Expenses
Background
Expenses and Their Categorization
a. The Largest Expenses
b. Lesser Expenses
c. “Non-Productive” Expenses
d. Two Visible, But Typically Modest Expenses
Financial Accounting
Inventory Accounting and Inventories
Final Comments
Background
An old adage cautions that it is not how much a business takes in, but how much it does not spend. That adage is obviously an exaggeration. Yet, it makes an important point that most successful small-business owners understand: controlling expenses is a must and demands constant owner attention. Controlling expenses is, of course, different than making minimal expenditures. Investments, that is, expenditures, to make the business more productive and competitive, are absolutely necessary. But the difference between necessary and unnecessary expenses is often the difference between profitability and not. Because controlling expenses is such an important part of most successful small businesses, this issue of the National Small Business Poll is devoted to Expenses.
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Expenses and Their Categorization
The survey on which this report is based places a business’s primary expenses into broad categories. These categories do not mirror an acceptable accounting statement. Accounting “buckets” would likely have been too complex given the respondent did not have his or her financial records immediately accessible at the time of the interview. Still, the business expense categories queried are familiar to most small employers and are generally understandable to the public.
Other issues arose in the survey. Depreciation is the most important example. Equipment, vehicles, and owned space should be depreciated to obtain an accurate portrayal of costs. A $30,000 car depreciated over five years should be a $6,000 annual expense (straight line). However, if the respondent paid for the car when purchased, the outlay would be $30,000 in one year and nothing since. While the survey emphasized respondents should include depreciation, it is not always clear they considered such matters in their responses. The cost of building/structure ownership did not appear on the survey precisely in fear that depreciation issues would taint results. In addition, the recent, highly visible run-up of oil prices might have caused respondents to exaggerate energy costs. Interest costs might have been minimized for the opposite reason. Expenses appear underestimated when totaled across expense categories. However, the distribution attributed to the major cost categories is the important element. Survey results clearly show which categories of business expense are more and less important.
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a. The Largest Expenses
The largest expense in small businesses is employee wages, salaries, commissions, etc. Nineteen (19) percent report that wages and salaries constitute the single largest expense that they have (Q#1L). The figure rises to 34 percent among those employing 20 people or more. Another 21 percent claim that wages and salaries are in the top two or three expense categories and 39 percent claim them in their top five. However, 7 percent say they do not have such costs. Those responses are difficult to understand given that only employers participated in the survey. Since all such reports originated among the very smallest, it is possible there are issues involving family members as employees, part-time employees, profit-sharing arrangements, or transitions between employing and non-employing firms.
Technically, employers in a corporation are employees. The result is that salaries of owners and/or officers will often be rolled into the firm’s wage and salaries account. It is highly doubtful that occurred here as owners do not consider themselves employees even when they own a corporate entity, and the survey question specifically addressed employee wages and salaries.
The numbers above include only wages, salaries, etc. They do not include the other portion of employee compensation, that is to say, employee benefits. Large firms often provide 20 to 30 percent of their total compensation in benefits. Small firms typically provide a much smaller portion of their total compensation in benefits. In fact, 23 percent report no employee benefit costs. The overwhelming portion of those providing no benefits owns the very smallest enterprises. Just 2 percent of small-business owners report employee benefits excluding taxes such as FICA, as their largest expense and another 7 percent say it is in the top two or three (Q#1E). However, 50 percent of those who employ 20 or more people say that employee benefits are among their highest five expense categories. Adding wages (salaries) and benefits, employee compensation becomes the largest single business expense for more small firms than any other.
Twelve (12) percent term materials and supplies their single greatest business expense (Q#1K). Another 16 percent of small employers list materials and supplies in the top two or three expenses. In accounting terminology, materials and supplies are not inventories that are resold or become products which are sold. Rather they are the items typically used in the business, including paper, pencils, and cleaning supplies. It is possible that some confusion arose between materials and supplies, and inventories (cost of goods sold).
Ten (10) percent claim energy, that is, electricity, gasoline, natural gas, etc., is their single largest business expense (see immediately prior Poll issue on Energy Consumption). Moreover, another 25 percent claim energy is in their top two or three and yet another 34 percent place it in their top five. There are several reasons for the significance attached to energy expenditures. The first is the recent run-up in energy prices which not only caused expenditures on energy to rise sharply, but also made those costs highly visible. The second is that most small businesses pay their heating, cooling, and lighting costs directly. Even when they rent/lease their physical facilities, they typically pay their energy costs directly. The third is that over 80 percent have business vehicles.
Eight percent report inventories (in accounting terminology the cost of goods sold) as their single largest business expense (Q#1G). Another 9 percent say that it is one of the two or three largest, and 21 percent say that it is in the top five. While 25 percent expend nothing on inventories, the distribution of responses appears to understate the importance of inventories in many small firms. The proportion of inventory-intensive industries such as retail, wholesale, and manufacturing have numerically declined substantially as a portion of the total population over time. That means relatively fewer businesses carry large inventories. Further, the emphasis over the last few years has been to hold fewer inventories for shorter periods of time. There are even wholesale and retail businesses today that carry no inventory; they are effectively a display room/catalogue. The business simply matches customer and manufacturer. Other firms are, of course, very different and still have very large inventory holdings and hence inventory expenses.
Many small employers own the physical facilities in which they operate, particularly where the business is located in the home. Still, rent is usually a substantial expense for those who have it. Seventy-one (71) percent say that they pay rent on building or office space, though it may not be for the firm’s primary location (Q#1C). Five percent report rent to be their primary business expense. Another 10 percent say rent is in their top two or three. Still, another 28 percent rank it in the top five. The cost of rent, therefore, is one of the five greatest business expenses in over 40 percent of all small enterprises.
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b. Lesser Expenses
The remainder of the expense categories finds relatively few listing them as their single greatest expense. More revealing is the number of small employers who have none of these expenses, or relatively few of them. A good example is interest expenses. Twenty-eight (28) percent report that they have no interest expenses and another 47 percent say that interest is not in their top five expenses (Q#1F). While low interest rates and a healthy economy partially explain the relatively small amounts paid as interest, it also indicates that small-business owners do not typically accumulate large debt in the operation of their businesses. Just 2 percent report interest is their single greatest business expense and another 4 percent place it in their top two or three.
Since owners do not necessarily purchase vehicles or major pieces of equipment every year, depreciation becomes important when assessing the relative costs of these investments. And, while the survey asked that depreciation be included, it is not clear that respondents did so. Three percent claim that car, truck, and other vehicle expenses, including depreciation, is the single largest category of expense that they have (Q#1D). But another 14 percent place it in the top two or three. While about 85 percent of businesses have vehicles, only two to three percent of businesses are in the transportation industry. These firms would typically be the heaviest users of vehicles, and their numbers correspond closely to those reporting vehicles as their single greatest expense. It is also important to note that while the overwhelming majority has a business vehicle(s), they usually represent a relatively small expenditure. Thirteen (13) percent report no expenditures on vehicles, including their depreciation, and another 40 percent say they are not in the top five expense categories.
Business equipment presents a similar situation. Three percent indicate their single greatest business expense is equipment, including depreciation (Q#1H). Another 10 percent say that it is in the top two or three expenditure categories. But 51 percent say that business equipment is not in their top five expenditure categories and another one in 10 (9%) say that they have no such costs.
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c. “Non-Productive” Expenses
Small employers lodge persistent complaints over both the taxes they pay and the cost of their business insurance. Their complaints appear tied to the amount expended on each. However, the business insurance evaluation excluded incessantly rising health insurance expenses (classified as an employee benefit) and the tax evaluation excluded income taxes (not technically a business tax except for about half of the limited and falling number of corporations.
Three percent say that business insurance is their largest business cost (Q#1B). The key to the immense small employer concern over business insurance can be found in the 13 percent who assign it to the top two or three expense categories and the other 31 percent who place it in the top five. Owner assessments exclude employee health and workers’ compensation, two of the most expensive types of insurance. The critical point, however, is that these relatively large expenses have no direct productive value to the firm. They simply protect it or the owner and its assets from unforeseen events ranging from weather to lawsuits. Forty-five (45) percent indicate that business insurance costs are not in their top five expenditure categories and 7 percent indicate they have no such costs. The latter figure might be explained in some cases by coverage from household insurance when businesses are relatively simple and operated out of the home. But it also suggests that a small number are simply going bare.
The second of these two expense categories is business taxes. The exclusion of personal income taxes from this expense leaves FICA (Social Security), FUTA (unemployment), real property, corporate income, franchise, and in some locations personal property taxes as the principal specific imposts in the evaluation. Just 1 percent of small-business owners report these types of taxes are their single largest expense, but another 43 percent assign them to their top five expense categories (Q#1I). Four percent claim they have no such costs. Since all respondents are employers, by definition they cannot be correct or are evading the tax. More likely, they either did not think of payroll taxes as business taxes when answering the question.
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d. Two Visible, But Typically Modest Expenses
About 85 percent of all small-business owners spend some money on promotion or advertising (Q#1A). However, promotional expenses tend to be a small portion of their budgets. Fifty-five (55) percent say it is not in their top five expenditure categories, which when added to the 15 percent who have none, means that 70 percent place minimal emphasis on the paid promotion aspect of their businesses. Just 1 percent claim that it is the largest expenditure they have while another 7 percent report it in the top two or three.
This promotion category of expense illustrates an important small-business dilemma. It is vital in most instances that customers and potential customers be aware of a business and its offerings. The cost of raising awareness is high, but the resources available to small businesses to raise awareness are limited. Thus, owners of smaller enterprises must find low-cost means to nurture old customers and find new ones. A hefty dose of paid promotion does not appear to be one of them. Alternative and lower cost means must be found to promote the business. Hence, the dilemma, particularly for starters - the need to publicize the business using minimal means. It is curious, however, that the very smallest (fewer than 10 employees) are more likely to spend relatively more on paid promotion than are those that are larger, small businesses.
The second of these visible, but typically modest expenses, is professional services. Common professional services small-business owners use include: accounting, legal, design, engineering, and computer installation and/or programming. About 87 percent make expenditures on professional services in any year (Q#1J). Yet, just 3 percent, or fewer than one in 20, place professional services expenses in the top three expense categories. The bulk of small employers spends something on them, but in comparatively small amounts.
There is a business-size component to expenditures on professional services as well. While owners of the very smallest are more likely to spend no money on professional services than are owners of larger, small firms, owners of the smallest who do use them appear to spend relatively more.
The last expenditure category is utilities, including telephones. This category clearly overlaps with the energy category since most heating, cooling and lighting costs are almost all paid to utilities. However, just 1 percent say utilities is their most expensive cost category and another 9 percent place it in the top two or three (Q#1M). Fifty (50) percent report that they are not in the top five categories. The juxtaposition of utility and energy costs in small-business owner evaluations is baffling. They should be similar, but are not. It is possible the reference to telephones in the question led respondents to forget the energy portion.
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Financial Accounting
While a majority of small-business owners use outside accountants and other professionals to do their taxes and periodically review their financial records, the owner himself or herself most often is the one who does the day-to-day financial record-keeping. Owners complete it in 47 percent of cases (Q#2). Those with the smallest businesses (fewer than 10 employees) assume that function in 52 percent of enterprises compared to 26 percent with the largest (20 or more employees). A family member of the owner, most likely the spouse, is the person next most likely to do the books day-to-day (21%) followed by an employee (20%). Twelve (12) percent report another party performs the task.
There are three generally recognized types of accounting methods used in small businesses: cash, accrual, and a hybrid of the two. Precision, complexity, and government requirements are the primary reasons why an owner might choose one over the other. Cash accounting is the simplest and one the Internal Revenue Service (IRS) allows most small-business people to apply. Forty-one (41) percent use this method, including 25 percent of owners employing 20 or more people (Q#3). The preferred method of knowledgeable people, due to its precision and capacity to provide a superior picture of a business’s finances, is the accrual method. Seventeen (17) percent of the population, including 32 percent of the largest, uses this method. Thirteen (13) percent report that they use a hybrid. That leaves over one-quarter (28%) who do not know what system they use. Those who do their own record-keeping are somewhat more likely to identify an accounting system than those who have someone do it for them. Some of the 28 percent “don’t knows,” therefore, are likely the result of not having a hands-on approach to financial record keeping. Still, given the importance of accounting to businesses, the number of owners who do not know the method of accounting used seems quite high.
Inherently, there is nothing wrong with a small-business owner not knowing or remembering the method of accounting employed so long as it is consistent, documented, etc. However, a problem arises if there are tax implications, though these would be confined to larger, small firms. A second potential problem occurs when relatively large obligations or commitments are routinely made without a concurrent expenditure.
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Inventory Accounting and Inventories
Creating, implementing and operating an inventory system must be a high priority for the owner of an inventory-intensive business. Intrinsic to such a system is the method of financial accounting for inventory. However, those small employers who report that inventories are in their top five expenditure categories often cannot identify the inventory accounting system that they use. The primary methods to account for inventories for tax purposes are first-in, first-out (FIFO) and last-in, first out (LIFO). Yet, only 28 percent of small employers with significant inventories can identify their use of one or the other (Q#3c). Thirteen (13) percent say that they use LIFO and 16 percent FIFO. Thirty-five (35) percent say they use a different method, and another 35 percent are not sure. Those who say “Other” may mean the average cost method which cannot be used for tax purposes. Again, there is nothing inherently problematic by not knowing the name. It is the application of the knowledge about an inventory accounting system that can create issues.
A proposal has been made in the Congress to eliminate use of LIFO and require that all inventory systems revert. Since LIFO effectively results in a deferral of income, those who use the method have accumulated a deferral amount known as a LIFO reserve. A change back to FIFO effectively means tax must be paid on the reserve in addition to regular tax. The hit could be very large (on a relative basis) and cause a severe cash flow problem for many LIFO-using, inventory-intensive businesses. So, the first issue is whether the owner has even heard of a LIFO reserve. The second is whether the owner knows the size of his LIFO reserves and hence his potential tax liability.
Too few small-business owners use LIFO, at least knowingly, to answer these two questions from the survey’s data. However, it would appear that LIFO reserves is a relatively unfamiliar term and virtually no one can estimate theirs. That suggests a change would leave many current LIFO users very unpleasantly surprised.
The same set of owners appears reasonably informed about other aspects of their inventories. Eighty-eight (88) percent identify the number of days of inventory that they try to maintain on their most important items, though 15 percentage points say that it differs by item (Q#3a). Of the 73 percent who gave a specific time, 24 percentage points say that they try to maintain seven days of inventory or less on their most important items; 12 percentage points, eight to 14 days; 21 percentage points, 15 to 30 days; and, 16 percentage points, 31 days or more.
Many businesses, particularly inventory-intensive businesses, tie their inventory to a point of purchase device or a computer that allows small employers to keep up-to-the-minute records of the inventories they have on hand. Of those who have significant inventories, 41 percent possess an electronic inventory accounting system (Q#3c). However, the figure differs substantially in ventures above and below 10 employees. The latter have them in 57 percent of cases while the former have them in just 35 percent of cases.
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Final Comments
The data from the survey is often inconsistent and sometimes even contradictory underscoring the difficulty of obtaining reliable financial information from small-business owners about their firms. However, several important points without question emerge: the largest expense categories in small businesses are far and away employee compensation, inventories (cost of goods sold), and materials and supplies. Within the employee compensation category, the cost of wages and salaries overwhelms the cost of employee benefits due both to the relative difference in expense and to the smaller numbers providing benefits. Rent or lease payments are also often significant for those having them, but a large number own their facilities and do not pay rent.
Smaller expense categories include business insurance, excluding employee benefits such as health insurance, and business taxes, excluding personal tax on business income. Perhaps the most misunderstood business expense, however, is interest. Interest expenses are a significant business expense in relatively few firms. While the evaluation of interest costs could have become snared in the larger issue of depreciation and therefore underestimated, the principal interest issue for most small-business owners is customers who purchase larger items on credit. Higher interest costs for them result in higher prices for customers and lower sales for small businesses.
The accounting/financial record-keeping has never been one of the more popular parts of a small-business owner’s time allocation. That resoundingly appears in small-business owner familiarity or lack thereof with some of the more basic concepts of accounting. While a sophisticated understanding of accounting is not required by owners of most smaller firms, they should understand basic concepts if for no other reason than to keep themselves out of trouble with tax authorities. It is possible, perhaps even highly likely, that a substantial number of small-business owners have had their accounting systems set-up by professionals who informally check their application at tax time. The responsible person in the firm simply maintains the records as he or she has been instructed to do. None of this suggests any type of misrepresentation or misappropriation. But it does suggest that owners may not be using all the management tools available to them and that, on occasion, they could be subject to unpleasant surprises.