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New business ventures have a high rate of failure. In fact, the large majority of them fail in less than three years. Even a large, well-established business must perform all the management functions effectively in order to stay in business.  Since poor financial management is perhaps the most common direct cause of business failure, it's important that the making of money and the controlling of costs be done by the use of a good financial management system rather than in a hit-or-miss fashion.

A good financial management system has three elements: an objective, a measuring device and a control device. The objective is to make a certain amount of profit.   The measuring device is the operating budget which is management's plans for making a profit and controlling  costs. The control device is the system whereby actual performance is compared to the budget and necessary adjustments and corrections are made.

How much profit do you expect to achieve in 2007? Is 1% enough, is 20% too much? How did you do last year? If you want to improve your bottom line, the first step is to set your profit goal. The next step is to determine how you will reach that goal. 

The company's operating budget is the formal, written plan for achieving it's profit goal. In retailing there are three key ingredients in making a satisfactory profit: sales development, gross margin planning and expense control. Sales development encompasses many different aspects, from advertising to setting salespersons personal sales goals.

Since each store is unique, each will have its own method for reaching it's profit goal. For example, if we set 10% as our profit goal we can achieve it by attaining a 48% Gross Profit and keeping our expense level at 38%. We could also achieve a 10% profit with a 44% Gross Profit if we lower our expenses to 34%. The choice is yours. The important thing to remember is that a good profit level does not just "happen".  You must realistically set your goal and then strive to achieve it.

You can plan what your Gross Profit will be this year by looking at your historical figures from past year-end financial statements. But this method is prone to error since it does not take into consideration the current business situation. For example,  you may be planning to add new merchandise lines that have a higher Initial Markup. The method we recommend to our clients is that a Gross Margin Plan be done at the classification level. To simplify the calculation we  exclude freight and purchase discounts at the class level. Of course, these must be included in calculating Cost of Goods Sold at the company level. The information required to calculate Gross Margin for each classification is: planned annual sales, achievable Initial Markup %, planned markdown % and anticipated shrinkage.  The formula is as follows:

Planned Gross Margin % = IMU% - [(100.00 - IMU%)(MD% + Shrink%)]  

To calculate the planned Gross Margin dollars, simply multiply the planned annual sales for each classification by the planned Gross Margin % for that classification. Once the Gross Margin is planned at the classification level, the results must be totaled to arrive at the total company planned Gross Margin dollars. Of course, an effectively used Open-To-Buy is critical to the achievement of the planned Gross Margin.

The basic ingredient of expense control is an effective expense classification system. Without a systematic and meaningful method of recording expenses, comparisons and analysis cannot be made. Using the industry standard expense classifications also allows you to compare your results with industry averages and statistics so you can see how you are spending your expense dollars in comparison to other similar retailers. This can help you spot areas where your expense may be out of line. 

The MRA  (Menswear Retailers of America) developed a standard expense classification system for retailers called the Natural Divisions of Expense, many years ago. All the normal expenses associated with a retail store will easily fit into one of the 16 categories included in the Natural Divisions of Expense. The 16 basic categories are:

Payroll Pensions
Advertising Insurance
Taxes Depreciation
Supplies Professional Services
Services Purchased Donations
Unclassified Bad Debts
Travel Equipment Costs
Communications Real Property Rentals

Each of the above Natural Divisions of Expense can, and in most cases should, be expanded to give a more detailed accounting of expenses. For example, Advertising can be further sub-divided into:
TV & Radio
Direct Mail
Merchant's Association

How does the retailer go about planning expenses for next year? One method is to look at the company's historical records to determine how much each expense was last year, then adjust that amount for inflation and other factors for the coming year.  Another method is called zero-base budgeting. Zero-base budgeting requires that you start from zero and justify every expenditure. It examines the costs and benefits of all expenditures. Whichever method you use, and it may be a combination of the two, this is a good time to thoroughly review all the company's expenses to find new and better ways of doing things or discover what things can be eliminated entirely. For example, would an outside alteration service work as well for your store and be less expensive than an in-house tailor?  Are there housekeeping tasks you are doing yourself, such as cleaning windows and waxing floors that could be done cheaper by outside contracting services?  Don't continue doing things just because that is the way things have always been done.  Re-examine and re-evaluate your practices. Every expense dollar saved is added to the bottom line for increased profits. 

Once the annual budget is determined, it should be broken down by month and entered onto a worksheet or hopefully, your internal computer system has a financial reporting system with the following column headings for each month: Planned, Actual, and Variance To Plan. If sales or Gross Profit are below plan or if any expense item is above plan steps must be taken as soon as possible to correct the problem or revise the plan accordingly so it is realistic.

A good financial management system is a necessity for every business. The preparation of the budget forces you to take a good hard look at your business - where it is, where you want it to be a year from now. Profits do not just "happen".  You must realistically set your profit goal and then work towards achieving it.