that your business uses money for… month in and month out. You know about all of these things obviously because you just wrote them all down. So we have no excuse for not allocating money to cover these things over the year.
So let’s do a little organizing here. Take all the things that you wrote down and start grouping them together with other like items.
- electric, water, rent, paper towels, coffee, etc – maybe this is considered Overhead (items to operate the business)
- leather, hardware, saddle trees, glue, custom hardware, etc – maybe this is Material Cost (raw material for each job)
- sales tax collected, income tax to be owed, property tax, etc – part of the revenue that is owed in Taxes
- contract labor, payroll, payroll taxes – if you have employees this would be Payroll
- paying yourself – this would be a standalone category maybe called My Pay
When you are doing this, try to consolidate all these expenses into as FEW a categories as possible… I have only 6 as of the writing of this article. These are my six expense categories:
- My Pay
- Profit (savings)
- Income Tax
You should now have a small number of categories that represents any and all expenses for the business to operate and pay you and your employees or contract laborers. Every one of these are crucial to the survival of the business and each requires a certain amount of money to stay alive. If they are all funded with cash then the business is healthy and if not then the business is struggling.
The Allocation of Revenue
Now we need to decide how much money needs to go into each of these categories. This will be different for every business and will take you some time through trial and error to get it dialed in.
I take a percentage approach to this. What I mean by this is that every dollar that comes into the business comes in as a complete dollar made up of all of your categories.
$1 in revenue = %My Pay + %Overhead + %Profit + %Income Tax + %Payroll + %Material
The dollar is not a whole dollar. If you take that dollar and buy a Dr. Pepper with it instead of allocating its portions to each category then you have not replenished the categories that worked for you to have that dollar. Basically you have stolen from the business and it isn’t as healthy as it could be.
We first must break our dollar into what percentage of it each category represents. This is where the Profit and Loss Statement can be very helpful.
If you have some history within your business, then you can very easily look at last year’s P&L sheet and have a pretty good sense of what these percentages are. If you are new to the business you will have to make projections on what percentage each category may be and adjust as time goes on. But have no fear, even those of us that have been around awhile need to adjust them periodically as our business changes.
Take the Material category for example. Your total number of dollars spent on raw materials last year should be right at the top under your Gross Revenue. This will be called Cost of Goods Sold (COGS). You can take this number, say $10,000, and then divide it by your Total Gross Revenue, say $80,000. This will give you 0.12 or 12%. This means that last year your business spent 12% of revenue on raw material. We can assume, on average, that every month was around 12% expenses on material, every week and so on. This is on average, some months may have been more and some considerably less. With this then, we can assume that out of every Dollar that comes into the business, then 12% of that dollar needs to go into the Material category.
Now do the math to figure out the other categories that you have that you can easily get from the P&L sheet. Depending on how you broke down your expenses into categories, this should be fairly simple to calculate.
These figures will give you a clear understanding of what percentage of your Dollar is going to what I call hard expenses. These are things that have measurable amounts every month that must me paid.
If you add up these percentages when you are done, you will notice that they don’t add up to 100%. If they do, then this is why you may find it hard to pay yourself or grow your business. The hard expenses within the business are eating up the whole dollar.
If you see this, then there are only two things you can do to fix this. You have to decrease the expenses within the business or you need to increase the revenue of the business. It sounds easy, but both of these may be difficult. Nonetheless, this is where the simple equation from earlier (Revenue – Expenses = Profit) comes in. The math doesn’t lie and something has to be done to change it.
If your business is profitable and your percentages add up to say 52%, then you have 48% of your Dollar to work with still. This is where we can now look at the categories that aren’t within the P&L sheet… such as My Pay, Profit, Savings, Equipment Purchase, or whatever you may have.
I would suggest that you decide what My Pay should be first. The only trick here is that you have to take it from the 48%. You can take it all if you want, but understand that if you want to save money within the business to expand or buy equipment then you will not have room for that because you took the whole 48% home.
An easy way to figure this is to look at what 48% of last year’s Gross Revenue looks like. So if Gross Revenue was $80,000 then that would be $38,000. So that is the most that you could pay yourself out of the business, if all numbers stay the same, and still have money to operate the business. But this would leave no room for growth or savings.
I would suggest having at least a little percentage towards savings within your business. This will cover slow months and give a little cash flow margin for the business. Even if its 3-5% that’s fine. Just be putting a little back so you have a small stash of cash in case you need it… because you will need it at some point.
So out of this 48%, or $38,000, any other category you have will come from this. Play with different percentages and see what would work best for your business and you. Refer back to your P&L sheet when possible and see if you can compare for accuracy.
The goal here is that when you are done, all your category percentages should add up to 100%. Now you will be able to look at your Dollar and know what percentage of it goes to each category. A dollar is not a whole dollar.
How does all this Help to Strengthen Your Business?
Now all the hard work is done. Now that you have a better understanding of the mathematics of your business you can begin putting it into action easily.
We will do this from here on out with every deposit that you make into your bank account… everytime.
This is how I use the Allocation Process in my business. I am using arbitrary numbers here in this example. These numbers are not the numbers I suggest you use. Every business is different and you need to figure your own percentages as we showed you above.
I use a small notepad to figure the allocations periodically. Since I take credit cards and only go the bank once every couple of weeks, I usually do this about every 2-3 weeks depending on deposits and revenue. But you can certainly do this every time you make a deposit no matter the size.
Write down the date at the top each time you do this. If you are looking back on your online banking statements for deposits, you will know the last date you did this. Then you can total the deposits since that date to now.
Next Deposit (Date)
Total of all Deposits (all deposits since last date allocated) – $1895
My Pay (25%) = $473.75
Overhead (25%) = $473.75
Profit (9%) = $170.55
Income Tax (6%) = $113.70
Payroll (15%) = $284.25
Material (20%) = $379.00
As us can see from the above example, we had a total deposit of $1895. I multiplied this total deposit by each percentage for each category and this represents the amount of that deposit that should be allocated for each of them. This is a representation of where the money in this deposit needs to go based on the business’s expenses and goals.
If you were to use $1,000 of this deposit to buy leather without knowing this information, then you can understand why you may come up short in another area… like paying yourself or saving money in the business.
This is a very powerful technique to getting control of the revenue coming into the business throughout the year. With this practice, each category is funded systematically throughout the month and these categories become independent and secure because they are properly acquiring the funds they need to perform their duties within the business.
Now when you go to buy material… there will be money there and you can spend more wisely.
Now when you pay your contract labor or employees… there will be money there.
Now when you want to pay yourself… there will be money there just for you.
In order to fully implement this process, I have separate bank accounts for each category. This may seem overkill for some. But for me, if it’s all in one account then I lose track of what’s what. You can certainly do this with a spreadsheet and use one account if you have more self discipline than I do.
Everytime that I do my allocations, I get the above numbers and then transfer that amount into the appropriate accounts. I have a Payroll account, Material account, Main Business (Overhead), Savings, etc. You can combine some of these and then just have a overall savings, overhead and then a materials account. It’s all up to you. The point is to create an environment to where the money is actually allocated to a specific duty within the business and not just put in one huge bucket to pull from.
When it comes to paying myself, I simply just transfer whatever “My Pay” is for that allocation into my personal account everytime. This is great too because I am never behind on paying myself (a real struggle in the past… the business still owes me money! Ha!). So some deposits I may pay myself $127.00 and others I may pay myself $1,350.00. But either way it is correct based on revenue and the business isn’t shorted on funds.
Running your own business, no matter the size, can be tremendously rewarding or it can be the scariest thing you ever do… and most of the time you get a little of both.
There are so many aspects of our businesses that we have to tend to and some of them are not something we are good at. But they are all things that you can learn to strengthen your business so that it can serve you during your long career.
The biggest mistake we can make in a business is “hoping” that we will get enough work to support ourselves and our business. Your marketing ability, your craftsmanship skill level, your storefront appearance, the amount of trade shows you attend… none of these will replace your ability to manage the money that comes into your business.
There is no difference between managing $50,000 a year in revenue in a business versus $1,000,000 a year in revenue… they are both equally difficult and the same equation applies:
Revenue – Expenses = Profit
How you decide to manage those dollars is up to you.
I hope you found this article informative and helpful. I make no claim to be a financial guru or that this is the only way to manage finances within a business. I only hope to offer up this idea as an example of how a small time leatherhead approaches the art of business finance. If it helps, use it. If it doesn’t, then keep on keeping on!
Thanks a bunch folks!